## _cr11107

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### Executive Summary — Macroeconomic setting and outlook
- The 2009 Stand-by Arrangement has been successful in restoring economic and financial stability.
- Economic growth is expected to surpass 10 percent this year.
- Real GDP growth could surpass 10 percent this year, following strong growth in the first three quarters fueled by investment in the mining sector, a surge in copper prices, and an expansion in coal exports.
- Inflationary pressures are emerging: the severe winter led to a sharp increase in food prices; a recent 30 percent increase in government wages and pensions is adding to inflationary pressures.
- Demand pressures are expected to mount further due to the construction and development of the Oyu Tolgoi mine, boosting imports and domestic demand and widening the current account deficit.
- The flexible exchange rate system was reinforced through non-discriminatory auctions of foreign exchange; the auction system for central-bank bills was improved with a new auction system for seven-day central-bank bills.
- Fiscal risk: parliament approved a 2011 budget that would raise expenditures 7 percent of GDP higher than the figure the authorities committed to in their last Letter of Intent under the SBA (which expired on October 1).
- The economy continues to rely heavily on mineral exports: mining and agriculture each contribute around 20 percent to GDP; exports exceeded 50 percent of GDP, with copper and coal accounting for more than half of exports.
- Foreign direct investment, especially in the mining sector, has triggered large foreign exchange inflows and international reserves are at an all-time high.

### Executive Summary — Structure of the financial system
- The Mongolian financial system is dominated by commercial banks: in September 2010, the 14 registered commercial banks accounted for 96 percent of total financial system assets.
- Banking system growth: yearly average asset growth of over 30 percent from 2006–09; in 2010, the ratio of total bank assets to GDP was 7 percentage points higher than in 2007.
- Non-bank financial sector is small:
  - The Mongolian life insurance industry is in its infancy; the first life insurer—National Life—commenced business in 2008.
  - The Mongolia Stock Exchange (MSE) has some 337 companies listed, with total market capitalization of MNT 1,180 billion.
- Dollarization: about a third of deposits are denominated in foreign currency, exposing the system to indirect credit risk (borrowers with local currency incomes and U.S. dollars–denominated debts) and solvency risk through currency mismatches.

### Executive Summary — Overall financial stability assessment
- Financial stability has been re-established but it is still delicate.
- The 2009 program helped stabilize financial markets; extreme pressures of 2008–09 have eased.
- Two state-owned banks were placed under conservatorship and will eventually be sold to strategic investors.
- Banking sector soundness indicators have improved since the 2008 crisis, but capital ratios are likely overstated:
  - The average non-performing loan (NPL) ratio declined from a peak of 20 percent in 2009 to 8 percent in 2010.
  - The system-wide Capital Adequacy Ratio (CAR) increased to 15.1 percent in 2010.
  - Reported CARs do not take into account expected losses from higher loan provisioning and inadequate risk weighting of interbank exposures.
- Weakest medium-sized banks: have not yet conformed to minimum capital requirements, have poor underwriting practices, and have been expanding their loan book.
- Principal vulnerabilities and risks:
  - Credit risk remains the principal vulnerability for banks.
  - Fragility is heightened by large single borrower and sectoral loan concentrations.
  - Cross-ownership linkages among banks and between banks and industrial companies have resulted in significant related-party lending and common borrowers across the system.
  - An increase in classified loans, a default of the banks’ single largest borrower, or a significant downgrade of performing loans to substandard would significantly erode the capital buffer of the banking system.
  - Banks are exposed to interest and exchange rate risks due to maturity mismatches and unhedged foreign currency lending.

### Executive Summary — Banking sector restructuring and regulatory framework
- The authorities have submitted to parliament the Empowering the Banking Sector and Capital Support Program, providing a comprehensive restructuring framework aimed at restoring solvency and ensuring banks’ medium-term viability.
- Bank-by-bank restructuring plans are supposed to be implemented as soon as parliament approves the Program, but prospects for its passing now seem slim.
- It is expected that bank restructuring costs will be borne by the budget and that BOM will be reimbursed for its expenses in connection with the Anod Bank resolution.
- The BOM permits regulatory forbearance; strict enforcement of regulatory requirements is lacking despite weak credit underwriting and governance.
- Supervision:
  - Compliance-based supervision continues as the norm; BOM is planning to switch smoothly to risk-based and forward-looking supervision.
  - BOM has incorporated market and operational risks in the calculation of capital adequacy ratios.
- Prudential regulations tightened recently:
  - New requirements mandate the recognition of restructured loans as nonperforming and the establishment of provisioning for excessive related-party loans.
  - Recognition of problem assets and increased loss provisions will reduce capital ratios and raise nonperforming loans.
- Further efforts needed in supervision and regulation, particularly:
  - Conducting risk-based supervision and implementing consolidated supervision.
  - Expanding fit and proper criteria for licensing, credit underwriting, and capital.
  - Adopting policies, procedures, and regulations on securities, accounting standards, and consolidated supervision.

### Executive Summary — Financial safety nets and crisis management
- The blanket deposit guarantee provided overly generous coverage and needs to be replaced by a well-designed deposit insurance scheme.
- The blanket guarantee helped bolster confidence during the crisis; authorities have recently tightened coverage by:
  - No longer covering interbank deposits.
  - Limiting coverage on interest earned on deposits in excess of the policy interest rate.
  - Netting guaranteed deposits against the depositor’s liabilities to the bank.
- The scope of the current guarantee remains extremely generous and the system requires fundamental reform.
- Crisis management actions recommended:
  - Develop time-bound remediation plans for banks that do not meet prudential requirements.
  - Develop a crisis management plan for the financial sector using the Financial Stability Council (FSC) as a vehicle for inter-agency cooperation.
  - Develop a plan for transition from the blanket guarantee to a well-designed, limited deposit insurance scheme.

### Executive Summary — Key recommendations (timing and priority preserved)
- Financial Stability (from Section II)
  - Strengthen the capital base of the banking system. Timing, Priority: ST, HP
  - Identify and monitor the loan quality of systemic exposures in the banking system and ensure that banks adequately provision for such exposures. Timing, Priority: ST, HP
  - Strictly enforce connected lending limits. Timing, Priority: ST, HP
  - Build appropriate data systems that allow tracking of bank ownership and inter-linkages between banks and other related parties. Timing, Priority: MT, MP
  - Enforce large exposure limits. Timing, Priority: MT, MP
  - Establish guidelines for foreign exchange lending. Timing, Priority: ST, MP
  - Conduct regular stress testing and scenario analysis exercises at the BOM and build capacity in this area. Require the individual banks to conduct regular stress tests under the supervision of the BOM. Strengthen BOM data monitoring systems to support the stress test exercise. Timing, Priority: ST, MP
- Financial Sector Oversight (from Section III)
  - Enforce existing legislation and halt the granting of forbearance. Timing, Priority: ST, HP
  - Develop a strategic plan for supervision. Timing, Priority: MT, HP
  - Improve communication and relationships within and outside the supervisory agency. Timing, Priority: MT, HP
  - Intensify efforts to effectively conduct risk-based and consolidated supervision. Timing, Priority: ST, HP
- Crisis Management Architecture (from Section IV)
  - Develop time-bound remediation plans for banks that do not meet prudential requirements. Timing, Priority: ST, HP
  - Develop a crisis management plan for the financial sector using the Financial Stability Council (FSC) as a vehicle for inter-agency cooperation. Timing, Priority: MT, HP
  - Develop a plan for transition from the blanket guarantee to a well-designed, limited deposit insurance scheme. Timing, Priority: MT, HP
- AML/CFT (from Section V)
  - Introduce measures for conducting overall AML/CFT risk assessments and risk profiling of institutions regulated by the Financial Regulatory Commission (FRC). Timing, Priority: ST, MP

### Development Bank of Mongolia: proposal and fiscal considerations
- The authorities are in the process of establishing the Development Bank of Mongolia as a state-owned limited liability company.
- Goal: to finance large public infrastructure projects and to provide credit to priority industries as defined in the government’s action plan.
- Financing plan: the government plans to finance the Development Bank through the proceeds of initial public offerings of government-owned mining companies in the MSE.
- Project stage and dependency: this project is at a very early stage and its success will depend on the authorities’ ability to make further substantial improvements in Mongolia’s capital markets.
- Fiscal and contingent liability risks:
  - The Development Bank could have significant fiscal implications, both directly and indirectly through guarantees and contingent liabilities.
  - Recommendation: the authorities should carefully consider the options for financing the Development Bank and their budget and other implications.
  - Governance recommendation: the Bank should be subject to a stringent set of guidelines and oversight to address these risks.

### Financial Soundness Indicators — exact statistics (2005–Sept 2010)
- Regulatory capital to risk-weighted assets: 18.2 (2005), 18.1 (2006), 14.0 (2007), 11.6 (2008), 5.5 (2009), 16.4 (June 2010), 15.1 (Sept 2010).
- Regulatory Tier I capital to risk-weighted assets: 15.8, 15.6, 11.8, 8.7, 2.3, 12.9, 12.1 (2005–Sept 2010).
- Capital (net worth) to assets: 13.6, 13.6, 11.3, 9.4, 4.2, 11.1, 10.6 (2005–Sept 2010).
- Non-performing loans (NPL) to gross loans 2/: 5.6, 4.7, 3.2, 7.1, 20.0, 7.7, 7.7 (2005–Sept 2010).
- NPL, incl. past due loans, to gross loans 3/: 8.6, 7.4, 5.3, 10.6, 24.5, 12.0, 10.3 (2005–Sept 2010).
- Provisions to NPL 2/: 99.2, 87.8, 87.1, 75.8, 67.4, 62.3, 64.0 (2005–Sept 2010).
- Provisions to NPL (incl. past due loans) 3/: 63.8, 55.6, 53.1, 50.9, 55.0, 40.2, 47.4 (2005–Sept 2010).
- Return on assets (before tax): 2.2, 2.7, 2.5, -1.5, -5.6, 1.7, 1.5 (2005–Sept 2010).
- Return on equity (before tax): 12.1, 14.3, 21.2, -21.2, -131.9, 14.0, 12.4 (2005–Sept 2010).
- Liquid assets to short-term liabilities: 19.8, 18.3, 27.4, 23.9, 31.8, 37.8, 33.5 (2005–Sept 2010).
- Foreign currency loans to total loans: 47.0, 23.6, 23.0, 33.6, 38.6, 35.1, 33.9 (2005–Sept 2010).
- Deposits to loans: 82.1, 83.4, 71.0, 60.1, 83.9, 80.7, 82.3 (2005–Sept 2010).
- Net open position in foreign exchange to capital: 27.4, 29.9, 30.3, 0.7, -9.7, 5.0, -0.2 (2005–Sept 2010).
- Caveats on reported CARs:
  - Reported CARs are overstated because: (i) provisioning requirements have been relaxed and do not account for some expected losses; (ii) exposures to the largest problem borrowers have not been adequately classified and provisioned; and (iii) some interbank exposures are not properly risk weighted for CAR calculation (20 percent instead of 100 percent).

### Stress testing vulnerabilities — scenarios, outcomes, and policy implications
- Scope and calibration:
  - Stress tests considered credit, liquidity, concentration, interbank contagion, foreign exchange, and interest rate risk, including single factor shocks and regression analysis conditioned on macro scenarios.
  - Shocks were calibrated—in agreement with BOM— using a combination of statistical methods and data from Mongolia’s 2008–09 crisis.
- Immediate findings:
  - After adjusting for new tighter provisioning on restructured loans and connected lending, three medium-sized banks with a market share of around 5 percent appear critically undercapitalized after adjustments, with CARs below 4 percent.
- Key stress-test outcomes (exact results preserved):
  - Five banks accounting for 15 percent of system assets would be undercapitalized as a result of a 40 percent increase in classified loans.
  - A simultaneous default of the banks’ single largest borrower would reduce aggregate CAR by 3.5 percentage points.
  - The system is vulnerable to severe shocks such as a downgrade of 30 percent of performing loans to substandard, or a simultaneous default of the banks’ two largest borrowers.
  - Interbank contagion: a simultaneous default of five medium-sized and small banks (accounting for 17 percent of banking system assets) could destabilize two other banks, including a systemically important one.
  - Sectoral concentration: construction, mining, and trade (together with agriculture and manufacturing) account for 66 percent of lending but for around 80 percent of NPLs.
- Market risk and interest rate shocks:
  - Direct FX and interest rate risks are largely contained, but indirect impacts on credit quality can be significant.
  - A 20 percent appreciation has, on average, a small impact; a 300 basis point decline in interest rates would lead only to a marginal deterioration in banks’ capital position. However, both would indirectly exacerbate credit risk by curtailing borrowers’ repayment capacity.
- Liquidity stress:
  - The system appears relatively resilient to a five-day deposit run leading to total outflow of around 20 percent of deposits, but two small banks (5 percent of system assets) would require liquidity assistance.
  - Aggregate liquid assets would fall to 7 percent of total assets as a result of the shock.
- Macro-driven credit quality:
  - High output volatility and high inflation can strain borrowers’ income and repayment capacity.
  - Inflation risks are high due to buoyant capital inflows and a planned large deficit for the next fiscal year.
- Regression-based scenario simulations:
  - High inflation scenario implies an average increase in banks’ NPL ratios of around 25 percent.
  - Slowdown (double-dip recession) scenario implies NPLs increase by 60 percent.
  - Simulations of a bank-by-bank stochastic VaR in Credit Risk Plus indicated aggregate CAR would fall to around 5.2 percent in the high inflation scenario and to 4.5 percent in the slowdown scenario, if such shocks materialize.
  - Recommendation: the BOM should issue directives to banks that fall below stated equity thresholds and take required corrective action, including appointing conservators or receivers when necessary.
- Policy recommendation on capital support:
  - Stress test analysis reveals the need to strengthen banks’ capital, undermined by the 2008–09 crisis.
  - Important to move ahead with the draft Bank Capital Support Program (BCSP), which was submitted to parliament for approval.
  - Observation: banks with lower capital buffers are more exposed to credit quality, concentration, and liquidity risks; several medium-sized and small banks are sensitive to simulated shocks.

### Selected stress-test table highlights (preserve reported figures)
- Table 4 (Selected Stress Test Results, June 2010):
  - Baseline capital adequacy (as reported) for Banking System: CAR 16.3, Tier 1 ratio 12.9.
  - Adjusted Base CAR for Banking System: 9.4, Tier 1 ratio 4.9.
  - Under a 40 percent increase of adversely classified loans, system CAR falls to 7.8.
  - Downgrade of 30 percent of standard loans to substandard reduces system CAR to 3.7.
  - Default of the single largest borrower yields system CAR 5.8.
  - Macro scenario unexpected losses (99th percentile VAR): Baseline unexpected losses 78.6 (banking system), Severe shock unexpected losses 100.8 (banking system).
- Table 5 (Distribution of Bank CARs, June 2010):
  - Adjusted capital adequacy ratios: number of banks with CAR <4 percent = 3; 4 percent to 14 percent = 5; >14 percent = 6. Asset share: <4 percent = 5.2, 4 percent to 14 percent = 58.0, >14 percent = 36.9.
  - Recapitalization needs (Adj. CAR case): MNT billions 178.9; in percent of GDP 2.3.
  - Sensitivity scenarios recapitalization needs range from MNT billions 159.5 to 327.4 and in percent of GDP roughly 2.0 to 4.1.
  - Macro scenarios recapitalization needs: High inflation scenario MNT billions 301.1 (3.8 percent of GDP); Slowdown scenario MNT billions 305.7 (3.9 percent of GDP).

### Banking system vulnerabilities and supervisory issues
- System exhibits vulnerability to credit risk, heightened by:
  - large single borrower concentrations
  - connected lending
  - under-provisioning
  - weak governance
- Cross-ownership linkages among banks and between banks and industrial companies create potential for risk spillovers and connected lending.
- Some banks have large interbank exposures and reportedly may use such funds to circumvent connected lending and large exposure limits.
- Progress since the 2007 FSAP and current supervisory issues:
  - BOM Bank Supervision Department (SD) issued risk guidelines, restructured the supervisory office to adopt risk-based supervision, conducted special independent audits of some banks, merged two banks, and placed another two under conservatorship.
  - Of the 14 commercial banks: three are 100 percent foreign-owned; four are partially foreign and partially domestically owned; six are 100 percent locally owned; one is state-owned.
  - Accounting and valuation standards: Mongolia has adopted International Financial Reporting Standards (IFRS), but compliance is limited.
  - Provisioning requirements (in percent):
    - Under Current Law: Performing 0, Past due 5, Substandard 25, Doubtful 50, Loss 100
    - Previous Provision: Performing 1, Past due 5, Substandard 40, Doubtful 75, Loss 100
  - Forbearance has been granted to a number of banks that would otherwise recognize net losses if required reserves were enforced.
  - In March 2009, the minimum capital adequacy ratio was raised from 10 percent to 12 percent of risk weighted assets.
  - At least three banks acknowledged capital shortfalls for which the SD has granted forbearance.
  - Consolidated supervision authority exists but legislation does not apply limits on a consolidated basis (e.g., single borrower exposure limits, related-party exposure limits, capital calculation).
  - Under the legal framework, BOM has an adequate range of supervisory tools for timely corrective actions, but failure to enforce laws has contributed to financial system fragility.

### Crisis management architecture and bank resolution
- Financial Stability Council (FSC):
  - Recent amendments established FSC; members: Governor of BOM, Chairman of the FRC, and a member of the government in charge of financial matters (Ministry of Finance).
  - Mission: evaluate financial sector safety and stability and warn the public about potential financial crises (bylaw adopted in April 2010).
  - FSC has met only twice, lacks institutional strength, and no formal rules for sharing information among members.
  - Recommendations: develop an effective crisis management process using FSC, clarify FSC mandate, put in place information sharing, and develop contingency plans aided by crisis simulation exercises.
- Bank resolution powers:
  - Under Article 48, BOM may appoint a conservator for a bank that falls below the equity threshold of 12 percent of risk-weighted assets but has equity above 2.4 percent of risk-weighted assets.
  - Receivership is mandatory when equity falls below 2.4 percent.
  - Conservator and receiver powers enhanced to enable restructuring, sale of assets, and transfer of assets and liabilities (Article 65).
- Emergency Liquidity Assistance (ELA):
  - BOM may extend credit as lender of last resort under Article 13 of the Central Bank Law if liquidity needs are temporary and borrower able to repay; assessment done by Supervision Department.
  - Liquidity facilities include repo transactions (policy rate+400 basis points), discrete repo auctions, a non-collateralized overnight facility, collateralized loans, and an intra-day facility.
  - Eligible collateral includes Central Bank Bills, Government bonds, short-term securities, and sovereign bonds.
  - Recommendation: issue a more precise regulation regarding collateral requirement for the intra-day facility to contain BOM’s risks.

### Deposit insurance — status, transition, and design considerations
- Blanket guarantee history and coverage:
  - Blanket guarantee introduced on November 25, 2008 for four years; amended in March 2009 and June 2010 to narrow coverage.
  - Currently more than MNT 3 trillion in deposits is covered by the blanket guarantee.
- Transition to limited deposit insurance:
  - Blanket guarantee should be transitory; plan to replace it with a limited deposit insurance scheme.
  - Banks now pay an annual fee of 0.5 percent of deposits; fees can be deposited in a special account at BOM to seed the new fund.
  - BOM and Ministry of Finance established a working group; an early draft of a deposit insurance law exists.
  - Transition planning recommendations:
    - Prepare a plan with a clear timeline and a strong public relations campaign clarifying coverage scope (e.g., only deposits in commercial banks, not NBFIs).
    - Undertake a situational analysis before transition to ensure banking system soundness and strong prudential supervision that halts forbearance.
  - Systems and legal requirements before adoption:
    - Put clear rules and procedures in place; ensure adequate systems to track insured deposits; ensure adequate financial resources.
    - Rules must allow prompt enforcement action and a pre-arranged source of back-up funding such as a government guarantee.
    - Membership in the deposit insurance fund should be compulsory for all banks accepting deposits from the public.
  - Mandate considerations:
    - BOM should carefully consider the deposit insurer mandate given available resources; common responsibility is ability to facilitate prompt payout for insured depositors.

### AML/CFT assessment (2007 FATF-style assessment and updates)
- The Asia/Pacific Group of Money Laundering conducted an assessment of Mongolia’s compliance with the FATF 40+9 Recommendations in 2007.
- Mongolia has a Law on AML/CFT and a Financial Intelligence Unit (FIU) established in 2006.
- Since 2007 significant progress: regulations governing commercial bank AML/CFT activity issued; agreement with Customs to monitor cross-border cash movements; Criminal Code amended in December 2009 to define money laundering crimes.
- FIU activity and resources:
  - FIU staff increased in 2010 to six.
  - Over 650,000 Cash Transaction Reports processed by the FIU as of October 2010.
  - FIU has Memoranda of Understanding with FIUs of eight countries and four local law enforcement authorities.
  - Eighteen on-site inspections since March 2009; FIU trains bank compliance officers twice a year.
- Remaining challenges:
  - Financial institutions have weak AML/CFT internal controls; compliance with Suspicious Activity Report filing is weak.
  - AML/CFT reporting for insurance, securities dealers, and NBFIs is nascent.
  - AML law has coverage omissions: foreign pawnbrokers, casinos, professionals and politically exposed persons.
  - FIU staff may lack sufficient legal protection; FIU is working with the Ministry of Justice to amend the law.

### Selected Risk Assessment Matrix entries (selected entries)
- Macroeconomic risk:
  - Heavy reliance on copper for economic growth and exports; Assessment: medium.
  - Although futures markets anticipate an increase in energy prices, copper prices are subject to sudden movements; Assessment: medium.
  - Expected impact: sudden reversal of copper prices will negatively affect financial sector stability and macroeconomic performance.
- Concentration risk:
  - The 20 largest borrowers at each bank (38 different entities) account for approximately 33 percent of net loans outstanding. The ten largest borrowers account for more than 10 percent of net loans outstanding. Assessment: medium.
  - Expected impact: failure of a large company would directly affect the banking system and the financial sector as a whole.
- Regulatory forbearance:
  - Asset quality is difficult to assess because permissible restructuring practices allow a bank to restructure a loan twice before it appears as “past due.” Assessment: high.
  - Supervisors have exercised regulatory forbearance; uneven implementation likely to result in weak capitalization. Assessment: medium.
  - Expected impact: continued lack of proper oversight of under-capitalized banks could lead to loss of confidence in BOM and financial instability.
- Inflation to interest rate and exchange rate risks:
  - Higher inflation due to procyclical fiscal measures. Assessment: medium.
  - Inflationary pressures are emerging from higher food prices, increased government wages and pensions, and increasing domestic demand from Oyu Tolgoi construction. Assessment: high.
  - Expected impact: realized inflation will affect the real value of assets and liabilities in the banking system, creating severe problems for sector stability.

*Source: Executive Summary, IMF staff report (content unit: _cr11107 - Executive Summary).*

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

### Executive Summary

### Macroeconomic setting and outlook
- The 2009 Stand-by Arrangement has been successful in restoring economic and financial stability.
- Economic growth is expected to surpass 10 percent this year.
- Real GDP growth could surpass 10 percent this year, following strong growth in the first three quarters fueled by investment in the mining sector, a surge in copper prices, and an expansion in coal exports.
- Inflationary pressures are emerging: the severe winter led to a sharp increase in food prices; a recent 30 percent increase in government wages and pensions is adding to inflationary pressures.
- Demand pressures are expected to mount further due to the construction and development of the Oyu Tolgoi mine, boosting imports and domestic demand and widening the current account deficit.
- The flexible exchange rate system was reinforced through non-discriminatory auctions of foreign exchange; the auction system for central-bank bills was improved with a new auction system for seven-day central-bank bills.
- Fiscal risk: parliament approved a 2011 budget that would raise expenditures 7 percent of GDP higher than the figure the authorities committed to in their last Letter of Intent under the SBA (which expired on October 1).
- The economy continues to rely heavily on mineral exports: mining and agriculture each contribute around 20 percent to GDP; exports exceeded 50 percent of GDP, with copper and coal accounting for more than half of exports.
- Foreign direct investment, especially in the mining sector, has triggered large foreign exchange inflows and international reserves are at an all-time high.

### Structure of the financial system
- The Mongolian financial system is dominated by commercial banks: in September 2010, the 14 registered commercial banks accounted for 96 percent of total financial system assets.
- Banking system growth: yearly average asset growth of over 30 percent from 2006–09; in 2010, the ratio of total bank assets to GDP was 7 percentage points higher than in 2007.
- Non-bank financial sector is small:
  - The Mongolian life insurance industry is in its infancy; the first life insurer—National Life—commenced business in 2008.
  - The Mongolia Stock Exchange (MSE) has some 337 companies listed, with total market capitalization of MNT 1,180 billion.
- Dollarization: about a third of deposits are denominated in foreign currency, exposing the system to indirect credit risk (borrowers with local currency incomes and U.S. dollars–denominated debts) and solvency risk through currency mismatches.

### Overall financial stability assessment
- Financial stability has been re-established but it is still delicate.
- The 2009 program helped stabilize financial markets; extreme pressures of 2008–09 have eased.
- Two state-owned banks were placed under conservatorship and will eventually be sold to strategic investors.
- Banking sector soundness indicators have improved since the 2008 crisis, but capital ratios are likely overstated.
  - The average non-performing loan (NPL) ratio declined from a peak of 20 percent in 2009 to 8 percent in 2010.
  - The system-wide Capital Adequacy Ratio (CAR) increased to 15.1 percent in 2010.
  - Reported CARs do not take into account expected losses from higher loan provisioning and inadequate risk weighting of interbank exposures.
- Weakest medium-sized banks: have not yet conformed to minimum capital requirements, have poor underwriting practices, and have been expanding their loan book.
- Principal vulnerabilities and risks:
  - Credit risk remains the principal vulnerability for banks.
  - Fragility is heightened by large single borrower and sectoral loan concentrations.
  - Cross-ownership linkages among banks and between banks and industrial companies have resulted in significant related-party lending and common borrowers across the system.
  - An increase in classified loans, a default of the banks’ single largest borrower, or a significant downgrade of performing loans to substandard would significantly erode the capital buffer of the banking system.
  - Banks are exposed to interest and exchange rate risks due to maturity mismatches and unhedged foreign currency lending.

### Banking sector restructuring and regulatory framework
- The authorities have submitted to parliament the Empowering the Banking Sector and Capital Support Program, providing a comprehensive restructuring framework aimed at restoring solvency and ensuring banks’ medium-term viability.
- Bank-by-bank restructuring plans are supposed to be implemented as soon as parliament approves the Program, but prospects for its passing now seem slim.
- It is expected that bank restructuring costs will be borne by the budget and that BOM will be reimbursed for its expenses in connection with the Anod Bank resolution.
- The BOM permits regulatory forbearance; strict enforcement of regulatory requirements is lacking despite weak credit underwriting and governance.
- Supervision:
  - Compliance-based supervision continues as the norm; BOM is planning to switch smoothly to risk-based and forward-looking supervision.
  - BOM has incorporated market and operational risks in the calculation of capital adequacy ratios.
- Prudential regulations tightened recently:
  - New requirements mandate the recognition of restructured loans as nonperforming and the establishment of provisioning for excessive related-party loans.
  - Recognition of problem assets and increased loss provisions will reduce capital ratios and raise nonperforming loans.
- Further efforts needed in supervision and regulation, particularly:
  - Conducting risk-based supervision and implementing consolidated supervision.
  - Expanding fit and proper criteria for licensing, credit underwriting, and capital.
  - Adopting policies, procedures, and regulations on securities, accounting standards, and consolidated supervision.

### Financial safety nets and crisis management
- The blanket deposit guarantee provided overly generous coverage and needs to be replaced by a well-designed deposit insurance scheme.
- The blanket guarantee helped bolster confidence during the crisis; authorities have recently tightened coverage by:
  - No longer covering interbank deposits.
  - Limiting coverage on interest earned on deposits in excess of the policy interest rate.
  - Netting guaranteed deposits against the depositor’s liabilities to the bank.
- The scope of the current guarantee remains extremely generous and the system requires fundamental reform.
- Crisis management actions recommended:
  - Develop time-bound remediation plans for banks that do not meet prudential requirements.
  - Develop a crisis management plan for the financial sector using the Financial Stability Council (FSC) as a vehicle for inter-agency cooperation.
  - Develop a plan for transition from the blanket guarantee to a well-designed, limited deposit insurance scheme.

### Key recommendations (from the Risk Assessment Matrix, Appendix I; timing and priority preserved)
- Financial Stability (from Section II)
  - Strengthen the capital base of the banking system. Timing, Priority: ST, HP
  - Identify and monitor the loan quality of systemic exposures in the banking system and ensure that banks adequately provision for such exposures. Timing, Priority: ST, HP
  - Strictly enforce connected lending limits. Timing, Priority: ST, HP
  - Build appropriate data systems that allow tracking of bank ownership and inter-linkages between banks and other related parties. Timing, Priority: MT, MP
  - Enforce large exposure limits. Timing, Priority: MT, MP
  - Establish guidelines for foreign exchange lending. Timing, Priority: ST, MP
  - Conduct regular stress testing and scenario analysis exercises at the BOM and build capacity in this area. Require the individual banks to conduct regular stress tests under the supervision of the BOM. Strengthen BOM data monitoring systems to support the stress test exercise. Timing, Priority: ST, MP

- Financial Sector Oversight (from Section III)
  - Enforce existing legislation and halt the granting of forbearance. Timing, Priority: ST, HP
  - Develop a strategic plan for supervision. Timing, Priority: MT, HP
  - Improve communication and relationships within and outside the supervisory agency. Timing, Priority: MT, HP
  - Intensify efforts to effectively conduct risk-based and consolidated supervision. Timing, Priority: ST, HP

- Crisis Management Architecture (from Section IV)
  - Develop time-bound remediation plans for banks that do not meet prudential requirements. Timing, Priority: ST, HP
  - Develop a crisis management plan for the financial sector using the Financial Stability Council (FSC) as a vehicle for inter-agency cooperation. Timing, Priority: MT, HP
  - Develop a plan for transition from the blanket guarantee to a well-designed, limited deposit insurance scheme. Timing, Priority: MT, HP

- AML/CFT (from Section V)
  - Introduce measures for conducting overall AML/CFT risk assessments and risk profiling of institutions regulated by the Financial Regulatory Commission (FRC). Timing, Priority: ST, MP

*Source: Executive Summary, IMF staff report (content unit: _cr11107 - Executive Summary).*

### 9.      The authorities are in the process of establishing the Development Bank of

### _cr11107 - 9.      The authorities are in the process of establishing the Development Bank of

### Development Bank of Mongolia: proposal and fiscal considerations
- The authorities are in the process of establishing the Development Bank of Mongolia as a state-owned limited liability company.
- Goal: to finance large public infrastructure projects and to provide credit to priority industries as defined in the government’s action plan.
- Financing plan: the government plans to finance the Development Bank through the proceeds of initial public offerings of government-owned mining companies in the MSE.
- Project stage and dependency: this project is at a very early stage and its success will depend on the authorities’ ability to make further substantial improvements in Mongolia’s capital markets.
- Fiscal and contingent liability risks:
  - The Development Bank could have significant fiscal implications, both directly and indirectly through guarantees and contingent liabilities.
  - Recommendation: the authorities should carefully consider the options for financing the Development Bank and their budget and other implications.
  - Governance recommendation: the Bank should be subject to a stringent set of guidelines and oversight to address these risks.

### II. OVERALL FINANCIAL STABILITY ASSESSMENT — key messages
- Financial stability is still delicate.
- The banking crisis of 2008–09 was a significant setback, highlighted by increased vulnerabilities in banks’ balance sheets.
- Post-crisis dynamics:
  - Banking system profitability fell, and nonperforming loans more than doubled.
  - Leverage in the banking sector was unchanged while loans as a share of GDP declined, suggesting more cautious behavior by both banks and customers.
  - The average Z-score of the system is still lower than pre-crisis levels, pointing to continued fragility.
- Major identified threats to financial sector stability:
  - Concentrated banking system lending due to few domestic investment opportunities.
  - Potential downside risk to growth, continuing weaknesses in supervisory practices.
  - Failure of systemically important banks or a loss of depositor confidence would have a devastating impact given the weak crisis management framework.
  - Regulatory forbearance and weak bank balance sheets—especially in medium-sized banks—exacerbate risks.

### A. Financial Soundness Indicators — findings and exact statistics
- Aggregate FSIs show partial recovery from the crisis; most indicators have recently strengthened.
- Selected indicators (preserve source table values exactly):
  - Regulatory capital to risk-weighted assets: 18.2 (2005), 18.1 (2006), 14.0 (2007), 11.6 (2008), 5.5 (2009), 16.4 (June 2010), 15.1 (Sept 2010).
  - Regulatory Tier I capital to risk-weighted assets: 15.8, 15.6, 11.8, 8.7, 2.3, 12.9, 12.1 (2005–Sept 2010).
  - Capital (net worth) to assets: 13.6, 13.6, 11.3, 9.4, 4.2, 11.1, 10.6 (2005–Sept 2010).
  - Non-performing loans (NPL) to gross loans 2/: 5.6, 4.7, 3.2, 7.1, 20.0, 7.7, 7.7 (2005–Sept 2010).
  - NPL, incl. past due loans, to gross loans 3/: 8.6, 7.4, 5.3, 10.6, 24.5, 12.0, 10.3 (2005–Sept 2010).
  - Provisions to NPL 2/: 99.2, 87.8, 87.1, 75.8, 67.4, 62.3, 64.0 (2005–Sept 2010).
  - Provisions to NPL (incl. past due loans) 3/: 63.8, 55.6, 53.1, 50.9, 55.0, 40.2, 47.4 (2005–Sept 2010).
  - Return on assets (before tax): 2.2, 2.7, 2.5, -1.5, -5.6, 1.7, 1.5 (2005–Sept 2010).
  - Return on equity (before tax): 12.1, 14.3, 21.2, -21.2, -131.9, 14.0, 12.4 (2005–Sept 2010).
  - Liquid assets to short-term liabilities: 19.8, 18.3, 27.4, 23.9, 31.8, 37.8, 33.5 (2005–Sept 2010).
  - Foreign currency loans to total loans: 47.0, 23.6, 23.0, 33.6, 38.6, 35.1, 33.9 (2005–Sept 2010).
  - Deposits to loans: 82.1, 83.4, 71.0, 60.1, 83.9, 80.7, 82.3 (2005–Sept 2010).
  - Net open position in foreign exchange to capital: 27.4, 29.9, 30.3, 0.7, -9.7, 5.0, -0.2 (2005–Sept 2010).
- Caveats on reported CARs:
  - Reported CARs are overstated because: (i) provisioning requirements have been relaxed and do not account for some expected losses; (ii) exposures to the largest problem borrowers have not been adequately classified and provisioned; and (iii) some interbank exposures are not properly risk weighted for CAR calculation (20 percent instead of 100 percent).
- Sectoral and portfolio observations:
  - Deterioration in credit quality strongest in construction, manufacturing, and agriculture; agriculture particularly affected by severe winter in 2009–10.
  - Recent improvements in NPLs in mining, real estate activities, and wholesale and retail trade.
  - Widespread loan restructurings mask problems in banks’ loan portfolios.
- Liquidity and funding:
  - Ratio of liquid assets to short-term liabilities increased to over 30 percent in 2010, but system remains exposed to liquidity risks.
  - Deposits-to-loans ratio has increased substantially since 2008; only a few banks have access to international capital markets.
- Foreign currency lending:
  - Foreign currency lending has increased recently; lending to unhedged borrowers renders system vulnerable to foreign exchange induced credit risk.
  - Net open position in foreign currency to capital shows increased exposure to exchange rate risk.
  - So far, overall impact of togrog depreciation should be positive, given most banks hold positive net open positions in U.S. dollars.
  - Recommendation: stronger limits on foreign exchange lending are needed.

### B. Stress testing vulnerabilities — scenarios, outcomes, and policy implications
- Scope and calibration:
  - Stress tests considered credit, liquidity, concentration, interbank contagion, foreign exchange, and interest rate risk, including single factor shocks and regression analysis conditioned on macro scenarios.
  - Shocks were calibrated—in agreement with BOM— using a combination of statistical methods and data from Mongolia’s 2008–09 crisis.
- Immediate findings:
  - After adjusting for new tighter provisioning on restructured loans and connected lending, three medium-sized banks with a market share of around 5 percent appear critically undercapitalized after adjustments, with CARs below 4 percent.
- Key stress-test outcomes (exact results preserved):
  - Five banks accounting for 15 percent of system assets would be undercapitalized as a result of a 40 percent increase in classified loans.
  - A simultaneous default of the banks’ single largest borrower would reduce aggregate CAR by 3.5 percentage points.
  - The system is vulnerable to severe shocks such as a downgrade of 30 percent of performing loans to substandard, or a simultaneous default of the banks’ two largest borrowers.
  - Interbank contagion: a simultaneous default of five medium-sized and small banks (accounting for 17 percent of banking system assets) could destabilize two other banks, including a systemically important one.
  - Sectoral concentration: construction, mining, and trade (together with agriculture and manufacturing) account for 66 percent of lending but for around 80 percent of NPLs.
  - Historical precedent: default of a gold mining company in 2008 undermined viability of several banks.
- Market risk and interest rate shocks:
  - Direct FX and interest rate risks are largely contained, but indirect impacts on credit quality can be significant.
  - A 20 percent appreciation has, on average, a small impact; a 300 basis point decline in interest rates would lead only to a marginal deterioration in banks’ capital position. However, both would indirectly exacerbate credit risk by curtailing borrowers’ repayment capacity.
- Liquidity stress:
  - The system appears relatively resilient to a five-day deposit run leading to total outflow of around 20 percent of deposits, but two small banks (5 percent of system assets) would require liquidity assistance.
  - Aggregate liquid assets would fall to 7 percent of total assets as a result of the shock.
- Macro-driven credit quality:
  - High output volatility and high inflation can strain borrowers’ income and repayment capacity.
  - Inflation risks are high due to buoyant capital inflows and a planned large deficit for the next fiscal year.
- Regression-based scenario simulations:
  - High inflation scenario implies an average increase in banks’ NPL ratios of around 25 percent.
  - Slowdown (double-dip recession) scenario implies NPLs increase by 60 percent.
  - Simulations of a bank-by-bank stochastic VaR in Credit Risk Plus indicated aggregate CAR would fall to around 5.2 percent in the high inflation scenario and to 4.5 percent in the slowdown scenario, if such shocks materialize.
  - Recommendation: the BOM should issue directives to banks that fall below stated equity thresholds and take required corrective action, including appointing conservators or receivers when necessary.
- Policy recommendation on capital support:
  - Stress test analysis reveals the need to strengthen banks’ capital, undermined by the 2008–09 crisis.
  - Important to move ahead with the draft Bank Capital Support Program (BCSP), which was submitted to parliament for approval.
  - Observation: banks with lower capital buffers are more exposed to credit quality, concentration, and liquidity risks; several medium-sized and small banks are sensitive to simulated shocks.

### Selected stress-test tables and summarized results (preserve table findings)
- Table 4 (Selected Stress Test Results, June 2010) highlights:
  - Baseline capital adequacy (as reported) for Banking System: CAR 16.3, Tier 1 ratio 12.9.
  - Adjusted Base CAR for Banking System: 9.4, Tier 1 ratio 4.9.
  - Under a 40 percent increase of adversely classified loans, system CAR falls to 7.8.
  - Downgrade of 30 percent of standard loans to substandard reduces system CAR to 3.7.
  - Default of the single largest borrower yields system CAR 5.8.
  - Macro scenario unexpected losses (99th percentile VAR) show very large numbers: Baseline unexpected losses 78.6 (banking system), Severe shock unexpected losses 100.8 (banking system) and extremely large unexpected losses reported for some groups (refer to table for exact cell values).
- Table 5 (Distribution of Bank CARs, June 2010) key entries:
  - Adjusted capital adequacy ratios: number of banks with CAR <4 percent = 3; 4 percent to 14 percent = 5; >14 percent = 6. Asset share: <4 percent = 5.2, 4 percent to 14 percent = 58.0, >14 percent = 36.9.
  - Recapitalization needs (Adj. CAR case): MNT billions 178.9; in percent of GDP 2.3.
  - Sensitivity scenarios show recapitalization needs ranging from MNT billions 159.5 to 327.4 across shocks and in percent of GDP roughly 2.0 to 4.1.
  - Macro scenarios recapitalization needs: High inflation scenario MNT billions 301.1 (3.8 percent of GDP); Slowdown scenario MNT billions 305.7 (3.9 percent of GDP).

### Policy implications and recommended supervisory actions
- Strengthen provisioning and classification practices to avoid overstated CARs (address relaxed provisioning, misclassification of exposures, and improper risk weighting of interbank exposures).
- Impose stronger limits on foreign exchange lending to limit FX-induced credit risk.
- Enhance crisis management framework and reduce regulatory forbearance; ensure timely corrective action for banks below equity thresholds (conservators/receivership).
- Proceed with the draft Bank Capital Support Program (BCSP) to rebuild capital buffers.
- Increase oversight of sectoral concentrations and interbank exposures to mitigate contagion and correlated-default risks.
- BOM should issue directives and take required corrective action for banks breaching equity thresholds.

*Source: IMF staff assessment as presented in the provided content unit.*

### 25.      The banking system has structural weaknesses, which stem from weak

### 25. The banking system has structural weaknesses, which stem from weak supervision and regulation.

### Banking system vulnerabilities
- System exhibits vulnerability to credit risk, heightened by:
  - large single borrower concentrations
  - connected lending
  - under-provisioning
  - weak governance
- Cross-ownership linkages among banks and between banks and industrial companies create potential for risk spillovers and connected lending.
- Some banks have large interbank exposures and reportedly may use such funds to circumvent connected lending and large exposure limits.

### Progress since the 2007 FSAP and current supervisory issues
- Upgrades and actions taken:
  - BOM Bank Supervision Department (SD) issued risk guidelines, restructured the supervisory office to adopt risk-based supervision, conducted special independent audits of some banks, merged two banks, and placed another two under conservatorship.
- Licensing and market structure:
  - BOM is the licensing authority and supervisor of banks.
  - Of the 14 commercial banks operating in Mongolia:
    - three are 100 percent foreign-owned;
    - four are partially foreign and partially domestically owned;
    - six are 100 percent locally owned;
    - one is state-owned.
  - Bank subsidiaries and affiliates are authorized to engage in certain activities under a license granted by the FRC of Mongolia.
- Legal and preconditions for effective supervision:
  - Comprehensive legal structure exists for companies, corporate and collateral registries, bankruptcy, taxation, insurance, the securities market and other financial subsectors, but weaknesses remain (lack of testing of laws, weak judiciary, amendments that mute effectiveness).
  - Accounting and valuation standards:
    - Accounting law passed in 1993 and updated sporadically.
    - Mongolia has adopted International Financial Reporting Standards (IFRS), but compliance is limited due to limited capacity, costs, and difficulties in implementation.
    - No standards for property valuation despite collateral-based lending.
  - Lenders face challenges accessing collateral due to debtor issues and a weak judiciary, making judicial recovery protracted.
  - Enforcement and discipline are uneven: BOM closed two banks in 2009 but SD has a poor record of enforcing securities laws and has granted forbearance in many cases without requiring substantive improvements.
  - Lack of coordination and meaningful information sharing between BOM and FRC despite an existing Memorandum of Understanding (MOU).
- Supervisory infrastructure weaknesses:
  - SD received extensive Technical Assistance but has yet to become an effective supervisor.
  - Effectiveness limited by weak enforcement, political interference, limited capacity, incomplete documentation of procedures, and lack of effective communication between the three divisions of SD.
  - Supervisory summaries and reports prepared by BOM supervisors are not provided to the FRC.
  - Banking supervision remains compliance-based; no timetable for moving toward risk-based supervision.
  - SD lacks a strategic plan for itself and the oversight of the banking sector, although a short-term action plan for 2011 was approved by Parliament.
  - Strong recommendation: develop a strategic plan to (i) enforce the legal framework; (ii) develop supervisory policies and procedures; (iii) enhance laws and regulations; (iv) build capacity of supervisory staff; (v) coordinate with domestic and foreign supervisors; (vi) conduct outreach to various stakeholders; and (vii) implement technical assistance.
- Legal reforms:
  - In January 2010, the revised Law on the Central Bank/Mongol bank and the Banking Law of Mongolia were approved by the Parliament. Many previous FSAP recommendations were addressed, but gaps and conflicts—mostly related to corporate governance and internal controls—remain.
- Asset classification and provisioning:
  - Regulation on classification of assets and establishment of loss provisions reissued in August 2010 is adequate; lack of enforcement renders supervision ineffective.
  - Provisioning requirements (table shown in source):
    - Under Current Law (in percent): Performing 0, Past due 5, Substandard 25, Doubtful 50, Loss 100
    - Previous Provision (in percent): Performing 1, Past due 5, Substandard 40, Doubtful 75, Loss 100
  - Forbearance has been granted to a number of banks that would otherwise recognize net losses if required reserves were enforced; given concentration in construction, mining, and agriculture, provisioning levels are grossly inadequate.
- Capital adequacy and forbearance:
  - In March 2009, the minimum capital adequacy ratio was raised from 10 percent to 12 percent of risk weighted assets.
  - A few banks raised capital via subordinated debt issuances, primarily convertible debt raised off-shore.
  - At least three banks acknowledged capital shortfalls for which the SD has granted forbearance.
- Consolidated supervision:
  - Authority for SD to conduct consolidated supervision incorporated into new Banking Law; banks, affiliated companies, and subsidiaries required to file individual and consolidated financial statements.
  - Restructuring and Policy Division of SD is working on a reporting format for consolidated statements.
  - SD must coordinate with FRC to obtain information on financial condition and risk management of different entities of banking groups.
  - Significant omission: legislation does not apply limits on a consolidated basis (e.g., single borrower exposure limits, related-party exposure limits, capital calculation).
- Corrective action powers:
  - Under the legal framework, BOM has an adequate range of supervisory tools for timely corrective actions, but failure to enforce laws has contributed to financial system fragility.

### The Financial Regulatory Commission (Box 1) — coordination and capacity
- FRC established in 2006 regulates securities market, insurance companies, non-bank financial institutions (NBFIs) and savings and credit cooperatives.
  - FRC currently regulates 387 institutions and has about 90 employees.
- Under amended Banking Law, FRC required to work with BOM to jointly adopt regulations on consolidated supervision and to work closely with the Financial Intelligence Unit (FIU) on AML/CFT initiatives.
- Recent joint examination of an insurance company by BOM and FRC noted, but more coordination and training needed to implement effective consolidated supervision.
- FRC chief is a member of the FSC, but no plan developed for FRC, BOM, and MOF to work together on crisis management or contingency planning.
- FRC is not given financial institution-specific information regularly; it receives aggregate data by BOM when needed.
- As financial sector evolves, the risk to entities supervised by FRC will increase; pressing need for better coordination between BOM and FRC.

### Crisis management architecture (IV)
- Establishment and role of FSC:
  - Recent amendments to the Central Bank Law established a Financial Stability Council (FSC) to ensure financial sector stability.
  - Council members: Governor of BOM, Chairman of the FRC, and a member of the government in charge of financial matters (Ministry of Finance).
  - Mission of FSC outlined in a bylaw adopted in April 2010: evaluate financial sector safety and stability and warn the public about potential financial crises.
  - Raising public awareness about potential banking crises is sensitive and should be handled carefully.
- Current FSC effectiveness issues:
  - FSC has met only twice and lacks institutional strength to perform necessary tasks for crisis management.
  - Most recent appointee for Secretary of the FSC did not have a financial sector background.
  - FSC met to discuss the bank restructuring program but was unable to bring the plan into effect.
  - No formal rules for sharing information among FSC members; members do not have the right to receive and review information and appear to work independently with little coordinated planning.
- Recommendations for crisis management:
  - Develop an effective crisis management process making use of a fully functional FSC to coordinate information sharing and crisis preparedness by all financial sector agencies.
  - Clarify the FSC mandate to establish its role as the lead organization for financial sector crisis preparedness.
  - Put in place additional information sharing processes to allow the FSC to understand vulnerabilities across the entire financial sector, including securities and insurance markets.
  - Develop contingency plans for possible crisis scenarios, aided by crisis simulation exercises.

### Bank resolution framework and emergency liquidity
- Bank resolution powers:
  - Banking Law amendments increased BOM powers to deal with problem banks.
  - Under Article 48, BOM may appoint a conservator (or take other corrective actions) for a bank that falls below the equity threshold of 12 percent of risk-weighted assets but has equity above 2.4 percent of risk-weighted assets.
  - Receivership is mandatory for a bank deemed insolvent; BOM ―shall‖ appoint a receiver when the bank’s equity falls below 2.4 percent.
  - Conservator powers enhanced: shareholder appeals cannot form the basis for overturning appointment; no requirement for shareholder approval to appoint a conservator; shareholders’ rights suspended during conservatorship; conservator can implement restructuring plans including sale of bank assets to third parties.
  - Receiver powers: full range of management and shareholder rights upon appointment; receiver may write down shareholder equity and reflect changes in financial statements; court challenges cannot prevent receivership decisions; under Article 65 receiver can transfer assets and liabilities to others enabling purchase and assumption transactions.
- Emergency Liquidity Assistance (ELA):
  - Design of ELA Facility is appropriate under Article 13 of the Central Bank Law: BOM may extend credit as lender of last resort under specified conditions, determining liquidity needs are temporary and borrower able to repay.
  - Assessment of a bank’s condition and solvency is done by the Supervision Department of BOM.
  - Liquidity facilities used by BOM include:
    - repo transactions initiated by banks with a fixed rate (policy rate+400 basis points)
    - discrete repo facilities initiated by BOM and executed on an auction basis
    - a non-collateralized overnight facility used for maintaining reserve requirements
    - collateralized loans to banks
  - Eligible collateral set by regulation currently includes Central Bank Bills, Government bonds, short-term securities, and sovereign bonds.
  - Risk management unit of BOM identifies collateral to be used for ELA.
  - Post-crisis, BOM introduced an intra-day facility to allow banks to execute transactions in connection with the real time gross settlement system.
  - Recommendation: issue a more precise regulation regarding collateral requirement for the intra-day facility to contain BOM’s risks.

### Deposit insurance: status, transition, and design considerations
- Blanket guarantee history and coverage:
  - Government established a blanket deposit guarantee in 2008 in response to the financial crisis.
  - Blanket guarantee provided by BOM introduced on November 25, 2008 for a period of four years; amended in March 2009 to include current accounts; amended in June 2010 to eliminate coverage for interbank deposits and expand restriction on coverage of deposits of related parties; guarantees for deposits with interest paid in excess of the Central Bank Bill rate no longer provided.
  - Currently more than MNT 3 trillion in deposits is covered by the blanket guarantee.
- Transition to limited deposit insurance:
  - Blanket guarantee should be transitory; current plan is for the government to replace it with a limited deposit insurance scheme.
  - Although original guarantee did not assess a premium, banks now pay an annual fee of 0.5 percent of deposits. Fees can be deposited in a special account at BOM to seed the new deposit insurance fund.
  - BOM and Ministry of Finance established a working group to discuss appropriate design and level of coverage; an early draft of a deposit insurance law exists.
  - Transition planning recommendations:
    - Prepare a plan with a clear timeline for transition and a strong public relations campaign clarifying what deposits are covered (e.g., only deposits in commercial banks and not deposits in NBFIs).
    - Undertake a situational analysis before transition to ensure banking system soundness and strong prudential supervision that halts forbearance to avoid moving to limited coverage when significant possibility of bank failures exists.
  - Systems and legal requirements before adoption:
    - Put clear rules and procedures in place before formal adoption of a new deposit insurance system.
    - Ensure adequate systems to track insured deposits, models for assessment of the deposit fund’s financial needs, and methods for collection of premiums.
    - Assure existence of adequate financial resources to meet insurance obligations.
    - Rules must allow prompt enforcement action against banks that threaten the solvency of the insurance fund or do not pay required premiums.
    - A pre-arranged and certain source of back-up funding such as a government guarantee is essential, although primary funding responsibility should be borne by member banks.
    - Membership in the deposit insurance fund should be compulsory for all banks accepting deposits from the public.
  - Core Principles:
    - The Core Principles for Effective Deposit Insurance Systems provide guidance on designing a limited deposit insurance scheme; Mongolian-specific circumstances should be considered within existing laws and powers.
  - Mandate considerations:
    - BOM should carefully consider the mandate for the deposit insurance scheme given available financial and human resources.
    - Deposit insurer mandates vary from narrow paybox systems to broader powers including preventive action and loss or risk minimization/management.
    - Common responsibility: ability to facilitate a prompt payout for insured depositors once a triggering event occurs (e.g., withdrawal of bank license or declaration of insolvency).
    - Planning for payout requires commitment of significant resources for IT systems, framework agreements with contractors and paying agents, and financial management expertise to collect and invest premiums.

*Source: _cr11107 - 25. The banking system has structural weaknesses, which stem from weak (PDF chapter/section).*

### 40.      An assessment of Mongolia’s compliance with the Financial Action Task Force

### An assessment of Mongolia’s compliance with the Financial Action Task Force

### Summary of the 2007 FATF-style assessment and legal framework
- The Asia/Pacific Group of Money Laundering conducted an assessment of Mongolia’s compliance with the FATF 40+9 Recommendations in 2007.
- Mongolia has a Law on AML/CFT and a Financial Intelligence Unit FIU was established in 2006.
- Since the 2007 Assessment, there has been significant progress on establishing an effective AML/CFT regime.
- Regulations governing commercial bank activity in regard to AML/CFT compliance have been issued.
- Agreement has been reached with Mongolian Customs officials to establish a system of monitoring cross-border movements of cash.
- In December 2009, the Criminal Code was amended to specifically define money laundering as a crime with a wide range of predicate crimes, providing for penalties upon conviction.

### FIU activity, resources, and cooperation
- The staff of the FIU was increased in 2010 to six.
- Over 650,000 Cash Transaction Reports have been received and processed by the FIU as of October 2010.
- The FIU has Memoranda of Understanding with the FIUs of eight countries and four local law enforcement authorities.
- Eighteen on-site inspections have been conducted since March 2009, with follow-up visits to banks when violations are found.
- The FIU conducts training for bank compliance officers twice a year.

### Remaining challenges and coverage gaps
- Financial institutions have weak AML/CFT internal controls despite some progress in banks’ operations.
- Compliance with the requirement to file Suspicious Activity Reports is a particular problem; relatively few such reports have been filed since 2008.
- AML/CFT reporting for the insurance sector, securities dealers, and NBFIs is just beginning, with significant additional work needed to create effective AML/CFT processes in those areas.
- The AML law has coverage omissions, specifically: foreign pawnbrokers, casinos, professionals and politically exposed persons.
- Staff of the FIU may lack sufficient protection under the existing AML/CFT legislation to carry out their duties without fear of prosecution under other laws.
- The FIU is working with the Ministry of Justice to amend the law to address many of these deficiencies.

### Key items from Appendix I. Risk Assessment Matrix (selected entries)
- Macroeconomic risk: Heavy reliance on copper for economic growth and exports, making the economy vulnerable to changes in copper prices.
  - Assessment: medium
  - Although futures markets anticipate an increase in energy prices, copper prices are subject to sudden movements and difficult to predict.
    - Assessment: medium
  - Expected impact: The financial and economic impact of a sudden reversal of copper prices will negatively affect the stability of the financial sector, and macroeconomic performance.
- Concentration risk: The industry is heavily exposed to large borrowers; in aggregate, the 20 largest borrowers at each bank (38 different entities) account for approximately 33 percent of net loans outstanding. The ten largest borrowers account for more than 10 percent of net loans outstanding.
  - Assessment: medium
  - In light of the continued concerns about the industry’s exposure to high-risk and large borrowers, the probability of further difficulties in the sector is non-trivial.
    - Assessment: medium
  - Expected impact:
    - The threat of a failure of a large company would directly affect the banking system, thus endangering the stability of the financial sector.
    - Difficulties arising from large exposures can affect not only the industry but also the financial system as a whole due to interconnected risks of a conglomerate.
- Regulatory forbearance: Asset quality is difficult to assess because of permissible restructuring practices, which allow a bank to restructure a loan twice before it appears as “past due.”
  - Assessment: high
  - Supervisors have exercised regulatory forbearance. The uneven implementation and enforcement of existing regulations is likely to result in weak capitalization.
    - Assessment: medium
  - Expected impact: The continued lack of proper oversight of under-capitalized banks could potentially lead to a loss of confidence in BOM and financial instability.
- Inflation to interest rate and exchange rate risks: Higher inflation due to procyclical fiscal measures.
  - Assessment: medium
  - Inflationary pressures are emerging from higher food prices, increased government wages and pensions, and increasing domestic demand from the construction of the Oyu Tolgoi mine. Planned fiscal spending increases add to inflationary pressures.
    - Assessment: high
  - Expected impact: If realized, inflation will affect the real value of assets and liabilities in the banking system, creating severe problems for the stability of the sector.

*Source: An assessment of Mongolia’s compliance with the Financial Action Task Force (FATF) 40+9 Recommendations, IMF staff summary as provided in the content unit.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11107.pdf_