Looking ahead: A strong foundation despite ongoing challenges

As the Mongolian economy weakens, the country’s banking system faces challenges. Assets on balance sheets are looking far less solid and customers are finding it harder to service their loans as growth slows and as the boom of recent years comes apparently to an end. Nevertheless, the core of the Mongolian banking system is quite sound.

Banking During The Slowdown

The three best-managed institutions are regarded as keeping their books in good shape and are seen withstanding moderately severe shocks as the economy readjusts. The question is whether the second tier holds up and what weakness at that level means, if anything. The country has already weathered the collapse of one bank in recent months without incident. It is possible that trouble at the smaller institutions, should there be any, will be easy to contain and that the key institutions will come through unscathed.

The first report issued by Moody’s on Mongolian banks, dated April 11, 2013, sums up the situation nicely. While the ratings agency said that the outlook for the sector overall was negative, it rated the top four banks at that point as stable. The report demonstrated the existence of two distinct banking markets: one, with 78% of the deposits, which was in good shape, and the other possibly struggling.

The problem with the report is that much has changed since it was published: for instance, later in 2013 the number three bank in terms of deposits, Golomt, appeared to face troubles. However, despite the challenges, bankers have found cause for optimism. “Mongolia’s commercial banking sector will grow faster than GDP in the next five to 10 years, but the sector needs to focus on improving risk management and offering sophisticated products,” Norihiko Kato, CEO of Khan Bank, told OBG.

After The Boom

To a certain degree, the strains on the banking sector are just cyclical in nature. As in any boom and bust environment, an irresistible math takes over. Banks make more loans on the way up, and everything appears fine. The strong economy supports business, so companies and individuals are able to make their loan payments on time. Non-performing loan (NPL) ratios are further helped by the fact that the denominator is growing with the overall economy. On the way down, it is the opposite. Borrowers become stressed and less able to make their payments, while loan growth slows or reverses. NPLs rise rapidly, bank capital is strained and confidence on the part of depositors is shaken.

While Mongolia is still growing – 11.3% in the first nine months of 2013 – and NPLs have dropped from a peak of around 20% in 2009 to 4%, certain indicators in the real economy are worrying. The country is running a current account deficit and a trade deficit, foreign direct investment (FDI) has declined, coal exports are falling and, perhaps most importantly, the currency is down to historic lows. The tugrik has dropped more than 20% over the past year. It is possible that the country pulls out of the downturn and the metrics at the banks stay within safe limits. However, if the headlines numbers fail to recover, especially if FDI does not pick up, parts of the banking system could reach a breaking point.

The situation may be further exacerbated by the many programmes that are being undertaken to stimulate the economy and control imbalances within it. The country is working to address its issues, but at a cost. The Price Stabilisation Programme (PSP), for example, directs loans through the central bank to a number of sectors, including fuel supply, construction materials and consumer goods. In exchange for the low cost funding, the companies agree to maintain prices. An estimated MNT718bn ($422.3m) was disbursed through the PSP in 2013. A number of other programmes and policies have also been implemented. The central bank injected MNT900bn ($529.4m) into banks from March 2013 to the year’s end, according to the World Bank, and lent MNT430bn ($252.9m) to construction companies starting in June 2013. Recent efforts to boost home ownership amongst Mongolia’s growing middle class have also caused mortgage lending to increase substantially. In June 2013, the Bank of Mongolia provided MNT1.1trn ($647m) to banks at a 4% interest rate, with the goal of having this on-lent to qualified consumers as 20-year mortgages at 8%, around half the previous rate for home loans. To help mitigate the risks of the expected surge in borrowing, applicants were required to have constant income and provide a down payment of 30%.

After the introduction of housing programme, growth in mortgage financing went from an annual 30-40% range to 80-90% per year, with total mortgages outstanding up 48% in just three months, according to central bank data. In addition, about half of all existing mortgages were refinanced at 8%.

Possible Concerns

The risks are many. The role of the Bank of Mongolia in these programmes has caused worry for the World Bank, as it blurs the line between monetary and fiscal policy. The programmes have the potential to create bubbles, stoke inflation, further weaken the currency, distort the market and crowd out commercial enterprises. The 8% mortgage programme is especially rife with unintended consequences. While the intention is to lower the cost of housing and to make more of it available, the cheap money could lead to a rise in property prices and reduced affordability.

Perhaps most of all, the programmes have the potential to undermine the balance sheets of the country’s banks. While they are not required to take the money and make the loans, it is tempting to do so. These loans will likely produce small profits for the banks and could result in a lowering of asset quality and more bad loans in the sector.

“They will generate thin margins, and all the risks is on the banks,” said N. Oyunkhand, chief risk officer at Khan Bank. “The potential risk is huge if the bank does not follow proper credit procedures.”

The real estate sector is already shaky. Due to rapid growth in the past, even before the current subsidisation, a number of corners were cut during the development of projects. Proper approvals were not received and in some cases the land use rights may not have been legal. Several of the new buildings popping up on the south side of Ulaanbaatar lack basic services, such as electricity and water, because the rush to build outpaced the capacity of the utilities providers. However, bankers say that real estate is not the biggest problem for them. They note that significant demand exists and, importantly, that due diligence has improved, so the more marginal projects simply are not getting financed. This comes as the city government works to get illegal projects cancelled and substandard projects up to code.

While the mortgage market needs to be carefully monitored, the banks say that that is not what is keeping them up at night. With the trouble at Oyu Tolgoi, the initial public offering at Erdenes Tavan Tolgoi years out at best, and countless other projects on hold or cancelled, the mining supply chain and related subcontractors have come under pressure.

“Red lights are not blinking in the construction sector,” said Oyunkhand. “However, they are lighting up brightly for the mining sector.”

The falling currency may also be setting off alarms at some of the country’s banks. For Mongolia, this devaluation can be particularly stressful. The country imports most of its fuel and much of its food, so a weakening tugrik feeds almost directly into inflation. Moreover, Mongolia has no capital controls and dollars may be freely circulated. As a result, foreign currency plays a moderate role in the economy. This has resulted in many companies and some individuals borrowing in dollars, in part to lower their cost of funding (in late 2013, foreign currency loans were averaging some 12.02%, while local currency loans were at 18.82%, according to recent Bank of Mongolia data). As of February 2014, 29.2% of deposits and 28.3% of loans were in foreign currency.

Other Troubles

The larger trends are concerning and have the potential to significantly weaken the banking system. However, Mongolian banks are also facing other problems largely outside of their control, and management issues may have, in some cases, also contributed to weaknesses.

The collapse of Savings Bank, which had been ranked as the number five bank as of September 2012 – with a 7% market share in loans – was in part the result of a number of managerial errors. Among the problems facing the bank were a series of poor decisions and inadequate governance. According to press reports, the bank extended too many loans to related parties, including its parent, Just Group, which became insolvent in 2013. When Savings Bank collapsed, NPLs at the institution were equal to twice its capital. In addition, S. Batkhuu, the bank’s owner, borrowed some $20m from Standard Bank of South Africa, investing the proceeds into the Olon Ovoot gold mine and the domestic Savings Bank. Olon Ovoot contained significantly less gold than expected and Batkhuu defaulted on the loans.

Additionally, a dispute between Golomt Bank and two of its investors, Credit Suisse and the Abu Dhabi Investment Council, raised concerns throughout much of 2012 and 2013. The two foreign entities had lent the bank money under certain conditions, such as regular audits; however, Golomt Bank failed to produce a 2012 audit within the first three months of 2013 and serious concerns were raised about the bank’s corporate governance. The international community expressed concern and by August 2013, Moody’s was considering downgrading the bank’s rating because of the delay and because auditors had noted off balance sheet items. In November 2013, Moody’s withdrew its rating.

By early 2014, however, it appears that the dispute may have been resolved and Golomt Bank released independently audited financial results for the year 2013. Assets, deposits, loans, interest income, operating income and net profit were all up. The relevant ratios were also very much in line: NPLs, capital adequacy ratios (CAR), single-party exposure and total related party exposure.

It is possible that nothing is amiss. Bank of Mongolia has inspected Golomt Bank numerous times (regular and special inspections) and has said it found no major problems at the institution. The rating agencies have also noted that despite the recent problems at two of the country’s larger banks, the average Mongolian is unconcerned and carrying on. “Domestic depositor confidence in the banking system remains intact, and has so far prevented a systemic crisis,” wrote Fitch in July 2013. As long as runs are prevented, and as long as the off balance sheet issues are not too severe, the sector should be able to function normally despite the failure of one bank and the delay in reporting by another.

Confidence Boosters

Confidence will be helped by the introduction of deposit insurance. Since 2008, the banks have been backstopped by a guarantee for savings, whereby all deposits were guaranteed by the state following the turmoil of the global financial crisis. Current accounts were added in 2009, but after that the programme was curtailed. In June 2010, interbank deposits were no longer included and rules were added for deposits by related parties. A 0.5% fee was levied, but it was not strictly insurance. The state only promised to step in to prevent losses. That programme expired in late 2012 and was replaced by a more commercially oriented scheme. Under the new scheme, a special non-profit corporation has been created to provide something much like that found in other jurisdictions. An initial 1% levy is to be collected and from then on a maximum of 0.125% of the deposit amount is to be charged. A maximum of MNT20m ($11,675) per person or legal entity will be covered by the state.

Despite the concerns about the banking sector, it has many strengths and much going for it. The economy is, after all, growing still, and while the slowdown has been pronounced and resolution is needed on a number of outstanding issues, the country is not in recession. Supervision is lacking in some respects, but is nevertheless regarded as strong.

The Bank of Mongolia has placed stringent requirements on the banks. The single borrower limit is 20% of capital funds. Related party exposure is capped at 5% of capital and the CAR is at 12%. The entire sector as a whole has met these minimal criteria. According to Moody’s, the sector’s CAR in Mongolia, as of September 2012, was 15.1%, with tier one capital at 11.3%. Moreover, the central bank has taken aim at what it regards as the systemically important banks – Khan, TDB, Golomt, XacBank and Savings. It required them to lift their tier one capital to 8% and their overall CAR to 13% by December 2012 and to 9% and 14% by June 2013.

Mongolia, meanwhile, is surprisingly well banked, with 78% of the population having an account with a financial institution (according to 2011 World Bank statistics); the country has one of the highest number of branches per 100,000 in the world – 54 as of 2011 (compared with Korea’s 12). As of mid-2011, 80% of Mongolians had access to some sort of card for transactions and used debit cards more than people in Korea or China.

While Mongolia suffers from various issues related to its large landmass and small population, and some work is needed in terms of the in-branch experience – especially in the urban areas – the country has one of the more advanced banking markets among developing economies. The average Mongolian has good access in terms of the most basic banking services, and in the Ulaanbaatar the quality of the banking connectivity approaches or exceeds that in some Western markets.

Foreign Participation

Mongolia also benefits from foreign participation, both in terms of capital and expertise. Two banks are 100% foreign owned (Chinggis Khan Bank and Credit Bank), while four have foreign shareholders: Trade and Development Bank (TDB), Khan Bank, National Investment Bank of Mongolia and Transbank. The country has no limitation on foreign ownership of banks (unless the acquirer is state controlled) and no capital controls. The transfer of technology will certainly help the sector avoid crisis while the availability of international capital could be meaningful in the event of a downturn.

In January 2012, Goldman Sachs took a 4.8% stake in TDB and FMO, the Dutch Development Bank, bought $10m of the bank’s 10-year subordinated notes. Khan Bank raised $111m from the International Finance Corporation and foreign commercial banks in late 2013. Bigger moves may be in the offing.

A number of international banks have established legal presences in Mongolia, and much of the activity has been recent. ING was the first with a representative office, opened in 2008. Standard Chartered followed in 2011, while the Bank of China opened its representative office in January 2013, and Sumitomo Mitsui Banking Corporation and Bank of Tokyo Mitsubishi UFJ both came in October 2013. These moves, especially those in 2013, could be in preparation for opening local operating subsidiaries. Under bank licensing regulations adopted in 2012 by the Bank of Mongolia, a foreign bank needs a representative office in place for one year before it is allowed to open a local subsidiary. According to the bank’s rules, a subsidiary is needed to conduct business (not just a branch). Banks that set up representative offices in 2013 would be able to apply to incorporate and operate locally in 2014, though they would have to receive permission and meet a number a stringent requirements before that could actually happen. For example, they would need MNT65bn ($38.2m) in capital.

Foreign Fears

Some worry that a major foreign bank doing local business would virtually wipe out the local banks, as they would have the capital, access to cheap funds and technology not available to Mongolian banks. However, it is not exactly clear why a major international bank would want to do business locally. The biggest and possibly the best business deals – those done with major mining firms or the large Mongolian groups – can be handled offshore already. Over $1bn has been lent internationally to Mongolian companies, directly – by foreign banks, via syndication, from multilaterals, or from a combination of multilaterals and commercial lenders – or raised in the Eurobond market. Among the companies accessing funds outside Mongolia’s borders are MCS Coca-Cola, Xac Bank, Khan Bank TDB, Newcom Group and Mongolia Mining Corporation. For most major lenders, it is possible that little would be gained by having a local presence.

With or without significant foreign participation, it is certain that consolidation will take place. Already, the number of banks has dropped from 17 in 2005 to 13 now. But the sense is that a number of the smaller lenders, those not considered systemically important, could be merged or closed. Mongolian bankers say that this process is actually important to the system. Some of the smaller institutions, they argue, are paying excessively high deposit rates in order to attract funds. Because most savers do not bother distinguishing between the banks in terms of creditworthiness, they tend to simply to gravitate towards the highest returns, putting pressure on all banks to pay dangerously high interest. A consolidation would help stabilise the market by leaving it with only the stronger and more conservative players.

Outlook

The key to the future for the Mongolian banking sector is good corporate governance and sound regulatory supervision. Little can be done to stop the volatile cycles in the economy, but the banks and the regulators can make sure that institution stay in as good shape as possible during the ups and downs and that policy does not worsen matters during challenging times. Particular attention must be paid to the financials and the way the way key ratios are calculated and reported.

Moody’s, for example, notes that while the benchmark numbers may be high on paper, they may not accurately reflect the realities of the balance sheets. According to the ratings agency, the average CAR for banks is more than sufficient in theory, but that might be in part the result of failure by the banks to properly classify impaired loans and in part the result of improper risk weighting. Moody’s also makes note that the ratios are not all that high given the rapid growth of the economy.

If the main banks can honestly report the state of their assets and the regulators can steer a steady course through these turbulent times, and if strategic investors are able to come into the market when needed, the core of the sector should remain solid, solid enough to hold up even if the rest find the going tough. However, if discipline slips and if numbers are massaged for the sake of good reports, then confidence could suffer. Already, rumours have been flying around the capital concerning what may or may not be happening within the banking system, and whether or not any of it is true, the uncertainty is unsettling the markets. Banks need to stick to the proper limits and the central bank needs to make sure that they are generating accurate reports.