Mongolia's floundering economy is hitting the country's banks' growth, profits and asset quality. However, unlike previous such crises the lenders are coping well thanks in no small part to their impressive capitalisation. Stefania Palma reports.

Khan Bank

When the size of an economy is $12bn and population is about 3 million, economic shocks are likely to hit all areas of the market, including the banking sector. This is what is happening in Mongolia, an economy whose gross domestic product (GDP) growth has plunged from a high of 17.5% in 2011 to just 1.4% in June 2016, largely on the back of plummeting commodity prices and Chinese export demand nosediving in the past 18 months. China is the destination for the vast majority of Mongolia's exports.

Banks’ credit growth, profitability and asset quality are taking a hit as a result of Mongolia’s economic downturn. But, as opposed to past crises, the banking sector is remaining solvent. If credit squeezes in 2009 and 2012 led to bank failures, no lender has folded under the more recent pressure. 

Today, all eyes are on fintech as a growth market thanks to Mongolia’s high mobile phone penetration. But even here, for the sector to grow when the economy picks up again, Mongolia’s over-banked market is widely perceived to be in need of consolidation and a wider implementation of international governance and accountability standards if it is to fully benefit. 

Downgraded but solvent

Mongolian banks have gone through a lot in 2016. There was a turnover in government when the opposition, the Mongolian People’s Party, won elections with an overwhelming majority in June, all played out to a backdrop of a plummeting economy. Both Moody’s and Standard & Poor’s downgraded the Mongolian sovereign on the basis of low GDP growth, a weak balance of trade, a swelling fiscal deficit and mixed mining policies driving foreign investors away.

Moody’s has also downgraded eight Mongolian banks (Bogd Bank, Capital Bank, Golomt Bank, Khan Bank, State Bank, Trade and Development Bank [TDB], Xac Bank and Development Bank of Mongolia) on the back of the sovereign downgrade. “A return to a stable outlook for each bank would require a return to a stable outlook for the sovereign rating, as well as evidence that asset quality pressures can be contained within the review period,” says Moody’s.

But at the Invest Mongolia conference in Ulaanbaatar, Graeme Knowd, managing director, financial institutions group, at Moody’s Investor Services, underscored that Mongolian banks are better prepared to face this downturn than they have been during previous such episodes to have hit the country. 

Banks’ capitalisation has improved, with the sector’s Tier 1 capital ratio growing from 11% in 2011 to 13% in 2015. “Even if non-performing loans [NPLs] [in the banking sector] were to hit 20%, Mongolian banks would still be solvent,” says Mr Knowd. Battuvshin Badamdamdin, former CEO at state-owned State Bank, however, argues that banks need to grow capital further in preparation for a pick-up in growth.

On the funding and liquidity front, Moody’s deems Mongolia’s banking sector to be stable, considering it has access to funding from international financial institutions and is not reliant on commercial or market-sensitive funding.

Though on a downward trend, Mongolian banks’ profitability might start improving as the state's price stabilisation programme winds down. The programme involved the central bank financing commercial banks to help them address supply bottlenecks in the country. But the spread the banks earned on this lending was less than on traditional commercial financing.

Growing NPLs

While Mongolian banks have built stronger fundamentals, asset deterioration is a big area of concern. Principals in arrears increased by 76.9% across the sector in the year to August 2016, while NPLs grew by 22.3% in the same time period to Tg1058.2bn ($471.58m), according to the National Statistics Office of Mongolia.

Banks suffering the most are those focused on corporate banking, such as TDB. Corporate banking accounts for 85% of TDB’s profits, and its NPL ratio stands at 7.3%. Banks focusing on retail, such as State Bank, Khan Bank or Xac Bank, have lower NPL ratios at 2% to 3% and 5.6%, respectively.

But although the banks’ asset quality has deteriorated, Mr Knowd argues that NPLs in the sector are close to their peak as credit growth slows and no new loans are originated.

If loans were growing at 30% to 40% a year during Mongolia’s economic boom five years ago, in the year to December 2015, credit growth slumped to -5.7% across the banking sector. 

This drop is due in part to low credit demand – corporates and individuals tend to prefer saving during an economic slump. “People are not investing in new businesses, they’re not buying real estate and they’re not investing in new projects due to economic uncertainty. In times like these, people tend to save,” says Orkhon Onon, CEO at TDB. So while credit growth is dropping, banks are also benefiting from expanding deposit bases. In TDB’s case, deposits increased by 16% in the first half of 2016.

The credit squeeze is also due to banks not wanting to grow their books when the economy is doing poorly. “The market today is not conducive to [credit] growth. If we can maintain our credit portfolio where it is and work on the quality, we are happy with that. Blind market share growth is not good when the party’s over,” says John Bell, CEO at Khan Bank.

Bold Magvan, CEO at Xac Bank, says the bank started limiting credit growth three years ago in expectation of economic slowdown. “We did not grow credit, we toughened underwriting standards, we dropped exposure to US dollar loans, from 25% to 6% of total loans, and dropped deposit rates to get rid of expensive funding,” he says.

Record policy hike

A further blow to the banking sector this year came when Bank of Mongolia, the central bank, increased interest rates in mid-August by a record 4.5 percentage points to stop the currency from entering free-fall. The tugrik had lost 8% of its value in the first half of August.

While the need to halt the currency's depreciation was widely accepted, many bankers found the rate move to 15% excessive. “Increasing the policy rate was right but it might have been better to have a gradual increase. US dollar supply in the economy is limited as Mongolia is a small economy. Even if people had started buying dollars [due to a depreciating tugrik], the exchange rate would have stopped at some point. People would have sold dollars back,” says Mr Battuvshin.

“The policy hike was a drastic measure and a desperate move to stop the currency’s depreciation,” adds Mr Bold. “This is not sustainable mid-term. If the 15% rate stays, it will hit the private sector by sucking liquidity out of the banks.” Many expect banks to start investing in treasury bills, which will offer attractive yields with rates at 15%, rather than extending credit to the economy.

To Mr Bell, rates this high could even stifle economic growth. “I can’t see the economy growing with rates that high. It might spill into the mortgage market. Lending to house buyers at 18% is not going to work,” he said at the Invest Mongolia conference. 

Mortgage boom

So far, however, mortgages in Mongolia have boomed, mainly due to a government programme that provides commercial banks with cheap funding to underwrite mortgages at a subsidised rate of 8%. The programme aims to encourage dwellers of the Ger district, a shanty town surrounding Ulaanbaatar, to move into apartments in the city.

Middle-income Mongols piled into these mortgages, which are 8 to 16 basis points cheaper than mortgages set at the market rate. As of June 2016, there were Tg2900bn in outstanding 8% mortgages, which account for a chunky 31.5% of total loans in the Mongolian banking sector. The total volume of mortgages outstanding is even higher, at Tg3800bn.

The criteria to qualify for 8% mortgages is strict: the required downpayment is 30% and the property in question cannot be larger than 80 square metres. But having mortgages account for 41% of the banking sector’s loan portfolio has left many experts concerned. As Mongolia’s economy slows, unemployment might start creeping up, household incomes could drop and demand for real estate, whose boom is testified by construction sites at every Ulaanbaatar street corner, could slow down. “We might have to start worrying about mortgage repayments,” says Mr Battuvshin.

As of mid-September, however, Bank of Mongolia, the country's central bank, stopped giving commercial banks subsidised funding for 5% mortgages because it is no longer in line with Mongolia’s tightening monetary policy, says Ms D Ariunaa, a spokeswoman for the central bank. Bank of Mongolia also suspended financing for 8% mortgages because the central bank discovered commercial banks are misusing these funds, she adds. The central bank is not sure if or when the 8% programme will resume.

Retail rush

To navigate this choppy market, Mongolian banks are moving into retail and either avoiding corporate banking or minimising their exposure to the mining and construction sectors, both of which have been hit hard by the economic slowdown. Worries over companies’ ability to service debt are growing. If in 2015 the market slump mainly hit Mongolia’s largest corporates, now even smaller firms and sub-contractors are suffering, according to Mr Battuvshin. “This means staff numbers are decreasing. This might even affect the retail portfolio quality of retail-focused banks” he says.

Retail-focused banks such as Khan Bank and Xac Bank are keeping corporate banking to a minimum. “We are not aggressive in corporate banking because it is not prudent. We also don't pursue construction or mining sectors,” says Khan Bank’s Mr Bell.

Banks focused on corporate and trade finance, such as TDB, are now diversifying into retail. “For us, retail used to mean servicing staff of our corporate clients, but that means taking on the same risk. We want to go into mass retail now,” says Mr Orkhon. TDB’s aim is for retail to account for 30% of its profits, which is double the current figure.

But cracking the retail business in Mongolia is no easy task, as competition is fierce. “There are 14 banks competing for just 800,000 households,” says Mr Bold. In a market where the top five banks have a combined 90% market share, local bankers are largely in favour of bank consolidation and having larger lenders acquire smaller competitors. Having too many banks also increases competition for local deposits, which are a key source of bank funding in local currency.

The retail market is even more limited, as neither private banking nor the insurance market are highly developed. “We will focus on high-end retail and private banking, but mainly with VIP services and advisory. We cannot offer good wealth management when local capital markets are not very deep, the real estate market is volatile and banks are offering very high deposit rates,” says Mr Orkhon. 

Khan Bank is looking to become more competitive in retail by segmenting its customer base. “We are trying to change the factory approach of retail,” says Mr Bell.

Fintech opportunity

In an overbanked and competitive market such as Mongolia, local lenders see fintech as the next growth frontier. Electronic and mobile banking could help extend financial services across a country that is four and a half times the size of Germany and where herders live in remote areas with no bank branches in sight. 

“We don’t want to be competing with the bank next door. We want to be improving our fintech offering. We need to find ways to take advantage of all the customer data we already have,” says Mr Bell.

The data looks promising. As of June 2016, Mongolia’s mobile penetration was 110% (some users have multiple accounts) and smartphone penetration was 55%, according to telecoms operator Unitel. Mobile banking has also picked up outside the city, where herders use mobile phones for payments or money transfers.

“The platform for distributing banking products in a more efficient and cheaper way is there,” says Tuyen Nguyen, the International Finance Corporation’s resident representative in Mongolia.

Mongolia’s banking sector has come a long way since the creation of a private sector only 25 years ago, when the country became a democracy after decades of being a socialist Soviet satellite. Banks’ fundamentals are now stronger than ever. However, it will be worth keeping an eye out for deteriorating asset quality and swelling mortgage portfolios in the market. Mongolia’s banking sector also has room to improve when it comes to international standards of accountability and transparency. 

“To run the country properly, it needs rule of law, discipline, enforcement of the rules, and a proper governance structure from the top of the leadership down to corporate governance. At times this is ignored and it creates uninterrupted problems. Some bankers are doing well and learning fast, others are still learning,” says Mr Bold.

BOX: Building mortgage securitisation

As the volume of Mongolia’s 8% rate mortgages swelled, the government and local banks set up the Mongolian Mortgage Corporation (MIK) in 2013 to create a local secondary mortgage market. This has helped banks build liquidity and offload the mortgages’ asset risk on to MIK.

MIK's role is to buy 8% mortgages from commercial banks and sell them on as residential mortgage-backed securities (RMBS) mainly to the government, since these notes carry a coupon that is below market rate, according to Gantugs Damdin, CEO at MIK.

About 90% of the securitised mortgages are sold to Mongolia’s future pension fund in senior tranches that pay a 4.5% coupon. The remaining 10% are junior tranches that are sold back to commercial banks at 10.5%. So far, MIK has securitised Tg2400bn ($1.07bn) of the Tg2900bn outstanding 8% mortgage loans.

When asked about individuals’ capacity to service these mortgages now that the economy is nosediving, Ms Gantugs is not worried. “MIK has stringent rules that are followed when selecting the RMBS cover pool. There are requirements to be met both by the borrower and the commercial banks. We are very strict even if at the beginning it was not always popular among commercial banks,” she says. These measures have helped keep the non-performing loan ratio of MIK’s cover pool at 0.5%.

To Ms Gantugs, the 8% mortgage programme remains a success. “Mongolians need to have decent access to housing. The 8% programme has been key in incentivising this,” she says. As of mid-September, it was unclear if the 8% mortgage programme would continue after the central bank suspended funding. 


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