Second Financial Sector Program

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ASIAN DEVELOPMENT BANKOperations Evaluation Department

PROGRAM PERFORMANCE EVALUATION REPORT

FOR

MONGOLIA

In this electronic file, the report is followed by Managements response.


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Performance Evaluation Report

Operations Evaluation Department

Reference Number: PPE:MON 2007-37Project Number: 30101Loan Number: 1743-MONDecember 2007

Mongolia: Second Financial Sector Program


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CURRENCY EQUIVALENTS(as of 30 June 2007)

Currency Unit togrog (MNT)MNT1.00 = $ 0.000852

$1.00 = MNT1,173.70

ABBREVIATIONS

ADB Asian Development BankBIS Bank for International SettlementsBOM Bank of MongoliaCAR capital adequacy ratioCIB Credit Information BureauCDS Central Depository SystemFRC Financial Regulatory CommissionFSAC financial sector adjustment creditFSPL Financial Sector Program Loan

FSRP financial sector reform programFX foreign exchangeGDP gross domestic productIAS International Accounting StandardsIDA International Development AssociationIMF International Monetary FundISU Insurance Supervision UnitJSC joint-stock companyMARA Mongolian Asset Restructuring AgencyMIS management information systemMOF Ministry of FinanceMSE Mongolian Stock Exchange

MSEC Mongolian Securities and Exchange CommissionNBFI nonbank financial institutionNPL nonperforming loanOED Operations Evaluation DepartmentOEM operations evaluation missionPCR project completion reportPPER program performance evaluation reportPRGF poverty reduction growth facilityPRO Property Registration OfficeROA return on assetsROE return on equitySCC savings and credit cooperative

SCS Securities Clearing SystemSCHCDS Securities Clearing House and Central Depository SystemSME small and medium-sized enterpriseSML Securities Market LawSOE state-owned enterpriseSPC State Property CommitteeSSIGO State Social Insurance General OfficeTA technical assistanceTDB Trade and Development Bank


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NOTES

(i) The fiscal year (FY) of the Government and its agencies ends on 31 December.

(ii) In this report, "$" refers to US dollars.


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Keywords

asian development bank, banking sector, bank of mongolia, capital market, developmenteffectiveness, financial regulatory commission, financial sector reform program, financial sectorprogram, impact, nonbank financial institutions, operations evaluation, privatization, programloan, technical assistance

Director : Ramesh Adhikari, Operations Evaluation Division 2,Operations Evaluation Department (OED)

Team Leader : C. Kim, Senior Evaluation Specialist,Operations Evaluation Division 2, OED

Team Members : J. Dimayuga, Evaluation Officer,Operations Evaluation Division 2, OEDR. Perez, Senior Operations Evaluation Assistant,Operations Evaluation Division 2, OED

Operations Evaluation Department, PE-708


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CONTENTSPage

BASIC DATA ii

EXECUTIVE SUMMARY iii

I. INTRODUCTION 1A. Evaluation Purpose and Process 1B. Program Objectives 2

II. DESIGN AND IMPLEMENTATION 2A. Rationale 2B. Formulation 3C. Cost, Financing, and Executing Arrangements 4D. Application of Counterpart Funds 4E. Consultants 4F. Outputs 4

III. PERFORMANCE ASSESSMENT 9A. Overall Assessment 9B. Relevance 10C. Effectiveness 10D. Efficiency 10E. Sustainability 11F. Institutional Development 11G. Impact 12

IV. OTHER ASSESSMENTS 13A. ADB and Executing Agency Performance 13B. Technical Assistance 14

V. ISSUES, LESSONS, AND FOLLOW-UP ACTIONS 15A. Issues 15B. Lessons Identified 16C. Follow-Up Actions 17

APPENDIXES1. Program Framework: Second Financial Sector Program 192. Progress in Compliance with Second Tranche Release, Program Monitoring,

and End-Of-Program Conditions 243. Progress Made in the Second Financial Sector Program Outputs 294. List of Banks in Operation as of July 2007 425. Key Banking Sector Indicators 436. Summary of Stock Market Operations (20022006) 447. Macroeconomic Indicators (19992006) 45

Attachment: Management Response

The guidelines formally adopted by the Operations Evaluation Department (OED) on avoiding conflict ofinterest in its independent evaluations were observed in preparing this report. The fieldwork wasundertaken by consultants Sarath Thalakada (Financial Sector Specialist) and Baasanjav Tsolmon(Financial Analyst) under the guidance of the Mission Leader. To the knowledge of the management ofOED, the persons preparing, reviewing, or approving this report had no conflict of interest.


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BASIC DATA

Second Financial Sector Program (Loan 1743-MON)

PROGRAM PREPARATION/INSTITUTION BUILDING:

TANo.

TA Project Name Type Person-Months

Amounta

($)Approval

Date

3459 Strengthening Financial SectorDevelopment

ADTA 28 600,000 22 Jun 2000

As per ADBKEY PROGRAM DATA ($ million): Loan Documents Actual

Total Program Costb

15.0 15.8

ADB Loan Amount/Utilizationb

15.0 15.8

KEY DATES: Expected Actual

Fact-Finding 2430 Mar 2000

2430 Mar 2000Appraisal noneLoan Negotiations 15 May 2000Board Approval 22 Jun 2000Loan Agreement 21 Sep 2001Loan Effectiveness 21 Dec 2001 11 Dec 2001First Disbursement 31 Aug 2000 12 Dec 2001Loan Closing 30 Jun 2002 22 Mar 2004Program Completion Review 07-11 Mar 2005Months (effectiveness to loan closing) 6 27

BORROWER: Government of Mongolia

EXECUTING AGENCY: Bank of Mongolia

MISSION DATA:

Type of Mission No. of Missions Person-DaysFact-Finding 1 7Appraisal 0 0Program Administration- Inception- Review 9 42- Consultation- Program Completion 1 5- Operations Evaluation 1 15

ADB = Asian Development Bank, ADTA = advisory technical assistance, n.a. = not available, TA = technicalassistance.a

Represents approved amount of technical assistance.b

Equivalent to SDR11.5 million.


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EXECUTIVE SUMMARY

The financial sector reforms implemented during 19911999 facilitated restructuring andtransformation of the financial sector from a Soviet-style mono-banking system into a two-tiersystem with a central bank and a number of state-owned commercial banks. These reforms weresupported by the Asian Development Bank (ADB) through technical assistance (TA) and the

Financial Sector Program Loan, approved in December 1996. The reforms helped develop anenvironment conducive to private sector-led development supported by a relatively small andfragile financial system. However, those positive developments were short-lived. The difficultpolitical environment in the late 1990s and the 1999 financial crisis adversely affected the bankingsystem and interrupted the ongoing reform process. In addition, intermediation costs remainedhigh and the reach of the financial system continued to be limited. As a result, a need arose todevelop the nonbank and capital market subsectors, in order to diversify and deepen the financialsector to offer alternative mechanisms and institutions for depositors and borrowers, and tofacilitate a drop in high intermediation costs. These circumstances spurred the Government ofMongolia (the Government) to formulate a long-term vision and medium-term strategy for financialsector development. The Government asked ADB and the World Banks InternationalDevelopment Association (IDA) to support the second phase of financial sector reforms. In

response, they developed a comprehensive financial sector reform program (FSRP) that wassupported by ADBs Second Financial Sector Program (the Program) loan of $15 million andIDAs Financial Sector Adjustment Credit (FSAC) of $32 million, both approved in 2000.

The program loan and an associated TA grant of $600,000 for strengthening financialsector development were intended to promote the development of a competitive, stable, andbroad-based financial system to support enhanced resource mobilization and sustainableeconomic growth. Such a financial system was considered necessary to efficiently respond toboth the growing market-based economy and the demands of the private sector, and therebycontribute to accelerating economic development for employment generation and povertyalleviation. The improvement in financial intermediation was to be achieved by (i) strengtheningcorporate governance of the banks in line with international best practices, improving the loan

collateral system, implementing a management information system for banks, and developinginterbank markets; (ii) strengthening prudential regulations and the supervisory framework forthe nonbank financial subsector; (iii) developing capital market infrastructure, includingseparating and privatizing the Mongolia Stock Exchange, Central Depository System, andSecurities Clearing System; (iv) developing the pension system by transforming it to a partially-funded system; and (v) strengthening the legal and regulatory framework for the insurancesystem.

Overall, this program performance evaluation report rates the Program successful.TheProgram is rated highly relevant. It was in accordance and consistent with the sector strategiesand programs of the Government and ADB. It was a core part of the financial sector reformprogram that was put together in coordination with the Government, IDA, and International

Monetary Fund, with ADB playing a lead role, based on joint diagnostic analyses. ThePrograms positive response to changing circumstances, such as the volatile economicconditions in the late 1990s, was regarded imperative at that time. It remained focused andencompassed a balanced approach to assisting the development of all three constituentsubsectors of the financial sectorthe banking, nonbanking, and capital market subsectorswith satisfactory results. Government ownership of the reforms was relatively strong and therewas adequate harmonization with other development partners.


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The Program is rated effective. The Government and ADB were of the view that anefficiently functioning financial sector was the key to achieving a market-based economy forpromoting rapid economic development, with the private sector as the engine of growth. Thatobjective was achieved successfully, in so far as the country now has (i) a small but relatively-well regulated, vibrant and efficient banking system that is fully owned by the private sector, andis responding to the market-based economy; and (ii) nascent nonbank and capital market

sectors that show prospects for future growth. There was a lack of progress in regard to thelaws on trusts, investment funds, and private pension plans. However, the new FinancialRegulatory Commission (FRC) has begun to reexamine the draft laws prepared by ADBsconsultants, with the view to having them passed by the Parliament and Cabinet as soon aspossible, and implemented without furtherdelay.

The Program is rated efficient. The Programs funds and the counterpart funds wereused for the reform process and structural adjustments as planned. The banking system hasnow been entirely privatized. The 16 banks now in operation are performing autonomously andefficiently; growth rates in deposits and loans, returns on assets and equity, and decreases innonperforming loan ratios are all satisfactory. The data show that the banks are providingefficient services to the public, while growth rates in deposits and loans reflect the increasing

confidence by the public and investors in the banking system. The program was processedefficiently utilizing experiences from the preceding ADB program loan. There were someinefficiencies, however, with respect to delays in complying with conditions for release of thesecond tranche, which caused a two-year delay in completion of the Program.

The sustainability of the program outcomes is considered likely. The Bank of Mongoliahas set up a sound regulatory, supervisory, and accounting/auditing framework for the bankingsystem. It is being enforced effectively and the banking system is functioning well. In addition,the FRC established in 2005 is in the process of developing the full complement of requiredlegal, regulatory, supervisory, and accounting/auditing frameworks for the nonbank and capitalmarket sectors. This work is progressing satisfactorily with substantial achievements expectedby about the middle of 2008. Those frameworks in place at present are being enforced

effectively. The authorities are aware of the fragility of the three financial subsectors, particularlyin the face of financial crises similar to those that occurred in the late 1990s, and are taking thefollowing steps to increase the resilience of the subsectors: (i) strengthening and enforcingregulatory frameworks; and implementing (ii) good governance practices, internal controls, andmeasures to increase investor confidence in the nonbank and capital market sectors. Inaddition, the Ministry of Finance, Bank of Mongolia, and FRC recently established a FinancialStability Board that will jointly research, assess and analyze developments in the financialsector and jointly recommend actions to be taken by the appropriate agencies. The overallfavorable macroeconomic setting will help increase the sustainability of the reform process.

The FSRP contributed substantially to human resource and institutional development inthe financial sector. Institutional strengthening was undertaken of (i) the Bank of Mongolias

regulatory and supervision departments, with a focus on prudential norms and bringingaccounting and auditing standards into line with international standards; (ii) the CreditInformation Bureau; and (iii) the Asset Restructuring Agency. Under the Program, institutionalcapacities relating to supervision of nonbank financial institutions, capital markets, andinsurance industry were strengthened. The Program also strengthened the institutionalframeworks for developing the capital markets and contractual savings institutions. The capacitybuilding momentum is now being maintained by these beneficiary institutions, with the supportof their own budgets and other donor assistance. The FRC, however, needs considerable donorassistance for skills and institutional development. In the area of corporate governance in the


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sector, Mongolia has made a good start. The Bank of Mongolia has introduced a code of goodgovernance with a range of penalties for any contraventions. It also closely supervises theimplementation of that code. The 16 private banks have their own independent boardsappointed by the shareholders; credit decisions are made independently by credit committeesusing risk-management techniques; and operations are closely controlled and supervised, withindependent internal auditors reporting directly to their respective boards.

Through the Program and the FSAC, the FSRPs contribution to development ofMongolias financial sector is rated substantial, based on a four-category scale of high,substantial, modest, and negligible. The FSRP helped Mongolia complete the transformation ofits formerly mono-banking system to a two-tier system that is fully privately-owned andefficiently providing the banking services demanded by the general public and investors. It isnow capable of responding to market signals and assisting in the efficient operation of a market-based economy. Financial intermediation improved significantly over the 5-year period (20022006), led by banking sector growth. The ratio of broad money (M2) to gross domestic product(GDP), an indicator of the depth of the financial sector, increased from 38% in 2002 to 48% in2006, while the total assets of the banking sector increased from 40% of GDP in 2002 to 68% in2006. The private sector has benefited most from this transformation. The loans given by the

banking system have been predominantly for private sector development, averaging about 97%of its total loans outstanding over 20022006. As a result, the private sectors contribution toGDP increased from only 3.0% of GDP in 1989 to 70% in 1999, and to about 78% in 2006. TheGDP growth rate increased from 3.2% in 1999 to 8.4% in 2006.

The performance of both ADB and the executing agency (the Bank of Mongolia) wasmixed. ADBs performance was less than satisfactory. While it promptly undertook the design andformulation of the Program to meet the urgent demand, its performance during implementationwas inadequate. This complex program had multiple facetssuch as policy reform, developmentof new laws and/or amendment of existing laws, as well as institutional capacity enhancementaspects in three different subsectors of the financial sectorand required above averagesupervision to ensure effective implementation and overall success. ADBs supervision was not

commensurate with that level of complexity, however, and problems encountered led to delays inimplementation and second tranche release, and shortcomings in some TA outputs. Similarly, theperformance of the executing agency was mixed, being satisfactory with respect to program loanimplementation, but less than satisfactory in TA implementation. It remained fully committed toimplementing the reform program, particularly those aspects connected with the commercialbanking system. It successfully introduced legal, regulatory, supervisory, internal control,governance, and accounting/auditing frameworks for the commercial banking system, which meetinternational standards. However, its performance in dealing with the vital TA component was notentirely satisfactory. The TA addressed development of non-banking and capital marketsubsectors; the executing agency was not directly responsible for these areas, which may accountfor their less than satisfactory treatment during TA implementation. Had the implementing agencybeen the Mongolia Stock Exchange Commission, which is the agency responsible for these two

subsectors, the treatment would have been more positive, resulting in more successfulimplementation.


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Several lessons are evident from the program design and manner in which ADBsupervised program implementation. The key lesson identified and worthy of replication in futureADB operations in similar situations was that the success of the Program was a result ofcontinued Government commitment and ownership of the FSRP, which was formulated andimplemented through a combined effort involving the Government and key donors, with ADBplaying the lead role.

A second lesson is that the success in banking sector restructuring was a result of theGovernments emphasis on privatization of banks rather than restructuring them under the samegovernment ownership, which enabled establishment of a more efficient and effective financialintermediation system.

A third lesson is that reform program formulation should not overestimate the capacityand political will of the Government to formulate and implement reforms and new laws, and/oramend existing ones. The overall reform process was dependant on actions undertaken in amultitude of other sectors. Both the Cabinet and Ministry of Justice are overburdened, meaningthat proposed new reforms, laws and/or amendments to existing laws should have been bettersequenced and phased, and presented in a more convincing manner with additional research

and analysis, so as to improve the chances they would be considered and approved by theappropriate authorities.

Fourth, ADBs due diligence should be carried out more carefully. ADB staff andconsultants should have collaborated more closely and ensured that necessary procedures,such as those outlined in the previous paragraph, were followed in cases where ADBencountered implementation problems.

Fifth, the choice of appropriate executing agencies for implementing differentcomponents of a program is essential. The agencies directly responsible for handling differentcomponents in the existing organizational arrangement should be selected as the executingagencies for those components, rather than having one umbrella executing agency for all

components.

Lastly, in order to improve ADBs supervision of complex financial sector programloansparticularly those that entail policy reforms, development of new laws and/or amendmentof existing laws, and human resource and institutional development elementsthe supervisionbudgets, staff skills, and staff incentives in responsible ADB programs should be improved, soas to enable staff to maintain their program supervision roles for longer periods, therebyimproving implementation.


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The report recommends the following follow-up actions.

Recommendation Responsibility Timing

(i) Request the Financial Regulatory Commission to havethe two draft laws on trusts and investment funds passedby the Parliament and Cabinet, respectively.

(ii) Request the State Social Insurance General Office topresent the draft law on private voluntary pension plansfor consideration and approval by Parliament.

(iii) Consider providing further assistance and policy supportto the Government, with more emphasis on developmentof the nonbank and capital market sectors and lessemphasis on the banking sector, to address the issuesmentioned under paras. 3435 above, plus theestablishment of the proposed deposit insurance system.

East AsiaDepartment

As soon as possible

As soon as possible

During thepreparation of thenext countrypartnership strategy

(iv) Look into possibility of privatizing MSE, Credit InformationBureau, and Mongolia Asset Restructuring Agency within23 years.

(v) Consider assistance for strengthening some of thesmaller banks, including one of the banks operatingmainly in the rural sector, through equity and loaninvestments in the banks.

(vi) Consider assistance to help the banks undertakenonbank and capital market activities (e.g., fundplacement, initial public offerings, and underwriting) asbeing proposed by the Government.

(vii) Consider assistance for introducing new financial productsinto the market, such as mortgage securitizations throughequity and loan investments in the Mongolia MortgageCorporation, medium to long-term bonds, medium to long-term deposit and lending instruments for banks to promotethe development of small and medium-sized enterprisesand rural sectors, financial leasing, and cross-borderleasing and insurance products.

(viii) Consider broadening ADBs private sector involvementinto support for the corporate sector, particularly smalland medium-sized enterprises, for diversification of theeconomy.

Private SectorOperationsDepartment, EastAsia Department

MSE within 2008;others beginningfrom early 2008

Beginning from early2008




ADB = Asian Development Bank, MSE = Mongolia Stock Exchange.Source: Operations Evaluation Team.

Ramesh AdhikariOfficer-in-ChargeOperations Evaluation Department


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I. INTRODUCTION

A. Evaluation Purpose and Process

1. The Loan for the Second Financial Sector Program1 (the Program) and the associatedtechnical assistance (TA)grant2 were selected for evaluation for three main purposes. First, this

program performance evaluation report (PPER) evaluates and takes stock of the performanceand impact of the Program and TA on development of the financial sector. Second, itstrengthens policy dialogue, ensuring the continued achievement and sustainability of programoutcomes and enhancing any further assistance to the sector by the Asian Development Bank(ADB). Third, by highlighting important lessons, it provides inputs to future ADB financial sectorstrategies and programs, with the goal of achieving greater economic and social impact. Theassessment was based on the following core criteria, as defined in the evaluation guidelines:3(i)relevance, (ii) effectiveness, (iii) efficiency, and (iv) sustainability. International standards wereadopted in making the assessments in terms of financial performance of the commercial banks,4and frameworks for their regulation, supervision, accounting, auditing, and governancepractices. The other assessments included institutional development, impact, and ADB andexecuting agency performance. An operations evaluation mission5 (OEM) visited Mongolia from

20 June to 4 July 2007 and reviewed program-related documentation and other backgroundmaterials, interviewed key stakeholders6 in Mongolia, and ADB officials associated with theProgram.

2. The Program was intended to carry forward reforms that were successfully implementedunder the First Financial Sector Program Loan (FSPL I).7 Appendix 1 summarizes the programframework. A program completion report (PCR), prepared by the Regional Cooperation,Governance, and Finance Division of the East Asia Department, rated the Programsuccessful, but the TA partly successful (due mainly to delays in passing laws forestablishment of trust and investment fund operations, and for improvements in the insuranceand pension systems).8 Another key feature of the Program was the close coordination betweenADB and the International Development Association (IDA) of the World Bank. It complemented

IDAs Financial Sector Adjustment Credit (FSAC), and the progress of the Program and theFSAC was monitored through joint review missions. Under the agreed arrangements, FSACfocused on privatization of state-owned commercial banks and banking reforms such asprudential regulations, while the Program focused on reforms in financial sector governance andpromotion of nonbank financial institutions (NBFIs), including capital markets and contractualsavings. Another feature of the Program was the adoption of a more holistic approach to

1ADB. 2000. Report and Recommendation of the President to the Board of Directors on a Proposed Loan andTechnical Assistance to Mongolia for the Second Financial Sector Program. Manila. (Loan 1743-MON, for $15million, approved on 22 June 2000).

2TA grant (3459-MON) of $600,000 for strengthening financial sector development.

3ADB. 2006. Guidelines for Preparing Performance Evaluation Reports for Public Sector Operations Addendum 1. Manila.

4 The 16 commercial banks now in operation in Mongolia are all privately owned, and include three previously state-owned banks that have been restructured and are now fully privately owned (i.e., Khan Bank [previouslyAgriculture Bank], Trade and Development Bank, and Mongol Post Bank).

5The OEM was staffed by Cheolghee Kim (Senior Evaluation Specialist/Mission Leader), Sarath Thalakada(International Financial Sector Specialist), and Tsolmon Baasanjav (Domestic Financial Analyst).

6 Including representatives of the Ministry of Finance, Bank of Mongolia, Financial Regulatory Commission, StateProperty Committee, Mongolian Asset Restructuring Agency, privatized commercial banks, the Chamber ofCommerce, Mongolia Bankers Association, the Mongolia Stock Exchange, Securities Clearing House and CentralDepository System, the International Monetary Fund, and the World Bank.

7ADB. 2003. Program Performance Audit Report on the Financial Sector Program. Manila. (Loan 1509-MON-[SF]).

8ADB. 2005. Program Completion Report on the Second Financial Sector Program. Manila. (Loan 1743-MON).


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financial sector development through promotion of nonbank and capital market sectors, whichextended its focus for diversification and deepening of the financial sector.

B. Program Objectives

1. Program (Loan 1743-MON)

3. The primary objective of the Program was to promote the development of a competitive,stable, and broad-based financial system to support enhanced resource mobilization andsustainable economic growth. Such a financial system was considered necessary to efficientlyrespond to both the growing market-based economy and the demands of the private sector, andthereby contribute to the acceleration of economic development for employment generation andpoverty alleviation. The improvement in financial intermediation was to be achieved by (i)strengthening corporate governance of the banks in line with international best practices,improving the loan collateral system, implementing a management information system (MIS) forbanks, and developing interbank markets; (ii) strengthening the prudential regulations andsupervisory framework for the nonbank financial subsector; (iii) developing capital marketinfrastructure, including separating and privatizing the Mongolia Stock Exchange (MSE), Central

Depository System (CDS), and Securities Clearing System (SCS); (iv) developing the pensionsystem through transformation to a partially funded system; and (v) strengthening the legal andregulatory framework for the insurance system. Further details are in Appendix 1.

2. TA Grant 3459-MON: Strengthening Financial Sector Development

4. The TA was expected to strengthen the legal and regulatory framework for (i)supervision of NBFIs, (ii) secured collateral, and (iii) development of capital markets andcontractual savings institutions. The program loan and the TA were implemented over June2000March 2004.

II. DESIGN AND IMPLEMENTATION

A. Rationale

5. The financial sector reforms implemented during the period 19911999 facilitated therestructuring and transformation of the financial sector from a Soviet-style mono-banking systemto a two-tier system, with a central bank and a number of state-owned commercial banks. Thesereforms were supported by ADBs FSPL I, comprising a program loan and its associated TAgrant and a TA loan, approved in December 1996. Together, they made significant impact onthe progress of reforms, and development of both human resource and institutional capacity.The Operations Evaluation Department (OED) rated FSPL I successful, the TA grant highlysuccessful, and the TA Loan less than successful (due mainly to problems associated withthe selected consulting company), based on their relevance, effectiveness, efficiency,

sustainability, and impact. The reforms helped develop an environment conducive to privatesector-led development supported by a relatively small and fragile financial system. The overallimpact of the reforms led to an average real gross domestic product (GDP) growth rate of about3.9% during the 5-year period 19951999. Inflation was brought down from over 50% in 1996 tobelow 10% in 1998 (although it increased to 10% in 1999).

6. These positive developments were short-lived, however. The difficult politicalenvironment in the late 1990s and the 1999 financial crisis caused by the severe drop in theprices of major commodity exports adversely affected the banking system and interrupted the


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ongoing reform process. The commercial banks, faced by increasing deposit interest rates andmounting bad debts, once again began to face profitability, liquidity, and solvency problems, andrequired recapitalization as well as strengthening of their governance practices and internalcontrols. In addition, intermediation costs remained high and the reach of the financial systemcontinued to be limited. The weak financial sector, which lacked diversification and played onlya limited role in the economy, negatively affected Mongolias growth and macroeconomic

prospects. The reform process therefore needed to be revamped and carried forward to put thebank transformation process back on track. Specifically, there was a need to develop thenonbank and capital market subsectors to diversify and deepen the financial sector, so as tooffer alternative mechanisms and institutions for depositors and borrowers, and to facilitate adecrease in intermediation costs by providing greater competition and alternatives in themarketplace.

B. Formulation

7. Such circumstances and the need to carry forward the first phase of financial sectorreforms prompted the Government, with the assistance of the IDA, to formulate a long-termvision and medium-term strategy for financial sector development.9 This included the pace and

sequence of overall financial sector reforms over the medium term. To implement this strategy,the Government asked IDA and ADB to support the second phase of financial sector reforms. Inresponse, ADB and IDA developed a comprehensive financial sector reform program (FSRP)that included a common development policy letter and policy matrix, and covered the varioussubsectors of the financial sector for parallel financing of the associated structural adjustmentcosts.

8. The umbrella reform program was supported by (i) ADBs Second Financial SectorProgram Loan (FSPL II) of $15 million and the associated TA, approved in June 2000; and (ii)the FSAC of $32 million approved by IDA in April 2000. Under the agreed arrangementsbetween ADB and IDA, the FSAC focused on (i) restructuring and privatizing state-ownedbanks; (ii) banking reforms such as prudential regulations; (iii) strengthening banking

institutions, namely, the Mongolian Asset Restructuring Agency (MARA), and the CreditInformation Bureau (CIB); and (iv) supporting capacity building and skills upgrading through aTA credit. The banking reforms under ADBs program loan complemented those under FSAC,focusing on (i) reforms in financial sector governance; and (ii) promotion of NBFIs, capitalmarkets, and contractual savings. These combined policy actions were expected to develop abroad framework for the creation of a stable and competitive financial sector. That was animportant focus and agenda of the FSAC and built on the progress made under past ADBoperations. To facilitate coordination, ADB and IDA jointly monitored implementation progresswithin FSRP.

9. The second phase of reform package was developed jointly by the Government, ADB,and IDA, as is evident from paras. 78. Given the circumstances, ADB presumably considered

that a separate project preparatory TA (PPTA) was not necessary for formulation of theProgram and the TA. These were formulated relatively quickly, with about 5 months elapsingbetween the first reconnaissance mission, fielded in January 2000, to Board approval in June2000. This was possible as a result of the experience gained from (i) the ongoing reformprocess, which began in 1991; (ii) outcomes of advisory TA grants, the First Financial SectorProgram, and associated TA projects; and (iii) the joint program formulation work done underthe FSRP.

9World Bank. 1999. Mongolia Financial Sector Strategy. Washington D.C.


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C. Cost, Financing, and Executing Arrangements

10. The cost of structural adjustment under the FSRP was estimated at about $100 million,10financed through (i) the Program (covering adjustment costs, up to $15 million equivalent), (ii)the IDA loan of $32 million equivalent (supporting the balance of payments gap of $30 millionover 20012002), and (iii) the Governments budgets (covering financing gaps in the structural

adjustment costs). The Program comprised (i) a policy loan of $15 million equivalent(SDR11,448,000) to be disbursed in two tranches, and (ii) a TA grant of $600,000 to supportstrengthening financial sector development. The first tranche was disbursed on the day the loanbecame effective (12 December 2001). The second tranche was released on 8 December 2003,about 24 months later than planned. The Bank of Mongolia (BOM) was the Executing Agencyfor the Program and the TA, with overall responsibility for program implementation. It wasassisted by a steering committee, which was chaired by the deputy governor of BOM andincluded senior representatives of the Ministry of Finance (MOF), Ministry of Justice, and otherappropriate agencies.

D. Application of Counterpart Funds

11. Loan proceeds were withdrawn according to ADBs standard disbursement proceduresand were used to finance structural adjustment costs under the Program. The counterpart fundsof about $53 million equivalent for structural adjustments under the FSRPcomprising costsarising from restructuring problem banks, establishing the MARA, and managing the inheriteddirected loanwere included in the national budget and used in line with the Program. Bondswere issued beginning in 1996 to finance these costs.

E. Consultants

12. The Strengthening Financial Sector Development TA was an integral part of theProgram. It assisted the Government in developing a more competitive, stable, and broad-based financial system by increasing the efficiency of financial intermediation and supporting

the development of financial infrastructure. An international consulting firm with relevantexperience in banking and capital market development, in association with domesticconsultants, was engaged to provide the TA services required. The firm was recruited by ADBusing the simplified proposal format in accordance with ADBs Guidelines on the Use ofConsultants, and other arrangements satisfactory to ADB for the engagement of domesticconsultants. The consultants provided 18 person-months of international consulting and 10person-months of domestic consulting services.11

F. Outputs

13. The Program reforms were to be implemented for 3 years from loan effectiveness, withthe Program planned to end in December 2004. Although the loan was approved on 22 June

10The estimated cost of structural adjustment of about $100 million consisted of the following components: (i) bankrestructuring, including liquidation, restructuring, recapitalization, and settlement of severance payments ($51million equivalent); (ii) transition to a partially funded pension scheme ($28 million equivalent); (iii) institutionalstrengthening of BOM, MARA, the Mongolia Securities Exchange Commission, State Social Insurance GeneralOffice, and Insurance Supervision Unit ($13 million equivalent); and (iv) others including privatization of MSE, MISdevelopment, and liberalizing guidelines for pension and insurance funds ($8 million equivalent).

11The international consulting services were provided as follows: (i) supervisory framework for NBFIs (2 person-months); (ii) the framework for secured collateral (2 person-months); (iii) the legal, regulatory, and institutionalframework for developing capital markets (8 person-months); and (iv) the legal, regulatory, and institutionalframework for developing contractual savings institutions (6 person-months).


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2000, its effectiveness was delayed to allow negotiations to conclude between IMF and theGovernment on IMFs poverty reduction growth facility (PRGF) as (i) macroeconomic stabilitywas a condition for effectiveness of the FSAC, and (ii) the FSRP intended effective coordinationbetween the FSAC and the Program. The IMF and the Government reached agreement inSeptember 2001; following the necessary ratification by the Parliament, loan effectivenessoccurred on 12 December 2001. The first tranche of the loan was released on that date.

Release of the second tranche was conditional on 13 policy actions, and was originally targetedfor December 2001 (i.e., 18 months after the intended effectiveness).12 The Program included12 other monitorable conditions and eight end-of-program conditions. Release of the secondtranche occurred on 8 December 2003, following confirmed progress on overall programimplementation and compliance with all second tranche release conditions. The PCR,completed in July 2005, found that at the end of the Program, one monitorable condition andfour end-of-program conditions had not yet been fully complied with, although positive progresshad been made in that regard.

14. OEMs field work, undertaken in June and July 2007, revealed that the monitorablecondition pertaining to the target set for the sale of shares of privatized companies through theMSE 13 was not fully complied with. In regard to the four end-of-program conditions, one

pertaining to the introduction of good governance practices into banks had been met,14 but theother threepertaining to (i) introduction of a legal, regulatory, supervisory, and accounting/auditing framework for the insurance industry meeting international best practices; (ii) theprivatization of the MSE; and (iii) submission to Parliament for approval of a draft law onvoluntary private pension plansremained not fully complied with. In regard to the otherprogram conditions, the PCR reported that the needed amendments to the Law onCooperatives were proceeding, and therefore the covenant requiring them was largelycomplied with. The PCR also reported that the two covenants that required two new laws ontrusts and investment funds were complied with, as they were drafted by ADB/TA consultantsmeeting ADB requirements. However, the OEM found that in practice these three covenantsremained not fully complied with. Appendix 2 gives the present status of compliance of programconditions as verified by the OEM. Also, Appendix 3 elaborates on progress made thus far in

the respective output areas assisted by the Program; a summary of progress is presented below.

1. Improving Financial Intermediation

15. The FSAC (undertaken by IDA) and ADBs Program were integral and complementaryparts of the FSRP, and therefore in the following discussion the key outcomes of the overallFSRP are discussed together, in order to present a comprehensive picture of the combinedoutputs for financial sector development. The FSRP has been implemented satisfactorily andhas achieved significant results. The previous mono-banking system has been completelytransformed into a two-tier banking system, which is privately-owned, well regulated andsupervised, and established on a stable basis with good growth prospects. The following

12 Given the initial delay, second tranche release would have been expected by June 2003 (i.e., 18 months aftereffectiveness).

13That condition required the State Property Committee to sell at least MNT200 million worth of shares of privatizedstate-owned enterprises through the MSE. According to the PCR, such sales exceeded the target in 2001(MNT281 million), but did not reach that target in 2002 (MNT167 million) and 2003 (MNT107 million). The targetwas not met during the subsequent years (nil in 2004, MNT94 million in 2005, MNT115 million in 2006), while thenumber of listed companies on the MSE fell from 402 in 2003 to 387 in 2006. In 2006, about 100 privatized limitedliability companies remained to be listed on the MSE.

14BOM adopted the corporate governance regulation in 2006, and it has been effectively enforced since then. Amongother requirements, it delineates the codes of corporate governance that the board of directors, management,internal auditor and external auditor need to observe.


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outputs were made with assistance of the ADB Program:

(i) Strengthening Corporate Governance in Banking Institutions. All the bankspractice good governance principles. BOM adopted the corporate governanceregulation in 2006 and it is being enforced.

(ii) Improving the System of Collateral. The debt-recovery process needs to befurther expedited and the associated costs reduced. Doing so would bring downloan transactions costs, contribute to enhancing the efficiency of bankingservices, and further strengthen the financial intermediation process. A new lawon immovable property is now in Parliament for approval before end 2007.

(iii) Implementing an MIS in Banks. The banks continue to install and improve theirMISs. These were first introduced with ADB TA, and improvements are nowfunded from bank profits.

(iv) Developing an Interbank Market. BOMs liquidity support to banks has stopped,largely to encourage banks to manage liquidity among themselves. Theoperations of the interbank market remains small in comparison to overallbanking sector operations but the framework for operating an interbank marketsatisfactorily is now in place. The efficiency of the interbank operations is

improving.

16. In parallel, the following related outputsmade with the assistance of IDAs FSACformed part of the Governments overall sector reform program, which was supported by ADB:

(i) Privatization of the Commercial Banks. The banking system has now beenentirely privatized.

(ii) Prudential Regulations. The Basle Committee requires that about 25 coreprinciples relating to banking supervision be implemented by central banks. BOMhas implemented 23 that meet the requirements; one principle, pertaining tooverseas branch operations, is considered inapplicable to Mongolia.

(iii) Accounting and Auditing Standards. International accounting standards (IAS)

have been introduced.(iv) Bank Supervision. The basic framework for bank supervision is now in place,

which should help BOM to examine banks and enforce regulations moreeffectively. BOM conducts full onsite examinations of all 16 banks every year,based on the CAMELS principles, as well as adherence by the banks toprudential regulations and international accounting standards.

(v) Autonomy of Commercial Banks. The banks operate independently andwithout any government involvement in their policy-making, management andoperations.

(vi) Competition, Efficiency, and Viability. Private enterprise has led to intensecompetition among banks for both deposits and loans, resulting in benefits to thepublic in terms of greater efficiency in meeting public demand for various banking

services.(vii) Deposits and Loan Growth. Deposits with banks have been growingsignificantly, reflecting increasing public confidence in the banking system.

(viii) Loan Portfolio Diversification. The loan portfolios of the 16 commercial banksare fairly well diversified.

(ix) Interest Rates on Deposits and Loans and Interest Spread. Interest rates forboth deposits and loans are now fully liberalized, with the banks being free tocharge interest on a risk-reward basis. Market interest rates show a decliningtrend with the increasing competition.


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(x) Status of Non-Performing Loans. The aggregate nonperforming loans (NPLs)increased from MNT11.7 billion to MNT60.0 billion over the 5-year period 20022006. The ratio of NPLs to total loans outstanding increased from 5.1% in 2002to 6.4% in 2004 and decreased to 4.9% in 2006. These ratios indicate that theyare at a manageable level.

(xi) Banking Skills Upgrading. Banks are placing a high priority on skills upgrading

for (i) capacity enhancement, (ii) to cope with competition and possibleslowdowns in economic expansion, and (iii) to increase the efficiency of serviceprovision.

2. Strengthening Prudential Regulations and Supervision of NBFIs

17. The Program supported the introduction of appropriate legal, regulatory, supervisory,and accounting/auditing frameworks for the orderly development and viability of the nonbanksector. Their previous fragmented regulatory and supervisory framework has now been broughtunder one umbrella with the establishment of the Financial Regulatory Commission (FRC) inNovember 2005, as recommended by ADB. FRC has begun to fill the gaps in the required legal,regulatory, supervisory, and accounting/auditing frameworks, with completion scheduled for

2007 or 2008 at the latest. It has also begun to enforce these frameworks effectively, and istaking positive steps that promote a stable, competitive, and viable nonbank sector in thecountry. However, it would require capacity enhancement in order to more effectively perform itsfunctions and carry out its plans. The nonbank sector is open for foreign investment. There areabout 300 institutions in operation, comprising 141 NBFIs, 118 savings and credit cooperatives(SCCs), 27 securities companies, and 14 insurance companies. The present status of thenonbank sectors is given below.

(i) Nonbank Financial Institutions. NBFIs are engaged mainly in giving short-termloans for small businesses using their own funding resources. This subsector isthe most stable of all the nonbank sectors. The Law on Nonbank FinancialActivities enacted in December 2002 provides the legal basis for their operation.

The regulatory framework in place includes specifications for minimum capitalrequirements, asset classification, liquidity, foreign exchange (FX) exposure,accounting/auditing meeting IAS standards, and provisioning. There is anincreasing interest by foreign investors in the nonbank sector. The total assets ofNBFIs show an increasing trend.15

(ii) Savings and Credit Cooperatives (SCCs). A new law to govern the operationof SCCs will be submitted for the approval of Parliament before end 2007. It willgive the legal basis for SCC operations and will cover various issues, includingmembership, share-capital, loan operations, and obligations in respect of takingand repaying deposits from members and non-members. FRC is now the soleauthority regulating, supervising and controlling the SCC system.

(iii) Securities Companies. Securities companies are engaged in brokerage,

dealing in stocks and bonds, funds placement, underwriting, and initial publicofferings. The Securities Law, Company Law, and the Civil Code provide thelegal basis for their operations. Prudential regulations and accounting/auditingprocedures meeting international standards are in place. FRC is preparing furtherprudential regulations for implementation in 2007, while re-licensing of securities

15The total assets have increased from MNT12,459 million in 2002 to MNT69,262 million in 2006, for an annualgrowth rate of just over 50%. The total assets in 2006 equaled about 2.2% of GDP, slightly larger than theinsurance sector (0.7% of GDP), but much smaller than the banking sector (68.4% of GDP in 2006).


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companies is proceeding satisfactorily. FRC is taking steps to improve theviability of the subsector by increasing investor confidence in stock marketoperations and market liquidity through more public listings of good quality stocks.

(iv) Insurance Companies. The private insurance companies are engaged ingeneral insurance business. The Law on Insurance and the Law on InsuranceProfessional Participants passed by Parliament in April 2004 provide the legal

basis for their operations. These laws were prepared with the support of ADB TAand comply with the standards and principles set by the International Associationfor Insurance Supervisory Agencies. The required accounting/auditing frameworkmeeting international standards is now in place and is being effectively enforced.Another new law on compulsory insurance covering the liability of automobiledrivers is now being drafted by FRC for the approval of Parliament in 2007. Theneed to introduce life insurance and other forms of compulsory insuranceschemes is also being examined.

3. Developing Capital Market Infrastructure

18. The Program promoted the development of capital markets for diversification and

deepening of the financial sector. It supported improvements in (i) governance structure of theMSE, (ii) the Securities Market Law (SML) and related regulations, and (iii) the legal status oftrust relationships and investment funds. It also assisted in the institutional strengthening of theMongolia Securities Exchange Commission (MSEC), now known as the FRC under the TAassociated with the Program. These reforms have been implemented satisfactorily, with somegaps that are to be filled in 2007, or at the latest in 2008. Their implementation status is givenbelow.

a. Separating MSE Functions and Privatizing MSE

19. MSEs functions were divided in October 2003, with MSE made responsible forsecurities trading, and a separate state-owned limited liability company (the Securities Clearing

House and Central Depository Co. Ltd. [SCHCD])16

given responsibility for securities clearing,settlement and depository functions. Both are now well established and operating independentlyon a profitable basis. Privatization of MSE was included in the Governments overallprivatization program for 20052008, but privatization has not yet occurred, apparently due to alack of political will. The list of institutions to be privatized in 2008 will be finalized before the endof 2007. OEM impressed upon the State Property Committee (SPC) and FRC the need to followthat procedure and finalize privatization no later than end 2008. Various options for privatizationof MSE are being discussed, and it is probable it will be completed by then. It is OEMs currentopinion that the recommendation by ADB to privatize MSE may have been premature, as theprospects for successful privatization would improve following an increase in the viability17 ofand public confidence in MSEs operations.

16The SCHCD was created by the amalgamation of the previous Securities Clearing System (SCS) and CentralDepository System (CDS). It was licensed by FRC in October 2006 to conduct these functions.

17Two options being considered are (i) local privatization with involvement by the management and staff of MSE andother securities market players, and (ii) privatization on a joint-venture basis. OEM indicated that a third optionwould be privatization on a two-stage basis: initial privatization of management with foreign participation tointroduce international best practice, followed by full privatization subsequent to an improvement in MSEs viability,thereby improving the price obtained by the Government.


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b. Strengthening the Securities Markets Law (SML)

20. The Program called for amendments to SML to improve financial governance andrestore public confidence in the securities markets. The amended SML was passed byParliament in December 2002 and became effective in January 2003. The amended SMLincluded (i) increased penalties for violation of the SML; (ii) stricter audit requirements for listing

of companies; and (iii) higher minimum capital requirements for brokers. The Law on FRC LegalPosition (dated 17 November 2005), which established the FRC, adequately covers othershortcomings, such as (i) the inadequate legal basis for (a) the regulatory, supervisory, andenforcement powers previously held by MSEC, and (b) for self-regulation; and (ii) the need forclarity of some technical terms being used. Based on experience and the evolving nature of themarket, FRC proposes to amend the SML again and renew existing rules and regulations for thesecurities market before the end of 2007.

4. Strengthening the Pension System

21. The Program aimed to support (i) the Governments efforts to formulate a suitable legaland regulatory framework for partial funding of the state pension system, which was an

unfunded, pay-as-you-go system; (ii) the improvement of the administrative capacity of the StateSocial Insurance General Office (SSIGO); and (iii) the development of non-state voluntarypension systems. Properly managed and regulated pension funds could act as an impetus fordevelopment of an institutional investor base and a diversified financial sector. The requiredlegal and regulatory frameworks for development of these pension schemes are now in place asdescribed below. To build on this foundation, ADB approved additional TA,18 which is now beingimplemented in coordination with the World Bank.

5. Strengthening the Insurance System

22. The Program supported the drafting of amendments to the insurance laws and thedevelopment and adoption of a sound regulatory framework. As discussed under item F.2.(iv)

above, the legal and accounting/auditing frameworks are now in place. Most of the neededregulations are also now in place, and work on the balance needed is proceeding satisfactorily.

III. PERFORMANCE ASSESSMENT

A. Overall Assessment

23. The PPER rates the Program as successful based on its assessment rating of theProgram as highly relevant, effective, and efficient. The Programs output and outcomesare likely sustainable.19

18TA 4910-MON: Strengthening the Pension System, approved in December 2006.

19The performance ratings in this report were prepared following the Guidelines for Preparing PerformanceEvaluation Reports for Public Sector Operation.


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Table 1: Overall Performance Assessment

WeightCriteria (%) Rating Value Rating1. Relevance 20 3 0.62. Effectiveness 30 2 0.6

3. Efficiency 30 2 0.64. Sustainability 20 2 0.4Total Rating 2.2

Source: Asian Development Bank estimates.

B. Relevance

24. The Program is rated highly relevant. It was in accordance and consistent with thesector strategies and programs of the Government and ADB. It was a part of the FSRPdeveloped in coordination with the Government, IDA/World Bank and IMF, with ADB playing thelead role, and was based on joint diagnostic analyses. The main focus was support for bankingsector reforms, as proposed in the Governments FSRP and worked out in conjunction with theIDA/World Bank and ADB. A secondary focus involved support for development of the nonbankand capital market sectors as (i) alternative sources of funds for the private sector, and (ii) toprovide competition to the banking sector. The Program responded positively to changes incircumstances, such as the volatile economic conditions in the late 1990s; this was regarded asimperative at the time. The Program remained focused and encompassed a balanced approachto assisting the development of the three constituent subsectors of the financial sectorthebanking, nonbanking, and capital market subsectorswith satisfactory results. Governmentownership of the reforms was relatively strong and there was adequate harmonization with otherdevelopment partners. The outcomes in both those sectors confirm the Programs highlyrelevant categorization.

C. Effectiveness

25. The Program is rated effective. The Government and ADB were of the view that anefficiently functioning financial sector was the key to achieving a market-based economy forpromotion of rapid economic development, with the private sector as the engine of growth. Thatobjective was achieved successfully, and the country now has a small but relatively-wellregulated, vibrant and efficient privately owned banking system that is responding to the market-based economy; the nascent nonbank and capital market sectors show prospects for futuregrowth. The latter have contributed positively to private sector development and overalleconomic stability and growth in the country (see paras. 2930 for details). Limited progresswas made in regard to the laws on trusts, investment funds, and private pension plans, but FRCis re-examining the draft laws prepared by ADBs consultants, with a view to having themapproved by Parliament and Cabinet as soon as possible and implemented without furtherdelay.

D. Efficiency

26. The Program is rated efficient. The Programs funds and the counterpart funds wereused for the reform process and structural adjustments as planned. The efficiency can be

judged by the present performance of the banking system that it sought to improve andstrengthen. The banking system has now been entirely privatized. The 16 banks now inoperation are performing autonomously and efficiently with satisfactory growth rates in depositsand loans, return on assets and return on equity, and decreasing NPL ratios. These data show


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that the banks are providing efficient services to the public, while the growth rates in depositsand loans reflect increasing public and investor confidence in the banking system. The realinterest rates continue to be high, but show a downward trend. They should decline further withgreater competition among the banks, and with further diversification and deepening of thefinancial sector, supported by the expanding nonbank and capital market subsectors. Theprogram was processed efficiently utilizing the experience from the preceding ADB program

loan, although some inefficiencies were experienced as well; specifically, the 2-year delay in thecompletion of the Program due to delays in complying with conditions for release of the secondtranche. Overall, however, the Program is considered to have been efficient.

E. Sustainability

27. The sustainability of the outputs and outcomes of the Program is considered likely. TheBOM has set up a sound regulatory, supervisory, and accounting/auditing framework for thebanking system. It is being enforced effectively and the banking system is functioning well. Inaddition, the FRC that was established in 2005 is in the process of developing a full complementof the required legal, regulatory, supervisory, and accounting/auditing frameworks for thenonbank and capital market sectors. This work is progressing satisfactorily, with substantial

achievements expected by about the middle of 2008. Those frameworks presently in place arebeing enforced effectively. The authorities are aware of the fragility of the three subsectors,particularly should financial crises similar to those of the late 1990s reoccur, and are taking thefollowing steps to increase the resilience of the subsectors: (i) strengthening and enforcing theregulatory frameworks; and implementing (ii) good governance practices, internal controls, andmeasures to increase investor confidence in the nonbank and capital market sectors. Inaddition, MOF, BOM and FRC recently established a Financial Stability Board that will jointlyresearch, assess and analyze developments in the financial sector and jointly recommendaction to be taken by the appropriate agencies. That is being done with the view to takingproactive action on likely developments that might adversely affect the operations of thefinancial sector. The recommendations are made on a quarterly basis. Furthermore, the overallfavorable macroeconomic setting will help increase the sustainability of the reform process.

F. Institutional Development

28. The FSRP contributed substantially to human resource and institutional development inthe financial sector. FSACs TA credit supported (i) skills upgrading and capacity building in thecommercial banks, particularly in risk assessment and asset-liability management; (ii) BOMsregulatory and supervision departments in the areas of prudential norms; and (iii) bringingaccounting/auditing standards in line with international standards in the CIB and MARA. Inaddition, under the Program the Strengthening Financial Sector Development TA (TA 3459-MON) strengthened the capacity of the MSEC (now FRC) for supervision of NBFIs, capitalmarkets and the insurance industry. It also developed a business plan for MSE, and a code ofethics and guidelines for MSEC and MSE employees. The TA also strengthened institutional

frameworks for development of capital markets and contractual savings institutions. Thesebeneficiary institutions are now maintaining the capacity-building momentum with the support oftheir own budgets (in the case of commercial banks) and other donor assistance (e.g., GTZsupport for the BTC). The FRC needs further donor assistance for skills and institutionaldevelopment, however.


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G. Impact

29. Through the Program and the FSAC, the FSRPs contribution to development ofMongolias financial sector is rated substantial, based on a four-category scale of high,substantial, modest, and negligible. The FSRP helped Mongolia complete the transformation ofits mono-banking system to a two-tier system that is now fully privately-owned and efficiently

providing the banking services demanded by the general public and investors. The bankingsystem is now capable of responding to market signals, and is contributing to the efficientoperation of the countrys market-based economy. Financial intermediation improvedsignificantly over the 5-year period (20022006), led by banking sector growth. The ratio ofbroad money (M2) to GDP, an indicator of the depth of the financial sector, increased from 38%in 2002 to 48% in 2006, while total banking sector assets increased from 40% of GDP in 2002to 68% in 2006. These banking sector developments are illustrated in Appendix 5. The privatesector has benefited most from this transformation. The loans given by the banking system havebeen predominantly for private sector development, and these average about 97% of the totalloans outstanding over the period 20022006. As a result, the private sectors contribution toGDP increased from only 3.0% in 1989 to 70% in 1999, reaching about 78% of GDP in 2006.The private sectors significant contribution to GDP also helped accelerate overall economic

growth in the country.20 GDP growth increased from 3.2% in 1999 to 8.4% in 2006. Thenonbank and capital market sectors are contributing to diversification and deepening of thefinancial sector, but are at an incipient stage of developmentthey account for about only 10%of the total assets of the financial sectorwith the result that their impact is hard to discern atpresent. The impact on development of the stock market is given in Appendix 6, and overalleconomic indicators are in Appendix 7.

30. Mongolia has made a good start with respect to corporate governance in the sector.BOM has introduced a code of good governance with a range of penalties for anycontraventions, and closely supervises implementation of the code. The 16 private banks haveindependent boards appointed by their shareholders, with credit decisions made independentlyby credit committees using risk-management techniques; operations are closely controlled and

supervised, with independent internal auditors reporting directly to their respective boards. Theaccounts are also audited by independent auditors on an annual basis. The NPLs are keptunder control (the NPL ratio in 2006 was 4.9%) and all the 16 banks are operating profitably. Aspointed out in the PPER two banking scandals are being investigated by BOM, but these did notadversely affect public confidence in the overall banking system. The progress made by theNBFIs and the other capital market institutions at this incipient stage of their development isimpressive. A specialized regulatory body has been established and has begun to operatesuccessfully. Data on the progress being made by the NBFIs and capital market institutions aregiven above (paras. 1722) and in the appendixes.

20Exports increased from $454.2 million in 1999 to $1,545.2 million in 2006; current account balance turned a surplusof $63.4 million in 2004 increasing to $306.3 million in 2006; total foreign reserves increased from $155.9 million in1999 (representing 14.3 weeks of imports) to $718 million in 2006 (representing 25.2 weeks of imports); inflationdropped from a high of 11% in 2004 to 6.0% in 2006; unemployment remained at a reasonable level of around3.5%; and the exchange rate has remained steady around MNT1,200 per US dollar.


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IV. OTHER ASSESSMENTS

A. ADB and Executing Agency Performance

31. ADBs performance was mixed. While it promptly undertook the design and formulationof the Program to meet the urgent demand, its performance during implementation was

inadequate. The design remained largely valid at entry as well as during implementation and upto the completion date. It was formulated, in a relatively short period of time, in conjunction withthe other donors in the sector and took into account the key issues that needed to be addressedfor further development of the financial sector. It was also coordinated well with theGovernments strategies and plans, thus ensuring Government ownership of the Program. TheProgram was complex, involving many facets including policy reform, development of new lawsand/or amendment of existing laws, as well as human resources development and institutionalcapacity enhancement aspects in three subsectors of the financial sector. It therefore requiredenhanced supervision to ensure effective implementation and success. Oversight was furthercomplicated when implementation of a key component (i.e., the TA project) experiencedproblems due to deficiencies associated with the selected consulting firm. However, ADBssupervision was not commensurate with (i) the level of complexity; and (ii) the problems

encountered, which led to delays in implementation and second tranche release, andshortcomings in some TA outputs. During the entire 3-year implementation period only 42 staffperson-days (equal to 6 staff person-weeks, or 2 staff person-weeks per year) were allocatedfor supervision of the Program. This appears to have been insufficient. The staff skills selectedfor supervision also appear to have been inappropriate, as no counsel visited the field to provideassistance during the 3-year implementation period, despite problems experienced with delaysin covenants compliance and drafting of needed laws. Also, lack of continuity of staff dealingwith supervision of the Program further weakened the effectiveness of supervision. Overall, theperformance of ADB is rated less than satisfactory.

32. Similarly, the performance of the executing agency (BOM) was mixed, being satisfactorywith respect to program loan implementation but less than satisfactory as regards TA

implementation. It remained fully committed to implementing the reform program, particularlythose aspects connected with the commercial banking system. It successfully introduced legal,regulatory, supervisory, internal control, governance, and accounting/auditing frameworks forthe commercial banking system that meet international standards, and which are being enforcedsatisfactorily. This facilitated the bank transformation process, and Mongolia now has a privatelyowned and stable banking system that provides efficient services for private sector-ledeconomic growth. However, its performance in dealing with the vital TA component was notentirely satisfactory. The TA appears not to have received the level of attention it requiredduring implementation, with the consulting firm reporting difficulties in arranging a workshop fordiscussion of its findings and recommendations, and delays in reviewing and discussing thedraft final report at a tripartite meeting. This resulted in part from the selection by ADB of anunsuitable consulting firm to undertake the TA (see para. 33), and led to a significant delay (of

about 3 years) in completion of the TA. The TA focused on development of the nonbank andcapital market sectors, and it is possible that implementation would have been more successfulif the executing agency had been the MSEC rather than BOM. As the main regulatory body,MSEC was directly responsible for development of the nonbank and capital market subsectors,and would therefore have had greater ownership for the TA objectives.


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B. Technical Assistance

33. The OEM confirms the PCR rating of the Strengthening Financial Sector Development TA(TA 3459-MON) as partly successful. The TA was well formulated and adequately provided forthe areas identified as in need of assistance (e.g., development of the legal, regulatory, andinstitutional framework for the supervision of the nonbank and capital market sectors). The terms

of reference were in accordance with the scope of the TA. The TA helped to strengthen (i) thelegal and regulatory framework for NBFIs; (ii) the framework for secured collateral; (iii) the legal,regulatory, and institutional frameworks for development of capital markets; and (iv) the legal,regulatory, and institutional framework for development of contractual savings institutions.However, the overall performance of the TA was adversely affected by the placement of the firmselected by ADB to undertake the TA under receivership of another firm. This occurred in themiddle of the project, and led to a change in the team leader, and the need to recruit otherconsultants to complete his work. The quality of the work was also less than satisfactory, as somework did not appear to be properly researched, necessitating redrafting and/or rejection of someof the draft laws that were prepared (e.g., the draft laws for trust, investment funds, and forvoluntary private pension plans). These events adversely affected TA implementation anddelayed TA completion by about 3 years.

Table 2: TA Performance AssessmentStrengthening Financial Sector Development (TA 3459-MON)

WeightCriteria (%) Rating Value Rating1. Relevance 20 3 0.62. Effectiveness 30 1 0.33. Efficiency 30 1 0.34. Sustainability 20 1 0.2Total Rating 1.4Source: Asian Development Bank estimates.

(i) Relevance. The TA is rated highly relevant. It had a dual focus, providingassistance in implementation of the Program, and helping to develop thenonbanking and capital market sectors, which were considered essential fordiversification and deepening of the financial sector as a whole, in order toexpand the range of financial services for private sector development andeconomic growth.

(ii) Effectiveness. The TA is rated less effective. It did not fully assist inimplementation of the Program within the originally specified program completionperiod of 3 years, and failed to establish the full complement of legal, regulatory,supervisory and accounting/auditing frameworks that were needed fordevelopment of the nonbank and capital market sectors, leaving gaps in the

frameworks that needed to be filled. ADB took subsequent action to fill thosegaps by approving another program loan and associated TA in December2005.21

(iii) Efficiency. The TA is rated less efficient. Problems associated with theselected consulting firm delayed implementation of the TA and Program. Also,some work performed was considered less than satisfactory, leading to the

21ADB. 2005. Report and Recommendation of the President to the Board of Directors on a Proposed Loan andTechnical Assistance Grant to Mongolia for the Financial Regulation and Governance Program. Manila.


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redrafting of some laws, and rejection or postponed approval of others. Thus, thefull outcome of the TA was not realized.

(iv) Sustainability. The TA is rated less likely. A considerable amount of additionalwork would have had to be done to complete the full complement of legal,regulatory, supervisory and accounting/auditing frameworks needed for properdevelopment of the nonbank and capital market sectors. That work is now being

undertaken by the FRC but will not be finished for some time. In addition, theFRCs capacity would require enhancement to enable it do the work in anefficient and effective manner.

V. ISSUES, LESSONS, AND FOLLOW-UP ACTIONS

A. Issues

1. Commercial Banking Sector

34. The commercial banking system faces many challenges and issues, including (i) copingwith a rather volatile economy based on a few commodity exports; (ii) a relatively large numberof fully privatized banks; (iii) the marginal profitability of some of the smaller banks, because ofintense competition for deposits and resulting reduced margins; (iv) rapid expansion of bankingoperations, in terms of deposits and lending; (v) the need to keep NPLs at a manageable levelunder expanding loan portfolios; and (vi) the need for enhancement of staff skills and capacity,driven by the expanded operations and increasing sophistication of business activities. Inaddition, private banks are placing less emphasis on small and medium enterprises (SMEs) andrural development (by means of appropriate lending instruments and mechanisms foremployment generation and poverty alleviation), due to (i) the risk factor and short-term natureof their deposit structures, (ii) continuing high real interest rates in the market, and (iii) the needto become conversant with the nonbank and capital market activities that the Government willallow them to undertake in the future. The authorities (mainly MOF, BOM and FRC) are awareof these challenges and issues, in particular the marginal viability of the five smaller banks, andare constantly reviewing developments and taking steps to deal with these as appropriate,through actions such as (i) strengthened regulatory, supervisory, and accounting/auditingframeworks; (ii) corporate governance requirements; (iii) internal controls; and (iv) diversificationand deepening of the financial sector through strengthened and expanded nonbank and capitalmarket sectors. MOF is addressing the need to pay more attention to development of financingschemes for promotion of SMEs and rural sectors.

3. Nonbank and Capital Markets Sectors

35. The FRC is faced with the challenge of filling the remaining gaps in the legal frameworkand strengthening the regulatory, supervisory, governance, internal control, andaccounting/auditing frameworks in the nonbank and capital market sectors. It has a tremendousworkload in this regard, but is severely constrained by limited resources (physical infrastructure,

organization and management, staff capacity and knowledge, and capital and operationalbudgets). It is also faced with the challenge of increasing public confidence in the operations ofthe nonbank and capital market sectors, as well as helping guide their future growth prospects.To do that it would need to address the need for (i) listed companies to prepare their financialstatements accurately and on time, with full accountability and transparency, and to have thempublished on a timely basis and include all company information that needs to be in the publicdomain; (ii) training of local audit companies to enable accurate and timely auditing of theirfinancial statements, in accordance with the responsibilities laid down in the IAS; (iii) prevention


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of insider trading and off-exchange trading, which require close vigilance from the FRC tomaintain the significant reductions that have resulted from the specialized operations of MSEand SCHCD; (iv) education of the general public and market players on their respective rightsand responsibilities and the need for and mutual benefits of self-regulation; and (v) rapidintroduction of laws for promotion of trust, investment fund, and private voluntary pension planoperations as required by ADB. The FRC, MSE, and SCHCD are aware of these challenges

and issues and are taking steps to adequately address them.

B. Lessons Identified

36. Several lessons can be identified from the program design and manner in which ADBsupervised program implementation. The key lesson identified and worthy of replication in futureADB operations in similar situations is that the Programs success resulted from (i) continuedGovernment commitment and ownership of the FSRP; and (ii) the formulation andimplementation of the FSRP through a combined effort of the Government and the key donors,with ADB playing the lead role.

37. The success in banking sector restructuring resulted from the Governments decision to

privatize banks and establish a more efficient and effective financial intermediation system,rather than restructuring them under the same government ownership.

38. The other lesson identified was the need to not overestimate the Governments capacityand political will to formulate and implement reforms and pass new and/or amend existing laws.The overall reform process also involved many other sectors (e.g., health and education), andtherefore institutions such as the Parliament, Cabinet and Ministry of Justice were overburdenedwith reform-related requests. Under the circumstances, the chances of new reforms and lawsand/or amendments to existing laws being considered and approved by the respectiveauthorities would have improved had they been better sequenced and phased, and presentedmore convincingly following additional research and analysis. The 2-year delay in completion ofthe Program was caused mainly by delays in complying with second tranche release.

39. ADBs due diligence should have been done more carefully. ADB staff and consultantsshould have worked more closely and ensured the reform measures were better sequenced,phased and presented, as detailed in para. 38. These procedures appear not to have beenfollowed in those cases where ADB encountered implementation problems. Thus, (i) theprivatization of MSE should have been scheduled only after it had become viable (e.g., had metprofitability targets), when it would have been a more attractive prospect for privatization, andattracted a better price; (ii) following the sale and listing on the MSE of the more viable SOEs,the remainder were more difficult to privatize, making compliance with the covenant thatrequired a minimum of MNT200 million in shares of privatized SOEs to be sold through the MSEper year difficult; (iii) two draft laws on trusts and investment funds prepared with ADB TA wererejected, on the grounds that they were unnecessary as existing laws already provided for them;

and (iv) parliamentary consideration of the draft law on private voluntary insurance plansprepared with ADB TA was postponed, on the grounds that prevailing conditions in the countrydid not warrant its passing at that time.

40. Another lesson relates to the choice of appropriate executing agencies for implementingdifferent components of a program. The agencies with direct responsible for handling variouscomponents in the existing structure should be selected as the executing agencies for thosecomponents, rather relying on one umbrella executing agency for all components. Coordinationcould be undertaken by the steering committee that is typically appointed. This approach may


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help avoid situations in which implementation of components for which the selected executingagency is not directly responsible in the existing structure receive less attention. Based on thisreasoning, the TA component should have been executed by the MSEC (now FRC), rather thanBOM.

41. With respect to deficiencies in ADBs supervision work, complex financial sector program

loansparticularly those involving policy reforms, new laws and/or amendment of existing laws,and human resource and institutional development goalsrequire consistent, long-termprogram supervision to ensure effective implementation. Such programs should be providedwith enhanced supervision budgets and staff incentives, and staffed by individuals who havewith the skills required to enable them to undertake the needed supervision.

C. Follow-Up Actions

42. The following follow-up actions are recommended.


(i) Request the Financial Regulatory Commission to have thetwo draft laws on trusts and investment funds passed bythe Parliament and Cabinet, respectively.

(ii) Request the State Social Insurance General Office topresent the draft law on private voluntary pension plansfor consideration and approval by Parliament.

(iii) Consider providing further assistance and policy supportto the Government, with more emphasis on developmentof the nonbank and capital market sectors and lessemphasis on the banking sector, to address the issuesmentioned under paras. 3435 above, plus theestablishment of the proposed deposit insurance system.

East AsiaDepartment As soon as possible

As soon as possible

During thepreparation of thenext countrypartnership strategy

(iv) Look into possibility of privatizing MSE, Credit InformationBureau, and Mongolia Asset Restructuring Agency within23 years.

(v) Consider assistance for strengthening some of the smallerbanks, including one of the banks operating mainly in therural sector, through equity and loan investments in thebanks.

(vi) Consider assistance to help the banks undertake nonbankand capital market activities (e.g., fund placement, initialpublic offerings, and underwriting) as being proposed by

the Government.

(vii) Consider assistance for introducing new financial productsinto the market, such as mortgage securitizations throughequity and loan investments in the Mongolia MortgageCorporation, medium to long-term bonds, medium to long-term deposit and lending instruments for banks to promotethe development of small and medium-sized enterprisesand rural sectors, financial leasing, and cross-border

Private SectorOperationsDepartment, EastAsia Department

MSE within 2008;others beginningfrom early 2008





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leasing and insurance products.

(viii) Consider broadening ADBs private sector involvementinto support for the corporate sector, particularly small and

medium-sized enterprises, for diversification of theeconomy.


ADB = Asian Development Bank, MSE = Mongolia Stock Exchange.Source: Operations Evaluation Team.


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Appendix 1 19

PROGRAM FRAMEWORK: SECOND FINANCIAL SECTOR PROGRAM

Design SummaryPerformance

Targets/Indicators Assumptions ResultsGoal/ImpactDevelop a competitive, stable, and

broad-based financial system tostrengthen financial intermediation,and enhance domestic and externalresource mobilization

A sound, well-functioning, and

resilient banking system

Strengthened and enhanced rolefor nonbank financial institutions(NBFIs) in financial intermediation

Capital market development

Increased total bank assets

Credit and deposit growth

Increased bank profits

Fewer nonperforming loans inbanking system

Prudential regulations for NBFIsdeveloped

M2/gross domestic product (GDP)M1/M2

Loan tenure profile

Interest rate spread

Growth of NBFIs including financecompanies and savings and creditcooperatives (SCCs)

Market capitalization in theMongolian Stock Exchange (MSE)

Increased number of listedcompanies in the MSE

Decreased share of unfundedliabilities in pension system

Increase in insurance sector(assets/GDP)

The Governments financial

sector strategy is implemented

Macroeconomic adjustmentsand stabilization measures areadhered to

There is political resolve todeepen reforms.

Vested interests are contained

The banking system was

substantially strengthened.

The NBFIs role in financialintermediation was enhance

Capital market remainsunderdeveloped

Total bank assets increased

Credit and deposits have grorapidly.

Bank profits (amount)

increased but profitability(return on assets) declined

Nonperforming loan (NPL) radeclined but the outstandingamount increased.

Prudential regulations forNBFIs developed

M2/GDP increased

Loan tenure profile morediversified but still mostly sh

Interest rate spread narrowe

NBFIs and SCCs have growrapidly. SCCs are in financiatrouble and a new law hasbeen proposed for financialstrengthening, supervision acontrol.

Market capitalization in theMSE declined

The number of listedcompanies in the MSE decliPension system reform not ycompleted

Insurance sector assetsincreased


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20 Appendix 1

Design SummaryPerformance

Targets/Indicators Assumptions ResultsPurpose/OutcomeImprove the soundness and efficiencyof the banking system

Strengthen regulation andsupervision in the sector

Improve corporate governance inthe banking system

Impro