## _cr06305

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### Overview of the financial system
- Commercial banks hold 84 percent of total system assets.
- All commercial banks are foreign-owned; subsidiaries of three large internationally active French banks have a combined market share of around 65 percent of assets.
- Nonbank financial institutions are small and do not pose a systemic threat.
- Credit to the private sector stands at around 10 percent of GDP.
- Total banking assets are equivalent to around 25 percent of GDP.
- Payment services are slow and intermediation margins are high.

### Banking system soundness and risks
- Profitability, liquidity, capital:
  - Banks are generally profitable, liquid, adequately capitalized and stable.
  - Overall capital adequacy ratio (CAR) is well above the required minimum of 8 percent; one large foreign institution's CAR fell slightly below 8 percent in late 2004 but rose to above 10 percent in March 2005 after recapitalization.
  - Banks held large amounts of excess liquidity, on average 24 percent of required reserves during 2004.
- Asset quality:
  - NPLs over 11 percent are a concern.
  - NPLs were 11.4 percent as of December 2004.
  - Ratio of provisions to NPLs is 49 percent (staff calculation); authorities' calculation nets accrued interest yielding 66 percent.
- Concentration and guarantees:
  - Bank loans to the ten largest corporate clients account for 24 percent of the total corporate loan portfolio.
  - About 10 percent of bank lending to domestic borrowers is covered by guarantees from parent banks.

### Credit risk and stress-test findings
- Credit risk identified as the main risk facing the banking system.
- Aggregate and bank-level impacts (stress tests, Data per December 31, 2004):
  - Baseline Tier I Capital (in percent of RWA):
    - Group 1: 9.4
    - Group 2: 14.0
    - Groups 1+2: 10.5
    - Worst Bank: 6.4
    - Best Bank: 31.4
  - Sensitivity analysis — Change in Tier I capital resulting from hypothetical shocks (in percent of original Tier I capital):
    - Credit Risk — Shift in assets 2/: Group 1 -21.2, Group 2 -12.5, Groups 1+2 -18.2, Worst Bank -37.1, Best Bank -0.1
    - Credit Risk — Increase in NPLs by 100 percent: Group 1 -49.0, Group 2 -31.1, Groups 1+2 -43.0, Worst Bank -97.0, Best Bank -0.1
    - Credit Risk — Increase in ratio of NPLs to total loans to 20 percent 3/: Group 1 -24.7, Group 2 -47.5, Groups 1+2 -32.3, Worst Bank -76.7, Best Bank -13.9
    - Credit Risk — 10 percent of outstanding loans become NPLs: Group 1 -36.8, Group 2 -39.3, Groups 1+2 -37.7, Worst Bank -55.4, Best Bank -17.9
    - Exchange Rate Risk — Depreciation by 30 percent 4/: Group 1 0.8, Group 2 2.4, Groups 1+2 1.3, Worst Bank -21.5, Best Bank 4.5
    - Exchange Rate Risk — Depreciation by 50 percent: Group 1 1.3, Group 2 4.0, Groups 1+2 2.2, Worst Bank -35.9, Best Bank 7.5
    - Interest Rate Risk — Increase in FMG rates by 500 points 5/: Group 1 -4.1, Group 2 -5.0, Groups 1+2 -4.4, Worst Bank -6.6, Best Bank 3.5
    - Interest Rate Risk — Increase in FX rates by 200 points: Group 1 -0.2, Group 2 -0.5, Groups 1+2 -0.3, Worst Bank -0.8, Best Bank -0.1
  - Scenario analysis 6/ — Change in Tier I capital (in percent of original Tier I capital):
    - Scenario 1: Group 1 -28.7, Group 2 -30.0, Groups 1+2 -29.1, Worst Bank -42.4, Best Bank -14.2
    - Scenario 2: Group 1 -55.4, Group 2 -58.5, Groups 1+2 -56.4, Worst Bank -82.6, Best Bank -27.2
    - Scenario 3: Group 1 -77.0, Group 2 -81.2, Groups 1+2 -78.4, Worst Bank -114.8, Best Bank -38.0
- Macro recapitalization implications:
  - Doubling of NPLs (comparable to aftermath of 2002 political crisis) would require recapitalization of around 0.1 percent of GDP.
  - Worst-case macroeconomic stress test scenario would require broadly 0.6 percent of GDP.
- Notes:
  - 1/ Group 1 includes three French-controlled banks, and Group 2 includes the other four banks.
  - 2/ 50 percent of current bank holdings of government securities and placements with other banks are assumed to be shifted toward loans.
  - 3/ The magnitude of such a shock would correspond to the level recorded in the aftermath of the political impasse in 2002.
  - 4/ The magnitude of these shocks was similar to the largest monthly depreciation and the largest monthly appreciation of the FMG against the Euro and the U.S. dollar observed over the last 10 years.
  - 5/ The magnitude of such a shock would be similar to the increase in the central bank main rates in May-July 2004.
  - 6/ Scenario definitions:
    - Scenario 1: moderate shock to the agriculture sector (25 percent of all agriculture loans become nonperforming, the FMG depreciates by 20 percent, and the FMG interest rates increase by 300 bp).
    - Scenario 2: significant shock to the agriculture sector (50 percent of all agriculture loans become nonperforming, the FMG depreciates by 20 percent, and the FMG interest rates increase by 300 bp).
    - Scenario 3: economy-wide shock (10 percent of all outstanding loans become nonperforming, the FMG depreciates by 30 percent, and the FMG interest rates increase by 500 bp).

### Systemic liquidity and lender-of-last-resort (LOLR)
- Market functioning and instruments:
  - Interbank money and foreign exchange markets function reasonably well; chronic excess liquidity reduces their necessity.
  - Standardized instruments (repos and reverse repos) and a standard contract recommended.
  - BCM liquidity instruments: reserve requirements, central bank benchmark rates, open market operations with T-bills, two automatic refinancing windows for 24-hour and 2-10 day credit at penalty rates of 5 and 7.5 percent above the BCM base rate.
  - These instruments have not always been used in a timely and efficient manner.
- Liquidity drivers and risks:
  - Restrictions on loans in foreign currency lead banks to hold foreign assets as correspondent accounts overseas.
  - Lack of suitable borrowers contributes to high liquidity.
  - Treasury statutory advances from the BCM equal to 15 percent of previous year’s budget receipts; in 2005 use was limited voluntarily to 10 percent of budgeted receipts.
  - Such advances should be strictly limited to a low percentage of average recurring revenue and be promptly repaid.
  - BCM weak financial condition could limit its ability to provide liquidity and LOLR support; BCM LOLR transactions require BCM management approval causing possible delays.
- Market infrastructure needs:
  - Better coordination between the BCM and the Treasury on T-bill issuance timing and amounts.
  - Improved forecasting of systemic liquidity needs and development of a comprehensive public debt management program.

### Banking supervision, remedial measures, and safety net
- CSBF responsibilities and capacity:
  - CSBF supervises commercial banks, finance companies and microfinance institutions under the Banking Law of 1996.
  - Enforcement needs strengthening; supervision of microfinance and AML/CFT will add burdens.
  - Until March 2005 the Commission had not functioned for several years due to unfilled Board vacancies; vacancies filled but backlog remains.
  - CSBF action program includes revision of the banking law, introduction of International Accounting Standards (IAS), regulations on interest rate risk and liquidity, on-site inspection program, stress testing, new prudential regulations, corrections in capital definition to conform with Basel I, and increase in minimum risk-weighted capital adequacy ratio from 8 to 10 percent.
  - CSBF has issued only three reports since creation in 1995, most recently in 2001; should issue regular reports.
- Sanctions and intervention tools:
  - CSBF sanctions: requests for explanations, warnings, binding instructions, removal of management, appointment of a provisional administrator (maximum six months, renewable once), and withdrawal of banking license leading to immediate liquidation.
  - Withdrawal of license can be suspended by the Minister of Finance for eight days; during suspension CSBF may take conservatory measures.
  - CSBF Chairman may “invite” shareholders for financial assistance and request other banks, on a nonmandatory basis, to participate in a life-boat operation.
- Deposit insurance and mutualist groups:
  - No deposit insurance system exists; authorities are debating introduction with multiple design issues.
  - Approximately 140 “caisses” of mutualist credit institutions (around 4 percent of banking system assets); about 80 benefit from mutual solidarity arrangements; two of five networks (around 60 “caisses”) do not participate and consider a guarantee fund.
  - Three out of five mutualist networks have not been licensed and are not under supervision; licensing and placement under CSBF supervision should be finalized immediately or networks closed.

### BCM financial position and required measures
- BCM financials (audited accounts, book year 2004):
  - BCM had negative equity equivalent to US$26 million and reported operating losses over each of the last three years.
  - In 2004, BCM losses amounted to the equivalent of US$14 million (or 1.5 percent of its total assets).
  - Loans to the government stood at around 21 percent of total BCM assets at end-2004.
  - 77 percent of those loans consisted of unpaid, BCM-guaranteed London Club debt assumed when the guarantee was called.
  - BCM loans to a former state enterprise (obligations transferred when company privatized) account for an additional 15 percent of total exposure of BCM to the state and have remained unremunerated.
- Key measures to return BCM to profitability:
  - (i) remuneration at market rates of all government debt on the central bank’s balance sheet, or repayment or other removal by the treasury from the BCM’s balance sheet;
  - (ii) review of noninterest operating expenditures with a view to their reduction to a level commensurate with revenues;
  - (iii) nonrecurrence of transfers of government debt or quasi-fiscal expenses to the BCM, other than through statutory advances on tax revenues at the beginning of the budget year, provided these advances are at an acceptable level and are promptly repaid.

### Insurance, pensions, and other nonbank sectors
- Insurance sector:
  - Underdeveloped and inadequately supervised; regulator lacks independence, skills and resources.
  - Sector dominated by two state-owned companies; a third company is an insolvent mutual insurer under provisional administration.
  - Insurance penetration is low; nonlife insurance accounts for 77 percent of total premiums; life insurance has not evolved for the past thirty years.
  - Market dominated by two state-owned companies holding 89 percent of premium income.
  - Key market numbers (2003):
    - Madagascar: Per capita GDP (In U.S. dollars) 229; Premiums per capita (In U.S. dollars) 1.18; Insurance penetration (Gross premiums/GDP) 0.60
    - Comparable countries: Rwanda Per capita GDP 300; Premiums per capita 1.22; Insurance penetration 0.43; Kenya Per capita GDP 320; Premiums per capita 10.11; Insurance penetration 2.98; Benin Per capita GDP 455; Premiums per capita 2.30; Insurance penetration 0.75; Ghana Per capita GDP 320; Premiums per capita 2.22; Insurance penetration 0.64
- Pension sector:
  - Dominated by three publicly-managed institutions for formal sector employees.
  - Present schemes (private and public combined) cover less than 10 percent of the active population.
  - Two of the three public pension funds show cash flow deficits; short-term projections indicate deterioration likely.
  - No actuarial studies performed; no comprehensive regulatory and supervisory framework for pension providers.
  - Proposed regulatory framework should cover powers of supervisor; funding, reporting, valuation and actuarial standards; permissible assets; tax treatment; member information; prohibitions on self-dealing and related-party transactions.

### Access to financial services and microfinance
- Access statistics:
  - Only 35 percent of low-income households (roughly 80 percent of the population) have access to depository services; 2 percent have access to credit.
- Microfinance sector growth (recent five years):
  - Number of customers of financial cooperatives grew 28 percent per year.
  - Deposits grew 62 percent per year.
  - Loans grew 36 percent per year.
- Microfinance structure and supervision:
  - At end-2004, MFI sector included nine financial cooperatives, one finance company (établissement financier), three international NGOs, and the Caisse d’Epargne de Madagascar (CEM).
  - CEM not a licensed financial institution and not authorized to grant credits; accounts for roughly 80 percent of total depositors of MFIs and is not subject to supervision.
  - Only six groups of MFIs are formally registered, licensed and under CSBF supervision (five cooperative networks and a finance company).
  - Minimum capital adequacy ratio and loan loss provisioning rules for MFIs are currently the same as for commercial banks; tighter requirements for MFIs may be appropriate but balance needed to avoid over-regulation.
- SME finance and long-term finance:
  - SMEs face financing gap: too large for microfinance, not formal enough for banks.
  - Constraints: lack of formal financial statements, unclear property rights over land, lack of credit information sharing.
  - Centrale des Risques collects information on all bank loans above FMG 50 million; does not collect or provide information on nonperforming loans at the client level.
  - Immediate measures suggested: standardize mechanism to adjust floating interest rates; modify taxation of financial products to eliminate bias against long-term instruments.
  - Securities markets: no established securities markets or public raising of private capital; government issues bills and bonds, substantial financing through short-term treasury bills.

### Payment system, legal framework, and judicial reform
- Payment system underdevelopment:
  - Cash transactions dominate; only approximately 3 percent of the population has a bank account.
  - Only 7 bank branches per million inhabitants.
  - Clearing system entirely manual with physical exchanges in 14 clearing houses.
  - Clearing and settlement via BCM books is not automated; processing times range from 21 to 60 days for "out station" checks.
- Legal framework deficiencies:
  - Core provisions date to 1935.
  - Recently adopted law on uncovered checks is overly harsh and rigid and needs revision.
  - No regulatory framework for insolvency liquidators.
  - Individuals cannot pledge assets without transferring possession; no foreign-owned bank/mortgagee may be awarded title to real estate following foreclosure.
- Judicial reform initiatives and constraints:
  - 2004: Ministry of Justice started judicial reform including simplification of procedures and pilot courts for random allocation of cases.
  - Establishment of the Training College for Judges and Clerks (École Nationale de la Magistrature et des Greffes).
  - Constraints: Ministry lacks resources; corruption remains a major concern; 2005 budget for justice curtailed.

### AML/CFT — status, weaknesses, and priority actions
- Current status and weaknesses:
  - AML/CFT policies and practices are at an early stage and do not meet international standards.
  - AML/CFT law adopted in 2004, but necessary regulations and implementing procedures are not yet in place.
  - Financial Intelligence Unit (FIU) is not yet operational.
  - Financing of terrorism is not a specific criminal offense.
  - Preventive rules absent in majority of sectors; nonfinancial professions not covered.
  - Prudential authorities lack training, experience, manuals and instructions for AML/CFT oversight.
  - Eleven casinos have been set up in four years; rapid growth appears more than market can support.
- Key recommended compliance actions (selected highlights):
  - Criminalize acts of terrorism and the financing of terrorism.
  - Explicitly cover nonfinancial professions, Politically Exposed Persons (PEPs), NGOs, dealers in precious metals and precious stones and money transmitters in the law.
  - Provide the FIU with sufficient resources and make it operational; compile statistics on STRs.
  - Strengthen administrative controls and supervisory inspections for banks, exchange bureaus and other financial institutions.
  - Train police and judiciary in AML/CFT and provide adequate resources.
  - Issue instructions to banks, insurance companies, currency dealers and market intermediaries on implementing the AML law; require stronger due diligence on wire transfers and PEPs; prohibit shell banks.
  - Create a National Coordination Committee for AML/CFT policy; organize cooperation procedures and ratify relevant international conventions.
- Authorities’ response:
  - Authorities recognized need for legal and operational improvements, perceive enactment of a specific law combating terrorist financing as an important short-run issue, and expressed interest in assistance, particularly for operationalization of the FIU.

### FSAP key findings and recommended priorities (selected)
- Recommended measures clustered around:
  - (i) upgrade regulation and supervision;
  - (ii) deal with the BCM’s financial weakness;
  - (iii) address deficiencies in financial infrastructure; and
  - (iv) broaden access to financial services.
- Selected recommendations:
  - Regulation and supervision:
    - Implement additional refinements to banking rules and regulations and implement the CSBF’s action plan promptly.
    - Monitor carefully NPLs and loans with guarantees from parent banks.
    - Establish a legal and regulatory framework for private pensions.
    - Analyze actuarial soundness of the three public pension plans and place them on a sustainable financial footing.
  - Central bank issues:
    - Diagnose and remedy causes of negative equity of the BCM and develop a plan to ensure sustained financial viability (including remuneration at market rates of all government debt on the BCM’s balance sheet, or re-assumption of this debt by the government).
    - Statutory advances to the treasury should be strictly limited to a low percentage of average recurring revenue and be promptly repaid.
  - Financial infrastructure:
    - Start a comprehensive program for legal, judicial, and land and pledge registry reform.
    - Improve corporate financial data preparation and disclosure.
    - Establish a comprehensive credit information bureau accessible to all credit institutions.
    - Draft a feasibility study for payment system reform, including legal framework and check clearing systems.
    - Adapt legal framework to allow foreign banks to own foreclosed property.
  - Access to financial services:
    - Draw up a plan for long-term technical and financial assistance for development of sound, sustainable and professional microfinance.
  - AML/CFT:
    - Issue regulations and procedures for effective implementation of the AML/CFT Law consistent with best international practices.
    - Make the Financial Intelligence Unit operational through issuance of guidelines and allocation of resources.
    - Train staff of all involved authorities, including all financial supervisory authorities, in AML/CFT.

*Extracted from IMF FSAP mission report content (Data per December 31, 2004).*

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

### Executive Summary

### Overview of the financial system
- Commercial banks hold 84 percent of total system assets.
- All commercial banks are foreign-owned; subsidiaries of three large internationally active French banks have a combined market share of around 65 percent of assets.
- Nonbank financial institutions are small and do not pose a systemic threat.
- Credit to the private sector stands at around 10 percent of GDP.
- Total banking assets are equivalent to around 25 percent of GDP.
- Payment services are slow and intermediation margins are high.

### Banking system soundness and risks
- Banks are generally profitable, liquid, adequately capitalized and stable, although nonperforming loans (NPLs), at over 11 percent, are a concern.
- NPLs were 11.4 percent as of December 2004.
- The ratio of provisions to NPLs is low at 49 percent (staff calculation); the authorities' calculation that nets accrued interest yields a higher provisioning ratio of 66 percent.
- The overall capital adequacy ratio (CAR) is well above the required minimum of 8 percent; one large foreign institution's CAR fell slightly below 8 percent in late 2004 but rose to above 10 percent in March 2005 after recapitalization.
- Banks held large amounts of excess liquidity, on average 24 percent of required reserves during 2004, mainly due to lack of viable lending opportunities.
- Bank loans to the ten largest corporate clients account for 24 percent of the total corporate loan portfolio.
- About 10 percent of bank lending to domestic borrowers is covered by guarantees from parent banks.

### Insurance, pensions, and other nonbank sectors
- The insurance sector is underdeveloped and inadequately supervised; the regulator lacks independence, skills and resources.
- The sector is dominated by two state-owned companies; a third company is an insolvent mutual insurer under provisional administration.
- Insurance penetration is low.
- The three public pension systems cover less than 10 percent of the active population and appear to be fiscally unsustainable.
- Private pensions operate in a legal and regulatory vacuum.

### Access to financial services and microfinance
- Only 35 percent of low-income households (roughly 80 percent of the population) have access to depository services; 2 percent have access to credit.
- The microfinance sector has grown rapidly, especially during the last five years:
  - Number of customers of financial cooperatives grew 28 percent per year.
  - Deposits grew 62 percent per year.
  - Loans grew 36 percent per year.
- Banking supervision of microfinance institutions still has to become fully effective.
- Further development of microfinance requires long-term donor assistance.

### Financial infrastructure and AML/CFT
- The banking regulatory and supervisory framework is broadly adequate, but implementation and enforcement need further strengthening.
- The CSBF has not functioned for several years and faces a backlog of actions plus additional responsibilities for microfinance supervision and AML/CFT.
- Insurance regulators lack resources, skills and operational independence.
- The pension sector lacks a regulatory and supervisory framework.
- AML/CFT policies and practices are at an early stage and do not meet international standards:
  - An AML/CFT law has been adopted, but necessary regulations and implementing procedures are not yet in place.
  - Oversight by the authorities is not yet effective; preliminary drafts have been approved by the CSBF and the industry has been consulted.
  - The Financial Intelligence Unit is not yet operational.

### Central bank financial position
- According to the audited accounts over book year 2004, the Central Bank of Madagascar (BCM) was insolvent.
- The weak financial position of the BCM complicates effective monetary and exchange rate policy and can impact the quality of financial sector supervision, as the BCM funds and staffs the CSBF.
- The authorities recognize the problem and have sought Fund technical assistance to help lay the basis for sustained financial viability of the BCM.

### Macroeconomic and vulnerability context
- The economy grew by over 5 percent per year in real terms in 2003-05.
- Real growth is expected to average 6 percent per year over the medium term.
- Madagascar remains susceptible to exogenous shocks: weather-related shocks (e.g., cyclones), commodity price shocks (e.g., vanilla, petroleum), and trade policy shocks (e.g., termination of textiles agreements and the expected termination of the third party provision under the African Growth and Opportunity Act in 2007).
- The political crisis of 2001-02 led to a sharp downturn in economic activity, with real GDP falling by around 13 percent in 2002; the banking sector remained operational but loan quality deteriorated.
- The current account deficit widened considerably in 2004; vanilla export earnings weakened considerably in 2005.

### FSAP key findings and recommended priorities
- The FSAP recommended measures to:
  - (i) upgrade regulation and supervision;
  - (ii) deal with the BCM’s financial weakness;
  - (iii) address other deficiencies in the financial infrastructure; and
  - (iv) broaden access to financial services.
- Boxed Key FSSA Recommendations (selected):
  - Regulation and supervision:
    - Implement additional refinements to banking rules and regulations and implement the CSBF’s action plan promptly.
    - Monitor carefully NPLs and loans with guarantees from parent banks.
    - Establish a legal and regulatory framework for private pensions.
    - Analyze actuarial soundness of the three public pension plans and place them on a sustainable financial footing.
  - Central bank issues:
    - Diagnose and remedy the causes of negative equity of the BCM and develop a plan to ensure sustained financial viability (including remuneration at market rates of all government debt on the BCM’s balance sheet, or re-assumption of this debt by the government).
    - Statutory advances to the treasury should be strictly limited to a low percentage of average recurring revenue and be promptly repaid.
  - Financial infrastructure:
    - Start a comprehensive program for legal, judicial, and land and pledge registry reform.
    - Improve corporate financial data preparation and disclosure.
    - Establish a comprehensive credit information bureau accessible to all credit institutions.
    - Draft a feasibility study for payment system reform, including the legal framework and check clearing systems.
    - Adapt the legal framework to allow foreign banks to own foreclosed property.
  - Access to financial services:
    - Draw up a plan for long-term technical and financial assistance for the development of sound, sustainable and professional microfinance.
  - AML/CFT:
    - Issue regulations and procedures for effective implementation of the AML/CFT Law consistent with best international practices.
    - Make the Financial Intelligence Unit operational through issuance of guidelines and allocation of resources.
    - Train staff of all involved authorities, including all financial supervisory authorities, in AML/CFT.

*Executive Summary — _cr06305 - Executive Summary_*

### 19.      Results of the stress tests conducted by the mission suggest that credit risk is the

### _cr06305 - 19.      Results of the stress tests conducted by the mission suggest that credit risk is the

### Credit risk and stress-test findings
- Stress tests indicate credit risk is the main risk facing the banking system.
- In the event of a severe asset-quality shock (e.g., a doubling of NPLs for each individual bank, or a migration of 10 percent of outstanding loans to more severe classifications), the banking system as a whole would lose more than 30 percent of its capital base.
- The impact on the overall capital adequacy ratio would be slightly smaller but still significant as Tier I capital accounts for around 90 percent of the total regulatory capital.
- For the majority of banks, even substantial exchange rate or interest rate shocks would not have serious impacts on capital.
- Given the small size and significant foreign ownership of the formal commercial banking system, the cost of recapitalization could most likely be borne by the banks or their parent institutions.
- A doubling of NPLs would correspond to the level recorded in the aftermath of the political crisis in 2002, and would require recapitalization of around 0.1 percent of GDP.
- The worst case macroeconomic stress test scenario would require broadly 0.6 percent of GDP.
- High profitability will help cushion any recapitalization effort.

### Systemic liquidity and lender-of-last-resort (LOLR)
- Interbank money and foreign exchange markets function reasonably well, although chronic excess liquidity reduces their necessity and is a disincentive for development.
- The market would benefit from introduction of standardized instruments, such as repos and reverse repos, with a standard contract (“contract cadre uniforme”) agreed upon by all market participants.
- Restrictions on loans in foreign currency lead banks to hold a large share of foreign assets as correspondent accounts with parent banks or other banks overseas, making banks unlikely to face shortages of foreign exchange liquidity.
- Earlier missions identified a need for counterparty risk management in the money market; authorities have requested technical assistance.
- Lack of suitable borrowers contributes to banks’ high liquidity.
- The Treasury contributes to system liquidity through statutory advances from the BCM equal to 15 percent of previous year’s budget receipts; in 2005 use was limited voluntarily to 10 percent of budgeted receipts.
- Such advances should be strictly limited to a low percentage of average recurring revenue and be promptly repaid.
- The BCM has instruments to manage liquidity: reserve requirements, central bank benchmark rates, open market operations with T-bills, two automatic refinancing windows for 24-hour and 2-10 day credit at penalty rates of 5 and 7.5 percent above the BCM base rate.
- These instruments have not always been used in a timely and efficient manner.
- Banks rely mainly on interbank liquidity; BCM can provide LOLR support but each transaction needs BCM management approval, which can lead to undesirable delays in emergencies.
- There is an active market for T-bills, but better coordination between the BCM and the Treasury is needed on timing and amounts; T-bill issuance is primarily dictated by budgetary needs and does not always account for liquidity conditions.
- Forecasting of systemic liquidity needs improvement; development of a comprehensive public debt management program is required.
- The BCM’s weak financial condition could limit its ability to provide liquidity.

### Summary results of stress tests (Data per December 31, 2004)
Baseline Tier I Capital (in percent of RWA)
- Group 1: 9.4
- Group 2: 14.0
- Groups 1+2: 10.5
- Worst Bank: 6.4
- Best Bank: 31.4

A. Sensitivity analysis — Change in Tier I capital resulting from hypothetical shocks (in percent of original Tier I capital)
- Credit Risk
  - Shift in assets 2/: Group 1 -21.2, Group 2 -12.5, Groups 1+2 -18.2, Worst Bank -37.1, Best Bank -0.1
  - Increase in NPLs by 100 percent: Group 1 -49.0, Group 2 -31.1, Groups 1+2 -43.0, Worst Bank -97.0, Best Bank -0.1
  - Increase in the ratio of NPLs to total loans to 20 percent 3/: Group 1 -24.7, Group 2 -47.5, Groups 1+2 -32.3, Worst Bank -76.7, Best Bank -13.9
  - 10 percent of outstanding loans become NPLs: Group 1 -36.8, Group 2 -39.3, Groups 1+2 -37.7, Worst Bank -55.4, Best Bank -17.9
- Exchange Rate Risk
  - Depreciation by 30 percent 4/: Group 1 0.8, Group 2 2.4, Groups 1+2 1.3, Worst Bank -21.5, Best Bank 4.5
  - Depreciation by 50 percent: Group 1 1.3, Group 2 4.0, Groups 1+2 2.2, Worst Bank -35.9, Best Bank 7.5
  - Appreciation by 10 percent 4/: Group 1 -0.3, Group 2 -0.8, Groups 1+2 -0.4, Worst Bank -1.5, Best Bank 7.2
- Interest Rate Risk
  - Increase in FMG rates by 500 points 5/: Group 1 -4.1, Group 2 -5.0, Groups 1+2 -4.4, Worst Bank -6.6, Best Bank 3.5
  - Increase in FX rates by 200 points: Group 1 -0.2, Group 2 -0.5, Groups 1+2 -0.3, Worst Bank -0.8, Best Bank -0.1

B. Scenario Analysis 6/ — Change in Tier I capital (in percent of original Tier I capital)
- Scenario 1: Group 1 -28.7, Group 2 -30.0, Groups 1+2 -29.1, Worst Bank -42.4, Best Bank -14.2
- Scenario 2: Group 1 -55.4, Group 2 -58.5, Groups 1+2 -56.4, Worst Bank -82.6, Best Bank -27.2
- Scenario 3: Group 1 -77.0, Group 2 -81.2, Groups 1+2 -78.4, Worst Bank -114.8, Best Bank -38.0

Notes associated with tests (preserve original definitions)
- 1/ Group 1 includes three French-controlled banks, and Group 2 includes the other four banks.
- 2/ 50 percent of current bank holdings of government securities and placements with other banks are assumed to be shifted toward loans.
- 3/ The magnitude of such a shock would correspond to the level recorded in the aftermath of the political impasse in 2002.
- 4/ The magnitude of these shocks was similar to the largest monthly depreciation and the largest monthly appreciation of the FMG against the Euro and the U.S. dollar observed over the last 10 years.
- 5/ The magnitude of such a shock would be similar to the increase in the central bank main rates in May-July 2004.
- 6/ Scenario definitions:
  - Scenario 1: moderate shock to the agriculture sector (25 percent of all agriculture loans become nonperforming, the FMG depreciates by 20 percent, and the FMG interest rates increase by 300 bp).
  - Scenario 2: significant shock to the agriculture sector (50 percent of all agriculture loans become nonperforming, the FMG depreciates by 20 percent, and the FMG interest rates increase by 300 bp).
  - Scenario 3: economy-wide shock (10 percent of all outstanding loans become nonperforming, the FMG depreciates by 30 percent, and the FMG interest rates increase by 500 bp).

### Banking supervision, remedial measures, and safety net
- The CSBF supervises commercial banks, finance companies and microfinance institutions under the Banking Law of 1996.
- Enforcement by the CSBF needs to become more effective; supervision of microfinance and AML/CFT responsibilities will create additional burdens.
- Until March 2005 the Commission had not functioned for several years due to unfilled Board vacancies, creating backlog in regulation, decisions and enforcement; Board vacancies have been filled but a long agenda remains.
- The CSBF action program includes: revision of the banking law, introduction of International Accounting Standards (AIS), regulations on interest rate risk and liquidity, on-site inspection program, stress testing, new prudential regulations, corrections in capital definition to conform with Basel I, and an increase in the minimum risk-weighted capital adequacy ratio from 8 to 10 percent.
- The CSBF plan’s self-imposed deadlines show heavy bunching in final months of the annual work program and may not be realistic given staffing timelines.
- Banking supervision policies and practices are broadly sufficiently transparent for interested parties, aided by the small size of the system; however, the introduction of new foreign exchange regulations in Spring 2005 lacked meaningful consultation and should be reviewed.
- The CSBF should issue regular reports; since creation in 1995 it has issued only three reports, most recently in 2001.

Remedial measures and safety net specifics
- CSBF sanctions include: requests for explanations, warnings and binding instructions, removal of management, appointment of a provisional administrator for a maximum of six months (once renewable), and withdrawal of the banking license leading to immediate liquidation.
- Withdrawal of a banking license can be suspended by the Minister of Finance for eight days, during which CSBF must review its decision; pending this period CSBF may take conservatory measures.
- The CSBF Chairman may “invite” shareholders for financial assistance and may request other banks, on a nonmandatory basis, to participate in a life-boat operation.
- No deposit insurance system currently exists; authorities are debating introduction with issues including legal personality, mandatory membership, risk-based contributions, exclusion of wholesale clients or foreign exchange deposits, ceilings per client/institution, and authorization for the fund to intervene in a bank.
- A properly structured deposit insurance system is important to limit moral hazard and potential quasi-fiscal liabilities and could help protect small depositors.
- Of approximately 140 “caisses” of mutualist credit institutions (around 4 percent of banking system assets), about 80 (three networks) benefit from mutual solidarity arrangements; two of five networks (around 60 “caisses”) do not participate in solidarity arrangements and are considering a guarantee fund.
- Serious concerns exist about safety of mutualist groups: three out of five networks have not been licensed and are therefore not under supervision; licensing and placement under supervision by the CSBF should be finalized immediately or the networks closed.

### BCM financial situation (Box 2) — key figures and policy measures
- According to audited financial statements for 2004, the BCM had negative equity equivalent to US$26 million and reported operating losses over each of the last three years.
- In 2004, BCM losses amounted to the equivalent of US$14 million (or 1.5 percent of its total assets).
- Loans to the government stood at around 21 percent of total assets of the BCM at end-2004.
- 77 percent of those loans consisted of unpaid, BCM-guaranteed London Club debt assumed when the guarantee was called.
- BCM loans to a former state enterprise (obligations transferred to the state when the company was privatized) have remained unremunerated and account for an additional 15 percent of the total exposure of BCM to the state.
- Underlying causes of insolvency need urgent address; authorities intend to seek Fund TA to develop sustained financial viability.
- Key measures to return the BCM to profitability:
  - (i) either remuneration at market rates of all government debt on the central bank’s balance sheet, or repayment or other forms of removal by the treasury from the BCM’s balance sheet;
  - (ii) review of noninterest operating expenditures with a view to their reduction to a level commensurate with revenues;
  - (iii) nonrecurrence of transfers of government debt or quasi-fiscal expenses to the BCM, other than through statutory advances on tax revenues at the beginning of the budget year, provided these advances are at an acceptable level and are promptly repaid.

### Insurance companies
- With only three companies in operation, the insurance industry remains underdeveloped even relative to regional peers.
- A new insurance code adopted in 1999 (largely in conformity with international standards) has not been effectively implemented.
- The insurance market is dominated by two state-owned companies holding 89 percent of premium income; no foreign presence since 1975 nationalization.
- Nonlife insurance accounts for 77 percent of total premiums; life insurance has not evolved for the past thirty years.
- Market performance: claims ratios are low and stable, expense ratios are fairly high, suggesting tariffs may be set too high relative to risk and nominal rates of return are relatively low.
- The private insurer is insolvent and unable to meet claims; it has been under provisional administration since early 2005.
- Insurance supervision is the responsibility of the Ministry of Finance, which lacks trained staff, resources and operational independence; considerable upgrading will be required for a liberalized market.

Table 4 (insurance market and international comparison, 2003) — key numbers
- Madagascar: Per capita GDP (In U.S. dollars) 229; Premiums per capita (In U.S. dollars) 1.18; Insurance penetration (Gross premiums/GDP) 0.60
- Rwanda: Per capita GDP 300; Premiums per capita 1.22; Insurance penetration 0.43
- Kenya: Per capita GDP 320; Premiums per capita 10.11; Insurance penetration 2.98
- Benin: Per capita GDP 455; Premiums per capita 2.30; Insurance penetration 0.75
- Ghana: Per capita GDP 320; Premiums per capita 2.22; Insurance penetration 0.64

### Pension funds
- Pension sector dominated by three publicly-managed institutions for formal sector employees; insurance companies offer limited private pension products; at least one private company provides endowment and annuity products.
- Present schemes (private and public combined) cover less than 10 percent of the active population.
- Two of the three public pension funds currently show cash flow deficits; short-term projections indicate financial situation likely to deteriorate.
- None of these pension providers has performed an actuarial study of their schemes.
- There is no comprehensive regulatory and supervisory framework for pension providers; no direct oversight or supervision for public or private pensions and no reporting requirement for private funds.
- A proposed regulatory framework should provide powers of the supervisory body; funding, reporting, valuation and actuarial standards; permissible assets; tax treatment; information to members; and prohibitions on self-dealing and transactions with related parties.
- Capacity of the designated supervisor will need to be built from the ground up.

*Source: FSAP mission report content (Data per December 31, 2004).*

### 38.      Several legislative reform initiatives have taken place recently in the financial

### _cr06305 - 38.      Several legislative reform initiatives have taken place recently in the financial

### Legislative reform initiatives — progress
- Business, banking and other financial laws have been modernized and improved.
- New legislation governs: securities trading, commercial and credit registries, companies, secured transactions and insolvency.
- Madagascar is currently formulating a new land reform strategy to address the existing obsolete formal property rights regime.

### Remaining legal and institutional deficiencies
- No regulatory framework exists for insolvency liquidators.
- Individuals remain unable to pledge an asset without transferring possession of the collateral, hindering access to credit.
- No foreign-owned bank/mortgagee may be awarded title to real estate following foreclosure on a mortgage, further constraining lending.
- Alternatives to mortgage-based lending need encouragement and legal mechanisms created or improved to develop lending to small- and medium-size enterprises (SMEs) and consumer loans to individuals.
- In the absence of a bank insolvency law, depositors have limited protection against insolvency of a deposit-taking institution.
- Efforts to improve the legal framework are hindered by weak drafting skills, limited appreciation of technical nuances, and inaccessible legal information including jurisprudence.

### Judicial system — developments and constraints
- 2004: Ministry of Justice started a judicial reform program, including simplification of procedures to reduce massive backlogs in commercial cases.
- Pilot courts: random allocation of cases initiated to limit personal considerations.
- Establishment of the Training College for Judges and Clerks (École Nationale de la Magistrature et des Greffes).
- Constraints:
  - Ministry of Justice lacks necessary resources to carry out basic administrative mandates and important reform.
  - Corruption in the judiciary remains a major concern; only a few concrete measures have been taken so far to address corrupt behavior in the public sector.
  - 2005 budget for the justice sector generally, and for judicial reform in particular, has been curtailed at a time when significant expansion is needed.
  - Without necessary financial and full-time human resources of the required caliber, execution of generalized and thorough judicial reform is at high risk of failure.

### Payment system — status, risks, and reforms
- Underdevelopment:
  - Cash transactions dominate due to low bank penetration: only approximately 3 percent of the population has a bank account.
  - There are only 7 bank branches per million inhabitants.
  - Clearing system is entirely manual, with physical exchanges of checks and bills in 14 clearing houses.
- Clearing and settlement risks:
  - Clearing and settlement via the books of the BCM is not automated and depends on how long it takes for checks to reach BCM headquarters by fax or mail.
  - Time lags can result between closing of positions at bank branch accounts and settlement on BCM books, making end-of-day closing positions unpredictable for banks.
  - Banks are highly liquid and have not encountered acute settlement risk, but this could change under tighter liquidity conditions.
  - Processing times: while acceptable for transactions not requiring physical transportation of checks, they range from 21 to 60 days for "out station" checks.
- Legal framework:
  - Core provisions date back to 1935.
  - A recently adopted law on uncovered checks, intended to promote check usage, is overly harsh and rigid and may be counterproductive; this law needs revision and the legal framework modernized to allow secure development of noncash (especially electronic) payment instruments and processing systems.
- Reform initiatives and support:
  - Positive developments: standardization of checks, modernization of bank information systems, launch of card systems.
  - Under the U.S Millennium Challenge Account agreement, up to US$21 million has been earmarked for payment system reform.
  - Administrative capacity to lead reform efforts needs strengthening.

### Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT)
- AML/CFT policies and practices are in an early developmental stage and do not meet international standards.
- AML/CFT law has been adopted, but necessary regulations and implementing procedures are not yet in place; oversight by authorities is not yet effective (preliminary drafts approved by the CSBF and industry consultations have taken place).
- Draft implementation instructions are in an advanced stage but require improvements.
- Prudential authorities currently lack training, experience, manuals and instructions to exercise effective off-site and on-site oversight of banks’ AML/CFT compliance.
- Large foreign-owned banks have well-developed internal AML/CFT rules based on parent banks; microfinance institutions, money changers and smaller commercial banks generally do not.
- Considerable uncertainty exists as to the legal status of money changers: Ministry of Finance delegated to the CSBF responsibility to regulate, license and monitor money changers, which have so far not been subject to CSBF oversight; an appropriate legal basis is needed to provide sanctioning authority for the CSBF regarding money changers.

### Financial sector developmental issues — access to financial services

Microfinance
- Importance: further development of the microfinance sector is key to increasing access to finance given the magnitude of the unserved market and limited bank outreach.
- At end-2004, the MFI sector included:
  - nine financial cooperatives,
  - one finance company (établissement financier),
  - three international nongovernmental organizations,
  - the Caisse d’Epargne de Madagascar (CEM).
- CEM:
  - Not a licensed financial institution and not authorized to grant credits.
  - Caters mostly to low-income savers and accounts for roughly 80 percent of total depositors of MFIs.
  - Concern: CEM is not subject to supervision by any regulatory authority and relies solely on external audits as a control mechanism.
  - Related concern: launch of deposit taking from the public by former CEM partner La Poste in 2004, seemingly without regulatory oversight.
- Supervision:
  - Adequate CSBF supervision is a prerequisite; only six groups of MFIs are formally registered, licensed and under CSBF supervision (five cooperative networks and a finance company).
  - Off-site supervision and reporting are routinely delayed, primarily due to manual preparation of reports and slow communication.
  - CSBF resources have been reinforced, but adequacy needs ongoing review to ensure capacity for regular, systematic oversight including on-site inspections.
- Prudential rules:
  - Minimum capital adequacy ratio and loan loss provisioning rules for MFIs are currently the same as for commercial banks.
  - Given higher risks in microfinance, tighter capital and provisioning requirements for MFIs would be more appropriate, but balance is needed to avoid over-regulation.
- Services and outreach:
  - Deposit services provide safety and reliability but the range of deposit types is limited.
  - Scarcity of credit provision and paucity of payment and insurance services are major challenges; current efforts are largely confined to urban areas.
  - Scaling-up outreach for deposit and credit services outside of the CEM is a priority for poverty alleviation impact.
- Legal framework:
  - Deposit-taking MFIs which are not financial cooperatives are not subject to any regulation.
  - Tax exemptions and deposit collection have led all licensed MFIs except one to be registered as financial cooperatives regardless of actual structure.
  - Options: pass a new microfinance law (a draft prepared recently has important shortcomings) or revise the banking law to include an MFI category.

Small- and medium-size enterprise (SME) financing
- Gap: SMEs too large for microfinance but not formal enough for banking system.
- Constraints:
  - Many SMEs lack formal financial statements required by banks.
  - Lack of clear property rights over land impedes use of land as collateral.
  - Lack of effective credit information sharing with MFIs prevents borrowers from building credit histories for banks.
- Existing initiatives:
  - Guarantee fund created in 2003 and financed by Malagasy banks does not guarantee the smallest loans; few new borrowers brought under the guarantee.
- Recommendations:
  - Enforce legal obligation to disclose annual financial statements of enterprises.
  - Establish a credit reference bureau to collect past and outstanding credit and payment history and make it available to financial institutions.
  - Given existence of the Centrale des Risques in the BCM, the central bank is a natural location for such a bureau.
    - Note: the Centrale des Risques collects information on all bank loans above FMG 50 million and distributes aggregate information on outstanding bank credit for each client to all banks; provides information on maturity (short-, medium- and long-term); does not collect or provide information on nonperforming loans at the client level, though information on bounced checks is collected and provided through a separate system.
- Leasing and factoring:
  - Development of leasing and factoring could help SMEs obtain financing as they rely less on judicial enforcement.
  - Recently enacted leasing law provides legislative basis for expansion; currently only one leasing provider exists in Madagascar.
  - Under the old law, leasing had no legal advantage in enforcing claims though property right of financed equipment stayed with the lessor; this has been remedied under the new law, which follows international accounting standards on balance sheet treatment.
  - No Malagasy provision seems to allow sale of claim to a third party, a pre-condition for factoring.

Promoting long-term financing
- The financial system provides little long-term financing.
- Impediments: macroeconomic instability, lack of reliable accounting information, deficiencies in legal and judiciary systems, political and economic uncertainty, high and volatile inflation and interest rates.
- Preconditions for long-term finance: sustained macroeconomic and political stability, accurate accounting records, financial disclosure, predictable rule of law, functioning registration and enforcement of property rights.
- Immediate measures suggested:
  - Standardize mechanism to adjust floating interest rates (periodicity and transparency).
  - Modify taxation of financial products to eliminate bias against long-term instruments; bank savings accounts currently represent a greater share than product appeal would justify because of a distorted tax regime on interest earned relative to time deposits.
- Securities markets:
  - No established securities markets or public raising of private capital.
  - Government issues bills and bonds; no issuance of debt securities to the public in recent years.
  - Substantial government financing is raised through short-term treasury bills; with sustained macro stability, consider gradually lengthening maturities.
- Institutional investors:
  - Liberalization of the insurance market and development of a nascent private pension sector should increase demand for longer-term securities and help develop long-term finance.

### Observance of standards and codes — summary assessments (Annex excerpts)
- Annex contains summaries of assessments of:
  - FATF 40+9 Recommendations on AML/CFT.
  - Basel Core Principles for Effective Banking Supervision (BCP).
- FATF 40+9 assessment prepared from July 4 to 16, 2005; BCP assessment performed from April 21 to May 3, 2005.
- Assessments based on laws, regulations and practices in place at time of assessment and used sources including self-assessments by authorities, reviews of legislation and interviews with officials, market participants, service providers, donor agencies and others.

### Current situation regarding money laundering and financing of terrorism
- Main offenses connected to money laundering/financing of terrorism: drug trafficking, precious metal and precious stone trading, and offenses related to international trade transactions.
- 2004 law on AML expands money laundering concept to cover proceeds of all serious crime.
- Financing of terrorism has not yet been made a criminal offense.
- Drug trafficking is significant, including regional activity; authorities aware but resource-constrained and find little regional cooperation.
- Mining and international trade are vulnerable sectors:
  - Precious stones mined and exported often without authorities' knowledge.
  - Marketing of stones generates external financial flows susceptible to money laundering and financing of terrorism.
  - The profession is not covered by the new law on money laundering.
  - Government mining project intends to streamline concession allocation, professionalize the industry and improve oversight.

*Italic: Extracted and summarized from the supplied content unit.*

### 64.      Customs inspections have uncovered numerous fraudulent practices. Finally, the

### 64. Customs inspections have uncovered numerous fraudulent practices. Finally, the rapid growth in the number of casinos appears more than the market can support.

### Main findings and overall conclusion
- Despite recent progress, assessment shows a low level of compliance with the FATF 40 + 9 recommendations.
- Urgent needs identified:
  - Increase pace of reform of the current legal system.
  - Provide the FIU with the technical and human resources it needs to meet international standards.
  - Clarify and considerably strengthen the AML roles of the central bank and the CSBF.
  - Provide adequate financing, structures and training for the FIU, supervisory authorities, police and judiciary.
  - Develop procedures for AML investigation and prosecution.
- Combating money laundering and the financing of terrorism are new concepts for Madagascar; a stronger control culture is required, particularly in banking and other financial sectors.

### Summary assessment — key weaknesses
- Financing of terrorism is not a specific criminal offense.
- The Financial Intelligence Unit (FIU) is not yet in operation.
- Absence of preventive rules in the majority of sectors subject to supervision.
- Noncoverage of nonfinancial professions.
- Embryonic AML/CFT supervisory measures in the financial sector.
- A judiciary inexperienced in cases involving financial crime.

### Summary assessment — recommended compliance actions
- Criminalize acts of terrorism and the financing of terrorism.
- Explicitly cover nonfinancial professions (lawyers, notaries, accountants, etc.), politically exposed persons (PEPs), NGOs, dealers in precious metals and precious stones and money transmitters in the law.
- Provide the FIU with all necessary resources.
- Strengthen administrative controls in key sectors.
- Implement more in-depth supervision of banks, exchange bureaus and other financial institutions.
- Train police and judiciary in AML/CFT.
- Allocate the necessary resources.

### Legal framework and international cooperation
- International conventions:
  - Ratified: UN Convention Against Illicit Traffic in Narcotic Drugs and Psychotropic Substances of 1988 (Vienna Convention) on March 12, 1991.
  - Signed: 2000 UN Convention against Transnational Organized Crime (Palermo Convention) and the 1999 International Convention for the Suppression of the Financing of Terrorism. Ratification is under way.
- Criminal law:
  - The new AML law of 2004 covers all the main crimes and offenses, except the financing of terrorism.
  - Enforcement powers and international cooperation strengthened (undercover operations, controlled delivery, systematic extradition).
- Provisional measures:
  - Malagasy law provides confiscation, freezing and seizure of goods, moneys, or proceeds of crime; seizure of assets connected to the offense and evidence.
- FIU provisions in the 2004 law:
  - FIU may obtain information from public authorities and a wide range of persons relating to the “know your customer” rule, beneficial owners, originators, or transactions.
  - FIU refers suspicions to public prosecutor.
  - FIU may exchange information with foreign FIUs subject to reciprocity and confidentiality.
  - Only judicial and law enforcement authorities may apply freezing, seizure or confiscation powers.
- Combating corruption:
  - Madagascar ratified the UN Convention against Corruption.
  - Institutional framework under the Office of the President: High Council on the Fight Against Corruption (CSLC), Independent Anti-Corruption Office (BIANCO), Anti-Corruption Criminal Data System (CPAC) within the judiciary.

### Effectiveness of current measures and preventive measures
- FIU not yet operational; no nationwide structure to oversee AML effectiveness or promote reform.
- Know-your-customer system in law includes retention of identity documents but lacks provisions on politically exposed persons (PEPs).
- Law vague on due diligence and document retention for nonfinancial legal and accountancy professions; coverage limited to persons/entities professionally carrying out, controlling, or advising on financial transactions.
- Reporting obligations to FIU required for banks, financial institutions, insurance companies and casinos; no explicit obligation on dealers in precious stones or metals, NGOs, money transmitters, lawyers, and accountants.
- Bank requirements:
  - Banks required to set up internal AML programs, centralize customer identity information, train staff, and monitor program effectiveness.
  - Practical weaknesses: many banks (other than subsidiaries of major foreign groups) lack IT to monitor unusual/doubtful/complex transactions; compliance officers not appointed.
  - As FIU not operational, individuals and legal entities cannot report suspicious transactions; FIU has not issued practical procedures against money laundering.
- Insurance and securities sectors: no internal procedures or rules to prevent use of companies to launder money or finance terrorism.
- Supervision and inspections:
  - CSBF is relevant authority to monitor banks’ compliance but has not performed any AML-focused on-site inspections.
  - No similar inspections conducted in insurance, securities, money transmitters, bureaux de change or micro-credit institutions.
  - Insurance and securities regulators have not issued AML instructions; CSBF is on the point of issuing an AML instruction.
- Self-regulatory bodies of nonfinancial professions (lawyers, accountants) do not monitor compliance.
- Controls of NGOs, casinos and mining concessions are inadequate, poorly coordinated and intransparent.
- Footnote: Eleven casinos have been set up in four years.

### Priority Action Plan to Improve Compliance with the FATF Recommendations (selected highlights)
- Legal system and institutional measures:
  - Include financing of terrorism in the scope of main criminal offenses of money laundering; criminalize acts of terrorism.
  - Create computerized centralized police records and computer databases for police, customs and courts.
  - Create an interministerial coordination body to coordinate AML policy and provide progress reports.
- Confiscation, freezing, and seizure:
  - Build a database on the number and nature of assets seized.
- FIU (R26, R30, and R32):
  - Operationalize the FIU: provide sufficient resources; compile statistics on STRs; criminalize financing of terrorism to include it in STR scope.
- Implementation, enforcement and judiciary:
  - Train judges in combating organized financial crime; provide judiciary with sufficient resources; compile statistics on prosecutions, convictions, and sentencing.
- Preventive measures for banks:
  - Issue instructions to banks, insurance companies, currency dealers and market intermediaries on implementing new AML law.
  - Analyze the financial sector to identify high AML-risk categories of customers and transactions.
  - Require banks to update files on former customers; encourage internal instructions on customer due diligence.
  - Amend law to apply stronger due diligence to Politically Exposed Persons.
  - Add specific rules on wire transfers strengthening due diligence on originator.
  - Instruct banks when and how to monitor unusually or unjustifiably complex transactions; define role of internal AML/CFT control structures.
  - Prohibit shell banks and require refusal of correspondent relationships with shell banks.
  - CSBF urged to monitor implementation, ensure means to prevent/detect/report, verify AML-trained staff, and apply similar recommendations to insurance and securities sectors.
- Preventive measures for nonfinancial professions:
  - Extend legal due diligence and document retention to lawyers, notaries, public accountants.
  - State in law that due diligence, document retention, and STR requirements apply to nonfinancial professions.
  - Identify agencies responsible for monitoring AML standards for nonfinancial professions; ensure self-regulatory bodies enforce compliance and issue guidance.
- Legal entities and NGOs:
  - Subject NGOs to greater regulation and strengthen controls.
- National and international cooperation:
  - Create a National Coordination Committee to define and direct national AML/CFT policy and facilitate cooperation.
  - Organize cooperation procedures among agencies (MoU on information exchange, confidentiality).
  - Ratify Vienna and Palermo Conventions; investigate institutions to ensure customers do not include persons suspected of terrorism per Resolution 1373 lists.
  - Implement mutual legal assistance and extradition rules for financing of terrorism; prepare analytical and statistical tools.
  - Prepare partnership agreements for information exchange between the FIU and foreign counterparts.

### Authorities’ response
- Authorities recognized the AML regime needs improvements legally and operationally.
- Enactment of a specific law combating terrorist financing is perceived as an important short-run issue to comply with international standards.
- Authorities broadly agreed on team recommendations for supervisory, law enforcement and judiciary weaknesses.
- Authorities expressed interest in assistance, particularly for operationalization of the FIU.

### Basel Core Principles for Effective Banking Supervision — institutional and market structure overview
- Banking sector characteristics:
  - Total assets equivalent to around 25 percent of GDP.
  - Stable, liquid, adequately capitalized and profitable, but shallow and undiversified.
  - Credit to the private sector stands at around 10 percent of GDP.
  - Commercial banks hold 84 percent of total system assets and offer basic savings and credit products to a select clientele.
- Structure of banking system:
  - The Malagasy banking system consists of seven banks.
  - The three subsidiaries of large French banks account for around 65 percent of system assets.
  - Of the four remaining banks: one is a subsidiary of a Benin-domiciled parent bank, two are subsidiaries of Mauritian banks, and one formerly domestic bank was recently acquired by investors from Hong Kong.
- Microfinance and nonbank intermediaries:
  - Mutualist financial institutions with five networks (180,000 members), microcredit institutions (5,500 clients) and the Caisse d’Epargne de Madagascar (CEM) are the main microfinance providers.
  - Only the mutualist financial institutions are formally on paper under CSBF oversight.
  - A new legal framework for nonbank intermediaries is in preparation, linked to a National Microfinance Strategy.
  - The banking system is one of the smallest in comparable African countries, although the branch network is relatively dense.
- Supervision:
  - Banking and microfinance supervision is exercised by the CSBF, based on the 1996 Banking Law.

### Preconditions and operational environment
- Macroeconomic stability:
  - Recent macroeconomic performance broadly satisfactory; growth supported by agricultural, construction, tourism, transport, and export processing zone sectors.
  - External sector remains weak; susceptibility to exogenous shocks (adverse climatic conditions, commodity price shocks, import prices, trade shocks such as termination of Agreement on Textiles and Clothing).
  - In 2001-2002 political turmoil led to a fall in real GDP of around 13 percent in 2002; banking sector continued operations though asset quality suffered.
- Public infrastructure and market discipline:
  - Operating environment shows weaknesses: legal, judicial and accounting frameworks weak; financial information on borrowers limited; integrity and governance concerns; high lending risk and nonperforming loans lead to high risk premiums and lending rates; payment systems are slow.
  - No systematic policy to promote transparency of monetary and financial policies; CSBF envisages publishing an annual report over 2004 (since 1995 only one report was issued, in 2001).
  - Financial market discipline limited due to small number of institutions and nonenforcement of disclosure rules; corporate financial statements not available to the public.
  - Accounting and auditing capacity limited with 70 chartered accountants in the country.
  - Banks’ annual statements are generally disclosed by the institutions themselves.

*Content derived from the provided IMF chapter/section text.*

### 92.      For several years, remedial action by CSBF against banks and microfinance

### _cr06305 - 92.      For several years, remedial action by CSBF against banks and microfinance

### Remedial action, supervisory powers, and intervention tools
- CSBF has an adequate range of sanctions, including:
  - invitation to bank management to explain its position,
  - issuance of warnings and binding instructions,
  - removal of management,
  - appointment of a provisional administrator,
  - withdrawal of the banking license.
- CSBF’s order to surrender the banking license—after an eight-day period within which the Minister can ask the CSBF to reconsider—leads to immediate liquidation of the bank.
- The Chairman of the CSBF may “invite” shareholders or members to provide assistance (authority unused since enactment of the LB in 1996).
- Debate underway on introduction of a deposit insurance system.
- Banks rarely use BCM lender-of-last-resort facilities because they are highly liquid, with:
  - high liquid reserve requirements of 15 percent,
  - loan to deposit ratios averaging around 50 percent (end 2004).

### Microfinance and mutualist groups
- Concerns about safety of mutualist groups:
  - three out of five networks have not been licensed and are therefore not under supervision.
  - Slightly over half of the mutualist “caisses” benefit from mutual solidarity arrangements.
  - Two of the five mutualist networks, with around 60 “caisses,” do not participate in such solidarity arrangements but are considering establishing a guarantee fund.
- Stronger legal and regulatory framework for microfinance institutions still needed.

### Main findings and overall conclusion
- Considerable work is still needed to improve compliance with the Basel Core Principles (BCP).
- Authorities are commended for acting promptly on the most urgent measures once the CSBF became operational again.

### Summary assessment (by principle groups)
- Objectives, autonomy, powers, and resources (CP 1)
  - Legal framework allocates clear supervisory authority to the CSBF, but:
    - supervisory operational independence is not complete because the Minister can suspend CSBF de-licensing decisions for an eight-day period.
    - Strengthening of CSBF resources is ongoing.
    - Concerns exist that the financial situation of the BCM could impact adequate funding and staffing of the CSBF.
    - CSBF IT capacity, staffing and training opportunities have been reinforced (training supported by Banque de France, the World Bank and the Financial Stability Institute).
    - Supervisory officials have no explicit protection against lawsuits or legal defense costs; authorities agree more protection needs to be included in the law.
    - Group of Francophone Supervisors preparing formal arrangements for exchange of information with home supervisors (France and the Monetary Union of West Africa); arrangements with Mauritius are being formalized.
- Licensing and structure (CPs 2–5)
  - Banking law sufficiently describes permitted activities and prohibits use of the word “bank” by nonlicensed entities.
  - Bank licensing rules align with international good practice and are applied appropriately.
  - Minister’s eight-day reconsideration right limits operational independence and creates an opportunity for dissipation of assets that needs to be closed off.
  - Transfers of ownership, mergers, investments in other companies, voluntary closing and restructuring of capital are subject to supervisory approval.
- Prudential regulations and requirements (CPs 6–15)
  - Corrections required in regulatory definition of capital to fully conform to the Basel standard.
  - No explicit regulations on credit policies and asset quality review; internal control regulations are considered insufficiently strong and not specifically aimed at banks’ credit policies.
  - Off-balance sheet items should be covered by impaired asset rules.
  - Large exposure limits need stricter enforcement.
  - Authorities developing regulations on liquidity and interest rate risk; standards for exchange rate risk already in place.
  - Internal controls are adequately regulated.
  - A law against money laundering and financing of terrorism still needs to be operationalized.
- Methods of ongoing supervision (CPs 16–20)
  - CSBF is updating on-site inspection manuals and, with additional staff, will better implement its on-site program.
  - Off-site analysis and on-site inspections could be better integrated; more frequent on-site visits recommended.
  - CSBF has powers to set reporting standards and collect any information.
  - An electronic data storage system needs to be developed.
  - Supervision on a consolidated basis largely unnecessary given only one small holding abroad, but CSBF should be familiar with group structures.
- Information requirements (CP 21)
  - Starting in 2005, IAS are being applied; banking law will need to provide for supervision on a consolidated basis.
  - CSBF has powers to sanction inaccuracies in financial statements, review and veto external auditors, and require auditors to prepare reports on specific issues.
- Formal powers of supervisors (CP 22)
  - CSBF has sufficient remedial and intervention powers, including financial penalties, though Minister can delay withdrawal of a banking license for eight days.
  - Temporary administration can be imposed.
  - After reconstitution in March 2005, CSBF better able to exercise powers, although a past serious instance occurred when no corrective action was taken despite full composition of CSBF.
- Cross-border banking (CPs 23–25)
  - Agreements need to be concluded with foreign supervisory authorities on exchange of supervisory information.
  - Negotiations with Mauritian supervisory authorities are ongoing; Group of Francophone supervisors decided to formalize cross-border cooperation arrangements.

### Recommended Action Plan (selected items and authorities’ stated actions since the mission)
- CP 1(2) Operational independence and adequate resources
  - Recommended: Increase professional resources of the CSBF, in particular for supervision of microfinance institutions, and eliminate Ministerial power to delay license withdrawal by 8 days.
  - Authorities’ actions: 10 new professional staff recruited, of which 4 for microfinance, and 4 for on-site inspections. Authorization requested to hire 3 additional staff for supervision of microfinance institutions.
- CP 1 (5) Legal protection for supervisory officials and staff
  - Recommended: Introduce appropriate legal protection into the Banking Law.
  - Authorities’ actions: Language included in the draft revised Banking Law.
- CP 1 (6) and CP 25 Confidential exchange of information among supervisory agencies
  - Recommended: Formalize contacts with home supervisory agencies (WEAMU, France, Mauritius).
  - Authorities’ actions: Agreement with Mauritius awaiting finalization; decision taken within Group of Francophone supervisors to formalize exchange of information.
- CP 6 Capital adequacy
  - Recommended: Increase minimum capital adequacy ratio from 8 to 10 percent; align capital definition to Basel 1988 Accord; exclude reserve for general banking risks from Tier I.
  - Authorities’ actions: Authorities agree to raise minimum capital adequacy ratio to 10 percent; introduction of international accounting standards starting January 2005 implies exclusion of the reserve for general banking risks from Tier I, and relevant reporting form adjusted.
- CP 7 Credit policies
  - Recommended: Introduce specific regulation on banks’ credit policies, procedures and practices.
- CP 8 Asset quality and provisioning
  - Recommended: Include off-balance sheet items in regulation on internal controls.
- CP 9 Large exposure limits
  - Recommended: Enforce limits on large exposures.
  - Authorities’ actions: CSBF has started a program to discuss with banks outstanding breaches and the need to increase capital.
- CP 11 Country risk
  - Recommended: Issue specific regulation on country risk and transfer risk.
  - Authorities’ actions: Regulation on internal controls will shortly be amended to incorporate this.
- CP 13 Other risks
  - Recommended: Issue precise limits on liquidity risk, exchange risk and interest rate risk.
  - Authorities’ actions: Limit on open foreign exchange positions already issued; regulations on liquidity risk and interest rate risk are being drafted.
- CP 14 Internal control and audit
  - Recommended: Include conclusions of internal audit reports in on-site inspection program; provide training on internal controls to officials and staff of microfinance institutions.
  - Authorities’ actions: Agreed to use internal audit information for on-site inspections; training of staff and officials of microfinance institutions will be incorporated in the Millennium Challenge Agreement.
- CP 15 Know your customer- rules, ethical standards and prevention of criminal abuse
  - Recommended: Introduction of implementing regulations and instructions.
  - Authorities’ actions: Authorities are in the process of introducing regulations to implement new legislation against money laundering and terrorist financing.
- CP 16 Off-site and on-site supervision
  - Recommended: Fill two vacancies in supervisory staff; revise on-site inspection manual; introduce electronic filing of prudential returns; renewed attention to follow-up of inspections.
  - Authorities’ actions: Vacancies filled per 9/1/05; revision of manual underway; circular issued in August requiring electronic filing and shortening submission deadline from 25 to 15 days.
- CP 17 Contacts with bank management
  - Recommended: More frequent on-site inspections.
  - Authorities’ actions: Additional staff recruited; two additional inspections planned for remainder of 2005.
- CP 21 Accounting and audit
  - Recommended: Publication of financial statements by microfinance institutions, as required by law.
- CP 22 Corrective measures
  - Recommended: Draw up inventory of outstanding breaches and establish remedial program; introduce measures to penalize managers and power to prohibit dividend payments.
  - Authorities’ actions: CSBF has started a program to discuss with banks outstanding breaches of regulations.

### Authorities’ response
- Authorities submitted two rounds of comments to the detailed assessment; many technical and factual updates were incorporated.
- Authorities argued that assessment criteria did not require a training institute for supervisors so long as an adequate training program existed.
- Authorities considered that assessment of principles on credit policy and provisioning could be upgraded because these issues (including concentration risk) were addressed in regulation on internal controls.
- For the remainder, the assessment met with the broad agreement of the authorities.

*IMF staff summary of assessment and recommended actions contained in the source document.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06305.pdf_