The health of wealth: Despite setbacks, the sector looks set to enjoy a steady trajectory

In the two decades since Mongolia’s economy shifted to capitalism, it has endured several boom-bust cycles in its financial sector, as banking services professionals adjusted to their new paradigm and began learning the basics of risk management. Assets grew at a rapid pace nonetheless, with a compound annual growth rate (CAGR) of almost 32% from 2003 to 2009 according to Resource Capital, an investment bank specialising in Mongolia. But the period 2008-09 saw two banks fail as a result of economic overheating and internally driven inflation, with several smaller banks propped up by the state, which temporarily slowed growth rates.

Now, with the industry still recovering, another challenge is coming via the mining sector. Mining activity is surging and the key will be to manage the growth. How much the sector will add to the country’s GDP is still unclear, but a doubling or a tripling of it is not out of the question. One mining project alone, the Oyu Tolgoi gold and copper mine, is expected to expand the nation’s GDP by 33%.

Without it, though, growth is still high: the economy grew at a 16.7% annual rate in the first three quarters of 2011. According to a report by Citibank, Mongolia is likely to have the highest GDP growth rate of any country in the next two decades.

GROWTH OPPORTUNITIES: Such massive leaps provide a large number of opportunities for banks. As the new mining wealth filters throughout the general economy, it will create more government spending, more job opportunities, better infrastructure, and, taken as a whole, greater demand for loans and more sophisticated financial services.

Although the mining sector is not at this point a major employer, wage increases offer an indication that this is changing – salaries were projected to rise 53% in 2012, according to the Mongolian government. In the coming years, Mongolians will be applying for mortgages and financing car purchases in greater numbers than ever before, and more small and medium-sized enterprises (SMEs) will be on the hunt for capital as well. For the mining sector itself, Mongolia’s banks lack the size, expertise and capital to service the big international firms that will enter the market. Indeed, according to an overview of the industry from Golomt Bank, Mongolia’s second-largest lender, if the country’s top-five banks pooled all of their available lending capacity and gave it to the flagship Oyu Tolgoi project, it would amount to just 20 days of operating expenses.

STARTING SMALL: Instead, the aim is to capture new clients on a smaller scale, such as lending to services companies and domestic start-ups. Mongolia’s leadership is keen to make sure the benefits of the mining bounty stay in Mongolia, and getting the banking sector in good shape to participate in a meaningful way, even if in a support role to the larger global institutions, would be a great help. To do so, the banks are racing to get more capital and speeding up their learning curve on the intricacies of the mining sector and risk management.

“We anticipate growth to be in every segment,” said S. Sandagdorj, the deputy CEO of Savings Bank, one of the country’s five largest lenders. “Most of the banks will try to in some way be part of the mining sector boom. This growth will increase the income of the people and banks can tap into this new wealth, including mortgages and loans.”

DEMAND TRENDS: Demand is highly anticipated to pick up, but is also an ongoing concern in some ways. After a period of muted growth due to the trickledown effects of the global financial crisis, Mongolian banks are again coping with the rush, perhaps intensified in 2011 by pent-up demand after a period in which credit was difficult to acquire.

The loans-to-deposits ratio went from 75.5% at the end of the third quarter of 2010 to 88% in the same period in 2011; thus consumer spending is on the rise, and is likely to continue increasing. Retail banking is becoming more a part of the mix for lenders. In 2004, for example, for each tugrik lent to consumers, 1.6 had been extended to a private sector commercial client. By the end of 2010, however, that ratio had narrowed to 1.15.

SMEs are also expected to form a larger part of economic activity. The country has initiated several programmes to improve access to credit, as well as having lined up donor funds to help Mongolian lenders play their part in making sure there is enough working capital to help the economy grow.

“There will be greater demand for credit in the coming years as the economy goes into a strong growth phase,” according to a report on the Mongolian economy by the Hong Kong-based investment firm CLSA. “It is therefore key that the government continues its quest to further reform the industry, as a robust banking system is vital for sustained economic health.”

SIZE & SCOPE: The history of commercial banking in Mongolia is short – the first private bank in the country was opened in 1990. The country transitioned from a communist economy to capitalism in the same year, and one of the first government actions was to replace the former state bank with a traditional central bank and a short list of publicly and privately owned deposit banks. They inherited the defaulted loans of the disbanded state bank, and proceeded to make some of their own – crises caused by non-performing loans arose in 1994, 1996 and 1998, according to Resource Capital.

The year 2006 brought progress to the banking sector, however. A comprehensive financial regulator, the Financial Regulatory Commission, was formed. Banks are still regulated by the central bank – the Bank of Mongolia (BOM) – but the new body helped restore confidence. In the same year, numerous non-bank financial institutions were shut down after collapsing due to bad loans, and customers have been migrating to banks since then.

There have been two banks that failed in the past five years and the sector is still shaking off the impact of the global financial crisis. However, some headline statistics have remained positive throughout – the sector’s asset base grew on an annual basis even during the crisis. According to the most recent statistical update from the BOM, assets for the whole sector totalled MNT8.19trn ($6.39bn) at the end of the third quarter – 56% higher than the MNT5.26trn ($4.1bn) at the end of the third quarter of 2010.

MAIN BANKS: There are 14 commercial banks in Mongolia, although three have typically dominated the market, accounting for almost three-quarters of market share as of third-quarter 2011. The largest as measured by assets, Khan Bank, owned by Sawada Holdings of Japan and Tavan Bogd, holds 23.7% of market share, according to a sector overview by Golomt Bank. Asset growth reached 31.2% in the first nine months of 2011, according to the BOM.

The second-largest lender by assets is Golomt, which accounted for 23.4% at end-September 2011. The bank recently gained credit ratings from Standard & Poor’s (S&P) and Moody’s. It is considering going public on a foreign stock exchange in 2014 (none of Mongolia’s main banks are publicly traded on the Mongolian Stock Exchange). The Trade and Development Bank (TDB) was opened in 1990, just after the transition from socialism to capitalism, making it the oldest bank in the country. It has 20.9% of the market. In February 2012, Goldman Sachs announced it would acquire a 4.8% stake in TDB.

After the top three, classified as “category A” banks by the BOM, are two medium-sized banks. XacBank, which began in 1998 as a community development bank and microfinance provider before transitioning to a commercial lender, had a 9% market share as of third-quarter 2011. XacBank has retained some of its roots, as it is a main provider of microfinance, and obtains links and receives aid from donor funds interested in that mission. The other mid-sized bank is Savings Bank, with a share of 8.3%. It was established in 1996 as a state-owned enterprise and in 2009 took over operations of Mongol Post Bank.

Although the above five banks have significantly more heft than the rest, ranking the whole roster can be difficult as the fast growth is not uniform at all times, leaving the list somewhat fluid. As of early 2011 there were also 188 non-bank financial institutions and a total of some 207 cooperatives that offer basic savings and loans.

No foreign banks have been fully licensed in Mongolia as of yet, but the Dutch lender ING opened a representative office in 2008, becoming the first foreign presence in the country. London-based Standard Chartered announced the opening of a representative office in autumn 2011.

Another new actor on the scene is Development Bank of Mongolia, which was formally created in May 2011, to aid in the country’s national development. Its role is to provide loans for infrastructure, industrial and energy projects. It had planned on selling $600m worth of tugrik-denominated bonds internationally in 2011 or early 2012 with a sovereign guarantee. That would make them one of the first sovereign bonds offered in international markets by the country. The plan was to offer debt in five-, 10- and 15-year maturities. However, as of year-end 2011, only a modest amount of short-term notes had actually been issued.

Though its mandate includes national development, the new lender is not expected to disburse loans for projects that are not commercially viable, said L. Bolormaa, its first-deputy chief executive. “Projects need to be bankable and efficient,” she told OBG. “There will be other government support for non-economic projects.”

CREDIT COMPOSITION: In third-quarter 2011, 56% of credit was extended to private sector businesses, and 43.5% to individuals. The balance – around 0.5% – went to public sector borrowers.

The rate of default was 6.5%, down from a peak of 17.4% in 2009. By economic activity, the largest share of credit in first-half 2011 was extended to consumers and the whole and retail trade – about 18.8% of the total; – while the mining and quarrying sector took 12.1%, manufacturers took 11.4% and construction 11.1%.

Real estate comprised just 13.1% of the total, but that share is certain to increase because of housing needs. Estimates vary, but anywhere from about half to two-thirds of Mongolians live in felt tents called gers. These are traditional nomad dwellings but, particularly in Ulaanbaatar’s outskirts, people are increasingly pitching them without intending to move about with the seasons. The long-term trend in Mongolia is moving away from that traditional lifestyle and into a settled one. That means Mongolia needs a large building drive to satisfy housing demand.

“From 2010 to the present, we have seen prudent monetary policy from the government and the sector has become much more stable,” said A. Gerelmaa, the director of the loan division at Capital Bank. “As a result, we have seen an industry-wide increase in loans and mortgages. Our portfolio has increased by nearly 50% in the last 12 months.”

SOLVENCY: Though Mongolia’s banks were too small to have any direct exposure to the global financial crisis that started in late 2007, the country and its lenders were nonetheless profoundly impacted. Responding to the challenge has greatly helped improve risk management as well as regulatory oversight and the legal environment.

With lower demand for raw materials worldwide, including copper, Mongolia experienced a drop in the value of its currency, since fewer copper buyers needed it to complete their transactions. In 2008 the government passed a temporary measure providing comprehensive deposit insurance designed to protect banks against a run on deposits. The law mandates that the government guarantees most types of deposits until 2012. By that time, parliament is widely expected to have introduced a permanent partial deposit insurance scheme.

Mongolia’s previous domestic banking solvency problems were of a smaller scale, but by 2009, six years of a CAGR of 35% had boosted the systemic loan portfolio to $2.15bn. The crisis pushed up nonperforming loans (NPLs) in several key economic sectors – up by $60m in 2009 in construction, as some builders had to halt or abandon construction, for example. In part, the sudden lack of access to credit meant people could not get mortgages.

Mongolian banks had a harder time securing funds in international credit markets as well, further limiting local banks’ ability to use external funds to grow because the availability of local funds had been diminished. Total non-performing loans (NPLs) tripled on the year, to $435m. The central bank spent $77.6m adding liquidity to the system in 2009, through collateralised loans, reverse repurchase facilities as well as foreign currency swaps.

There were two banks that failed and had to be brought under state control. Anod Bank was taken over by the central bank in December 2008, amid reports of falsified accounts. Zoos Bank was placed in conservatorship in November 2009 with its operations partially succeeded by the new State Bank. Zoos’ failure was publicly attributed to excessive loan concentration, which gave rise to NPLs.

GROWING BALANCE SHEETS: Crisis or not, in some ways the sector kept growing. Total assets in the system actually increased in 2008 and 2009, although at a slower pace than in the mid-2000s. Total deposits shrank from 2007 to 2008 but, perhaps an indication of the underlying economic fundamentals in the country, started to recover almost immediately after 2008’s mid-crisis deposit insurance measure. The deposit base reached pre-crisis levels by the end of 2009, and as of the end of the third quarter of 2011 was at a record level of MNT2.6trn ($2.03bn).

Mongolians clearly view bank deposits as a good investment and that augurs well for the banks as long as current conditions apply, despite inflation rising at a pace that nearly wipes out interest gains – savings-account rates were at about 13% in late 2011, and inflation 10.5%, according to figures from the central bank. But the tugrik’s gain of 12.9% against the US dollar in 2010 nearly doubled the return on savings accounts, which suggests that part of the attraction of a bank deposit comes from currency appreciation. However, much of that currency appreciation was reversed during 2011 when the currency fell by 11.1% against the dollar.

RESPONSES: The 2008 deposit-guarantee law was the first legislative response to the crisis, and there have been more since. The biggest and most important was the 2010 Banking Law of Mongolia, a comprehensive law renovating the legal environment for banks, and a response to some of the weaknesses revealed by the crisis. Highlights include pegging the minimum amount of paid-in capital for banks at MNT8bn ($6.24m) and mandating that banks alert the regulator of significant changes in shareholder structure. “Shareholders with significant influence” in one bank are not allowed to amass similar holdings in others. Banks cannot pay dividends at the cost of meeting mandatory prudential ratios. Lending exposure to any one client is limited as well.

The original Mongolian banking law was approved in 1991, and set minimum paid-in capital at MNT50m ($39,000). It was subsequently amended in 1995, 1999, 2001 and 2006 before the 2010 update. “The changes the country has made are not enough; it is not possible to have all at once,” Sergey Gromov, the chairman of Chinggis Khaan Bank. “Changes within banking regulation over the last 10 years have improved it significantly and are on the right track. The banking regulations however, still need a lot of work, especially better implementation and application of the laws. Change happened so fast that people could not react and were not prepared to lead to a new era. This will take time.”

COMPLIANCE: The central bank plans to boost the minimum capital threshold again in 2013, doubling it to MNT16bn ($12.48m), according to local media. Bank officials said seven institutions have already amassed more than that level; however, as of September 2011 one banking executive told OBG that just three lenders were still below that threshold. Should any fail to make the deadline they will lose their licences and be forced to merge, sell or close. The capital increase may not be the only catalyst for consolidation, however, which is considered more likely in 2013 than in 2012.

Although only a select few banks currently follow a specific set of solvency and risk-management standards, such as the Basel II banking regulations issued by the Basel Committee on Banking Supervision, some of their familiar solvency ratios are applied in the country. For example, the minimum capital adequacy for banks is 6% for Tier 1 capital (common stock and disclosed reserves), and the total capital ratio must be at least 12%. That ratio combines Tier 1 and Tier 2 capital, which includes various other reserves, hybrid debt-equity securities and subordinated debt. The banks have thus far shown a tendency to respect the importance of solvency ratios – as of third-quarter 2011, for example, the largest lenders were significantly above the 12% minimum. Golomt Bank’s ratio was 14.7%, with Khan Bank ay 14.5%, followed by XacBank (12.9%) and TDB (12.5%).

However, with loan growth so high and several rounds of capital increases expected in the coming years, it is projected that these ratios will be subject to greater than normal fluctuations.

CAPITAL MARKETS: Concerns about the bankability of loans are also eating into confidence about banks’ capital adequacy. S&P, in a report initiating credit coverage of Golomt Bank, described its asset quality as “moderate” but also among the highest in Mongolia. “We believe the bank’s rapid loan growth since 2010 could weaken its asset quality, but this risk is partly offset by Mongolia’s strong economic prospects,” the S&P analysts wrote.

While Mongolian banks are likely to be seeking additional capital in the next few years, whether to meet the threshold or to scale up lending capacity, it appears that they are going to be doing so outside the country. At present, none of the main lenders are traded on the Mongolian Stock Exchange. The bourse has more than 300 equities listed, however trading activity is very light and many of the stocks are never or rarely traded. The majority of the listings were derived from the country’s transition from communism to capitalism, in which state enterprises were privatised by issuing shares to all Mongolians and creating a stock exchange.

OFFERINGS: The ability to raise capital within the country is limited, so the surge of international interest in investing in Mongolia means the banks big enough to tap international markets through bond or stock sales or direct investment will be able to do so.

Golomt Bank has said it is considering an initial public offering on a foreign bourse in 2014. XacBank has established a relationship with the Netherlands’ ING and Switzerland’s UBS to help it issue debt in any currency up to $430bn. The banks will not be the only major Mongolian companies eschewing local capital markets. Mongolia is considering listing shares in its state mining company, Erdenes Tavan Tolgoi, in order to raise capital to develop a massive coal deposit, and is going to need more than the domestic market can provide.

“There is not currently a wide range of debt products available in Mongolia where the debt market is primarily comprised of timed deposits, certificates of deposit, central bank bills, government bonds and corporate issues,” B. Bayarsaikhan, the CEO of National Investment Bank, told OBG. “A secondary debt market is presently non-existent in the country. Furthermore, access to some of these products on the primary market can be seasonal.”

Smaller banks that cannot tap into international markets will have fewer options and consolidation with larger local banks could occur. However, this may not necessarily be a negative move for some banks and may indeed help them in securing additional customers in the future. “The market consolidation is extremely important because it will create value among the local banks in the sector or we’ll risk losing a number of key projects to international players,” D. Bat-Ochir, the CEO of XacBank, told OBG.

LENDING TRENDS: The long-term trend has been fast growth in credit combined with the lowering of interest rates. In early 1998, lending rates were at 48% for tugrik-denominated loans, and 40% for dollar-based borrowing. By February 2010 the sector-wide average had fallen to about 20% and 14%, respectively. The trends are likely to continue, though single-digit borrowing costs could be a long way off, as the central bank can be expected to fight double-digit inflation rates by attempting to moderate economic growth by keeping its policy rates high.

“Foreign direct investment has increased dramatically and banks have started lending more aggressively both in retail and corporate,” Bat-Ochir said. The rate of credit expansion was in the high double digits for both 2010 and 2011. According to data from BOM, loans outstanding reached MNT4.59trn ($3.58bn) by the end of the third quarter of 2011, up 79% from the total of MNT2.56trn ($1.99bn) at the same time in 2010. Part of that represents pent-up demand, however, as the pace of loan growth halved during 2008 and then again in 2009 as a result of the global financial crisis. One of the main concerns for regulators and investors has been whether the growth will come too fast, bringing the risk of defaults and bailouts.

Bank capital has been increasing steadily. The aggregated total was MNT801bn ($622.7m) at the end of the third quarter of 2011, according to central bank data, and had increased 30% year-to-date. In the month of September 2011 alone, capital rose by almost MNT33bn ($25.74m), a 6.2% gain.

OUTLOOK: Mongolia’s banking sector lacks the option to develop at its own pace. It is the pace of the mining sector that is driving the rapid growth, as banks attempt to scale up their operations in time to service the needs of resource companies. Concerns about growth coming too fast are common, particularly until the expected round of capital increases further improves solvency ratios. For example, Golomt Bank was recently rated in new coverage by S&P, which assigned the Mongolian lender a “BB-/B” rating and a stable outlook.

A survey conducted by S&P considered Golomt’s “asset quality” – the likelihood of repayment of loans – to be moderate in comparison to global standards, but ranked them “among the best in Mongolia’s banking industry”. Furthermore, S&P also cited the expectation that the Mongolian government would be willing to step in to bail out its major banks as a cause for reassurance in buying banks’ bonds.