Financial Mirror, Cyprus
Dec 28 2007

Stable outlook for Armenian banks, but challenges remain

28/12/2007

The credit outlook for rated Armenian banks is stable, reflecting an
evolving regulatory framework, buoyant credit growth, low banking
penetration, robust aggregate capitalisation and good asset quality,
Moody’s Investors Service said in its new Banking System Outlook for
Armenia.

These strengths are offset, however, by the challenging operating
environment, potential for accelerated asset quality deterioration
due to the unseasoned nature of loan portfolios, as well as real
concerns regarding operating risk due to under-developed
infrastructure.

The Armenian banking sector has undergone considerable consolidation
in the past decade following the banking sector turmoil of the
mid-1990s and subsequent tightening of prudential regulations.

Moody’s noted that the system, comprising twenty-one banks, remains
highly fragmented, however, the four largest banks control 45.54% of
total banking system assets and the ten largest banks 79.61%. In its
current structure, the Armenian banking sector lacks economies of
scale, resulting in low productivity and thereby raising the
potential for further market consolidation.

Armenia’s regulatory environment is evolving, having made significant
progress since the mid-1990s. On 1 January 2006, the Law on the
Establishment of a Unified System of Financial Regulation and
Supervision (242N/2005) came into force, appointing the Central Bank
of Armenia (CBA) as the sole regulatory and supervisory authority for
all financial services in Armenia.

To better perform its new duties, CBA has been reorganised along both
operational and functional lines. CBA enforces stringent liquidity
requirements, and will introduce Pillar I requirements for Basel II
from 2008. Moody’s notes that regulation is improving from a
historically low base, however, and could benefit from further
refinement and better infrastructure and risk controls.

Favourable conditions have driven buoyant credit growth over the past
year. In particular, according to CBA data, consumer credit grew by
35% while mortgage lending registered a growth of 114%.

Moody’s maintains a generally positive view regarding banks’ efforts
to expand their retail and mortgage lending operations, although the
rating agency emphasises that fast credit expansion could result in
elevated non-performing loans (NPLs) for the system in an economic
downturn, particularly as loan portfolios are not seasoned. As the
country’s nascent banking sector evolves and the sector’s loan book
term structure lengthens, Moody’s expect NPLs to grow to levels
observed in other countries at similar stages of development.

Banking penetration in the country remains low, however, despite the
good credit growth of recent years.

"As a transitional economy, the country continues to grapple with a
historical lack of public confidence in banks and a largely
cash-based system," said Stathis Kyriakides, a Moody’s analyst and
author of the report. Nevertheless, this offers great potential for
further growth, particularly in the SME and retail sectors.

To date, HSBC-Armenia is the only domestic bank majority-owned by a
large, highly rated international banking group, but recent years’
relative geopolitical stability, economic growth, low banking sector
competition and high spreads are starting to attract other
international banks. In such circumstances, locally owned, smaller
banks may find it increasingly difficult to compete, leading to
sector consolidation. "To the extent that consolidation leads to
stronger franchises for rated Armenian banks, this is likely to have
positive rating implications in the medium term," said Kyriakides.

Meanwhile, extensive borrowing in foreign currency, mainly US
dollars, has exposed customers to foreign-exchange (forex) risk.
Although this has been mainly driven by the population’s historical
mistrust of the local currency, as well as lower US dollar interest
rates and the dollar’s weakness in recent years, foreign currency
lending has been facilitated by Armenian banks ostensibly hedging
their own forex open positions arising from foreign-currency credit
lines from international institutions.

Moody’s cautions that a potential depreciation of the Armenian dram
could result in customers facing difficulties in servicing their
obligations, leading to currency-induced credit risk for banks.

Nevertheless, the weight of foreign-currency loans as a proportion of
total loans has decreased significantly in recent years, from a high
of 78% of total loans in 2002 to around 42% towards the end of 2007.
"If the weight of foreign currency-denominated loans continues to
contract at current rates, our concerns are likely to be alleviated,"
said Fimi Gostanian, a Moody’s Senior Associate and co-author of the
report.