Ann Laevskaya, IBA Financial Services Section Scholarship

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4 Ann Laevskaya, IBA Financial Services Section Scholarship

5 Liabilities in the financial sector; are the regulatory and contractual obligations placed on intermediaries in the financial sector set at the right level to promote a thriving market and avoid the next crisis? The classic example of a financial intermediary is a bank that consolidates deposits and uses the funds to transform them into loans. The term financial intermediaries also typically refers to private equity and venture capital funds, private pension funds, leasing companies, insurance companies, and microloans providers. Out of mentioned types of the financial intermediaries, Belarusian financial market is dominated by banks and insurance companies, which are subject to most detailed and comprehensive regulation and will be the primary focus of this essay. The leasing market emerged in 1991 and has been rapidly developing since then. In 2014 supervision over leasing companies was transferred from the Ministry of Economy to the National Bank and new regulation was introduced. The number of microloans providers is actively growing. So far activity of such companies has not been subject to keen attention of the state, resulting in exorbitant interest rates and outrageous fines for defaulting borrowers. Microloans providers are expected to be put under the supervision of the National Bank shortly and their activity will be heavily regulated. Collective investment institutions are almost non-existent. Few pension funds are functioning on the basis of insurance companies and several collective investment funds are managed by Belarusian banks. The legal framework for joint stock investment funds has been in place since 1992; however, no such funds are functioning at the moment. It is expected that the concept of a new law on investment funds will be developed by the end of 2014, while drafting and adoption of the law may take additionally two or three years. The law will provide the legal framework for joint stock investment funds and unit investment funds. Recently few companies emerged in Belarus, positioning themselves as private equity and venture capital funds. Those do not represent the collective investment institutions, but instead consolidate the

6 money of business angels, foreign private funds and international financial institutions. No specific regulatory framework for the activity of such companies exists. This essay considers the regulatory framework for the banks and insurance companies, as the biggest, most actively developing and most heavily regulated financial intermediaries in Belarus. The essay seeks connections between the level of liabilities placed on the financial intermediaries and promotion of successful, healthy and strong market on the one hand and prevention of the crisis on the other hand. Before proceeding with the review of the particular requirement in the finance sector, it is due mentioning that in Belarus the level of regulation of the financial markets per se does not have a direct connection with prevention of crisis. This is explained by peculiarities of Belarusian economy structure that per se may provoke or contribute to, the financial disorder and economic crisis. 70% of Belarusian GDP is produced by state-controlled companies. State-controlled companies often enjoy substantial benefits and subsidies from the state to keep them on the market, including cheap financial resources. Such structure of Belarusian economy is also associated with extra burden for budget in terms of salary increase and salary-related social payments for employees. In 2011 Belarus was hit by crisis that was accompanied by almost 180% devaluation of Belarusian national currency and hyperinflation breaking the 109% level. Though it was preceded by world financial crisis, the situation in Belarus in 2011 was determined to the large extent by internal reasons. The roots of the crisis are commonly attributed to excessive state spending and heavy government dominance in the country s economy. Prior to the crisis the government announced a number of government-directed lending programs to ensure modernisation of the Belarusian economy. This modernisation contributed to the current account deficit and heightened pressure on the exchange rate and foreign exchange reserves. The crisis was fuelled by generous administrative growth in salaries, pensions, minimum wage and other social benefits shortly before the Presidential elections in 2010, which lead to significant rise of demand for foreign currency and imported goods. The right level of regulation of the financial intermediaries activity is a precondition for a thriving market. It also influences the possibility of crisis and its consequences. However, such regulation alone, irrespective of its level and adequacy, is not able to prevent the crisis in Belarus due to specifics of Belarusian economy structure.

7 Banks Out of 31 banks functioning in Belarus, four of them are state-owned, holding the largest value of assets around 64% of the whole banking system. The National Bank performs supervision over the Belarusian banking system and acts as the registration authority for the newly established banks. Banks may be established by local and foreign shareholders, be it individuals or legal entities. There is a quota set up on the foreign capital participation in the Belarusian banking system. It amounts to 50% of the total volume of authorised fund of the banking system and is set by the National Bank upon approval of the President. Banks with foreign investments should obtain prior authorisation from the National Bank to increase the authorised fund of a bank using non-residents funds and to sell shares to non-residents. National Bank may establish restrictions on banking operations for foreign banks if similar restrictions on activities of banks with Belarusian investments have been imposed in the relevant foreign countries. Banking activity is licensed in Belarus. In order to obtain and maintain the license, the bank should ensure, inter alia, that: - it maintains the regulatory capital above the required threshold; - it is compliant with safe functioning requirements; and - adequate risk management and internal control system are established. The basic requirements ensuring safety of the banking system include the requirements to the authorised fund of the newly established bank and safe functioning requirements. The minimum amount of the authorised fund of a new bank, including a bank formed as a result of reorganisation, constitutes EUR 25 million. This requirement was introduced in June 2011, however, the operating banks have not been forced to adjust their authorised funds in accordance with the new requirement (previous minimum was EUR 5 million). The authorised fund may be formed with cash and certain other types of property. The minimum amount of the authorised fund should be paid in cash. Non-monetary contributions are allowed to the extent relevant property constitutes the fixed assets and is necessary for carrying out banking activity.

8 For the formation of the authorised fund of a bank, only own means of its founders may be used. I.e. the shareholders are not allowed to form or increase the authorised fund with the borrowed funds. Monetary contributions to the authorised fund of a bank may be made both in Belarusian roubles and in foreign currency. However, the entire authorised fund is declared and accounted in Belarusian roubles. In June 2012 in view of anticipated integration of the financial markets of Belarus, Russia and Kazakhstan, the requirements as to the minimum size of regulatory capital of banks that do not attract monetary funds of individuals to accounts or deposits and do not open and operate individuals bank accounts were revised. These banks should have increased their regulatory capital to EUR 15 million no later than 1 January 2014 (previous threshold was EUR 5 million). The requirement as to the minimum amount of regulatory capital will be unified for all banks in Belarus as of 1 January 2015 and will constitute EUR 25 million. Regulatory capital consists, inter alia, of the authorised fund. The regulatory capital requirement should be complied in Euro, while the authorised fund is declared and accounted in Belarusian roubles. Hence, upon devaluation of Belarusian rouble the regulatory capital substantially decreases and the banks and their shareholders need to take measure for increasing the regulatory capital through injections in the authorised fund, provision of subordinated loans or increase of the authorised fund at the expense of the bank s profit. Subordinated loans are usually a preferred choice, especially among banks established by foreign shareholders. However, the amount of the subordinated loan that may be considered for the purpose of regulatory capital calculation is limited. Other safe functioning requirements include regulatory capital adequacy requirements, liquidity ratios, risk concentration restrictions, foreign exchange risk restrictions, and requirements to the banks participation in the authorised capital of other profit-making organisations. The requirements are generally adequate, both from the perspective of promotion of thriving market and prevention of banks failure. However, the banks are far from being fully compliant with the requirements. As of 1 May 2014, almost half of Belarusian privately-owned banks do not comply with regulatory capital requirements or regulatory capital adequacy ratios. Partially, this is caused by reluctance of private shareholders to make injections in the authorised capital of the banks in view of potential

9 devaluation of respective contributions. In 2011 the devaluation swallowed up around 65% of the authorised funds recorded within the regulatory capital; in 2014 devaluation expectations are high again. In spite of this incompliance, during the past two years the National Bank took comparatively mild measures, including loosening foreign exchange risk restrictions for those increasing the authorised capital with contributions in foreign currency, introducing limitations imposed on the amount of attracted retail deposits from the individuals or, in the worst case scenario, prohibiting declaration of profit and payment of dividends to the shareholders. No banking licenses were recalled or suspended due to incompliance with regulatory capital requirements. In order to promote stability of the banking system, requirements to establishment of reserve funds and making mandatory reservations with the National Bank exist. On the date of approval of their annual reports banks are required to create a reserve fund not less than 5 per cent of the registered authorised fund. Standards for mandatory reservation deposited in the National Bank are as follows: - for retail deposits in Belarusian rubles 0 per cent; - for corporate deposits in Belarusian rubles 9 per cent; and - for the funds raised in foreign currency 13 per cent. Activity on acceptance of retails deposits and providing loans to individuals and corporate customers is subject to limitations. All banks accepting retail deposits are required to register with the Agency for Guaranteed Reimbursement of Bank Deposits, pay one-time registration fee and make quarterly contributions. Registration fee constitutes 0.5 per cent of the registered authorised fund. Quarterly contributions constitute 0.3 per cent of the remainder of the retail deposits attracted by the bank as of the beginning of the month following respective quarter. In view of pre-crisis situation in Belarusian economy and financial system the National Bank recently took certain measures to restrict lending pace, reduce loan rates, primarily on consumer loans, as well as to limit foreign currency lending.

10 Since 1 January 2014, the approach to assessing credit exposure risk in respect of loans to individuals, when calculating regulatory capital adequacy was changed. A risk weight of 200 per cent was set for loans at an interest rate exceeding the refinancing rate increased by 150 per cent but below or equal to three times that amount. For loans at an interest rate exceeding three times the amount of the refinancing rate a risk weight of 500 per cent was set. Thus, loans with annual interest rates exceeding per cent and up to 64.5 per cent belong to the VIII risk group with a risk weight of 200 per cent, while loans with an annual interest rate exceeding 64.5% belong to the IX risk group with a risk weight of 500 per cent. In addition, since 12 December 2013, for consumer loans at annual interest rates exceeding twice the amount of the refinancing rate (ie 43 per cent as of 19 May 2014) the banks are required to form a special reserve for potential losses on assets subject to credit risk of 100% of the total amount of those loans. The above mentioned measures are aimed at limiting the economic feasibility for banks to provide consumer loans at high interest rates. Since 15 January 2014, banks are prohibited from providing loans to Belarusian enterprises in foreign currency for settlement with residents of the country. The prohibition does not apply to attracting foreign currency loans by residents from non-residents. It also does not affect loans provided by banks from non-residents resources, connected with these loans in terms, amounts and currencies. Since 8 May 2014 the limitations on the maximum interest rates for loans to the legal entities were established. The decision was made in order to increase availability of loan facilities for the real economy. Under the new legislation, the interest rates for loans to the legal entities must not exceed average interest rate for new loans extended by the legal entities in Belarusian roubles, calculated and notified by the National Bank on monthly basis. In April such average interest rate constituted 39.4 per cent. The ceiling on interest rates will be in force until 1 January It is expected that during this period the interest rates in the economy will go down to adequate level and the financial situation will be generally more stable (ie interest rates on interbank loans and retail deposits go down as well). Insurance companies

11 The Belarusian insurance market is heavily controlled by the state. The Ministry of Finance performs supervision over the insurance market and acts as the registration authority for the newly established insurers. Foreign insurers, except for some cases, are not allowed to conduct insurance activity in Belarus, other than through establishment of a subsidiary and obtaining a licence for such subsidiary. There is also an obligation on the Belarusian legal entities, foreign legal entities that carry out their activities in Belarus, Belarusian citizens and persons with no citizenship that permanently reside in Belarus to insure their valuable interests in Belarus only with insurers authorised to run an insurance business in Belarus. Foreign investments in the Belarusian insurance sector are limited by 30 per cent quota. For the purpose of quota calculation, the total value of all contributions of foreign investors and their subsidiaries in authorised funds of insurers registered in Belarus is divided by the aggregate authorised funds of insurers registered in Belarus, multiplied by 100. Belarusian law provides for two types of insurance voluntary and mandatory, the latter making a substantial share in overall insurance. In 2013 payments under mandatory types of insurance constituted about 45.5 per cent of all insurance fees collected in Belarus. Unlike in the banking sector, where different players act in relatively uniform legal environment, the state and private insurance companies (especially those with foreign investments) clearly act under different rules of play. Mandatory insurance can be arranged only by state-owned and state-controlled insurance companies 1. Additionally, the insurance companies with the share of private (local or foreign) investors of at least 50% are prevented from insuring the interests of the Republic of Belarus, its territorial administrative units, state authorities, state legal entities, the legal entities in which the Republic of Belarus or its territorial administrative units own the controlling stake. Considering that 70% of Belarusian GDP is 1 State-controlled insurance company means insurance company with a state share of over 50 per cent in their authorised fund.

12 produced by state-owned and state-controlled enterprises, private insurance companies are allowed to act in a quite narrow niche. Insurance companies of foreign parent companies may not engage in the life insurance, property insurance related to delivery of goods, supplying services or performing contractor work for state needs, and insurance of the valuable interests of Belarus and its territorial administrative units. Since 1 July 2014 foreign subsidiaries will be able to engage in life insurance of the individuals. However, this is only a tiny step of long-expected liberalisation of the insurance market. Belarus is still far from introduction of fair rules of play for private and state-owned insurers and promotion of healthy and strong insurance market. Currently the insurance market is dominated by the state company Belgosstrakh, which share in the total volume of insurance fees collected by Belarusian insurers accounts for around 48.5 per cent. The requirements to the minimum amount of authorised fund of insurers are as follows: - EUR 1 million equivalent for insurers not engaged in life insurance; - EUR 2 million equivalent for insurers engaged in life insurance. - EUR 5 million equivalent for insurers exclusively involved in the reinsurance activity. The contribution of each founder to the authorised fund and respectively the share of each shareholder may not exceed 35 per cent of the company's authorised fund. An insurer must at all times have funds in its bank accounts with Belarus banking institutions in an amount equal to the minimum amount of the insurer's authorised capital. Since 1 July the requirements to the authorised fund of all insurers will be unified and will constitute EUR 5 million. Limitations on the maximum amount of share will be lifted. The existing insurers will have to increase their authorised funds gradually by 1 May Respective changes were adopted in anticipation of integration of the financial markets of Belarus, Russia and Kazakhstan. The insurers are required to form reserves out of the collected insurance fees and comply with the requirements to the investment of such reserves. The investment must be performed on the basis of recurrence, profitability, liquidity and diversity. State-owned and state-controlled insurance companies place funds with the state-owned banks and may invest funds of their reserves in the securities of the Republic of Belarus, the National Bank and

13 local executive authorities. Such investments may be performed only on the basis of agreements concluded with Belarusian state-owned banks. Additionally, state-owned and state-controlled insurance companies may invest their reserves in the securities of state-owned Belarusian banks (except for the shares) and precious metals, subject to their placement with Belarusian state-owned banks. Other insurance companies may invest funds of their reserves only in the following instruments: - securities of the Republic of Belarus, - securities of the National Bank, - securities of local executive authorities, - securities of Belarusian banks (except for shares), - securities of Belarusian legal entities (except for shares and promissory notes), - real estate (except for residential premises), - precious metals (except for waste) subject to their placement with Belarusian banks. The law also establishes the minimum or maximum amounts (in percentage) that must be invested in various instruments. The objects for investment of funds of insurance companies are limited and restrain flow of funds in the Belarusian economy and role of insurance companies as financial intermediaries. Belarusian law limits purposes of use of funds created by the insurance companies, including insurance reserve funds, guarantee funds, and prevention measures funds and assets, acquired out of such resources. In particular, insurance companies are prohibited: - to pledge securities, acquired out of the insurance reserve fund resources; and - to use otherwise insurance reserve fund resources and assets, acquired out of such resources in order to secure performance of obligations which are not connected with insurance activity. The Ministry of Finance carefully monitors compliance with requirements to investing the funds of the reserves. In 2014 licences of two private insurers were suspended, inter alia, for failure to comply with the requirements on formation of reserve funds and their proper investment. * * *

14 The right level of regulation of the financial intermediaries activity is a precondition for a thriving market. It also influences the possibility of crisis and its consequences. However, such regulation alone, irrespective of its level and adequacy, is not able to prevent the crisis in Belarus due to specifics of Belarusian economy structure. Belarusian banking legislation sets generally adequate requirements to the banks as financial intermediaries, both from the perspective of promotion of a thriving market and prevention of banks failure. At the moment, banks lending operations are heavily restricted; however, these measures are justified considering high interest rates in the economy. Legislation on insurance activity sets substantial preferences for state-owned and state-controlled insurance companies, restricting development of strong and healthy market. As the result, the insurance market is dominated by one state company, collecting almost half of the insurance fees. The objects for investment of funds of insurance companies are limited and restrain flow of funds in the Belarusian economy and role of insurance companies as financial intermediaries. Recently, Belarus increased the requirements to the regulatory capital of banks and authorised funds of the insurance company in view of anticipated integration of financial markets of Belarus, Russia and Kazakhstan. However, there are many challenges on the way of integration, associated with liberalisation of Belarusian financial market, on the one hand, and support of the national players, provision of Belarusian financial stability and prevention of future crises, on the other hand.