PricewaterhouseCoopers Audit LLC
Financial Diagnostic of the Development Bank of Mongolia
Final Report
04.12.2018
1 Fi nal report – Dev elopment Bank of Mongolia
ST RICTLY PRIVATE AND CONFIDENTIAL
Batbayar Balgan, Chief Executive Officer,
Development Bank of Mongolia Sukhbaatar Disctrict, Peace Avenue 19 Ulaanbaatar Mongolia
04 December 2018
Dear Mr. Batbayar Balgan,
Contract #: DBM012018 T ransmittal letter –Final Report – Development Bank of Mongolia This report has been prepared by PricewaterhouseCoopers Audit LLC (“PwC” or “Consultant”) for the Development Bank of Mongolia under the terms of the contract between PwC and the Development Bank of Mongolia, numbered as DBM012018, dated 31 August 2018 (the “Contract”) for the provision of a Financial Diagnostic of the Development Bank of Mongolia (the “Project”), and its contents are strictly confidential. This deliverable has been prepared for the purposes of providing final information to the Development Bank of Mongolia on the results of the Project. This report is intended to be read and used as a whole and not in parts. Separation or alteration of any section or page from the main body is strictly forbidden. The assignment was carried out from 03.09.2018 to 09.11.2018. This document has been prepared as a collection of comments and recommendations, where applicable, from individual project work blocks.
The assignment was not an audit, it was a special in-depth financial diagnostic. The purpose of this assignment was to inform the main stakeholders (i.e. Ministry of Finance, the Bank of Mongolia and DBM board) of DBM’s financial status so that needed actions can be formulated. Scope of work was divided into 2 parts and following methodology was used: 1. Corporate Governance and Internal Control - Consultant assessed the adequacy and effectiveness, using internationally recognized benchmarks and methodologies, of DBM’s corporate governance and internal control environment from January 2012 to December 2017. 2. Assets, Liabilities, Earnings, Risks profile and Off-Balance Sheet Transactions - Consultant assessed DBM’s capital adequacy and capacity for debt servicing and repayment of borrowed funds for the period from January 2012 to December 2017. Based on the assessments specified in Contract, the Consultant estimated the amount of capital required to absorb losses, if any, in accordance with the regulatory requirement and the applicable IFRS/IAS, such as IFRS 9 and 13, and IAS 39. The Financial Diagnostic of the Development Bank of Mongolia includes a review of the loan portfolio performed predominantly based on the AQR Manual v1 of the European Central Bank, as localised for Mongolian local market specificities in several areas. This review of the loan portfolio takes into account historical accounting information at snapshot dates as at 31 December (from years between 2012 and 2017).
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The Financial Diagnostic, including the loan review element, represents a targeted review of individual transactions over time. It focuses on assets held by the bank as at the snapshot dates and does not assess transactions prior to or after the snapshot dates. Consequently, information is not available and has not been received and obtained for matters that were not relevant as at the snapshot dates.
Our work included the performance of all workblocks from the Contract (in accordance with the methodology agreed in the Contract). For a full understanding of the approach and methodology that serves as the base to this report and the associated restrictions and limitations of that work, we refer you to the Contract. Our deliverable contains information obtained or derived from a variety of sources described within the deliverable in more detail, in particular information from the Development Bank of Mongolia, real estate valuers, mining licences valuers and other sources. PwC has not sought to establish the reliability of those sources or verified the information so provided. Accordingly no representation or warranty of any kind (whether express or implied) is given by PwC to any person (except to the Development Bank of Mongolia) as to the accuracy or completeness of the deliverables and information provided by third parties. We have not carried out any work or made any enquiries of the management of the bank since 01.11.2018 being the date to which we hav e carried out our fieldwork for the purposes of the deliverable. The deliverable does not incorporate the effects, if any, of events and circumstances which may have occurred or information which may have come to light subsequent to that date. We make no representation as to whether, had we carried out such work or made such enquiries, there would have been a material effect on the deliverable. We draw your attention to important comments regarding the scope of our work, the purpose for which the advice is to be used, our assumptions and limitations in the information on which the advice is based set out in our deliverable. This report is subject to the terms and conditions set out in the Contract including exclusions of liability, particularly with regard to third parties. PwC is not responsible for any decisions made in connection with the implementation or use of this report. No investor or security holder should rely on the content of this report in any way in connection with the purchase or sale of any security. Consultant shall accept no liability to any other party. There are no third-party beneficiaries of this engagement and Consultant accepts no duty of care to any person (except to DBM / Procuring entity [see above] under the Contract) for the preparation of the deliverable. Consultant accepts no responsibility to any third party for any reliance that is taken by the third party on the results of its work and the contents of any report. Regardless of the form of action, whether in contract, tort or otherwise, and to the extent permitted by applicable law, Consultant accepts no liability of any kind and disclaims all responsibility for the consequences of any action (other than to DBM on the above basis) or for any decisions made or not made which are based upon any deliverable. In consideration for PwC agreeing to the publishing of the Report on your website, you agree that you will not hold PwC responsible for the consequences of us doing so; accordingly PwC, its partners, staff and third parties engaged by us to providing the Services related to the Project, shall have no liability to you for any loss, damage, cost or expense suffered by you as a result of publishing the Report, unless it contradicts the provisions of law. Should you have any questions concerning this deliverable, please contact our office.
Y ours sincerely,
PricewaterhouseCoopers Česká republika s.r.o. Hvězdova 1734/2c, 140 00 Prague 4, Czech Republic
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Table of Contents
1. Executive summary 5 2. Our work and approach 11 3. Corporate governance 15 4. Internal control 36 5. Liquidity position 38 6. Investment portfolio 45 7. Foreign exchange risk 48 8. Accounts receivable 51 9. Liabilities 53 10. Quality of earnings 55 11. Review of financial statements 63 12. Loan portfolio and off-balance sheet transactions review 66 13. Fixed assets 93
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1. Executive summary This report has been prepared under the terms of the contract between PwC and the Development Bank of Mongolia (“DBM”), numbered as DBM012018, for the provision of a Financial Diagnostic of the Development Bank of Mongolia (the “Project”). This executive summary outlines the main developments of the Bank in recent years, weaknesses identified, improvements implemented, and areas for further development. It is fair to say that we have noted during our work that the level of corporate governance, policies and procedures and internal control has improved significantly since the enactment of the DBM law in April 2017. It is clear that the Bank has spent considerable effort to improve its internal governance, processes and controls since that date. On the other hand, it is also fair to say, that there are still some areas where DBM can further strengthen its practice comparing to the international standards, this is however pretty much in line with the overall maturity of the Mongolian banking sector. Prior to those changes, there were significant weaknesses within the Bank. As can be seen below, the Bank has implemented a number of new policies post-April 2017 in a number of areas of operations.
Work Block Existing Policies pre-2017 Additional New Policies post-2017
Liquidity Management 8 6 (2 replacements)
Investment Portfolio 0 3
FX risk 2 3 (1 replacement)
Accounts Receivable 2 1 (replacement)
There have also been new policies implemented in the areas of corporate governance, internal control and risk management, but we have not quantified those new policies here.
Our findings on each of the key work blocks is set out below.
1. Key Work Block of Interest: Loans and Provisions for Doubtful Debts
We have reviewed classification and provision requirement as per agreed methodology for years 2012- 2017 for all three main portfolios: Corporate portfolio, on-lending portfolio and portfolio of loans to be repaid from state budget. Loans and advances given to corporate projects are to be repaid from the project’s or borrower’s future cash flow generation and the Bank also holds collateral. On-lending to corporate projects which the Government considers priority commercial activities (air transport development, support of mining industry, railway, infrastructure, Small and Medium Enterprises (SME), housing and manufacturing projects). All portfolios were rapidly growing from 2012 to 2016, when almost full amount of loans to be repaid from state budget was transferred to Ministry of Finance. From 2017, new lending was only done to corporate and on-lending portfolios. During our review we have reclassified several debtors in corporate portfolio from performing to non- performing status, which led to an additional provision, as defined in the methodology. We have done no reclassification in on-lending or loans to be repaid from the state budget portfolios. Reclassification is summarised in table below.
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Cor porate 2017 2016 2015 2014 2013 2012 por tfolio Ba n k Ou r Ba n k Ou r Ba n k Ou r Ba n k Ou r Ba n k Ou r Ba n k Ou r r ev iew r ev iew r ev iew r ev iew r ev iew r ev iew
PE debtors 21 10 3 3 4 3 8 3 4 3 3 2
NPE debtors 19 30 13 13 11 12 6 11 3 4 0 1
Reclassification % 2 7 .50% 0.00% 6 .67% 3 5.71% 1 4.29% 3 3.33%
The most common impairment triggers on which reclassification was based are: 1) DSCR below 1.1; 2) a material decrease in cash flows over the last 12 months; Collateral values also affect the amount of additional provision for non-performing debtors. In our review we have identified that market value of collaterals recorded in Bank’s system is consistently lower than corresponding market value our subcontractor have estimated for same collaterals. The results of the review of collateral and real estate valuation suggest that the value of collateral recorded in the Bank’s systems is not compliant with BoM’s requirements on collateral valuation, i.e. not performed according to IVSC International Valuation Standards. Further, in our review we have discounted market value of collaterals using time to sell, cost to sell and effective interest rates as agreed in the methodology. This discounted collateral value was consistently lower than value recorded in Bank’s system. Please note, number of collaterals revalued were always minimum of 70% of total monetary collateral value for each debtor. Remaining part of collaterals was extrapolated based on the revaluation data. Differences in values as described above are summarised in following table:
In mln MNT Bank’s market Market value Discounted % change % change value after review market value to our to our after review market discounted valuation valuation
2017 7 81,543 1,196,813 579,795 153.1% 7 4.2%
2016 604,534 871,925 450,635 144.2% 7 4.5%
2015 311,650 535,762 274,703 171.9% 88.1%
2014 248,732 291,642 148,688 117.3% 59.8%
2013 32,859 45,058 23,524 137.1% 7 1.6%
2012 0 0 0 0% 0%
Both the reclassification of debtors from performing to non-performing status combined with lower amounts of applied discounted collateral values led to additional provisions to be created. These additional provisions have negative impact on capital adequacy of the Bank. We have aggregated impact of these additional provisions on Bank’s requirement of capital adequacy ratio over years in table below. Only in years 2014 and 2015, Bank would not be able to meet the regulatory requirement of 10%. Most importantly, as end of 2017 Bank was sufficiently capitalised and there is no need to increase capital for the time being.
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Capital Impact
T ot al T ot al Identified T ot al T ot al Ca pital ca pital ca pital a djustments ca pital ca pital su rplus or prior t o a dequacy du ring ou r following a dequacy deficit over rev iew ra tio prior rev iew ou r review ra tio after regulatory (m ln. t o review (m ln. MNT) ou r review m inimum (m ln. MNT) MNT ) of 10% (%) (%) (%)
2 017 1 ,038,823 3 3.60% -2 17,056 8 21,747 2 6 .58% 1 6.58%
2 016 9 53,557 3 0.50% -2 32,584 7 20,973 2 3.06% 1 3.06%
2 015 2 87 ,402 1 4.22% -1 89,130 9 8 ,272 4 .86% (5 .14%)
2 014 2 46,536 1 3.66% -2 10,852 3 5,684 1 .98% (8 .02%)
2 013 1 43,879 17 .76% -1 9,163 1 24,716 1 5.39% 5 .39%
2 012 6 6 ,992 1 3.65% -7 ,443 5 9,549 1 2.14% 2 .14%
Identified adjustments during our review for year 2017 are predominantly stemming from 3 debtors, which have been granted loans in years prior to 2017. There are still on-going relationships between the Bank and the Government of Mongolia, especially in terms of the state budget, for loans provided to customers prior to April 2017, where the government is a guarantor of the loan. Since April 2017, no new loans granted by the Bank are collateralised by a government guarantee. 2. Work Blocks with Significant Remedial Actions Required
Work block Initial situation pre-2017 Im provements post-2017
Corporate Corporate governance not fully Changes in organisational structure supporting Gov ernance dev eloped. m ore independent decision making process and Im portance: H m on itoring function In ternal policies and guidelines m issing or out of date. Update and implementation of crucial/vital in ternal policies and guidelines No transparent decision making process and monitoring function Reporting of prudential ratios and m onitoring by BoM Im plementation of on line loan application sy stem
A reas for Risk management framework (e.g. establish risk strategy, RAS and RA F); Improvements Cr edit approval process (debtor creditworthiness assessment process, collateral valuation m ethodology) and risk monitoring; and Cor porate governance itself (e.g. conflict of interest policy implementation)
Int ernal Very limited amount of internal Dev elopment a nd approval of the In ternal audit Cont rol con trols in place. ch arter in line with international standards and gu idance for the professional practice; Im portance: H Audit function not sufficiently Dev elopment a nd approval of the In ternal audit independent pla n; a nd
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Im provement of the second line of the defence and monitoring of the fulfilment of the BoD resolutions
A reas for Im provement of internal controls sy stem; Improvements Regu lar assessment and reporting of internal controls sy stem; and
Mu ltiyear internal audit plan based on the r isk assessment
Liqu idity Liquidity m anagement was not well Im proved liquidity management policies Im portance: M dev eloped. Described in a very general In tr oduction of LCR/NSFR limits m anner. No limits, liquidity stress testing or contingency funding plan in troduced. No a ctive identification, measurement, monitoring and con trolling of the liquidity risk
A reas for Need for a r obust liquidity framework with liquidity limits Improvements Need for a cumulative gap limits for overall position/per individual currencies
Need for a liquidity stress-testing concept. Results of stress test not taken into account for definition of liquidity limits.
FX Risk There was no active identification, Th e Bank’s management started to manage the Ma na gement measurement, monitoring and FX position and significantly reduced the open FX position. Im portance: M controlling of the FX risk. The Bank w as running an open FX position.
A reas for Need for a r obust FX risk management framework and FX stress testing concept Improvements Ma x imum open FX position for a ll currencies/in each currency cannot exceed 50% of DBM ca pital. This limit allows the bank to expose itself to significant FX risk. However, this is also su bject to availability of FX h edging instruments.
3. Work Blocks with No / Minor Remedial Actions Required
Work block Initial situation pre-2017 Im provements post-2017
Investment Th e investment process was before the In v estment decision making process was Port folio introduction of the new law was very sta ndardised and passed to the Ba nk m anagement inflexible and subject to the approval of Ministry of Finance.
A ccou nts Receivable The Bank was managing a significant Th e volume of a ccounts r eceivables was sign ificantly reduced after 2017 and t here volume of accounts receivables, m a inly from the Ministry of Finance. a r e no material accounts receivables as of December 2017.
Liabilities The Bank started to acquire FCY log- Ba n k was a ble to diversify the funding in terms of currency and maturity. The bank term funding. The funding was mainly secured by the government w a s also a ble to a cquire a long-term funding w ithout government guarantees or by using guarantees. for eign credit insurance companies, however w e did not analyse to what extent the investors considered implicit government gu arantee as DBM r emains 100% Gov ernment of Mongolia owned.
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A reas for On the one hand, the Ba nk’s long-term r efinancing structure is fully dependent on Improvements FCY funding due to a lack of local long-term investors. On the other hand, the m aturity profile is well optimised. Consequently there is a refinancing risk in FCY in
ca se of w orsening the credit risk profile of Mon golia.
Qu a lity of Ea rnings No a dv erse findings noted from our work.
Rev iew of Financial We h ave reviewed the methodologies and techniques for data compilation and potential St a tements m issing items in notes to the financial statement for years ended 31 December 2016 a n d 2017. Our scope was limited to presentation and disclosures related to standalone
fin ancial statements, only. There were no deficiencies identified in methodologies and techniques for data compilation, in the m issing items in notes to the financial sta tement, however, w e have identified sev eral missing disclosures in accordance with th e IFRS.
Fixed Assets We h ave compared amount of fixed assets as r ecorded in your statement of financial position with market comparable value. Difference identified, however, does not ca use any issue with the compliance with local rules.
4. Recommendations for Next Steps
We recommend DBM to develop a remediation program that would address our key findings, which would further strengthen DBM’s practices in line with international standards following number of key improvements since the enactment of the DBM law in April 2017. From our point of view, the key area of focus shall be credit risk and collateral management due to the fact, that credit risk represents key risk for the bank and there are identified deficiencies against international best practices. Recommendations related to policies and procedures: Approve risk strategy, RAS and RAF and develop robust risk management framework to all material risks, and review at least annually for relevant risk policies and limits. This shall also include greater precision on the fiscal cost of such direct lending (short term recommendation) Review methodology for NPL definition and adopt methodology for identification of forborne exposures (short term recommendation) Adopt the stress-testing methodology and perform stress testing exercise for all material risks (medium term recommendation) Adopt the Conflict of Interest policy and clearly define the situations that could create conflict of interest (short term recommendation) Improve the charts of committees and specify their chairmanship and membership (short term recommendation) Develop a wider and more detailed range of credit risk indicators (medium term recommendation) Adopt the Internal control framework and define overall methodology, components of ICS and responsibilities of first and second line of defense (short term recommendation)
Recommendations related to processes: Separate Audit and Risk committees (short term recommendation) Improve credit granting process, so it mainly relies on reliable information and debtor’s ability to repay the loan from its cash flow (short term recommendation) Update collateral valuation methodology for accepting only IVS compliant valuation reports (short term recommendation) Perform and regularly review risk mapping and risk materiality assessment (medium term recommendation) Perform a mapping and analysis of existing 1st and 2nd line controls and formalise them (medium term recommendation) Manage, control and monitor the risks on consolidated level (short term recommendation)
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Develop internal rating system and establish credit limits per debtor based on their rating (medium term recommendation)
Recommendation related to data: Obtain audited financial statements of the debtors on regular monitoring purpose Verify the reliability of business plans of the debtors more closely. Actual versus business plan should be analysed on regular basis to obtain reliance on the plan as it has directly used for cash flow projections when assessing the loan loss provisions. Track the collateral register properly and formal control and procedure should be in place to ensure the completeness and accuracy of the register and to reflect the register in case of amendment into the contract. Tracked off-balance exposures in complete and accurate way. New standards on loan loss provision started to consider the off balance exposure when assessing loan loss provision
Improvements in above-mentioned areas will further significantly strengthen stability of DBM.
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2. Our work and approach
2.1. Overview of the approach We have summarised our approach into work blocks, as described below: Corporate governance and internal control system This work block encompassed evaluation of the existing corporate governance and internal control system from the point of view of compliance with international “good practices” for corporate governance, internal control, risk and credit risk management. This evaluation has been done against recognised international standards. Liquidity position We have assessed DBM’s liquidity both in terms of its ability to manage its assets and liabilities positions as well as in terms of its ability to generate operating cash sufficient to cover its operating expenses. Assessment has been done against international standard for liquidity management. Investment portfolio In this work block, we have assessed the adequacy of reflection of the securities investment portfolio and related gains/losses in the bank’s financial statements. Securities portfolio has been assessed based on the IFRS standards and ECB’s AQR manual. Accounts receivables We have reviewed the portfolio of accounts receivables and determined the adequacy of the reflection in the bank’s financial statements. Accounts receivables portfolio has been reviewed against IFRS standards. Liabilities In this work block, we have analysed funding risks, such as maturity and/or currency mismatches and assess possible impact on liquidity management as well as on earnings. Foreign exchange risk We have analysed DBM’s foreign exchange risk exposure and its translation into bank’s financial statements. This has been done following IFRS standards and good practice. Quality of earnings We have analysed quality and sustainability of earnings. This has been done against IFRS rules. Review of financial statements In this work block, we have reviewed financial statements of DBM for years 2016 and 2017. Loan portfolio and off-balance sheet transactions review In this work block, we have reviewed classification of a loan portfolio, on- and off-balance sheet transactions and where a non-performing status is recognised, reviewed available cash flow and collateral valuations. Subsequently, a relevant provision is calculated. Review of the collateral has been done using methodology as described in ECB’s AQR manual localised with requirement of at least of 70% of total monetary collateral value to be revalued through this process and the remainder extrapolated. Fixed assets We have reviewed fixed assets as recorded in the balance sheet. Market value approach is to be used in comparison to bank’s valuation approach.
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2.2. Overview of the work conducted We have summarised list of activities we have done during this project below: Corporate governance and internal control system In this workblock we have reviewed: The existing corporate governance structure including the composition, roles and responsibilities and proceedings of the board of directors; The organisational structure including the board committees and management committees and the reporting lines; The processes for the nomination and appointment of board members and senior management Internal controls system – regulatory requirements, design of internal controls, linkage to strategies, activities products Internal audit function – role and structure of internal audit, reporting lines, responsibilities and functions, capacity Board oversight of controls – role of audit committee, coordination with external auditors/supervisors/regulators, reporting and internal controls External audit and follow up actions with regard to issues identified in management letters Policies and procedures for loan administration and credit risk. Managing and administering its loan portfolio in general and problem loans in particular Risk management policies and procedures for identifying and monitoring initial and changing levels of risk associated with approved credit exposure; The process for classification of loans and other assets; DBM’s capacity to assess, administer, supervise, and recover loans, advances, guarantees and other credit investments, based on the review of its internal policies and procedures; Adequacy of accounting policies and effectiveness of the accounting system in recording/ monitoring Adequacy of risk control associated with off-balance sheet transactions management and board oversight Liquidity position We have reviewed following activities in this work block: Maturity gaps between assets and liabilities Liquidity support provided by any organisation, such as the Government, the BOM, another financial institution and the relative impact of such support on DBM in terms of profitability, liquidity, and interest rate exposures Large funding concentrations and their legal status, particularly as regards related parties and/or large lenders The frequency and level of borrowing Sensitivity to external/domestic credit lines and syndicated financing, etc. Reliance on the other government agencies, or other sources of liquidity or term support Investment portfolio In this workblock we have reviewed activities as below: Listing and classification of securities; The underlying asset quality, where appropriate and possible The paying capacity of the obligors based on information provided by the Bank in their Comments on borrowers Clear title to the securities being held by DBM Any permanent reduction for recoverable values of securities Appropriate allowances for losses provided for where necessary; The translation exposure of any securities denominated in foreign currencies
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Foreign exchange risk We have reviewed following areas: DBM’s Market risk management framework, Market risk strategy DBM’s FX risk exposure (the extent of actual and potential foreign exchange losses, open positions) The posting of forex transactions in the bank’s financial statements Credit risk arising from possible un-hedged client positions (FX lending risk) Accounts receivable In this work block we have reviewed following activities: Determined the appropriateness of the Regulations on Asset Classification for assessing accounts receivables (A/R) Addressed the underlying asset quality of the A/R, evaluating the asset quality of the A/R in light of the Regulations Identified gaps by preparing a pro forma provision comparing to the current provision Assessed the legal risks involved, in particular, ascertaining that the bank has clear title to the assets Determined accuracy of the translation of the asset value Ensured that all reconciliations between banks are reviewed and outstanding items satisfactorily cleared Liabilities We have reviewed following activities: Collected data on liabilities, funding sources, maturities and currencies Identified mismatches with assets in maturity or currencies Identified and assess impacts on liquidity management and potential impact on earnings Quality of earnings In this work block we done following activities: Reviewed earnings generated from related party transactions Reviewed the earnings generated from accrued but uncollected interest, fees and FX revaluations Reviewed the policies and criteria for decision making process on capitalisation of interest and renewal and refinancing of existing loans Reviewed the income recognition policies Reviewed the accounting procedures for deferred expenses and derivative trading Review of financial statements We have done following activities in this work block: Identify any material items which could, in the absence of a note, mislead a reader accustomed to financial statements prepared in accordance with IFRS/ IAS Explain methodologies and techniques used in compiling the data which may differ from methodologies normally relied upon by DBM Loan portfolio and off-balance sheet transactions review Reviewed classification of the loans within selected period based on latest applicable methodology For impaired loans we have reviewed the level of provisioning Portfolio analysis to understand credit risk concentrations The nature and volume of credit commitments, contingent liabilities, and guarantees
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Credit risk associated with those off-balance sheet instruments, especially when the counterparty to an off-balance sheet instrument is also a borrower Derivative transactions and/or exposures The financial strength of clients related to off-balance sheet liabilities and the prospects and timing for possible draws on guarantees and other off-balance sheet items; Unsettled claims and contingent losses Reviewed of the collaterals and cash flows when calculating provisions Fixed assets We have reviewed the value of Bank’s valuation of fixed asset and compared it against the market value.
2.3. Tim eline and key activities
A graphical display of all activities, their linkages and real dates
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3. Corporate governance Within this workblock we have analysed the existing overall corporate governance framework from the point of view of compliance with BCBS Guidelines - Corporate governance principle for banks (BCBS d328).
3.1. Level of development of overall corporate governance Within the overall corporate governance framework, the assessment focus has been on: The existing corporate governance structure (rules and responsibilities, key policies - Internal control framework, risk and compliance policies and policies to identify and avoid conflicts of interest); The organisational structure including the Board of Directors (BoD) and management committees; The process for the nomination of BoD members and senior management; and Key policies - Internal control framework, risk and compliance policies, policies to identify and avoid conflicts of interest, remuneration policy). The DBM Act (in force since April 2017) defines the DBM as a for-profit commercial entity and requires the Bank to apply and follow the corporate governance principles of: Profitability; Sustainability of operations; Independence; Transparency; Responsibility; Decision making based on collective management; and Independent supervision.
The new DBM Act has improved the supervisory system of DBM and introduced The power of the Bank of Mongolia to set the prudential ratios for DBM and monitor the compliance with the regulation; Independent internal audit function; and Overseeing function on the implementation of projects financed by DBM.
However, the requirements of DBM Act do not cover all corporate governance principles according to the BCBS Guidelines (e.g. conflict of interest policy and related party transaction policy with crucial significance in order to ensure greater independence and profitability of the Bank especially in credit granting process). Therefore, DBM’s corporate governance guidelines based on the DBM act – despite a significant improvement comparing the period 2012-2016 - are not fully in line with international standards.
We have identified key findings related to the non-compliance with good practices for corporate governance and suggests recommendation in Table 1 below.
T able 1: Findings and recommendations related to corporate governance framework
Ref. Applicable standards and Finding Recommendation No. guidelines
1 Board’s overall The Bank has not adopted The bank should adopt the responsibilities – key internal control internal control framework policies framework. and define overall methodology, components
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(control environment, risk assessment, control Internal control system, activities, information & Risk management system Principle 1 (26) (BCBS d 328) communication, monitoring and corporate governance activities) of ICS and Board should approve the assessment reports not responsibilities of first and approach and oversee the performed in 2012-2017 implementation of key policies second line of defense.
pertaining to the bank’s capital adequacy assessment process, The BoD is not currently The bank should ensure that capital and liquidity plans, sufficiently involved in the ICS and RM reports are compliance policies and process of control and performed and obligations, and the internal oversight of ICS, RM, and communicated to the BoD control system corporate governance and the identified despite the fact, that the Principle 1 (BCBS d 223) shortcomings are resolved board has ultimate without undue delay. An effective internal audit responsibility for the function provides independent bank’s ICS, governance assurance to the board of structure and practices and
directors and senior management risk management. on the quality and effectiveness of
a bank’s internal control, risk management and governance systems and processes. Principle 7 (BCBS d 223) At least once a year, the board of directors should review the effectiveness and efficiency of the internal control system based, in part, on information provided by the internal audit function. Principle 13 (BCBS d 223) The internal audit function should independently assess the effectiveness and efficiency of the internal control, risk management and governance systems and processes created by the business units and support functions and provide assurance on these systems and processes.
2 Board qualifications and No comments, bank is in No recommendations composition line with international good practice Principle 2 (BCBS d 328) The fit & proper criteria are Board members should be and defined by DBM Act and remain qualified, individually and also are in line with collectively, for their positions.
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They should understand their international good oversight and corporate practice. governance role and be able to exercise sound, objective judgment about the affairs of the bank.
3 Board’s own structure and The Bank has not adopted The Bank should adopt the practices – conflict of the Conflict of Interest Conflict of Interest policy interest policy and follow only the and clearly define the general applicable law. situations that could create Principle 3 (82 - 86) (BCBS d conflict of interest. 328) The bank should adopt The board should oversee the formalised Related Parties implementation and operation of Transactions Policy. policies to identify potential conflicts of interest. Where these conflicts cannot be prevented,
they should be properly managed (based on the permissibility of relationships or transactions under sound corporate policies consistent with national law and supervisory standards). The board should have a formal written conflicts-of-interest policy and an objective compliance process for implementing the policy.
Board’s overall
responsibilities – related parties transactions Principle 1 (27) (BCBS d 328) The board should ensure that transactions with related parties The general procedures for (including internal group the credit granting and transactions) are reviewed to approval procedures are assess risk and are subject to applied to all clients - appropriate restrictions (eg by nevertheless, the Bank has requiring that such transactions not adopted Related party be conducted on arm’s length transaction policy. terms) and that corporate or business resources of the bank are The Bank has identified a list of related parties, but it not misappropriated or The bank should adopt misapplied. is not updated or verified policies and control for its completeness Principle 5 (98) (BCBS d mechanism governing regularly. 328) related-party transactions.
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The subsidiary Board should ensure that the group’s corporate
governance framework includes appropriate processes and controls to identify and address potential intragroup conflicts of interest, such as those arising from intragroup transactions, in appropriate recognition of the interest of the group.
4 Board’s own structure and The charts of BoD The Bank should : practices - committees committees and management committees Specified the Principle 3 (64 - 67) (BCBS d are not detailed enough membership of 328) (not defined chairmanship committees Each committee should have a and membership). Split the Audit charter that sets out its mandate, Disclosure not in line with Committee and Risk scope and working procedures. good practices. Committee This includes how the committee will report to the full board, what Audit and Risk committees Improve the is expected of committee are not distinct. content of members and any tenure limits disclosure for serving on the committee. The board should disclose the committees it has established, their mandates and their composition (including members who are considered to be independent). A BoD committee chair should be an independent, non-executive board member. Principle 3 (68, 71) (BCBS d 328) An audit committee should be distinct from other committees A Risk committee should be distinct from the Audit Committee.
5 Senior management The internal guidelines No recommendation governing the Executive Principle 4 (BCBS d 328) management operations Under the direction and oversight issued in 2016. New act of the board, senior management from 2017 didn’t trigger should carry out and manage the any change in this area. bank’s activities in a manner
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consistent with the business strategy, risk appetite, remuneration and other policies approved by the board.
6 Governance of group The Bank’s internal The Bank should manage, structures control and risk control and monitor the management, monitoring risks on consolidated level Principle 5 (BCBS d 328) and reporting function (including consideration of In a group structure, the board of does not cover the subsidiaries risk exposure . the parent company has the subsidiaries (i.e. DBM overall responsibility for the leasing LLC, which group and for ensuring the provides equipment lease establishment and operation of a services to the local clear governance framework entrepreneurs; appropriate to the structure, DBM Asset Management business and risks of the group Securities LCC, which aims and its entities. The board and to support the increase of senior management should know foreign currency inflow and understand the bank group’s and foreign direct organisational structure and the investment; and risks that it poses. National Export Insurance LLC).
7 Risk management function No comments. In line with No recommendations international good practice Principle 6(BCBS d 328) Banks should have an effective independent risk management function, under the direction of a chief risk officer (CRO), with sufficient stature, independence, resources and access to the board.
8 Risk identification, See findings – Risk See recommendations – m onitoring and controlling management framework Risk management framework Principle 7(BCBS d 328) Risks should be identified, monitored and controlled on an ongoing bank-wide and individual entity basis. The sophistication of the bank’s risk management and internal control infrastructure should keep pace with changes to the bank’s risk profile, to the external risk landscape and in industry practice.
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9 Risk communication See findings – Risk See recommendations – management framework Risk management Principle 8(BCBS d 328) framework An effective risk governance framework requires robust communication within the bank about risk, both across the organisation and through reporting to the board and senior management.
10 Compliance The Bank has established The Bank should update compliance function, the compliance policy in Principle 9 (BCBS d 328) nevertheless order to define the main The bank’s board of directors is areas of compliance risk appropriate risk responsible for overseeing the exposure and processes by mapping (i.e. management of the bank’s identification of risks which compliance risk are compliance risk. The board to which the Bank is or to be identified and should establish a compliance might be exposed) and managed. function and approve the bank’s risk materiality We recommend to perform policies and processes for assessment is not compliance reviews based identifying, assessing, monitoring performed on annual risk-based plan. and reporting and advising on a formalised mapping of second line of compliance risk. controls is missing.
Therefore it cannot be certain that all compliance risks are covered by regular internal controls procedures other than the ones performed periodically by IA ( third line).
11 Internal audit Internal control system, The Bank should ensure the risk management system regular assessment and Principle 10(BCBS d 328) and corporate governance reporting on ICS, Risk The internal audit function should report not performed in management framework provide independent assurance to 2012-2017 as a result of and compliance function. inadequate/insufficient IA the board capacity in 2012-2016. IA is required to perform a Capacity issues have been The Bank should ensure periodic assessment of the bank’s remedied in 2017. that reports are overall risk governance communicated to the BoD. framework, including the effectiveness of the risk management and compliance functions;
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the quality of risk reporting to the board and senior management; the effectiveness of the bank’s system of internal controls. 12 Compensation Remuneration policy of The Bank should ensure the risk takers not different remuneration system Principle 11 (BCBS d 328) from other employees. dependent on fulfilment of The bank’s remuneration There is no measurable the approved strategy and structure should support sound indicator related to risk limits (RAS). The corporate governance and risk motivating risk takers to remuneration system management. maintain and decrease risk should prevent conflicts of in required level. interest. Principle 1 (46) (BCBS d 328) BoD should set appropriate performance and remuneration standards for senior management consistent with the long-term strategic objectives and the financial soundness of the bank; Principle 3 (77) (BCBS d 328) The compensation committee works closely with the bank’s risk committee in evaluating the incentives created by the remuneration system. The risk committee should examine whether incentives provided by the remuneration system take into consideration risk, capital, liquidity and the likelihood and timing of earnings.
13 Disclosure and transparency The Bank has not adopted The Bank should adopt the internal guidelines disclosure policy and Principle 12 (BCBS d 328) governing disclosure. We ensure the review of reports The governance of the bank have identified before disclosure should be adequately transparent discrepancies in reports to its shareholders, depositors, published 2012-2018. other relevant stakeholders and These include Annual market participants. Reports, Consolidated Financial Statements and independent Auditor’s Report
3.2. Risk management framework Within this section we have analysed the existing risk management framework from the point of view of compliance with international good practice:
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BCBS Guidelines - Corporate governance principle for banks (BCBS d328) FSB – Principles for an Effective Risk Appetite Framework BCBS Principles for the Management of Credit Risk (BCBS d75) BCBS Standards - Supervisory framework for measuring and controlling large exposures (BCBS d283) BCBS Guidelines - Prudential treatment of problem assets –definitions of non-performing exposures and forbearance (BCBS d403) We have reviewed Bank’s risk governance principles, internal policies and procedures: Risk management policy (April 2017 and old version dated 2012) Credit policy (April 2017) Regulation on decision for financing projects and program ( November 2017) Regulation on credit committee operation (July 2018) Regulation on credit operation (October 2017 and previous version dated July 2012) Decision making procedures on project financing ( November 2017) DBM strategy 2018-2022 Loan provisioning policy
We have identified findings related to the risk appetite framework, risk strategy and risk appetite statement and suggests recommendations as shown in tables 2 and 3 on page 23 and 26.
3.3. Adequacy of risk management framework The FSB Principles and BCBS Guidelines require the banks to develop a risk appetite framework (hereinafter also referred to as “RAF“) that is institution-specific and reflects its business model and organisation. The RAF should consider material risks to the institution and align with the Bank's strategy. The Risk appetite statement (hereinafter RAS) represents the aggregate level and types of risk that the Bank is willing to accept- or to avoid. It should include qualitative statements and quantitative measures. The risk management strategy should include the internal definitions of the risks to which the Bank is (or might be) exposed, the policies governing the assessment of risks and the risk management methods, including the stress testing.
Within the RAF and Risk strategy, assessment focus has been primarily on following key area: whether the risk appetite framework considers all material risks to which the DBM is (or might be) exposed and contains risk limits, tolerances and thresholds; whether the risk appetite and risk strategy are consistent; whether the risk appetite framework is forward-looking and in line with the strategic planning horizon (2018-2022), and regularly reviewed; whether the responsibility of the management body in respect of the risk appetite framework is clearly defined and exercised in practice; whether the risk strategy appropriately considers the financial resources of the Bank (i.e. risk appetite should be consistent with own funds and liquidity resources)
The DBM’s risk governance is not fully in line with good practices. We have identified findings related to the risk appetite framework, risk strategy and risk appetite statement and suggests recommendations as shown in tables 2 and 3 on pages 23 and 26.
3.4. Adequacy of the existing process for granting and monitoring loans We have reviewed and discussed with the Bank’s management the internal policies and procedures for credit granting process (with focus on credit granting criteria and assessment of the client’s risk profile. We have also reviewed the loan approval process against the meeting minutes of the Credit Committee (to potentially identify any discrepancies between approval process recommended and applied.
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Within the credit risk management framework assessment focus has been primarily on following key areas: Credit risk environment Credit approval process Measurement and monitoring Control and oversight
The DBM’s policies and procedures for loan administration and credit risk management are not fully in line with international good practices. We have identified key findings related to the non-compliance with good practices and suggest recommendations as shown in tables 2 and 3 on pages 23 and 26.
3.5. Adequacy of the existing process for the classification of loans and other assets The Bank’s definition of non-performing loans (hereinafter NPL) is not in line with BCBS Guidelines - criteria for categorising loans are focused on delinquency status - 90 days past due or the unlikeliness of repayment.
The Bank follows the “Regulation on asset classification, provisioning and its disbursement“, issued by BoM in Oct, 2017. According to this regulation (which is non-compliant with BCBS) - based on an accounting-related concept, loans are classified at 5 levels depending on provisioning rate level:
1. Performing (up to 5%) 2. Special mention (5%-25%)
Non-performing:
3.Substandard (25%-50%) 4. Doubtful (50%-75%) 5. Loss (75%-100%)
The following exposures are considered as non-performing under BCBS Guidelines – “Prudential treatment of problem assets –definitions of non-performing exposures and forbearance” (hereinafter BCBS d403):
all exposures that are “defaulted” under the Basel II framework (i.e. a default is considered to have occurred with regard to a particular client when either or both of the two situations have taken place - the bank considers that the client is unlikely to pay its credit obligations in full, without recourse by the bank to actions and/or the client is past due more than 90 days on any material credit obligation; all exposures that are credit-impaired according to the applicable accounting framework; all other exposures that are not defaulted or impaired but nevertheless are material exposures that are more than 90 days past due or where there is evidence that full repayment based on the contractual terms (original or modified) is unlikely without the bank’s realisation of collateral; In the case of debt securities, a situation of partially or totally missed payment for more than 30 days will trigger a specific assessment of the counterparty’s creditworthiness. The BCBS’s definitions of non-performing exposures (hereinafter NPE) and forbearance represent a harmonised asset quality indicator that can provide an asset quality comparison across jurisdictions and is indifferent to a jurisdiction’s stage of implementation of the different versions of the Basel capital framework. BCBS standards are requirements which apply to internationally active banks – therefore they are important for DBM.
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Considerable improvements have been achieved during the period from 2017 - but important progress in risk management is still needed. We have identified key findings related to the non-compliance with good practices and suggest recommendations as shown in tables 2 and 3 below
T able 2: List of findings and recommendations related to risk management framework, credit granting and monitoring process, and classification of loans and other assets
Ref. Applicable standards and Finding Recommendation No. guidelines
1 Principle 1 (33, 36) The Bank has not adopted As part of the strategic (BCBS d328) the Risk Strategy. The Risk decisions, the BoD should management policy, approve RAF, RAS and Risk An effective risk governance (approved by BoD in April strategy to establish effective framework includes a well 2017 – replacing the Policy risk governance framework developed risk appetite adopted in 2012) does not articulated through the RAS. define the RAF and RAS. The bank’s RAS should:
• include both quantitative
and qualitative The frequency of Risk policy considerations; (risk limits) review and The bank should ensure the update have not been clearly regular (at least once a year) • establish the individual and defined. and ad-hoc (in response to aggregate level and types of significant changes of external risk that the bank is willing to or internal conditions) assume in advance of and in evaluation and – where order to achieve its business necessary - modification of all activities within its risk relevant risk strategies, capacity; policies, procedures and limits. Principle 1 (7 1) (BCBS d328) The bank is required to review the bank’s risk policies at least annually
2 Principle 1 (33, 36) The Bank has not performed The Bank should perform and (BCBS d328) appropriate risk mapping regularly review (i.e. identification of risks to Risks should be identified, which the Bank is or might Risk mapping monitored and controlled on be exposed) and risk Risk materiality an ongoing bank-wide and materiality assessment. assessment individual entity basis. Risk Control Self Assessment in order to identify all inherent and residual risks.
3 Principle 1, 7 (BCBS Because of missing forward- The Bank should ensure the d328) looking risk triggers (RAS) consistency among Bank’s the DBM Strategy for 2018-
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The RAF should be aligned 2022 does not cover and Strategy (medium and long with the business plan, include detailed risk targets. term), business plan and RAS. strategy development, capital
planning and compensation schemes of the financial The Bank has not developed institution. a capital plan The Bank should develop the capital plan.
The Procedure on designing a business plan does not
require the involvement of RM. The bank should update the Procedure on designing business plan
4 Principle 7 (124) (BCBS The Bank’s Risk The Bank should manage the d328) management, monitoring risks on consolidated level and reporting function does (including consideration of Effective risk identification not cover the risk exposure subsidiaries risk exposure in and measurement approaches in subsidiaries (on Risk strategy, RAF, RAS and are likewise necessary in consolidated level) risk reporting). subsidiaries. Material risk- bearing subsidiaries should be captured by the bank-wide risk management system and should be a part of the overall risk governance framework
Principle 8 (130) (BCBS d328) Risk monitoring and reporting should cover not only the disaggregated level (including material risk residing in subsidiaries) but also be the aggregated view to allow for a bank-wide or integrated perspective of risk exposures.
5 Principle 6 (105) (BCBS The DBM’s Risk The Bank should develop the d328) management policy defines traffic light system - colour only one level of risk limits coding system : Risk management should and therefore does not establish an early warning or green light/performance in trigger system for breaches of provide the triggers line with targets and the bank’s risk appetite or within early warning / allocated limits trigger system indicating yellow light/trigger breach limits breaches referring to - business goals and normal/warning/crisis shareholders’ expectations situation at risk
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allow sufficient lead time red light/ limit breach and timely intervention (Capital / liquidity adequacy and/or regulatory limits at risk) for setting the signalling threshold of relevant changes.
The traffic light system allows to prioritise escalation procedures and remedial actions timely intervention to avoid most costly or last resort remediation measures 6 Principle 7 (120) (BCBS No comprehensive stress test The bank should adopt the d328) is performed. The Bank only stress-testing methodology. perform liquidity stress test Internal stress tests should (no formalised stress testing cover a range of scenarios policy). As part of its quantitative and based on reasonable qualitative analysis, the bank assumptions (basic should utilise stress tests and macroeconomic indicators - scenario analyses to better GDP, unemployment and understand potential risk inflation rate). exposures under a variety of adverse circumstances Senior management should define and the Board should review the scenarios that are used in the bank’s risk analyses.
7 Principle 7 (BCBS d328) Responsibility for new The Bank should adopt the product approval lies on internal rules stipulated The CRO’s responsibilities Executive Committee – development and also include managing and nevertheless the bank has implementation (launching) of participating in key decision- not adopted formalised the new products (for DBM making processes (e.g written rules for new product and subsidiaries). strategic planning, capital approval (i.e. assessment of and liquidity planning, new risk inherent in new or non- products and services, standard products, compensation design and transactions, services and operation). other activities, markets, client segments, geographical areas and counterparties).
9 Principle 8 (129) (BCBS The Bank's financial We recommend extending the d328) performance risk report content of Risk report in order (performed on quarterly to ensure that the BoD and basis) does not provide the executive management are
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Risk reporting should also information on informed of all factors that include information about the macroeconomic and might have a negative impact external environment to financial markets on the Bank’s financial identify market conditions development. position - including the effects and trends that may have an of changes in external impact on the bank’s current environment. or future risk profile.
T able 3: List of findings and recommendations to Credit Risk Management Framework:
Ref. Applicable standards and Finding Recommendation No. guidelines
1 Principle 1 (BCBS d75) The DBM’s Credit policy has The bank should adopt the been approved by BoD in internal rule governing the April 2017 and replaced the preparation, approval, The BoD should have Regulation on Credit evaluation and regular update responsibility for approving Operations approved by CEO of the risk policies. in 2012 and periodically (at least annually) reviewing the This document has not been credit risk strategy and reviewed internally since, significant credit risk policies missing a required review of The Bank should develop a of the bank. The strategy minimum 12 months wider and more detailed range should reflect the bank’s The DBM’s Strategy 2018- of credit risk indicators (e.g. tolerance for risk and the 2022 is assessed on only one Cost of Risk ratio, growth rate level of profitability the bank credit risk target, the NPL of gross non-performing loans) expects to achieve for ratio. targets when defining its credit risk appetite and risk strategy. incurring various credit risks. The Bank does not establish
any other comprehensive credit risk targets based or The Bank should follow the Principle 1 (7 1) (BCBS alternative indicators BoM request for concentration d328) The Bank has not set up risk limit. limits for any industries (concentration risk) and for The bank is required to total loan to total asset, which The Bank should perform and review the bank’s risk is suggested by BoM in 2017. policies at least annually regularly review the risk As a result of missing risk mapping, risk materiality mapping, the Bank does not assessment and Risk Control consider all subcategories of credit risk (e.g. FX lending Self Assessment (see Risk risk and credit concentration management framework – ref. risk). No 2).
2 BCBS Guidelines (d403) The Bank follows the DBM should review the NPL “Regulation on asset definition and amend in line The harmonised recognition criteria for NPE consider: classification, provisioning with international good and its disbursement “, practice. Uniform 90 DPD issued by BoM in Oct, 2017. criterion applied to all types of exposure The definition of NPL is not including those in line with BCBS Guidelines secured by real estate (harmonised criteria for
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and public sector categorising loans focused on exposures. delinquency status - 90 days The 90 DPD past due or the unlikeliness of criterion is repayment). supplemented by considerations for analysing a counterparty’s unlikeliness to pay, for which the definition emphasises the importance of financial analysis. Collateralisation plays no direct role in the categorisation of NPE. Any recourse by the bank shall not be considered in this assessment. 3 BCBS Guidelines (d403) The Bank has not adopted the DBM should adopt the forbearance methodology. methodology for identification Forbearance includes of forborne exposures in line concessions that are granted with international good due to debtor’s financial practice. difficulty on any exposure (a loan, a debt security or an off-balance sheet item - loan commitments or financial guarantees), regardless of the measurement method for accounting purposes. Forborne exposures should be identified as non- performing when they meet the specific criteria provided for in this definition.
4 Principle 2 (BCBS d75) Finding described in greater Recommendation described in detail in finding No 1. greater detail in Senior management should recommendation No 1. have responsibility for implementing the credit risk strategy approved by the board of directors and for developing policies and procedures for identifying, measuring, monitoring and controlling credit risk. Such policies and procedures should address credit risk in
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all of the bank’s activities and at both the individual credit and portfolio levels.
5 Principle 3 (BCBS d75) The bank has not adopted the DBM should develop the New New product approval product approval policy. Banks should identify and framework. manage credit risk inherent in all products and activities. Banks should ensure that the risks of products and activities new to them are subject to adequate risk management procedures and controls before being introduced or undertaken, and approved in advance by the board of directors or its appropriate committee.
6 Principle 4 (BCBS d75) The credit granting criteria DBM should update the Credit are not based on policy to include formalised, Banks are required operate documented, data-based risk data-based credit risk targets within sound, well-defined targets. and debtor creditworthiness credit-granting criteria. There are no formalised criteria/levels to support the These criteria should include triggers (no specific financial lending decisions for all a clear indication of the indicators clearly defined) for products. bank’s target market and a debtor’s creditworthiness thorough understanding of assessment during credit the borrower or approval and monitoring Financial analysis of non-retail counterparty, as well as the process. Risk assessment clients may include following purpose and structure of the (low-medium-high) depends ratios: leverage ratio; credit, and its source of on expert judgment. debt/EBITDA ratio; interest repayment. coverage ratio; current In the absence of objective liquidity ratio; or ratio of
credit-risk triggers, the DBM (operating cash flow + interest is exposed to the risk of expenses)/interest expenses; inadequate creditworthiness loan-to-value ratio; and any assessment. other relevant indicators.
7 Principle 4 (BCBS d75) Despite the fact that The Bank should develop procedures for identification formalised internal procedure Banks should have of connected clients are for identification and procedures to identify performed (as a part of credit monitoring of groups of situations where, in granting process and connected clients. considering credits, it is monitoring), there is no appropriate to classify a formalised internal procedure group of obligors as for identification and periodic The procedure should define connected counterparties update of the composition of the criteria a periodic update and, thus, as a single obligor. of the composition of groups of connected counterparties to
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BCBS Standards (d283) groups of connected identify changes in ownership counterparties. and economic The framework specifies that interdependence. two parties are connected if The criteria for identification at least one of the following of connected parties are criteria is satisfied: based on ownership and does not take into account a control relationship, economic interdependence where one of the counterparties has direct or indirect control over the other; and/or economic interdependence, where, if one of the counterparties were to experience financial problems, such as funding or repayment difficulties, the other would also encounter financial difficulties. 8 Principle 4 (BCBS d75) The Regulation on collateral The Bank should update the and Guidance on collateral Regulation on collateral and clearly defined acceptable Guidance on collateral and Banks should have a policy and prohibited collaterals. implement the methodology in line with IVS. for collateral acceptance and Nevertheless in-house a methodology for evaluating valuation methodology is not the fair value and liquidity of detailed enough, no collateral both at acceptance certification and qualification and over the duration of the requirements for internal exposure. appraiser are defined and Banks should have independent appraisal is not procedures for the ongoing required. valuation of such collateral, The collateral revaluations and a process to ensure that are not required to be collateral is and continues to compliant with the be enforceable and realisable. International Valuation Standards.
9 Principle 4 (BCBS d75) The Loan provisioning policy The Bank should update the (based on IAS 39) is not Loan provisioning policy (i.e. In considering potential detailed enough and define clear indicators and credits, banks must recognise therefore does not allow to ratios) in order to ensure that the necessity of establishing follow an audit trail. all provisioning-related provisions for identified and controls and decisions can be
expected losses and holding step-by-step adequate capital to absorb retraced/replicated. unexpected losses. The bank should factor these considerations into credit-
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granting decisions, as well as into the overall portfolio risk management process.
10 Principle 5 (BCBS d75) The Bank assesses the The Bank should establish debtor's credit applications credit limits per debtor based Banks should establish on a one-by-one (ad-hoc) on their rating results overall credit limits at the basis, without establishing (creditworthiness assessment) level of individual borrowers overall exposure limits for to facilitate credit approval and and counterparties, and individual debtors or group of monitoring. groups of connected debtors (connected parties). counterparties that aggregate in a comparable and There is no credit limit policy See Finding /Recommendation meaningful manner different that would link a debtor's No 15 – missing internal types of exposures, both in creditworthiness risk (low, rating methodology. the banking and trading book medium, high) to an and on and off the balance exposure limit. sheet.
11 Principle 5 (BCBS d75) The bank has not performed DBM should adopt the any comprehensive stress methodology for the future Banks should consider the test. (see also Risk comprehensive stress tests. results of stress testing in the management framework - ref (See Risk management overall limit setting and No 6 and CRM finding No framework ref No 6 and monitoring process. 19). CRMF finding No 19).
DBM should consider the stress testing exercise in the credit granting/limit setting and monitoring procedures. (See Risk management framework ref No 6 and CRMF finding No 19).
12 Principle 6 (BCBS d75) No major comments, n/a responsibilities are clearly Banks should have a clearly- defined, but sound granting established process in place process need to be developed for approving new credits as as described in finding 6. well as the amendment, renewal and re-financing of existing credits.
13 Principle 7 (BCBS d75) The bank does not adopt the DBM should adopt the Related Related parties policy. parties policy. All extensions of credit must be made on an arm’s-length (See also section Corporate basis. In particular, credits to governance ) related companies and individuals must be authorised on an exception basis, monitored with
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particular care and other appropriate steps taken to control or mitigate the risks of non-arm’s length lending. Principle 1 (27) (BCBS d328) The board should ensure that transactions with related parties (including internal group transactions) are reviewed to assess risk and are subject to appropriate restrictions (e.g. by requiring that such transactions be conducted on arm’s length terms) and that corporate or business resources of the bank are not misappropriated or misapplied.
14 Principle 9 (BCBS d75) The Credit operation DBM should update the Credit regulation describes the operation regulation and Banks must have in place a monitoring procedures, include formalised, data-based system for monitoring the nevertheless the credit risk targets and debtor condition of individual responsibilities and creditworthiness credits, including frequency are not clearly criteria/financial ratios for determining the adequacy of defined. monitoring purposes provisions and reserves.
Principle 10 (BCBS d75) The bank performs Internal risk ratings are an monitoring in half year basis important tool in monitoring for provisioning purposes. and controlling credit risk. In order to facilitate early identification of changes in As a result of missing credit risk profiles, the bank’s granting/monitoring triggers internal risk rating system (re-assessment of low- should be responsive to medium-high risk status) the indicators of potential or Bank's capability to monitor actual deterioration in credit the development of the risk. quality of the loan portfolio is Credits with deteriorating significantly diminished. ratings should be subject to
additional oversight and monitoring.
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15 Principle 10 (BCBS d75) The Bank has not developed DBM should develop their own an internal rating internal rating system Banks are required to methodology and system. (internal rating scales to develop and utilise an categorise loans) and define internal risk rating system in various grades differing credit managing credit risk. The risk characteristics and loan rating system should be quality (from satisfactory to consistent with the nature, unsatisfactory). sise and complexity of a bank’s activities.
16 Principle7 (121) (BCBS The Bank has not performed DBM should develop the d403) any back testing of its methodology for the future internal credit risk back testing of the bank's Banks should regularly assessment of individual internal rating model. compare actual performance debtors. against risk estimates (i.e. backtesting) to assist in judging the accuracy and effectiveness of the risk management process and making necessary adjustments.
17 Principle 11 (BCBS d75) As a result of missing The Bank should implement concentration risk triggers the system for monitoring the Banks must have information (limits for one industry) the concentration risk. systems and analytical Bank's capability to monitor techniques that enable the concentration of risk is management to measure the significantly diminished. credit risk inherent in all on- and off-balance sheet (See Finding No 1). activities. The management information system should provide adequate information on the composition of the credit portfolio, including identification of any concentrations of risk.
18 Principle 12 (BCBS d75) As a result of missing The Bank should implement monitoring triggers (re- the system for monitoring the Banks must have in place a assessment of low-medium- development of riskiness of the system for monitoring the high risk status) the Bank's borrowers (quality of the loan overall composition and capability to monitor the portfolio). quality of the credit portfolio. development of the quality of the loan portfolio is significantly diminished.
19 Principle 13 (BCBS d75) DBM should improve the creditworthiness assessment
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Banks should take into The bank has not performed methodology in order to consideration potential any comprehensive stress consider external factors - to future changes in economic test. take into account the economic conditions when assessing cycles, market movements and (see also Risk management individual credits and their cyclical aspects of industry framework - ref No 6) credit portfolios, and should sectors and the resulting shifts assess their credit risk in the composition and quality exposures under stressful of the individual loans and conditions. overall credit portfolio.
DBM should adopt the methodology for the future comprehensive stress tests.
20 Principle 14 (BCBS d75) The Credit operation The Bank should perform a regulation covers the control mapping and analysis of its Banks must establish a procedures, nevertheless the existing firs and second line system of independent, responsibilities and controls and formalise them. ongoing assessment of the frequency are not clearly bank’s credit risk Based on the analysis, the defined. management processes and bank should adopt any the results of such reviews The Bank does not have a necessary additional regular should be communicated formalised mapping of first first and second line controls directly to the board of line and second line controls. (internal controls matrix) in directors and senior order to cover whole credit (Supervision and Monitoring management. granting and monitoring Division, Evaluation and process and credit risk Monitoring Department, Risk management. Evaluation and Management Department) controls. Therefore it cannot be certain that all areas of the credit granting and monitoring process and credit risk management are covered by regular internal controls procedures other than the ones performed periodically by IA (third line).
21 Principle 15 (BCBS d75) See findings No 6,7,10,15, See recommendations No 18,20 6,7,10,15, 18,20 Bank must ensure that the credit-granting function is being properly managed and that credit exposures are within levels consistent with prudential standards and internal limits. Banks should establish and enforce internal controls and other practices
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to ensure that exceptions to policies, procedures and limits are reported in a timely manner to the appropriate level of management for action.
22 Principle 16 (BCBS d75) According to Guidance on DBM should improve the early working with risky loan, warning system (monitoring Banks must have a system in credit officer include loan to and watch list triggers). place for early remedial watch list in case of pre- action on deteriorating defined changes after credits, managing problem granting loan. credits and similar workout situations. As a result of missing monitoring triggers (re- assessment of low-medium- high risk status) and internal rating grades ( ranging from satisfactory to unsatisfactory) the Bank's capability to identify problem loans in the beginning is significantly diminished.
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4. Internal control
4.1. Level of development of internal control system Within the internal control framework assessment focus has been on the extent to which the Bank has established an internal control framework (and its components) and on significant topics: Whether the framework is implemented in all areas of the institution and clearly defines roles and responsibilities of first, second and third line of defense Whether the Bank has established an independent control functions Whether the regular reporting on ICS, Risk management framework, corporate governance and compliance function is performed whether the institution has a compliance policy and a permanent and effective compliance function that reports to the management body We have identified positive progress related: Development and approval of the Internal audit charter in line with international standards and guidance for the professional practice Development and approval of the Internal audit plan The improvement of the second line of the defence and monitoring of the fulfilment of the BoD resolutions.
We have also identified key findings related to the non-compliance with good practices and suggest recommendations as shown in tables 4 below.
4.2. Internal audit function We have reviewed the IA chart, BoD and Audit and Risk committee meeting minutes and also a sample of IA reports performed in 2017. In our opinion the internal audit function is independent and operates in accordance with established international standards and requirements. We also have verified whether IA adequately covers all necessary areas in the risk-based audit plan, including the areas of risk management, internal controls, compliance and governance.
There is a significant improvement of the IA function quality in 2017 (comparing the period 2012-2016), however we have identified key findings related to the non-compliance with good practices and suggest recommendations as shown in tables 4 below.
4.3. Board oversight of controls As a result of above mentioned deficiencies identified in Internal control framework and Risk management framework (and assessment of its quality and effectiveness) the BoD is not currently sufficiently involved in the process of control and oversight of ICS, RM, and corporate governance despite the fact, that the board has ultimate responsibility for the bank’s ICS, governance structure and practices and risk management.
4.4. External audit and follow up actions We have verified that the Bank has established the system of remedial actions monitoring and reporting. The responsibility for assessment of the fulfilment of corrective measures lies on second line of defense (Valuation and monitoring unit) under CEO reporting line.
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T able 4: List of findings and recommendation to internal control system and audit function
Ref. Applicable standards and Finding Recommendation No. guidelines
1 Principle 6 (BCBS d 223) Multiyear audit plan not The bank should adopt performed. multiyear IA plan based The head of internal audit is on risk assessment and responsible for establishing an IA plan not based on risk input from senior annual internal audit plan that can be assessment (partially due to management. part of a multi-year plan. The plan the missing risk mapping) should be based on a robust risk assessment (including input from senior management and the board) and should be updated at least annually
2 Principle 6 (BCBS d 223) The responsibility for The IA should assess the assessment of the fulfilment remedial actions Every activity and every entity of the of corrective measures lies fulfilment in order to bank should fall within the overall on second line of defense ensure independent scope of the internal audit function. (Valuation and monitoring opinion. unit) under CEO reporting line. IA plan should cover the subsidiaries assessment. Subsidiaries not included in IA for and ICS /Risk /Governance report (2018 included)
3 Principle 7 (BCBS d 223) No independent external The bank should quality assurance review of consider the quality As part of their oversight IA function performed in assurance review in responsibilities, the board of 2012-2017 medium term horizon (5 directors should review the years). performance of the internal audit function. From time to time, the board of directors should consider commissioning an independent external quality assurance review of the internal audit function.
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5. Liquidity position
5.1. DBM’s approach for measuring and managing liquidity and funding risk In general, prior to the implementation of the newly amended law in April 2017, the Bank's operations were implemented under the Government's resolutions on lending, investment and debt management. There were no legal regulations on making decision as of professional banking institution and the Ministry of Finance used to set the regulations and limitations on Bank’s activities and required prudential ratios. During 2011-2015, the Bank long-term funds and liquid assets were sufficient. However, there were no limits on measuring the risks, focusing on the free cash position and liquidity structure. In these years, the Bank used its free funds (Euro bond, Samurai bond) to finance the related projects according to the government’s re solutions and favourable market conditions for issuing debt bonds. From 2014 the Bank’s management team raised the problems to its regulators regarding the Bank’s independence. As a result, the Law on DBM has been updated by the Parliament in February 2017 (effective from April 2017) to improve the independence of the Bank. The Bank’s approach for measuring and monitoring liquidity risk currently does not meet the good practices in this area as stated in the table below. Nevertheless, we observed a positive progress in improving a liquidity risk since 2016 when a new revised law on DBM was established and in funding management from 2017. All previous decisions were taken via Government resolutions. The below mentioned analysis was based on the following documents received during the project. The following table also shows a lack of relevant procedures, policies and strategies in previous years.
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T able 5: List of provided documents that were obtained and reviewed
Approved Document name 2012 2013 2014 2015 2016 2017 date Asset and liability 4/20/2017 Absent Absent Absent Absent Absent management policy Asset and liability 8/21/2012 Replaced management policy Operational manual on assets Absent Absent Absent Absent Absent 9/7/2017 and liabilities committee Operational manual on 2/10/2015 Absent Absent Absent treasury Short and long term funding Absent Absent Absent Absent Absent regulation to improve solvency 9/7/2017 and profitability Regulation on capital Absent Absent Absent Absent Absent adequacy requirement and 5/30/2017 monitoring Regulation on capital Absent Absent Absent Absent Absent adequacy requirement and 9/7/2017 monitoring Risk management policy 4/20/2017 Absent Absent Absent Absent Absent Risk management policy 1/10/2012 Replaced Resolution on minimum Absent Absent Absent Absent 10/21/2016 amount of liquid asset Resolution on minimum Absent Absent Absent Absent amount of deposits at 1/20/2016 commercial bank Resolution on procedures 12/28/201 Absent Absent Absent Absent improvement of liquid asset 5 Contingency funding plan 3/9/2018 Absent Absent Absent Absent Absent Absent General terms on interest rate 1/10/2012 and commission rate Policy on placement at Absent Absent Absent 2/10/2015 commercial banks
T able 6: Components of liquidity risk management subject to review Areas Comment Risk appetite statement Current situation: There is no RAS/RAF in place since 2012. RAS/RAF, (RAS)/Risk however, is one of the main components in risk management (including appetite liquidity risk) described under international good practice. RAS and RAF framework importance is more explained in section 3.2 Risk management framework. (RAF) Current situation: There is no such framework in place since 2012. The Robust liquidity provided documents describe the framework only in a very general manner. risk m anagement This approach does not meet the good practice in this area. Since 2017 based framework on the revised law on DBM, policies and business strategies are approved by BoD, asset classification procedure and prudential ratio procedure are
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approved by BoM based on discussion with MoF and other methodologies are approved by Management of the Bank. Past situation: In 2012 the Bank’s Board of Directors approved the newly amended risk management policy which contains main principle of robust liquidity risk management such as identifying the potential risk, monitoring and performing stress test. Moreover, in 2016 the Risk management department started to work on to setting the methodology to evaluate prudential ratios for Bank’s financial performance. This methodology was not approved by the Bank’s management team. According to the newly amended law of DBM the Board approved the policies that regulate the Bank’s all activities in every business area and investment and financing and decision making process.
Current situation: The Bank has in place a methodology for transferring the cost of funding. Since 2016 the Bank is applying the cost of funding based on the Bank's funding pool. The Bank's ALCO committee reviews the cost of funding every quarter. The cost of funding is set for each currency and each Liquidity costs, benefits and tenor. In case of funding MNT deals from the FCY funding the Bank applies the risks in the cost of hedging into overall client credit margin. We consider this approach in internal pricing line with best practice. Past situation: The approach the Bank was using before 2016 was based on the case-by-case (credits were assigned to the given funding; cost of hedging was not taken into account in every case).
Current situation: Current identification, measurement, monitoring and controlling processes are not still in line with best practices and in line with Basel recommendations. The bank currently measures and monitors the liquidity only via LCR/NSFR ratios. No cumulative gap limits are introduced. Past situation: There was no active identification, measurement, monitoring and controlling of the liquidity risk since 2012. In 2014 the Bank established a new division responsible for the financial risk. In terms of liquidity risk management the only activity was to prepare a liquidity gap report from 2015. Identifying, Nevertheless, no liquidity limits were imposed, measured and managed. m easuring, m onitoring and Since 2013 the Bank started to evaluate its capital adequacy ratio, liquidity controlling ratio and foreign currency positions and this includes daily and monthly liquidity risk reports that provided by Risk Management department. In 2014 the Bank established the Risk management department which started many researches on GAP report (based on expected maturity of assets and liabilities) and identifying the financial risk management. The Risk management department introduced the above mentioned reports and researches to the Bank’s top management committee and Board committee. Unfortunately, no decisions were taken due to the delayed amendment of the Law on Development Bank of Mongolia.
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Current situation: Since 2014 the funding strategy is a part of the business plan that is approved by BoD on a yearly basis. Past situation: There was no funding strategy since 2012 that would provide effective diversification of the sources and tenor of funding. Funding strategy Formerly revised Law of DBM approved and business and legal environment changes, from 2014 the bank reflected the government’s policies and medium– long term strategies into the bank’s yearly business plans. In 2012 to 2013 the Bank successfully issued the bonds in international capital market and raised funds.
Current situation: There is no officially approved liquidity stress testing methodology in place since 2012. Past situation: the Risk management department was preparing the liquidity Liquidity stress stress tests for the end of the years of 2014, 2015 and 2017. testing All these stress-testing reports were submitted to the relevant committees. However, there were no follow-up decision taken with respect to the results of the stress testing.
Current/past situation: There was no contingency funding plan in place within the years 2012-2017. Contingency funding plan (Such plan was developed and approved by BoD in 2018. According to our review, this plan already meets partly the requirements for a CFP. The plan is reviewed on a quarterly basis)
Disclose The bank discloses the information about liquidity risk positions and information on a management since 2012. This is in a line with good practice. regular basis
5.2. Key risk drivers for liquidity and funding risk exposure There are two key risk metrics the Bank is using: Liquidity Coverage ratio (LCR) and Net Stable Funding Ratio (NSFR). Both ratios were introduced in 2017 for the first time. Before 2017 the Bank was using no key risk metrics. After we reviewed the methodology for the calculation, both ratios are calculated in line with BoM methodology. However, the BoM approach is not in line with Basel International Standards for calculation of LCR/NSFR. In addition, from 2015 the Bank approved the policy that regulates all activities related to placing surplus of free funds into domestic commercial banks. The bank was producing liquidity gap reports since 2015 but no limits were introduced. The limits are set in the following manner: Min LCR limit = 100% (position as of 2017 YE= 365 %) Min NSFR limit=80% (position as of 2017 YE=151%) Recommendations:
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A common practice is also to introduce cumulative gap limits for all currencies and cumulative gap limits for each currency. This approach reduces the mismatch in long term funding and prevents the Bank from getting into funding problem due to a limited access to the FX market. The good practice is to also calculate and manage the LCR/NSFR ratios for all individual currencies. Follow the methodology /recommendations set by Basel standards for the calculation of LCR/NSFR ratios.
5.3. Integration of liquidity risk management into management and decision-making processes The integration of liquidity risk management into management and decision-making process is limited since 2012 and focusing and relying on the liquidity gap. As mentioned above there were no limits in place and the decision making process was executed solely on the given business requirement. Final decision on acquiring a new funding from international markets was made by DBM's Board of Directors resolution based on Government of Mongolia, ALCO's decision, Risk assessment and Internal Legal opinion. Since 2017 the bank introduced the liquidity ratios (LCR/NSFR). Regular reporting and monitoring of these ratios is a part of the decision–making process within DBM bank. According to the operational regulation of short/medium term funding plan approved in 2017, the Bank’s management makes strategic decisions based on the revised DBM charter (BoD sets the decision making rules). Based on our view the integration of liquidity risk management into decision-making process is not in line with good practice. The main reason is the lack of cumulative gap limits.
5.4. Liquidity needs over different time horizon Refinancing needs Based on the liquidity gap report as of December 15, 2017 the bank will have in a short term horizon (up to 1 year) a negative USD position starting from 2018 amounting to USD 230 mln. The position will continue worsening unless the bank will renew the USD funding for a longer term. The bank will need to refinance in longer-term horizon (over 1 year) until 2020 a total amount USD 318 mln. As for EUR currency, in a short-term horizon the Bank will need to refinance EUR 4.8 mln. In a long-term horizon, the Bank will need to refinance EUR 18 mln. The bank expects to refinance the above needs with the following counterparties: United States Department of Agriculture, USD 200 mln, expected maturity 3 years International Investment Banking, EUR 30 mln, maturity 7 years The bank is also planning to issue long term USD bonds totalling USD 500 mln for the refinancing purposes. New business Based on the business plan for 2018 the Bank expects to obtain a long/medium term horizon funding from the following counterparties Counterparty 1, USD 1 bln, for gas and oil factory project
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Counterparty 2, RUB 100 bln for expansion of power plant, improvement of the efficiency and railway projects Counterparty 3, USD 148.6 mln for improvement of industrial park and infrastructure However, the above-mentioned funding are determined for the development projects as stated are in risk due to the IMF restriction. Any new FCY debt is a subject of the IMF approval. The exemption is any FCY debt for refinancing purposes. Based on the our view the long-term refinancing structure is fully dependent on FCY funding due to a lack of local long-term investors. Even though the maturity profile is reasonably optimised, the refinancing risk in FCY represents a major risk for the Bank in case of worsening the credit risk profile of Mongolia.
5.5. The liquidity support provided by the Government, the BOM and financial institutions Since inception, the Government provided systematic capital injections to the Bank to improve its liquidity position. Although the Bank was able to grow, the Government passed Resolutions to increase the share capital in order to facilitate the rapid growth. The liquidity and funding support provided by the Government focused also on issuing 10Y/5Y USD Chinggis bonds in 2013 on the international markets. This 5Y USD Chinggis bond has been refinanced in 2018 by another 5Y bond. T able 7: Information on the Government support. All numbers in bln MNT. Year 2012 2013 2014 2015 2016 2017 T otal Detailed Capital Capital Capital Capital Capital Capital Capital increase increase increase increase increase - increase- increase – – -Jun -June 6, Dec 28, 31 Mar, and Depo Dec 28, Jul 24, 30, MNT MNT MNT information MNT MNT MNT 101,457 850,457 120,507 23,600 10,000 20,579 Aug 22, MoF - MoF - MNT Short Short 5,000 Depo: Depo: Sep 03, Dec 18, May 8, MNT MNT 13.2 MNT 50.0 35,000 June 3, May 31, 201: MNT MNT 18.0 30.0 Total MNT MNT MNT MNT MNT MNT MNT Capital 23,600 50,000 20,579 101,457 850,457 120,507 1,166,600 increase Total Depo - - - - MNT 43,2 MNT 68,0 MNT 111,2
The reason for an increase of the capital in 2016 is related due to the lack of capital and the repayment of the Chinggis bonds. There is no liquidity support from the BoM, although DBM is able to conduct swaps with BoM if needed. The main role of BoM is a supervising function. This role is also defined in the Law on DBM.
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5.6. Concentration of funding The funding strategy for DBM is based on the issuance of international bonds and accepting loans from abroad. The long-term funding is consisted of different sources (commercial banks, supranational institutions and local government) and is well diversified. The external funding is usually obtained in USD, EUR or JPY and is usually supported by the guarantee of the local government (USD 732 mln, JPY 30 bln) or insured by a credit insurance (USD 19.9 mln, EUR 13 mln) of the country from where the funding is coming from. There is also a long term funding in FCY provided to DBM by the supranational institutions without any guarantee (EUR 50 mln, USD 85 mln). The government will continue providing guarantees in case of need. However, the Bank strategy is to acquire the long term funding without state guaranties. T able 8: Summary of funding structure Funding type 2012 2013 2014 2015 2016 2017 Bond International 99,53% 31,49% 28% 27 % 52% 21% Bond Domestic 0,00% 0,00% 0% 3% 6% 9% Borrowing International 0,00% 0,00% 15% 17% 38% 41% Borrowing Domestic 0,00% 64,37% 52% 44% 0% 0% Due to banks 0,00% 3,60% 4% 8% 2% 27% Customer account 0,00% 0,53% 1% 1% 1% 0% Other 0,47% 0,01% 0% 0% 1% 1% T otal 100,00% 100,00% 100,00% 100,00% 100,00% 100,00%
5.7. Vulnerabilities of DBM’s funding risk The Bank has a very good access to local money market for short term funding. In case of long term, funding the bank is facing the lack of credit lines from the local banks (similar to other commercial banks). Other limitation is that any external FCY debt must be approved by the Ministry of Finance. This exemption is not required in case of refinancing the old/maturing FCY debt. The restriction comes from the IMF Extended Fund Facility for Mongolia in 2017. According to the previous version of Law on DBM, the bank had been entitled to various types of support from the Government, including unconditional and irrevocable sovereign guarantees on debt issuance and borrowings, FX hedging with BoM, and others. DBM’s Government guaranteed obligations include Samurai bonds issued in the Japanese capital market (JPY 30 bln), Senior- syndicated loan through Credit Suisse (USD 30 mln), Credit Facility from China Development Bank (USD 162 mln). Even though, there are many advantages of having Government guarantee when acquiring funding, DBM is driving towards raising capital on own way without explicit guarantee from the Government of Mongolia in order to implement good management and governance practises.
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6. Investment portfolio
6.1. Classification of securities We have reviewed the classification of all investment securities (MNT government bonds, USD notes, equity investment into MIK Corporation). The investment securities are classified in line with business expectations of the Bank and accounting policy. In case of MIK the Bank does not have significant influence or joint control over the company. The table below summarises all investments held by the bank at each year-end. There were no investments in securities in the period 2012-2013. T able 9: Overview of investment structure Loans and Loans and Available for Available for Classification receivable receivable sale sale Investment Debt Debt Debt Equity type Counterparty Government Government Government MIK Currency USD MNT MNT MNT Amount 116,318 41,118,581 - 11,200,000 2014 % 81% 15% 0% 4% Amount 60,696 10,004,548 - 27,737,595 2015 % 7 6% 6% 0% 17% Amount - 128,025,101 104,647,352 37,599,851 2016 % 47% 39% 14% Amount - - - 32,206,430 2017 % 0% 0% 0% 100% 6.2. Underlying asset quality Debt instruments: In 2014, the Bank has started investing in a number of government bonds issued by the Ministry of Finance. Coupon rate of bonds ranged from 8.3% to 14.9% for MNT and 5.5% for USD. At the end of 2017, there were no outstanding government securities. In late 2016, the Bank had purchased MNT 1 trillion zero coupon government bonds in order to increase the equity based on Government resolution. In other words, the Bank purchased the bonds from Government and Ministry of Finance increased the capital of DBM. Those bonds were classified under cash equivalent and investment available for sale at year-end 2016. In March 2017, those bonds were all settled by offsetting payable to Ministry of Finance. All debt investments were issued by Government of Mongolia. The government securities were/are considered as risk-free investments. Equity instruments: From the risk point of view, the investment into MIK equity represents an investment risk. Mongolian Mortgage Corporation LLC (MIK) includes a subsidy scheme for mortgage financing to create stable environment for mortgage financing. Under the programme, the commercial banks in Mongolia are granted loans at lower interest rates to issue subsidised interest rate mortgage loans or refinance their existing loans with the subsidised interest rate mortgage financing.
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In March 2014, based on the Government decision, the bank acquired 14.88% of shares in Mongolian Mortgage Corporation LLC (MIK) at a cost of MNT 10 bln. In late December 2015 MIK initiated a successful IPO placement of its shares on Mongolian Stock Exchange at par value of MNT 12,000 per share. DBM was offered to purchase additional 462,264 shares at market value to sustain its existing ownership of MIK’s shares. During the period between 2015-2017, MIK has declared dividends of MNT 539 mln, MNT 743 mln and MNT 1,453 mln respectively as a result of the financial years 2014-2016 Relevant documents We have reviewed the following internal documents of the bank. Based on the interviews and provided documents the decision making process for investment securities in the period 2012- 2016 under Old Law on DBM required the approval of the Government of Mongolia. There were no internal documents defining the investment policy and strategy. Since 2017 when a new revised Law on DBM was introduced, the decision making process remains within DBM bank. For this reason the Bank developed in 2017 a set of internal investment documents that are a subject of the approval of the Government. Approved Document name 2012 2013 2014 2015 2016 2017 date Investment policy 4/20/2017 Absent Absent Absent Absent Absent Investment operations Absent Absent Absent Absent Absent 2/14/2018 Absent regulation Regulation on asset Absent Absent Absent Absent Absent classification, provisioning 10/3/2017 and its disbursement for DBM, approved by BoM Revised DBM Law 2/10/2017 Absent Absent Absent Absent Absent
Scheme of the decision making process for the Investment securities The Bank currently follows the Law on DBM, namely the Section 15.1. This Section of the DBM law is the part of the DBM Investment regulation approved by DBM in 2018 and Investment policy approved in 2017.
6.3. Investment portfolio and credit quality of obligors See the chapter 6.2
6.4. Inventory of all clear titles The list of all investment securities is in the table in the chapter 6.1. We have fully reviewed the inventory of all clear titles to the securities and comments on securities without any kind of lien from creditors or other parties and poses no question as to legal ownership.
6.5. Securities without lien All above-mentioned securities were without lien.
6.6. Permanent reduction for recoverable values of securities We did not identify any permanent reduction for recoverable value of securities.
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6.7. Levels of allowances for losses There were no allowances for debt and equity investments. Debt securities were issued by the Government of Mongolia and considered as risk free assets. For equity investments, the bank had its internal model for valuation in 2014-2015. In the period 2016-2017 the Bank started to value the equity based on the quoted prices from the Mongolian Stock Exchange.
6.8. Translation exposures of securities portfolio The Bank invested into government bonds denominated in USD currency (USD 115 mln) during the period 2014-2015. The funding of the Bank was also provided in USD currency at the same time. Thus, there was no foreign currency risk associated to those bonds (perfect hedging).
6.9. Adequacy, effectiveness and efficiency of hedging strategy The investment into USD denominated Mongolian government bonds in 2014-2015 was fully hedged by USD denominated liabilities.
6.10. Impact of FX denominated securities The investment into USD denominated Mongolian government bonds had no impact on the open FX position.
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7. Foreign exchange risk
7.1. Market risk management framework and market risk strategy concerning FX risk In years 2012-2016 the management of the market risk (specifically FX risk) was subject to the Government decisions for all operational and strategic decisions which made process inefficient. However, we observed since 2017 when a new law on DBM was revised a positive progress in improving FX risk management. The bank focuses primarily on open FX position; however, there is lack of the comprehensive and integral FX risk management across the bank. The Bank’s approach for measuring and monitoring FX risk currently does not meet the good practices in this area as shown in the table below. The below mentioned analysis was based on the following documents received during the project. T able 10: List of procedures, policies and strategies in previous years. Approved Document name What is included in the policy date 8.3.2 The bank can reduce FX risk by Asset and Liability Management 8/21/2012 swap agreement and hedge Policy accounting Regulation on capital adequacy Section 4. Open position on Foreign 5/30/2017 requirement and monitoring Currency 3. Each or total open position Resolution on capital adequacy 9/7/2017 amount should not be exceeding 50% requirement and monitoring of equity Risk Management Policy 4/20/2017 5.3.1 Definition of FX risk 6.2.1.2 Definition of FX risk Risk Management Policy 1/10/2012 (superseded) T able 11: Components of FX risk management subject to review Areas Comment Risk Appetite Statement There is no RAS/RAF in place since 2012 for FX risk. RAS/RAF, (RAS)/Risk however, is one of the main components in risk management Appetite (including FX risk) described under international good practice. Framework (RAF) Robust FX risk There is no such FX management framework in place since 2012. The m anagement provided documents describe the framework only in a very general Framework manner. There was no active identification, measurement, monitoring and controlling of the FX risk since 2012. In 2015 the Bank established a new division responsible for the financial risk. In terms of FX risk Identifying, management the only activity was to prepare a report on open bank’s m easuring, FX position from 2015. m onitoring and controlling The only FX limit in place is the limit approved by BoD DBM stating liquidity risk the open position cannot exceed 50 % of the equity for each currency and total open position of the Bank. This limit requirement comes from the Bank of Mongolia recommendation.
There is no FX stress testing in place since 2012 performed by the FX Stress Testing Bank even though the Bank states in its documents that such an FX stress test is an integral part of the FX risk management.
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Nevertheless, the bank discloses the stress test results on a yearly basis in the annual report, There is no bank’s policy in place that would prevent granting FCY Granting FCY loans loans to clients without the ability to hedge the FX risk (in cases to clients where the loan is not a natural hedge) Disclose The bank discloses the information about FX risk since 2012. This is information on a in a line with good practice. regular basis
7.2. Integration of market risk management into management and decision-making processes The Bank’s risk management department produces on a weekly basis the report about open FX position. This report is submitted to the Bank’s top management and regularly discussed by the ALCO committee. The treasury department produces its own report about open FX position. Both reports after our verification provide the same information. The Bank started to produce such reports from 2015. Based on risk reports the Bank makes final decisions about FX hedging of the FX open positions. There are no internal limits in place for open FX position. The only limit the bank is following is a limit set by BoD DBM . (Bank of Mongolia recommendation)
7.3. Accounting methodology for FX transactions The Bank’s FX accounting methodology is written in the accounting policy approved in 2012 and in line with good practice. Bank of Mongolia official rates are used in calculating of realised and unrealised gain/losses.
7.4. FX Risk exposure We have reviewed the information about the open FX position the bank carries out since 2012. Based on our analysis the Bank is operating with a significant open FX position in USD (-71 mln) and JPY (-9.7 bln) totalling MNT (-381 bln) as of Dec 2017. The maximum open FX position was in 2016 in USD (-447 mln), EUR (-22 mln) and JPY (-26 bln) making total of MNT(-1,71 tln). The bank commenced to reduce its open FX position in 2017. The reason for the open FX position is the absence of the FX hedging strategy in the Bank. As stated above a long-term funding consists fully from the FCY denominated long-term debt (loans, issued bonds). There is a very limited/no use of cross currency swaps used by the Bank to hedge the FX risk. Due to the size and maturity of the local market, DBM can transfer its FX exposure only to Bank of Mongolia, Ministry of Finance of Mongolia, agencies of Government of Mongolia or to the Mongolian private sector as there are not liquid hedging instruments available internationally. Only other reasonable alternative would have to be to reduce balance sheet of the DBM itself. The standard approach by the Bank management was to convert the obtained FCY proceeds from the bond issuance (loan obtained) into local currency at FX spot rate in the given date without hedging FX risk thus increasing its net open FX position. Other very important reason that does not enable the bank to manage properly the FX risk is the absence of any convenient FX hedging instruments (namely FX cross-currency swap) in the Mongolian banking sector. The only entity that can provide in a limited way a long term cross- currency swap is the Bank of Mongolia. On the other hand the cost of such hedging is very high and often removes the advantage of the issuance a long term funding in FCY on the foreign markets.
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T able 11: FX positions at year end (2012-2017) Currency 2012 2013 2014 2015 2016 2017 (‘000) USD (280,303) (1,042) (101,332) (108,919) (447,962) (71,898) EUR - 9 158 (25,187) (22,327) (61) JPY - - (11,919,254) (20,047,137) (26,470,981) (9,739,828) CNY - - 215 215 215 5 Total (USD) (280,303) (1,030) (200,991) (302,859) (697,961) (158,553) We recommend the following improvement: When accepting a FCY debt, the Bank should make sure that also a proper cross-currency swap is also pre-agreed
7.5. Analysis of methodology for credit granting and loan monitoring We were provided with no methodology for granting loans denominated in FCY and loan monitoring as such policy does not exist. Based on the interviews we had the Bank does not require from its clients to hedge the FX risk in case the credits are provided in FCY. Thus, the Bank is exposed to the credit risk due to significant movement of FX rate.
7.6. FX lending risk management As stated above the clients accepting a credit denominated in FCY, convert these proceeds into local currency at an FX spot rate. The clients have no access to any FX hedging products due to its absence in the Mongolian banking sector. Nevertheless, some companies are able to generate the FCY cash flow to reduce the FX risk. T able 12: Volumes of provided credits to clients that are able to generate a FCY cash flow Credit volumes to generate FCY Currency FX rate Total amount cash flow USD 2,427.13 540,431,662 294,341,031 54.46% EUR 2,897.87 13,620,311 428,788 3.15% JPY 21.53 4,267,481,973 3,597,625,514 84.30% Total 1,443,046,677,306.320 7 93,103,395,769.010 54.96% (MNT)
Only 44%/58%/84% of clients that were provided the USD/EUR/JPY loans, respectively, are able to generate FCY cash flow. In case of a significant FX rate movement against MNT, there is a material credit risk the Bank is exposed to that the clients that do not generate FCY cash flow will not be able to repay its FCY debt. Our recommendations are as follows: When providing a FCY credit(s) to its client, the Bank should make sure that the client has the access to cross-currency swap to hedge his FX risk or the client is able to generate
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the FCY income in a sufficient amount to accumulate and cover future repayments of the FCY debt. The clients that are not able to generate FCY cash flow or have no access to FX hedging products at reasonable cost, should not be provided the FCY credits 8. Accounts receivable
In general, the main purpose of the strategy of the use of receivables in the past (mainly from MoF) was to manage and offset the FX risk. This approach (the agreement between DBM and Ministry of finance allowed the Bank to ask for compensation in case there are FX losses on DBM side when providing SME loans to clients) eliminated the FX losses on the Bank’s balance sheet, however, the FX risk was passed to the MoF. The FX losses were covered by the state budget.
8.1. Regulation on asset classification for assessing accounts receivables The Bank has implemented into its internal procedures/policies the following policies and regulations related to accounts receivable during the period 2012-2017.
T able 13: List of policies related to accounts receivable A pproved Document name 2012 2013 2014 2015 2016 2017 date A ccounting policy 7 /23/2012 Regulation on asset classification, provisioning and its disbursement for 4 /3 /2012 Replaced DBM, a pproved by CEO Regulation on asset classification, provisioning and its disbursement for 1 0/3/2017 A bsent A bsent A bsent A bsent A bsent DBM, a pproved by BoM
Asset classification and provisioning are regulated by Bank of Mongolia’s regulation as per accounting policy. However, between Apr 2012 and Oct 2017, the Bank has approved regulation on classification and provisioning. Due to revised Law on DBM, BoM specifically approved asset classification and provisioning regulation for the Bank. In this policy, receivables from Ministry of Finance and state owned organisations are not subject to impairment.
8.2. Asset quality of accounts receivables During the year 2012-2017, significant part of accounts receivable was from Ministry of Finance.
T able 14: Accounts receivables outstanding balances each year-end. Amount (‘000 MNT) Percentage Receivable Financial Receivable from Other from Other year Ministry of Total receivables Ministry of receivables Finance Finance 2012 2,168,468 251 2,168,719 99.99% 0.01% 2013 5,097,610 530 5,098,140 99.99% 0.01% 2014 9,635,697 12,183 9,647,880 99.87% 0.13% 2015 8,447,858 611 8,448,469 99.99% 0.01% 2016 481,651,152.0 114,671 481,765,823 99.98% 0.02% 2017 - 107,686 107,686 0.00% 100.00%
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Receivable from Ministry of Finance in 2012-2015 and 2016 (MNT 7.3 bln) relates to SME loan agreement made among the Ministry of Finance, the Ministry of Food and Agriculture and the Bank. The Ministry of Finance agreed to cover any losses in MNT denominated loans due to the fact that these loans are financed through USD denominated bonds.
Significant increase in 2016 is related to repaid loans by a state budget that were transferred to Government of Mongolia based on the Parliament of Mongolia resolution from 28 December 2016. As a result, the Bank had MNT 3.1 trillion receivables while the Bank had payable to MoF amounting MNT 2.7 trillion in its balance sheet. Therefore, the Bank and MoF signed a reconciliation act to offset those receivables and payables and the bank booked receivables of MNT 474 bln in addition to those FX receivable.
As of end of 2017 there were no accounts receivables from MoF.
8.3. Gaps/Pro-forma Provisions The bank did not create any provisions for accounts receivables in 2012-2016. In 2017, due to newly approved asset classification regulation by BoM, the bank had MNT 18 mln provisions on outstanding receivables. These provisions relate to the private sector companies.
8.4. Inventory of clear titles to accounts receivables
See the table and comments above.
8.5. Adequacy and efficiency of reconciliation procedures The Bank does not have any policy to perform a reconciliation with customers. However, reconciliation was performed with Ministry of Finance during 2012-2016 due to material outstanding receivables mentioned in chapter 8.2.
8.6. Outstanding items
There are no outstanding material items of receivables identified.
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9. Liabilities
9.1. Funding risk with focus on currency and maturity mismatches The liability side consists of short-term and long-term funding. The short-term funding consists of MNT money market deposits and capital injection provided by the Government of Mongolia. The long-term part consists fully from the FCY long-term debt (loans, issued bonds). Based on the cumulative liquidity gap report as of end 2017 we observed the following: USD: The mismatch between assets and liabilities requires ensuring funding to cover a short position in 2018 USD 230.3 mln and USD 317 mln by the end of 2019. This short position represents a liquidity risk in case the bank will not be able to acquire and repay USD funding. EUR: There is no immediate need to acquire additional long term EUR funding in a short-term horizon for 2018 as the Bank is able to repay its EUR liabilities from its own sources. Nevertheless, starting from 2019 the Bank will need to cover its short position, measured cumulatively, about EUR 4.8, by 2019 the short position will decrease to EUR 10.2. Overall, the total short Bank position in EUR is about EUR 17.6. JPY : There is no need to ensure funding for JPY debt in the coming years as the Bank has a long JPY position. Nevertheless, the Bank will be forced to repay its JPY debt after 2022. T able 15: Estimated future liquidity position of the Bank as at Dec 2017
As of All in mln MNT Dec 15, 2017 2018 2019 2020 2021 >2022 Total 2017 Net di fference 279,523 210,173 169,543 32,604 217,228 85,845 (533,591) 461,325 MN/ MNT T / 24,213 254,500 586,006 252,449 211,514 34,893 9,200 1,372,775 USD 44 (15) (259) (88) 4 22 50 (242) EUR 7 (2) (3) (7) (5) (4) (4) (18) JPY 5,947 (185) 10,398 621 504 325 (30,205) (12,594) Net i ncrease i n gross 279,523 489,696 659,240 691,844 909,071 994,917 461,325 461,325 amount (MNT) MN T 24,213 278,713 864,719 1,117,169 1,328,682 1,363,575 1,372,775 1,372,775 USD 44 29 (230) (318) (314) (291) (242) (242) EUR 7 5 2 (5) (10) (14) (18) (18) JPY 5,947 5,763 16,160 16,781 17,285 17,611 (12,594) (12,594) T able 16: List of all funding sources (issued bonds, accepted loans). Date of Matured Counterparty funding Currency Maturity Interest Amount as at obtained 31/12/2017 Bonds EMTN 3/21/2012 USD 5 year 5.75% 580 mln Y es Samurai bond 12/16/2013 JPY 10 year 1.52% 30,000 mln No ACEM 2015 MN T 7 year 4% 233,400 mln No Borrowing Government 1 4/30/2013 USD 5 year 4.79% 1,000 mln Y es Government 2 4/30/2013 USD 10 year 4.79% 0,5 mln Y es Syndicated loan 1 9/8/2014 USD 3 year 4.5% + 6M 30 mln Y es Libor Syndicated loan 2 9/8/2014 USD 5 year 4.625% + 6M 270 mln No Libor
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Bank 1 9/4/2014 USD 8 year 6% 162 mln No Bank 2 6/29/2015 USD 8 year 2.88% 19.9 mln No
Bank 2 10/4/2017 USD 5 year 2.5% and 10 mln No 7.16% Bank 3 9/15/2015 EUR 7 year 6.00% + 6М 20 mln No Еuribor Bank 4 4/11/2014 EUR 6 year 1.90% + 6M 13 mln No Euribor Bank 5 4/10/2016 USD 2 year 9.50% 75 mln No
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10. Quality of earnings
10.1. Sustainability and accuracy of historical earnings generated from related parties transactions We have performed assessment based on the audited financial statement as at each snapshot date and relied on the information on it. Our scope was solely based on the audited financial statements and detailed breakdown provided by the Bank. As per IAS 24, a related party transaction is a transfer of resources, services or obligations between the Bank and a related party, regardless of whether a price is charged. The Bank is 100% owned by the Government of Mongolia and its operations include the financing of projects within Mongolia, which include projects undertaken by governmental entities. According to IAS24, related parties of the Bank comprise national companies and other organisations controlled, jointly controlled or under significant influence of the Government. We understand that related parties and transactions with related parties are assessed in accordance with IAS 24 and disclosed in the financial statement. The Bank has balances and transactions with the following related parties:
Government Common control entities Other Government (which includes organisations, such as Ministry Entities controlled by the Other related party MIK (which of Finance and other Ministries, Government, which include is an entity over which of which management is state organisations (i.e. Government has significant appointed by the central corporate entities), local influence). The Bank’s balance government); commercial bank (State Bank) to MIK relates to investment and central bank of Mongolia securities available for sale. (Bank of Mongolia); these entities represent entities under common control in relation to the Bank;
Given the nature of its operations, the Bank has significant volume of transactions with the Government and other related parties, including guarantees received from the Government. Loans and advances given to projects either to be repaid from the State budget or the debtor’s own operating cash flow (loans to related parties) refer to socially beneficial projects such as, improvement of rural and city roads, civil engineering construction, development of the air transport, extension and improvement of power and heat plant, building of a new railways and mortgage financing through commercial banks for middle income families and individuals. Significant transactions with related parties The Bank’s financial position and performance was highly dependent on the recoverability of the loans and advances to be repaid by the State budget during 2012-2016 and other loans and receivables guaranteed by the Government, as well as the Government’s execution of other guarantees and contractual obligations. As a result, the sustainability of the Bank’s growth and profitability depends on the continuing support from the Government, and sufficiency of the State budget revenue, which could be substantially influenced by developments in the operating environment until the end of 2016. Parliament resolution No.81 dates 28 December 2016 and following Government resolution No.42 and No.210 dated 1 February 2017 and 28 December 2016 directed DBM to transfer its loan portfolio to be repaid from State budget to Ministry of Finance. Pursuant to the resolution loan and advance to be repaid
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from state budget in the amount of MNT 3.3 trillion was transferred on 31 December 2016 and remaining MNT 249,616 mln was reclassified from “state budget” to “corporates” portfolio. The reason for this is described in greater detail in section related to loans to be repaid from state budged on page 74. Sustainability of the income generated from the related party transactions is summarised below. T able 17: Summary of interest income from related parties 2017 2016 2015 2014 2013 2012 In mlns of MNT
Total interest income 285,564 427,448 410,176 330,080 131,060 12,878 for the year Interest income from 123,978 301,055 262,533 177,802 84,075 4,170 related parties total - Loa ns and 8 2 ,377 2 7 7,543 2 36,691 1 57,092 7 9,506 4 ,057 a dv ances - Short term 3 6 ,200 1 4,994 1 0,877 4 ,246 - - in v estment - Cu stomer 4 ,520 8 ,517 1 4,965 1 6,463 4 ,569 1 13 a ccount - Du e from 8 81 - - - - - gov ernment Com position of interest income from related 100% 100% 100% 100% 100% 100% pa r ties - Loa ns and 66% 9 2 % 9 0% 88% 9 4 .57% 9 7 % a dv ances - Short term 2 9 % 5% 4% 2% - - in v estment - Cu stomer 4% 3% 6% 9% 5 .43% 3% a ccount - Du e from 1% - 0% - - - gov ernment Percentage of income 43% 67% 62% 53% 61% 47% generated from related
pa r ties in total income The share of interest income from transactions with related parties vary from year to year and it has been a significant part of earnings from interest income. Majority of the interest income from related parties is from loans and advances. T able 18: Interest expense summary to related parties
In mlns of MNT 2017 2016 2015 2014 2013 2012 Interest expense for the year 167,702 334,689 279,101 216,855 89,058 13,695 Interest expense 310 133,401 125,778 128,17 6 31,168 - to related parties - Financing from 2 124,581 122,326 122,137 31,168 - government - Promissory notes Bank - - 2,730 6,039 - - of Mongolia
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- Bond issued in local 309 8,820 7 23 - - - market Percentage of interest expense 0% 40% 45% 59% 35% 0% to related parties
The share of interest expense from transactions with related parties vary from year to year and being a significant part of interest expense until 2016. The share of interest expense from transactions with related parties was relatively high during 2014 to 2016. Initial financing from Government of Mongolia to the Bank was on 30 April 2013 in order to fund projects and programs. The Government has provided this funding from proceeds of the Chinggis Bond. Interest is charged at 4.7917% p.a. on this loan. One third of this funding has a 5 year maturity ending January 2018 and two thirds of this funding have a 10 year maturity ending December 2022. In 2017, the interest expense decreased significantly due to both financing from government and loans to be repaid from the State Budget as of 31 December 2016 was transferred to the Government pursuant to Parliament Resolution No.81 dated 28 December 2016. Due to majority of the income from related party is from loans and advances, interest rates for related parties are compared in table below: T able 19: Rates for non-related parties (nominal rates)
Yea r 2 017 2 016 2 015 2 014 2 013 2 012 Ra nge m in m ax m in m ax m in m ax m in m ax m in m ax m in m ax MNT Rela ted pa r ty 4 .50% 1 6% 4 .50% 1 0% 4 .7 9% 1 0% 4 .25% 1 0% 6% 9 .60% 6 .7 5% 7 .38% Non - r elated pa r ty 4 .50% 17 % 4 .50% 1 6% 4 .50% 1 2% 5% 1 2% 5 .7 0% 1 2% USD Rela ted pa r ty 6 .13% 9 .7 5% 5 .13% 8 .45% 5 .13% 8 .45% 5 .13% 8 .30% 5 .13% 7 .80% 7 .35% 7 .90% Non - r elated pa r ty 3 .60% 1 0.28% 7 .79% 8 .45% 7 .79% 8 .45% 8% 8 .10% 8% 8 .10% 8 .10% 8.10% JPY Rela ted pa r ty 6 .25% 6 .25% ------Non - r elated pa r ty 5 .95% 7 .50% ------MNT lending rate. In general, rates on loans issued in MNT to related parties are not lower than the rates to non-related parties between 2012 to 2017. There is only one case observed in 2014 and the minimum lending rate to non-related party in 2014 is 0.75% higher than the lending rate to related party. It is related to the loan to Debtor 1, in the balance of MNT 6,416 mln as of 31 December 2014. It was initiated from the Government resolution No.299 dated on the 16 August 2013 pertaining to enhancement of coal exports of Mongolia. The Resolution states the road and basic infrastructure building to enhance Port 1 capacity are to be purchased and ownership of the assets transferred to Debtor 1. Pursuant to Government resolution No.449 rate dated 16 November 2015, the loan was restructured so that principle and interest
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amount are due for repayment by state budget within the period of 2019-2020, and interest rate is increased from 4.25% p.a to 6.06.% p.a. USD lending rate. Generally, rates on loans issued in USD to related parties are lower than the rates to non-related parties between 2012 to 2016. At that period, lending to related parties were funded by Chinggis bond, rate of which (4.79% p.a.) is relatively lower from other funding.
10.2. Earnings generated from accrued but uncollected interest, fees and FX revaluations In this section we have summarised the impact of recognised but not collected interest income (accrued interest receivables), fees and FX revaluation gain/ (loss) at each snapshot. Please refer to table 20 and table 21 for accrued interest receivables for each snapshot and table 22 for commission income and FX revaluation summary. In table 20, we have performed movement schedule on interest income in order to identify how much of interest income recognised was not collected yet at each snapshot. We have broken down the result into “Performing and Non- performing” classifications per Bank. T able 20: Interest income accrued/recognised but not collected from loan and advances according to credit quality disclosure under IAS 39.
In m lns of MNT 2 017 2 016 2 015 2 014 2 013 2 012 Performing loan portfolio Loan portfolio 2 ,438,259 2 ,835,697 4 ,400,952 3 ,642,647 2 ,059,453 4 93,556 Tota l r ecognised interest income for 1 89,432 3 46,077 2 63,848 1 80,628 8 5 ,604 7 ,543 th e year Repayment during 17 9,744 3 38,797 2 36,700 1 55,839 5 7 ,690 4 24 th e year FX ga in/(losses) (8 ,265) (6 5,092) 6 ,160 (6 ,311) (2 91) 1 A ccrued interest 17 7,390 1 59,437 8 7 ,064 6 6 ,077 3 4 ,976 6 ,7 71 receivables Non -performing loan portfolio Loa n portfolio 1 99,472 2 92,710 5 85,639 1 91,627 1 26,362 - Tota l r ecognised interest income for 1 2,599 1 0,985 2 9 ,741 1 2,372 8 ,419 - th e year Repayment during 1 21 15 1 1,446 2 ,389 7 ,755 - th e year FX ga in/(losses) 5 ,170 5 ,919 (8 ,032) (4 32) (1 ,476) A ccrued interest 5 1,241 4 3 ,933 3 8 ,882 1 2,555 2 ,140 - receivables In table 21, we have performed movement schedule on interest income in order to identify how much of interest income recognised was not collected yet at each snapshot. We have broken down the result into two classifications “Performing and Non- performing” per revised classification by us. T able 21: Interest income accrued / recognised but not collected from loan and advances according to revised classification of reviewed loan portfolio
In mlns of MNT 2017 2016 2015 2014 2013 2012 Performing loan portfolio Loan portfolio 8 15,443 1 ,061,977 3 ,558,680 2 ,699,461 1 ,659,632 2 58,139 Tota l r ecognised interest income for 6 3 ,117 2 44,900 2 06,444 1 37,629 6 2 ,039 3 ,291 th e year
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Repay ment during the 6 7 ,554 2 7 8,854 2 03,295 1 37,977 4 0,705 4 24 y ear FX ga in/(losses) 5 ,301 (8 ,226) (5 ,554) (4 ,238) (1 ,430) 0 A ccrued interest 2 ,7 23 1 2,461 3 8 ,189 2 9 ,486 2 5,596 2 ,832 receivables Non -performing loan portfolio Loan portfolio 1 ,822,288 2 ,066,430 1 ,427,911 1 ,134,814 5 26,183 2 35,417 Tota l r ecognised interest income for 1 38,914 1 12,161 8 7 ,144 5 5,371 3 1,984 4 ,251 th e year Repay ment during the 1 12,311 5 9,957 4 4 ,851 2 0,251 2 4 ,740 0.2 y ear FX ga in/(losses) (8 ,395) (5 0,947) 3 ,682 (2 ,505) (3 37) 1 A ccrued interest 2 25,907 1 90,908 8 7 ,757 4 9 ,146 1 1,520 3 ,939 receivables When loans become doubtful of collection, they are written down to the present value of expected cash inflows and interest income was thereafter recorded for the unwinding of the present value discount based on the loans’ effective interest rate which was used to measure the impairment loss. Repayment of the interest income during the year was recomputed based on accrued interest balance and interest income recognised during the year. (opening balance of accrued interest receivables of + total recognised interest income during the year – closing balance of accrued interest receivables) T able 22: Earnings recognised in statement of profit and loss from fees and commission income and foreign exchange translation gain/losses based on audited financial statements as at each reporting date.
In mlns of MNT 2017 2016 2015 2014 2013 2012 FX revaluation gain/(losses) (17,934) (391,218) (45,315) 1,089 1,914 (5,771) Fee and commission income - 124 907 815 - - It can be seen that FX revaluation losses reached MNT 391,218 mln in 2016 (main driver is significant fluctuation in foreign currency rate in 2016 while the Bank has negative foreign currency position for both years). T able 23: Foreign currency positions as at 31 December 2017, 2016 and 2015 based on the audited financial statements and fluctuation in percentage of each currency (official rate in the end of the year and official rate in the beginning of the year).
In mln MNT USD EUR JPY
Net ba lance sheet positions as at 31 December 2017 (160,613) (177) (2 00,627)
Net ba lance sheet positions as at 31 December 2016 (1 ,115,215) (5 8,179) (5 60,920)
Net balance sheet positions as at 31 December 2015 (217,399) (5 4,976) (3 32,382)
Flu ctuation in 2017 (2 .51%) 1 1.21% 1 .60%
Flu ctuation in 2016 2 4 .73% 1 9.38% 2 7 .80%
Flu ctuation in 2015 5 .53% (5 .07%) 5 .07%
Ga ins / (losses) in 2017 4 ,031 (2 0) (3 ,210)
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Ga ins / (losses) in 2016 (27 5,793) (11,275) (155,936)
Ga ins / (losses) in 2015 (12,022) 2 ,7 87 (16,852)
It can be seen that foreign currency fluctuation heavily influenced profit or loss of the Bank through FX revaluation gains/losses as the Bank has a significant outstanding balances of funding denominated in foreign currency. JPY exposure is due to Samurai bond issued at Japanese bond market in January 2014 in the amount of JPY 30 bln with fixed interest rate of 1.52% p.a. and 10 years maturity. USD exposure has arisen from net position between loans and advances denominated in USD and bonds and borrowings denominated in USD. The bond is related to USD 600 mln Euro Medium Term Notes programme, started in November 2011 and second series was issued in March 2012 amounting to USD 580 mln. The borrowings in USD were obtained from various parties, e.g. in form of as syndicated loan facility. Since the Bank is exposed to foreign currency risk due to its nature of the operation, we recommend the Bank to consider applying hedge accounting under IFRS 9 and applying foreign currency hedging instruments such as foreign currency swaps, forward etc. Fee and commission income is recognised during the normal course of business and mainly from the guarantees provided to the third parties.
10.3. Criteria for decision to capitalise interest and roll-over extension of credit Purpose of this section is to identify and analyse the extent to which collateral values (rather than operating cash flows) are the basis for decisions to:
criteria for decision to capitalise interest criteria for decision to roll-over extension of credit decision making process
During our review we were not able to identify clear criteria used to capitalise interest or roll-over extension of credit. The Bank seeks to restructure loans rather than to take possession of collateral. This may involve extending the payment arrangements and the agreement of new loan conditions. Once the terms have been renegotiated, the loan is no longer considered past due but restructured. The Bank does not have in place a forbearance definition in line with international standards. We have reviewed the loan policy and loan operation policy effective for the periods between 2012-2017 and obtained understanding from responsible Bank personnel. There is no formal policy and regulation which regulates to restructure through capitalisation of accrued interest based on the collateral value. Process for restructuring the facility is initiated by the debtor’s official request and approved by the head of respective loan department. Once the approval for the assessment of restructure is granted, loan officer reviews the debtor’s financial ability, presents to the credit committee and final decision is made by the either credit committee or BoD where necessary. Please refer to corporate governance section for more details.
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10.4. Adequacy of income recognition policies T able 24: Income recognised on statement of profit or loss during 2012 to 2017 based on audited financial statements (accounting policy of each stream has been outlined accordingly)
In mlns of MNT 2017 2016 2015 2014 2013 2012 In terest income 285,564 427,448 410,175 330,079 131,059 12,878 Fee a n d commission income - 124 907 815 - - Div idend income 1453 743 539 - - -
Interest income is recorded for all debt instruments on an accrual basis using the effective interest method. This method defers, as part of interest income all fees received between the parties to the contract that are an integral part of the effective interest rate. Fees integral to the effective interest rate include origination fees received by the entity relating to the creation of a financial asset. Commitment fees received by the Bank to originate loans at market interest rates are integral to the effective interest rate if it is probable that the Bank will enter into a specific lending arrangement and does not expect to sell the resulting loan shortly after origination. When loans and other debt instruments become doubtful of collection, they are written down to the present value of expected cash inflows and interest income is thereafter recorded for the unwinding of the present value discount based on the asset’s effective interest rate which was used to measure the impairment loss. Commissions and fees arising from negotiating, or participating in the negotiation of a transaction for a third party, such as the acquisition of loans, shares or other securities or the purchase or sale of businesses, and which are earned on execution of the underlying transaction, are recorded on its completion. Dividends on financial instruments are recognised in profit or loss for the year when the Bank’s right to receive payment is established and it is probable that the dividends will be collected. Based on the review of accounting policy of the Bank, principles of income recognition are in line with IFRS.
10.5. Deferred expenses and derivative trading and their impact on P/L We have reviewed the audited financial statements as at each snapshot dates and balances of deferred expenses are shown below. T able 25: Balances of prepayments based on audited financial statements.
In mln MNT 2017 2016 2015 2014 2013 2012
Pr epaid employee benefit 5 39 5 91 6 43 6 94 7 46 -
Other prepayments 6 45 5 63 1 57 2 50 1 83 1 14
The Bank offers its employees below market rates on mortgage loans. The Bank has arranged this benefit by providing other commercial banks with interest free funding for a period of 15 to 20 years. The commercial banks, in return, issue loans to the Bank’s employees at below market rates. This scheme began in June 2013 with a MNT 1 bln deposit. It was recognised by fair value at initial recognition and subsequently, it is amortised as employee benefit on profit or loss over the lifetime of the deposit which is not expected to exceed the service period of the employees.
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Interest expense is recorded on an accrual basis using the effective interest method. This method defers, as part of interest expense, all fees paid between the parties to the contract that are an integral part of the effective interest rate, transaction costs and all other premiums or discounts. Therefore, deferred expenses related to bonds and borrowings are disclosed as part of the outstanding balances as at each snapshot dates. T able 26: Impact on statement of profit or loss from derivative valuation based on audited financial statements. In mlns of MNT 2017 2016 2015 2014 2013 2012
Gains/(losses) from financial derivative 354 (303) (6,434) (1,404) - -
On 4 December 2017, the Bank entered forward contract to sell USD 10 mln notional amount on 4 June 2018 at rate of MNT 2,523.1/USD. The Bank marks to market its derivative exposures and recorded a gain of MNT 354 mln. On 2 December 2014, the Bank entered into a swap arrangement with Trade and Development Bank of Mongolia. The first leg was to receive USD 20,086 thousand on 3 December 2014 and in return receive EUR 21,000 thousand on 3 March 2015. The swap arrangement has been prolonged to 3 June 2015, 3 September 2015, 3 December 2015 and to 29 January 2016 based on both parties’ agreement. The fair valuation of the swap agreement resulted in a loss of MNT 1,404 mln and MNT 6,434 mln to the Bank for the period ended 31 December 2014 and 31 December 2015, respectively. The swaps are fair valued through interest rate parity analysis using inter-bank rates of each currencies. The Bank estimated the forward rates as at each snapshot dates and according to the Bank’s estimate, USD rate is expected to depreciated against EUR rate and it resulted loses in profit or losses. When the second leg of the swap is exercised in January 2016, recognised losses from the swap arrangement in profit or losses was amounted to MNT 303 thousand as at 31 December 2016.
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11. Review of financial statements
11.1.Comparative information on methodologies and techniques for data compilation The data compilation of standalone and consolidated financial statements is prepared by the reporting specialist of Finance, Accounting and Reporting Division ("FARD"), and reviewed and approved by the senior reporting specialist and head of FARD. Standalone financial statements are prepared, reviewed and approved on monthly, quarterly, semi-annual, and annual basis, while the consolidated financial statements are prepared, reviewed and approved on semi-annual basis. CEO reviews and approves consolidated financial statements before issuing to third parties. Reporting specialist receives inter-department note for financial statements line items (FSLIs) which require valuation experts. T able 27: FSLIs and valuation techniques Met h odologies and valuation No. FSLI na me Responsible department t echniques - Specific assessment for corporate - Pr oject financing and credit portfolios are assessed by the credit Loan and advances department; 1 depa rtment; im pairment - Risk ev aluation and - Colletaral items are internally valued m anagement department; by the r isk management department; In v estment available Qu oted share price in Mongolian A sset, liability and treasury 2 for sa les stock exchange m anagement department 2 017: Forward - Ma r k to market using in terest rate parity analysis A sset, liability and treasury 3 Der iv ative instruments 2 016: Swap - In terest rate parity m anagement department a n alysis using inter-bank rates of each cu rrency Recov erability of Recov erability of DTA is a ssessed with Fin ance, accounting and r eporting 4 deferred tax asset consideration of business plan div ision (DTA ) These techniques are commonly applied methodologies in preparation of financial statements and it is in line with the IFRS 13 Fair Value Measurement. We summarised data compilation of Bank’s standalone financial statements for the years ended 31 December 2016 and 2017 below. Our scope was limited to presentation and disclosures related to standalone financial statements, only. T able 28: Data compilation of comparative information Applicable Report name Frequ ency Prepared by Rev iewed by st a ndard Reporting specialist Sen ior r eporting specialist A u dited Financial In a ccordance of fin ance, a n d head of finance, Sem i-annually Statements 2016 w ith IFRS accounting and a ccounting and reporting reporting division div ision Reporting specialist Sen ior r eporting specialist A u dited Financial In a ccordance of fin ance, a n d head of finance, Sem i-annually Statements 2017 w ith IFRS accounting and a ccounting and reporting reporting division div ision Manual transactions are obtained with supporting documents alongside with approval from relevant departments including the project financing and credit department, the risk evaluation and management department, and the asset, liability and treasury management department etc. The specialist of FARD records the manual transaction into core banking system and the transaction is approved by senior specialist on paper (memo). At the end of the day, daily report is printed and
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reviewed by senior specialist by reconciling it to the supporting documents, which is then reviewed and approved by the head of FARD. Automated transactions are reviewed by senior specialist and head of FARD on monthly and semi- annual basis depending on the type of transaction. Automated transactions are foreign exchange translation, interest accrual, depreciation of property and equipment and amortisation of intangible assets in 2016 and 2017. All manual adjustments are approved by head of FARD based on decision given from relevant departments, and posted by specialist in the core banking system before period-end financial reporting. We summarised control scheme of the standalone bank financial statements for the years ended 31 December 2016 and 2017 below. T able 29: Control scheme of comparative information Frequ ency Jou rnal entries Post ed by Rev iewed by of cont rol Senior specialist and head of A u tomated journal Mon th ly Gr apeBank sy stem fin ance, a ccounting and r eporting en tries Sem i-annually div ision Specialist of finance, Senior specialist and head of Ma n ual journal entries Da ily a ccounting and reporting fin ance, a ccounting and r eporting div ision div ision Specialist of finance, Adjustment/correction Hea d of finance, a ccounting and Ad-h oc basis a ccounting and reporting of er r ors r eporting division div ision
11.2. Missing items in notes to the financial statements We reviewed audited consolidated financial statements for the years ended 31 December 2016 and 2017 for the completeness and quality of disclosures presented in accordance with the applicable International Financial Reporting Standards. We summarised a list of missing disclosures in Bank’s standalone financial statements for the years ended 31 December 2016 and 2017 below. Our scope was limited to presentation and disclosures related to standalone financial statements, only. We have assessed individual provision requirements – according to ECB AQR manual – for loan portfolios of the Bank. Our assessment resulted in under-provisioning for corporate and on-lending portfolio as at 31 December 2016 and 31 December 2017. We summarised additional provisions requirement of corporate and on-lending loan portfolios in the section 12.1. For the financial year 2016, the Bank was not subject to any externally imposed capital requirements as it was not regulated by the Bank of Mongolia. Therefore, the Bank adopted the standardised internal approach, which takes into consideration of credit risk exposure by risk weighting on on-balance sheet exposures to credit risk according to broad categories of relative credit risk. For the financial year 2017, the Bank evaluates its capital adequacy ratio in accordance with the Bank of Mongolia’s Regulation on capital adequacy requirement and monitoring approved on 30 May 2017. The Bank’s capital adequacy ratio is overstated with consideration of additional provision requirement under our review for the years ended 31 December 2016 and 2017. We summarised potential impact on the capital adequacy ratio in the section 12.3. T able 30: List of missing disclosures List of m issing disclosures in a udited financial A pplicable 2016 FS 2017 FS No. st atements for the y ears ended 31 December 2016 st a ndard Not e/Page Not e/Page a nd 2017 ref. Other assets and other financial assets are not disclosed sepa rately in the face of statement of financial position and n ote 11 of audited financial statements for the years ended SFP SFP IFRS 7 . 36- 1 3 1 December 2016 and 2017. Provisions for other financial 1 1 pg31 1 1 pg30 37 assets should be disclosed by classes in audited financial sta tements for the year ended 31 December 2017.
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Disclosure of staff costs paid is missing in the statement of 2 ca sh flows in audited financial statements for the years SCF SCF IA S 7 en ded 31 December 2016 and 2017.
Not all critical accounting estimates a nd judgments are qu a ntified in notes 4 of audited financial statements for the 3 4 pg17 4 pg17 IA S 1 .125 y ears ended 31 December 2016 and 2017 including indirect gu arantee and government guarantee.
Credit quality analysis of unrated balances relates to Mon golian commercial banks are not presented separately in n otes 6 and n otes 7 of audited financial statements for IFRS 7 .36- 4 6 -7 pg21-22 6 -7 pg21-22 th e y ears ended 31 December 2016 a nd 2017. It should be 37 disclosed separately to differentiate and enable the user of fin ancial statements to compare the quality. Credit quality analysis of short term investment is not disclosed in n otes 8 of a udited financial statements for the y ear ended 31 December 2017 while it has balance in 2016 IFRS 7 .36- 5 n /a 8 pg22 a n d it was disclosed in the note. It is disclosed in the notes 37 8 of audited financial statements for the year ended 31 December 2016. No disclosure is presented for under-collateralised loan balance for the purpose of IFRS im pairment provision 6 9 pg27-28 9 pg27-28 IA S 3 9 assessment in notes 9 of audited financial statements for th e years ended 31 December 2016 and 2017. Balances and transactions with related parties are not disclosed by classes of related parties in notes 19 and notes 7 1 9 p38 2 1 p38 IA S 2 4 2 1 of audited financial statements for the years ended 31 December 2016 and 2017. Com pensation provided to key management personnel is not disclosed by type in n otes 19 and n otes 21 of audited 8 1 9 p40 2 1 p39 IA S 2 4 fin ancial statements for the years ended 31 December 2016 a n d 2017.
The nature of non-deductible expense is n ot specified in the reconciliation table of theoretical income tax expense 9 2 6 p43 2 9 p44 IA S 12 in n otes 26 and notes 29 of audited financial statements for th e years ended 31 December 2016 and 2017. Fin ancial r isk policy is not disclosed in sufficient details in th e financial r isk management disclosure in n otes 27 of 10 2 7 p47 n /a IFRS 7 a u dited fin ancial statements for the year ended 31 December 2016 (i.e. short position in USD, JPY, EUR).
Expected maturity of assets/liabilities disclosure is 11 om itted in Notes 27 of audited financial statements for the 2 7 p51 n /a IA S 1 y ear ended 31 December 2016 in or der of liquidity.
The effect of the changes of interest rates on equity is not disclosed in Notes 27 and 31 of audited financial IFRS 7 . 39, 12 statements for the years ended 31 December 2016 and 2 7 pg57 3 1 pg64 40-41 2 017. Sensitivity of the changes of interest rates must be disclosed separately on profit/loss and equity. Th e effect of the changes of for eign currencies on equity is not disclosed in Notes 27 and 31 of audited financial IFRS 7 . 39, 13 statements for the years ended 31 December 2016 and 2 7 pg58 3 1 pg66 40-41 2 017. Sensitivity of the changes of foreign currencies must be disclosed separately on profit/loss and equity.
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12. Loan portfolio and off-balance sheet transactions review
12.1. Review of classification and provisioning The bank’s loan portfolio consist of loans to be repaid from state budget and loans to be repaid from corporates. Further, loan portfolio to be repaid from corporates divided into 2 portfolios corporate loan and on-lending loan. The We have conducted loan portfolio analysis based on total loans and advances balance before impairment. T able 31: Breakdown of loan exposure In m lns of 2017 2016 2015 2014 2013 2012 MNT Loans to be repaid from corporates Loans to corporates On balance 1,976,978 2,101,536 1,461,111 1,218,114 555,729 235,417 Off balance 41,553 17,174 22,071 68,762 6,801 0 exposures Number of 40 16 15 14 7 3 debtors On lending loans to corporates On balance 660,753 1,026,872 7 81,494 564,503 308,993 1,979 Off balance 12,870 12,920 93,242 57,490 7 ,606 23,971 exposures Number of 13 12 12 11 2 1 debtors T otal loans to be repaid from 2,692,154 3,158,502 2,357,918 1,908,869 87 9,129 261,367 corporates Loans to be repaid from state budget On balance - - 2,743,986 2,051,683 1,321,251 256,216 Off balance - - 238,190 181,431 299,040 68,574 exposures Number of - - 4 3 4 1 debtors T otal loans to
be repaid from 2,982,176 2,233,114 1,620,291 324,790 - - State budget T otal loans and advances balances 2,692,154 3,158,502 5,340,094 4,141,983 2,499,420 586,157 before im pairment Total Bank impairment (213,818) (192,747) (77,347) (30,893) (6,225) - provision Net loans and advances 2,478,336 2,965,755 5,262,747 4,111,090 2,493,195 586,157 balance Loans and advances given to corporate projects are to be repaid from the project’s or borrower’s future cash flow generation and the Bank also holds collateral. The Bank provides lending to corporate projects which the Government considers priority commercial activities (air transport development, support of
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mining industry, railway, infrastructure, Small and Medium Enterprises (SME), housing and manufacturing projects). Loans and advances given to projects to be repaid from the State budget refer to socially beneficial projects that do not create cash flows of their own, these loans cover areas such as, improvement of rural and city roads, civil engineering construction, extension and improvement of power and heat plant, building of a new railways and mortgage financing through commercial banks for public servant. Classification review - Corporate We summarised overview of performing exposure (“PE”) and non-performing exposure (“NPE”) classification of corporate debtors of the Bank according to simplified EBA definition in Table 31 and 32 for the period 2012 to 2017. The main purpose of majority of loans were investment, so we have considered cash flow projection for the review of classification of debtor. Off balance sheet exposure is included in total value of exposure using credit conversion factor as per agreement with the Bank. T able 32: Summary of corporate debtors classified as PE
In mlns of MNT 2017 2016 2015 2014 2013 2012 Bank classification Number of debtors 21 3 4 8 4 3 Total exposure 2,018,531 2,118,710 1,483,182 1,286,875 562,529 235,417 Value of exposures 292,113 107,551 34,541 444,980 97,007 235,417
% of total debtors 52% 19% 27% 57% 57% 100%
% of total exposure 14% 5% 2% 35% 17% 100% Our classification Number of debtors 10 3 3 4 3 2 Value of exposures 232,776 107,551 34,315 113,483 36,347 227,974 Reclassifications Number of exposures (11) - (1) (4) (1) (1) Value of exposures (59,337) - (226) (331,498) (60,660) (7 ,443)
T able 33: Summary of corporate debtors classified as NPE
In mlns of MNT 2017 2016 2015 2014 2013 2012 Bank classification Number of debtors 19 13 11 6 3 - Total exposure 2,018,531 2,118,710 1,483,182 1,286,875 562,529 235,417 Value of exposures 1,726,418 2,011,159 1,448,641 841,895 465,522 -
% of total debtors 48% 81% 7 3% 43% 43% 0%
% of total exposure 86% 95% 98% 65% 83% 0% Our classification Number of debtors 30 13 12 10 4 1
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Value of exposures 1,785,755 2,011,159 1,448,868 1,173,393 526,183 7 ,443 Reclassifications Number of exposures 11 - 1 4 1 1 Value of exposures 59,337 - 226 331,498 60,660 7 ,443
Reclassification drivers Table 34 lists the corporate debtors reclassified from PE to NPE for the period 2012 to 2017. The most common impairment triggers on which reclassification of these debtors are based on: 1) Debt Service Coverage Ratio (“DSCR”) below 1.1; and 2) A material decrease in cash flows over the last 12 months.
In addition, the total valuation of reclassified debtors’ estimated future cash flows is insufficient to cover the Bank's exposure, and the debtors’ guarantors do not have sufficient cash flows to cover the debtors’ liabilities. Important commentary on financial statements Our review of loan classification included an assessment of debtors’ financial performance as reported in the financial statements provided by the Bank. For several debtors audited financial statements were not available, so Format A (tax) statements were provided by the Bank and reviewed by us to assess reliability of the provided financial information. Table 34 also indicates that impairment triggers based on which exposures are reclassified from PE to NPE generally include impairment triggers directly based on debtors’ financial statements. This implies that the insufficient assurance on the reliability of debtors’ financial statements might have affected the results of our classification assessment for several debtors. T able 34: List of reclassified corporate debtors in 2012 to 2017 (in mln of MNT) On- Off- T otal Description of rationale for Debtor ID balance balance exposure reclassification exposure exposure 2017 3600002408 14,705 - 14,705 The debtor's DSCR is below 1.1. The debtor's equity reduced by more than 50% over the last 12 months, and the debtor has a negative DSCR, as 3600002340 12,787 1,643 14,430 debtor is loss making and uncertainty in product demand exists as of 31 December 2017. The debtor experienced a material decrease in cash flows over the last 12 months, and the debtor has a negative 3600002539 10,098 2,500 12,598 DSCR, as debtor is loss making and timing to complete of construction is uncertain as of 31 December 2017. The debtor's equity reduced by more than 50%, and it experienced a material decrease in cash flows over the 3600002312 5,305 - 5,305 last 12 months. In addition, the debtor has a negative DSCR as debtor is a loss making and has material unexpected expenses as of 31 December 2017. The
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debtor is subsequently forborne in 2018 due to the financial difficulty.
The debtor has 68 days of overdue as of 31 December 2017 since the sales revenue of the debtor has been transferred directly to the Ministry of 3600000230 4,054 - 4,054 Energy since June 2017. Both the bank and debtor have no control over the cash management from its sales revenue. The debtor has a material amount past due to public creditors/employees, and it experienced a material decrease in 3600002465 1,591 694 2,285 cash flows over the last 12 months. In addition, the debtor's DSCR is below 1.1. The debtor's DSCR is below 1.1, and modification of repayment terms has 3600002363 1,510 - 1,510 been granted, hence the debtor is classified forborne in 2017.
3600002456 1,247 - 1,247 The debtor's DSCR is below 1.1.
The debtor's turnover reduced by more than 50%, and it experienced a 3600002472 1,216 - 1,216 material decrease in cash flows over the last 12 months. In addition, the debtor's DSCR is below 1.1. The debtor experienced a material decrease in cash flows over the last 12 months, and the debtor has a negative 3600002233 427 7 01 1,127 DSCR as debtor is a loss making and has a negative cash flow projection as of 31 December 2017. The debtor's turnover reduced by more than 50%, and it experienced a material decrease in cash flows over the last 12 months. In addition, the debtor 3600002444 860 - 860 has a negative DSCR as debtor is a loss making. Required mining equipment to explore the gold (main product) was absent as of 31 December 2017. 2015 Although the loan was fully repaid in 2017, the debtor experienced a material 3600000955 226 - 226 decrease in cash flows over the last 12 months, and the debtor's DSCR is below 1.1. as of snapshot date. 2014 The debtor's equity reduced by more than 50%, and it experienced a 3600000773 177,012 - 177,012 material decrease in cash flows over the last 12 months. In addition, the debtor's DSCR is below 1.1.
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The debtor's equity reduced by more 3600001198 134,940 - 134,940 than 50% over the last 12 months, and DSCR is below 1.1. The debtor's turnover reduced by more than 50% over the last 12 months, and DSCR is below 1.1. In addition, the debtor has requested the extension of 3600000479 19,192 - 19,192 loan maturity by one year and the additional funding as of snapshot date in order to implement project successfully. Although the loan was fully repaid in 2017, the debtor experienced a material 3600000955 354 - 354 decrease in cash flows over the last 12 months, and the debtor's DSCR is below 1.1. as of snapshot date. 2013 3600000551 60,660 - 60,660 The debtor's DSCR is below 1.1. 2012 Although the loan was fully repaid in 2013, the debtor has a negative DSCR 3600000043 7,443 - 7,443 as debtor is loss making as of snapshot date. Classification review - On-lending portfolio Overview The Bank regularly entered into on-lending program in order to create new jobs and support SMEs pursuant to parliament resolution N.138 dated 25 April 2012. The nature of on-lending projects ran during 2012 to 2017 is outlined in turn below. Terms and conditions differ for each programs. 1. SME support program, 2. Mongol 888 project, a. Loan amount up to MNT 2 bln through SME fund b. Loan amount above MNT 2 bln through commercial banks 3. Other on-lending projects through Commercial banks 4. On-lending project through DBM leasing LLC 1. SME support program The Bank signed on the tri-party agreement of “General financing term and condition” with Ministry of finance (“MoF”) and Ministry of food and agriculture (MoFA) on 5 July 2012 pursuant to Government resolution no.138 and no.208. According to the agreement, MoF is responsible for interest repayment at 7.38% p.a and foreign currency exchange loss arising from funding the project. The loan currency to SME Fund is in MNT while the funding is denominated in foreign currency. These exposures are included in the loan to be repaid from State Budget and assessed as part of the portfolio. MoFA is responsible for project implementation and monitoring of principal repayment. Tri-party agreement between the Bank, SME fund and commercial banks was signed on 10 July 2012. In this agreement, commercial banks are responsible for principal repayment to SME fund and provide
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guarantees at 110% of the total contractual amount. SME fund is responsible for announcing projects to the public and selecting the projects that meet the certain criteria determined in the operation manual approved by the Ministry of Labour. Commercial banks issue loans to SMEs at interest rate of 7% p.a. and are responsible for transferring the principal repayment into account of SME fund, placed at the Bank. Since ultimate credit risk is born by commercial banks, assessment is performed at commercial banks’ level. 2.a. Mongol 888 project loan amount up to MNT 2 bln through SME fund The Bank signed on the quadripartite agreement of “General financing term and condition” with Ministry of finance (“MoF”), Ministry of Economic Development and Ministry of Labour (on behalf of SME fund) on 4 July 2014 pursuant to Parliament resolution No.52 in 2012, Government resolution No. 239 in 2013 and No.176 in 2014. Ministry of Economic Development (currently MoF) is responsible for providing funding to the Bank from proceeds of government securities traded in the international stock exchange and monitoring the project implementation. Further, tri-party agreement between the Bank, SME fund and the selected commercial banks were signed on August 2014. Loan issued at 5% interest p.a to SME fund where SME fund collects 3% interest p.a from the commercial banks and 2% interest p.a from State Budget. MoF is responsible for including the income and expenses related to SME fund into the state budget via proposal initiated by Ministry of Labour. The due from State Budget of 2% p.a. is included on the loans to be repaid from State budget and assessed as part of the loans to be repaid from State Budget. SME fund is in charge of centralising/collecting repayments from commercial banks and MoF and to transfer to the Bank according to the repayment schedule. Simultaneously, SME fund is responsible for announcing projects to the public and selecting the projects that meet the criteria, determined in the operation manual approved by the Minister of Labour. Commercial banks guarantee SME fund at 110% of the total contract amount to the Bank. Therefore, assessment of classification has been performed at commercial banks’ level since the ultimate credit risk is born by commercial banks. 2.b Mongol 888 project loan amount above MNT 2 bln through commercial bank Sub-lending agreement is signed with commercial banks to support SMEs with preferential rate loans on 23 April 2014 where initial loan request is analysed by commercial banks and reviewed by the Bank’s credit committee. The credit committee ensures if the project is in line with targeted group/SMEs. The Bank issues loan to commercial banks at 5% p.a and sub-lending rate shall not exceed 9% p.a. and commercial banks are responsible for the interest and principle repayment. Commercial banks issues promissory notes as guarantees. Guarantees shall be exercised if commercial bank fails to repay the loan on time. DBM has right request the Bank of Mongolia to transfer the loan repayment from commercial bank’s current account to DBM account, which outlined in “Law on Promissory note”. 3. Other on-lending projects through commercial banks The Bank financed below projects through commercials banks.
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T able 35: On-lending projects through commercial banks
Project name Project Interest rate Su b-lending Funding of Gu a rantee Undertaken finance t o interest t h e project period bu dget com m ercia l ra te t o end- banks (p.a) borrower (p.a .)
Lea ther project MNT 5% 7% Gov ernment Promissory 2 014-2020 1 40.4 bln securities n ote from a n d commercial Gov ernment ba n k bon d
A griculture Up to 9 .0% 1 2.5% Fu n d from Promissory 2 016-2018 MNT 25 Cr edit Swiss n ote from bln commercial ba n k
Mea t project Up to 9 .5% 1 2.5% Not specified Promissory 2 016-2020 MNT 100 n ote from bln commercial ba n k
Promote export MNT3 00 6% 9% Not specified Promissory 2 015-2021 and substitute bln n ote from im port project commercial ba n k
Ca shmere Up to 6% 9% Un u sed Promissory 2 015-2018 pr oject MNT 100 funds from n ote from bln government commercial resolution ba n k No.165 dated 2 014.
V illa project MNT 125 4 .5% 4 .5%+Bank’s Un qu oted Promissory 2 015-2021 bln m argin Bon d issued n ote from to th e local commercial m arket ba n k
Hotels MNT 150 4 .5% 4 .5%+Bank’s Un qu oted Promissory 2 015-2019 bln m argin Bon d issued n ote from to th e local commercial m arket ba n k
SME 7 0 bln MNT 7 0 6% 9% Fu n d from Promissory 2 015-2019 bln Cr edit Swiss n ote from commercial ba n k
Ma n ufacturin g, MNT 269 5 .125% 8% Ch inggis Promissory 2 013-2016 agriculture, milk bln bon d n ote from and wool and commercial ca shmere ba n k
4. On-lending project through DBM leasing LLC DBM leasing LLC was established in 2017 pursuant to the Bank’s BOD resolution No.42 dated 19 May 2017. DBM Leasing LLC is 100% subsidiary of the Bank and provides finance lease to Mongolian
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economic policy-oriented projects including priority sectors such as agriculture, mining, and transportation. DBM leasing LLC obtained a loan from the Bank for agricultural projects pursuant to Government resolution No.212 dated 28 December 2016. The loan bears interest rate of 6%, 3.6% and 5.95% p.a. depending on the funding and mark up of 2% is made by DBM leasing LLC. Finance lease contract is signed between DBM leasing LLC and project unit of MoFA to promote farming industry. The Fund is responsible for providing list of the equipment needed and list of the lessee to DBM leasing LLC and DBM leasing LLC acts a lessor. DBM leasing LLC is responsible for the repayment of the interest and principle of the loans. Therefore, the classification is analysed for DBM leasing LLC. Approach summary of on-lending portfolio Classification assessment is performed at the commercial bank level for the period between 2012-2017 since either credit risk is born by commercials banks or guaranteed by the commercial banks. In 2017, DBM Leasing LLC is additionally assessed. We summarised overview of PE and NPE classification of on- lending debtors according to simplified EBA approach on tables 36, 37 and 38 for the period 2012 to 2017. T able 36: Bank’s classification of debtors In mlns MNT 2017 2016 2015 2014 2013 2012 Bank classification performing Number of debtors 12 11 12 11 2 1
Value of on-balance exposures 605,509 968,942 781,494 564,503 308,993 1,979
Value of off-balance exposures 25,739 25,839 186,484 114,980 15,213 47,942
Bank classification non-performing Number of debtors 1 1 - - - -
Value of on-balance exposures 55,243 57,929 - - - -
Value of off-balance exposures ------
T otals Number of debtors 13 12 12 11 2 1
Value of on balance exposures 660,753 1,026,872 781,494 564,503 308,993 1,979
Value of off balance exposures 25,739 25,839 186,484 114,980 15,213 47,942
T able 37: On balance exposure breakdown – All on lending projects In mlns of MNT 2017 2016 2015 2014 2013 2012 Bank classification Number of debtors/guarantors 12 11 12 11 2 1 Value of exposures 605,509 968,942 7 81,494 564,503 308,993 1,979 - Villa project 125,063 125,062 60,030 - - -
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- Mongol 888 above MNT 2 bln 115,871 150,815 178,997 123,635 - - - Promote export and substitute import project 111,922 119,948 6,004 - - - - Hotels 87 ,835 107,274 36,384 - - - - Leather 55,663 68,894 7 5,925 60,638 - - - Mongol 888 up to MNT 2 bln 48,161 7 2,592 92,239 96,648 - - - SME 7 0 bln 42,510 63,631 44,633 - - - - On-lending project through DBM leasing LLC 30,384 ------Cashmere project 15,456 46,884 36,543 - - - - Meat project 15,399 16,200 - - - - - Agriculture 11,644 22,203 - - - - - SME support programme 847 16,362 29,278 41,330 36,247 1,979 - Manufacturing, agriculture, milk and wool and cashmere - 217,006 221,461 242,252 272,745 - Our classification Number of debtors 12 11 12 11 2 1 Value of exposures 605,509 968,942 7 81,494 564,503 308,993 1,979 Reclassifications Number of exposures ------Value of exposures ------T able 38: Summary of on-lending debtors classified as NPE In mlns of MNT 2017 2016 2015 2014 2013 2012 Bank classification Number of debtors 1 1 - - - - Value of exposures 55,243 57,929 - - - - Our classification Number of debtors 1 1 - - - - Value of exposures 55,243 57,929 - - - - Reclassifications Number of exposures ------Value of exposures ------Loans to be repaid from state budget Overview We have reviewed the loans to be repaid from state budget during the period of 2012-2016. This loan portfolio was transferred to the Government of Mongolia as of 31 December 2016 pursuant to the parliament resolution #81 dated 28 December 2016, Government Resolution #219 dated 28 December 2016 and Government Resolution #42 dated 1 February 2017.
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Loans to be repaid from the state budget (or “budget loans”) are loans given to beneficiaries for socially beneficial projects (which cannot be repaid from project revenue ). Government guaranteed the repayment of the loans and was included in the state budget on annual basis. The loan portfolio was classified as PE loans as it was repaid from state budget during 2012 to 2016. Approach summary We have obtained understanding of the process of this loan portfolio as follows: 1) The project is initially discussed at government level and government issues the resolution for approval. The resolution assigns the Bank to finance specific project and directs the Ministry of Finance and BoD of the Bank to disburse loan. 2) According to the government resolution, the credit committee holds a meeting and approves the loan in the case of supports. 3) BoD of the Bank holds a meeting and declares a resolution according to Credit Committee decision. The BoD resolution approves to process the loan agreement and to take necessary actions for the disbursement. 4) Once decisions are finalised, the loan agreement is made between DBM, Ministry of Finance, relevant Ministry who is in charge of the implementation and the executing company. Contractual amount is set at the total financing amount, approved by the government, while the disbursements are made partially based on the completion rate of the project. Repayments are proposed to be included in the state budget annually. General term is to repay the principal in bulk on the maturity date and to repay the interest on quarterly or semi-annually basis.
Loans to be repaid from the State budget are comprised of four debtors (varying from year to year). Please refer to Table 30 for overview of the portfolio. We have selected 27 samples (facilities) from these debtors in the state budget loan portfolio based on their disbursement periods. For the selected samples, we have reviewed the below mentioned documents in order (1) to verify the loan agreement and actual disbursements are in line with resolutions and (2) credit risk is born by Government of Mongolia:
Government resolution Board of directors resolution Credit committee decision Loan agreement (or project financing and repayment settling agreement)
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T able 39: Summary of selected samples from the State budget loan
In mln MNT 2015 2014 2013 2012
Loans to be repaid from 2,743,986 2,051,683 1,321,251 256,216 state budget Number of newly disbursed 88 95 195 1 facilities Number of sample (from 3 9 14 1 newly disbursed facilities) Exposure amount of 153,852 158,339 7 83,021 119,160 samples Cumulative exposure 1,214,372 1,060,520 902,181 119,160 amount of samples Sample coverage 44% 52% 68% 47% (cumulative basis)
Proposal of inclusion into the state budget is collected by Ministry of Finance and the budget is approved by the Parliament in November. The Bank sends budget proposal of total amount due from the State budget for the following year with the details of projects. In case of exclusion from the State budget, it is informed to the Bank by the Ministry of Finance. As the Bank started its operation in June 2012, no repayment was scheduled and accordingly, no payment was received from the State Budget for the year 2012. Summary of due amount from State budget as per proposal and repayment from the State budget is shown below. T able 40: Summary of repayment received from the State
In mln MNT 2015 2014 2013 2012
Due from the state budget per 435,449 157,600 52,500 - proposal amount
Total receivable from the Ministry 170,946 166,965 No - of Finance after reconciliation act reconciliation act was - Offset against the payable performed for 121,991 60,541 - to Ministry of Finance this year
- Cash consideration 48,955 106,425 24,229 -
Difference between the proposed amount and receivable amount per (264,503) 9,365 28,271 - reconciliation act Certain amount is offset against the Chinggis Bond funding’s interest payables to Ministry of Finance every year. The funding from proceeds of the Chinggis Bond was provided to the Bank on 30 April 2013. Difference between proposal amount and the amount per reconciliation act with Ministry of Finance is explained by the Bank as follows:
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- 2015: Principal due in 2015 from the following debtors were delayed according to restructuring. Thus, the proposed principals were excluded from the reconciliation act. . Principal 1 (USD 25 mln=MNT 49.9 bln) . Principal 2 (USD 1.5 mln=2.9 bln) . Principal 3 (MNT 46.2 bln) . Principal 4 (MNT 170.6 bln) . Principal 5 (MNT 992 mln)
The above principals are amounting to MNT 270 bln while the difference is MNT 264 bln which is due to FX fluctuation between the date of proposal (Nov 2014) and the date of reconciliation act (Dec 2015). - 2014: Total receivable per reconciliation act is higher than the proposed amount due to the FX fluctuation. Proposal for 2014 was sent in November 2013 by translating USD repayments into MNT and the reconciliation act was made in the end of 2014. The average MNT/USD rate in 2013 was 1,523.5 while it was 1,817 in 2014, which is 16% of increase.
- 2013: It was the first year when the Bank sent proposal. At that time, the Bank assumed to disburse loan commitments according to the project completion rate. In reality, the project did not complete as it was projected. Therefore, projected and proposed amount differed from the actual consideration.
The loans to be repaid from the State Budget as of 31 December 2016 was transferred to the Government pursuant to Parliament Resolution No.81 dated 28 December 2016, Government Resolution #219 dated 28 December 2016 and Government Resolution No.42 dated 1 February 2017, (except 3 loans). The below table summarises the final reconciliation act made for the transfer. T able 41: Summary of final reconciliation act
Reconciliation act (in mln MNT)
T otal receivable from the Ministry of Finance 3,17 6,782 Principal due from loans to be repaid from state Budget 3,117,052 Interest due from loans to be repaid from state Budget 51,625 FX revaluation from SME fund 8,105 T otal payable to the Ministry of Finance (2,702,468) Financing from Chinggis bond (2,693,148) Interest due to financing from Chinggis bond (9,320) Amount due from Ministry of Finance to the Bank 47 4,314
As of 31 December 2017, there are no outstanding loans to be repaid from the State Budget and the receipt of cash payment due from the Ministry of Finance as per above reconciliation was verified. Provisioning Impacts We have assessed individual provision requirements – according to ECB AQR manual – for all loans classified as NPE at the snapshot dates of each period (2012-2017). The individual provision assessment was made using the going- and gone-concern approaches in line with agreed methodology. The assessment of provision requirements was initially based on a going-concern approach if the debtor is expected to continue to generate cash flows in the future, and a gone-concern approach if the assets of the debtor need to be foreclosed to cover the Bank’s exposure.
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Under going-concern approach, provision requirements are based on the difference between the present value of a debtor’s expected future cash flows and the Bank’s exposure amount. Under gone-concern approach, provision requirements are based on the difference between the present value of a debtor’s collateral and the Bank’s exposure amount. In order to identify the present value of a debtor’s collateral, first we determined whether a Bank has proper valuations in place for collateralised items. Such proper valuations are generally external, independent valuations from reputable companies and suppliers. Such external, independent valuations can be updated by an internal, independent review under certain conditions. In the event that a Bank has credible, external, independent valuations from a reputable company, we review the valuation and its assumptions to ensure that they appear reasonable based on knowledge of the market and similar transactions. Subsequently, we adjust the valuation of the collateral to a net, discounted value reflecting the costs and time. For specific asset types (real estate and equipment), our subcontractor performed the valuation of the real estate collateral held against loans in accordance with IVS as required by Mongolian law and the Consultant will then review that valuation as part of the project. To ensure that the subcontractor’s valuations are of the same quality as other external valuations performed by other valuers in accordance with IVS, our independent valuation review team was established. This team reviewed whether the methodology as described below has been followed by subcontracted valuers correctly. In addition, valuation indices were applied to adjust the valuation to snapshot dates of review periods (2012 to 2017). This index adjustment was applied for the valuation based on market comparative approach. For assets valued by income approach or discounted cash flow approach and for collateral types of vehicles and heavy machinery, these have been kept unchanged for years where the collateral was available. In case the present value of a debtor’s expected future cash flows is insufficient to cover the Bank’s exposure under going concern approach, provision requirements are also assessed under gone-concern approach, and the final provisions are based on the approach that results in the lowest provision requirements. Table 42 provides an overview of our assessment and aggregate additional provision levels for the portfolio of loans to be repaid from corporates. For the loans to be repaid from state budget, no provision is considered as all debtors within this portfolio were classified as PE. T able 42: Provisioning assessment – Loans to be repaid from corporates In mlns of MNT 2017 2016 2015 2014 2013 2012 Loans to corporates Total exposure 2,018,531 2,118,710 1,483,182 1,286,876 562,530 235,417 - Bank provision 199,138 177,343 7 5,577 30,893 6,225 - % of total exposure 9.87% 8.37% 5.10% 2.40% 1.11% 0.00% - Our provision 375,651 367,402 264,707 241,745 25,388 7 ,443 % of total exposure 18.61% 17.34% 17.85% 18.79% 4.51% 3.16% Additional provision 176,513 190,059 189,130 210,852 19,163 7 ,443 amount On lending loans to corporates Total exposure 673,623 1,039,792 87 4,736 621,993 316,599 25,950 - Bank provision 14,680 15,404 - - - - % of total exposure 2.18% 1.48% 0.00% 0.00% 0.00% 0.00% - Our provision 55,243 57,929 - - - - % of total exposure 8.20% 5.57% 0.00% 0.00% 0.00% 0.00%
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Additional provision 40,563 42,525 - - - - amount T otal additional provision 217 ,076 232,584 189,130 210,852 19,163 7 ,443 am ount Additional provision was calculated for on-lending loans to corporate in 2017 and 2016 which is associated with one debtor classified as NPE from 2016. Main trigger was that the debtor was over 90 days past due and required capital adequacy ratio per Bank of Mongolia regulation was not met for these 2 years. We have assessed the provisioning under going concern approach since the collateral of the loan was a promissory note issued by the debtor (zero collateral was assigned to collateral). Absence of financial statements as at 31 December 2017 and loss making performance as at 31 December 2017 led to the full provision for the debtor. As for loans to corporates, additional provisions was calculated by netting off the over-provisioned amounts of PE debtors (for all PE debtors is assumed zero provision) against under-provision amount of NPE debtors. Table 43 provides an overview of under or (over) provisions reported by the Bank distinguished by our classification. T able 43: Provisions by classification – Loans to corporates In mlns of MNT 2017 2016 2015 2014 2013 2012 PE debtors per our classification Number of debtors 10 3 3 4 3 2 - Bank provision 3,155 1,399 155 833 - - - Our provision ------Under/(over) provision (3,155) (1,399) (155) (833) - - NPE debtors per our classification Number of debtors 30 13 12 10 4 1 - Bank provision 195,983 175,944 7 5,422 30,060 6,225 - - Our provision 375,651 367,402 264,707 241,745 25,388 7 ,443 Under/(over) provision 179,668 191,458 189,285 211,685 19,163 7 ,443 T otal impact 17 6,513 190,059 189,130 210,852 19,163 7 ,443 Table 44 lists all NPE debtors in Loans to Corporate portfolio for all years on individual debtor level, according to our provisioning assessment. Additional provision for each year is mainly driven from three debtors of which impacts are MNT 213 bln in 2017, MNT 257 bln in 2016, MNT 202 bln in 2015 and MNT 207 bln in 2014, respectively. These three debtors are as follows: - Debtor 1– The loan was issued in 2014 and reclassified from the same year. - Debtor 2 – The loan was issued in 2012 and reclassified from 2013. - Debtor 3 - First loan was issued in 2013, while the other 3 loans were issued in 2014 and 2015.
These three debtors are listed first in the below table.
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T able 44: Provisions on individual debtor level – Loans to corporates T otal Bank Our Facility Under/ Going/ exposure provisions provisions Key -driver of our IDs per (over) Gone (m ln. (m ln. (m ln. assessment Debtor provision concern MNT) MNT) MNT) Loans issued before 2017 Debtor 1
2017 174,165 2,613 83,734 81,121 Going The loan was issued in 2014 and reclassified from the same year. Main 2016 178,461 2,680 114,796 112,116 Going collateral of the debtor is the future income which has no value per agreed 2015 143,134 2,135 141,111 138,976 Going methodology. Thus the provision assessment was made under going concern approach. 2014 134,940 1,349 133,032 131,683 Going
Debtor 2
2017 192,855 7 9,416 147,808 68,392 Going The debtor reports small amount of cash flow being 2016 185,724 52,805 114,583 61,778 Going generated which is higher than valuation amount of 2015 140,929 32,567 56,771 24,204 Going collaterals securing the exposure. Thus, going 2014 125,874 13,720 65,687 51,966 Going concern approach was applied. 2013 102,814 5,067 23,982 18,915 Going Debtor 3
2017 110,069 22,599 86,061 63,462 Gone The estimated future cashflow was insufficient 2016 101,124 42,616 77,116 34,500 Gone to cover the Bank’s exposure. Thus, the 2015 77,892 15,209 53,884 38,675 Gone provisioning assessment was made under gone concern approach. Bank's 2014 52,451 5,156 28,170 23,014 Gone valuation of collaterals were adjusted downward. 2013 23,548 1,158 1,406 248 Gone Debtor 4 The valuation of collaterals were lower than the estimated future cash 2017 7 6,713 1,153 12,524 11,371 Going flow. Thus, the provisioning assessment was made under going concern approach.
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The provisioning assessment was made under gone concern 2016 161,619 2,429 51,428 48,999 Gone approach as the valuation of collaterals were higher than the estimated future cash flow.
The provisioning assessment was made under going-concern approach, and is 2015 129,431 1,946 - (1,946) Going concluded with no additional provision as future cash flow is sufficient to cover the Bank’s exposure. Debtor 5 The estimated future cashflow was insufficient to cover the exposure. Thus, the provisioning 2017 97,656 9,415 20,548 11,132 Gone assessment was made under gone concern approach. Bank's valuation of collaterals were adjusted downward.
Provision requirements 2016 60,130 2,551 - (2,551) Going are assessed under going- concern approach, and is concluded with no provision as future cash 2015 42,247 551 - (551) Going flow valuation is sufficient to cover the loan exposure.
Debtor 6
2017 6,617 7 ,447 6,617 (830) Going The debtor is fully provisioned by the Bank. The provisioning assessment was made 2016 5,950 6,906 5,950 (956) Going under going concern approach due to absence of collateral information. As 2015 5,945 3,727 5,945 2,218 Going the debtor reports losses and estimated future cash flow was insufficient, the 2014 5,708 571 5,708 5,137 Going debtor is full provisioned.
Debtor 7 The debtor reports losses and the estimated future 2017 285,327 54,829 - (54,829) Gone cash flow was insufficient to cover the Bank's
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exposure. Thus, the provisioning assessment 2016 318,010 25,579 3,418 (22,161) Gone was made under gone- concern approach. There is an indirect Government Guarantee to repay the 2015 278,265 4,142 6,770 2,627 Gone principal and interest amount of facilities except one, hence no provision is created for these 2014 113,775 1,138 - (1,138) Gone guaranteed facilities. For the non-guaranteed facility, gone concern approach was applied. 2013 60,660 - - - Gone
Debtor 8 The provisioning assessment was made 2016 110 2 110 108 Going under going concern approach due to absence of collateral information. As the debtor reports losses and estimated 2015 226 3 226 223 Going future cash flow was insufficient, the debtor is fully provisioned.
Going-concern approach was applied and the 2014 354 4 - (4) Going estimated cash flow is sufficient to cover the Bank’s exposure.
Debtor 9 As the loan was fully 2017 5,493 82 - (82) Going repaid in 2018, collateral information was not provided. Thus, the provisioning assessment 2016 19,631 295 - (295) Going was made under going- concern approach. The estimated future cashflow is sufficient to cover the 24,021 361 - (361) Going 2015 Bank’s exposure.
As the loan was fully repaid in 2018, collateral information was not 2014 19,192 192 9,148 8,956 Going provided. Thus, the provisioning assessment was made under going- concern approach.
Debtor 10
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Going-concern approach 2017 24,961 374 - (374) Going was applied and the estimated cashflow is sufficient to cover the 2016 31,534 3,846 - (3,846) Going Bank’s exposure.
The estimated future cashflow was insufficient 2015 30,263 3,912 - (3,912) Gone to cover the exposure. Thus, gone concern approach was applied. The exposure has an indirect Government guarantee to repay whole outstanding 2014 13,175 1,181 - (1,181) Gone loan amount, hence no provision is created.
The estimated future cash flow was insufficient to cover the Bank's exposure. Thus, gone concern 2012 7 ,443 - 7 ,443 7 ,443 Gone approach was applied. Due to absence of collateral information, full provision is created. Debtor 11
2017 172,890 2,593 - (2,593) Going The provisioning assessment was made under going-concern 2016 183,529 2,756 - (2,756) Going approach, and the estimated cash flow is sufficient to cover the 2014 177,012 1,770 - (1,770) Going Bank’s exposure.
Debtor 12 The estimated cashflow is insufficient to cover the exposure. Thus, gone concern approach was 2017 4,054 61 - (61) Gone applied and valuation of the collateral is sufficient to cover the Bank’s exposure.
Debtor 13
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The provisioning assessment was made under going-concern approach, and the estimated cashflow is 2017 336,817.00 5,052.00 - (5,052) Going sufficient to cover the Bank’s exposure. In addition, the loan has an indirect Government Guarantee.
2016 592,860.00 8,907.00 - (8,907) Gone The debtor reports losses, so provision requirements 2015 461,836.00 5,988.00 - (5,988) Gone are assessed under gone- concern approach, 2014 530,912.00 4,979.00 - (4,979) Gone however, it has an indirect Government Guarantee. 2013 339,161.00 - - - Gone
Debtor 14 Provision requirements 2017 182,481 6,923 - (6,923) Going are assessed under going- concern approach, and is concluded with no 2016 172,476 24,572 - (24,572) Going additional provision as future cash flow valuation is sufficient to cover the 2015 114,677 4,881 - (4,881) Going loan exposure.
Loans issued in 2017 Debtor 15 Gone approach was used as due to reported losses debtor has insufficient 2017 14,430 192 11,048 10,856 Gone future CF. Bank's valuation of collaterals were adjusted downward. Debtor 16 The debtor reports losses and the estimated future cash flow was insufficient to cover the Bank's exposure. Thus, the 2017 5,305 239 2,438 2,198 Gone provisioning assessment was made under gone concern approach. Bank's valuation of collaterals were adjusted downward. Debtor 17 The debtor was fully 2017 2,368 577 2,368 1,791 Going provisioned by the Bank in Debtor 18 2018 as it went to court. Our assessment confirmed 2017 860 215 860 645 Gone this amount.
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Debtor 19 As the debtor was fully repaid in 2018, financial statements and collateral 2017 1,216 304 1,216 912 Going information were not provided. It resulted into full provision. Debtor 20 The debtor reports losses 2017 7 05 32 208 176 Gone and the estimated future cash flow was insufficient Debtor 22 to cover the Bank's exposure. Thus, the 2017 1,247 19 194 175 Gone provisioning assessment Debtor 23 was made under gone- concern approach. Bank's valuation of collaterals 2017 12,598 152 30 (122) Gone were adjusted downward. Debtor 24 Going concern approach 2017 2,285 24 - (24) Going was applied and future cash flow is sufficient to Debtor 25 cover the Bank’s exposure. Thus, no additional 2017 7 18 32 - (32) Going provision is needed. Debtor 26 2017 1,510 68 - (68) Gone The debtor reports losses Debtor 27 and the estimated future cash flow was insufficient 2017 2,326 105 - (105) Gone to cover the Bank's Debtor 28 exposure. Thus, the 2017 13,333 518 - (518) Gone provisioning assessment Debtor 29 was made under gone concern approach. 2017 37,394 562 - (562) Gone Valuation of collaterals is Debtor 30 sufficient to fully cover the 2017 1,127 6 - (6) Gone Bank’s exposure. Collateral values also affect the amount of additional provision for non-performing debtors. In our review we have identified that market value of collaterals recorded in Bank’s system is consistently lower than corresponding market value our subcontractor have estimated for same collaterals. The results of the review of collateral and real estate valuation suggest that the value of collateral recorded in the Bank’s systems is not compliant with BoM’s requirements on collateral valuation, i.e. not performed according to IVSC International Valuation Standards. Further, in our review we have discounted market value of collaterals using time to sell, cost to sell and effective interest rates as agreed in the methodology. This discounted collateral value was consistently lower than value recorded in Bank’s system. Please note, number of collaterals revalued were always minimum of 70% of total monetary collateral value for each debtor. Remaining part of collaterals was prorated based on the revaluation data. Differences in values are described above are summarised in following table.
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T able 45: Overview of Bank’s collateral value and collateral value after our review
In mln MNT Bank’s Market value Discounted % change % change m arket value after review m arket value to our to our after review m arket discounted valuation valuation
2017 7 81,543 1,196,813 579,795 153.1% 7 4.2%
2016 604,534 871,925 450,635 144.2% 7 4.5%
2015 311,650 535,762 274,703 171.9% 88.1%
2014 248,732 291,642 148,688 117.3% 59.8%
2013 32,859 45,058 23,524 137.1% 7 1.6%
2012 0 0 0 0% 0%
Classification under Bank of Mongolia regulation Overview The Bank of Mongolia (“BoM”) approved Asset classification and provisioning regulation for the Bank on 3 October 2017 pursuant to official letter from MoF No.8-1/5473 dated 18 September 2017. DBM law was revised in February 2017 and it directed BoM to issue a regulation on asset classification and provisioning for the Bank. Core requirements for establishing loss provision under BoM regulation The Bank assesses loan loss provision following categories: - Specific provisioning - Collective provisioning. Specific provisioning: The banks performs qualitative and quantitative assessment at debtor level and, the debtor shall be assessed individually through specific assessment in the case of any trigger hit from below. Those qualitative and quantitative criteria are specifically defined in the regulation as follow: 1. Economic conditions that correlate with defaults on the assets; 2. Adverse change in laws and regulation environment and adverse legal opinion that might affect value of financial asset; 3. It becomes probable that the borrower will enter bankruptcy or increase in probability of default 4. Deterioration on debtor’s financial ratio 5. The debtor requests to restructure the facility and to update repayment schedule and it is accepted by the Bank 6. A breach of contract, such as a default or delinquency in interest or principal payments; 7. Identified impairment indicator in the debtor in prior period 8. Decrease in the collateral value 9. Identified any material difference Collective provisioning: If none of above trigger hit debtor shall be assessed collectively. Assets can be pooled based on the quality, type, location, repayment period and risk profile, and other conditions of assets shall be similar. The Bank calculates the provision using the impairment model outlined in the above-mentioned regulation and which is inline with IFRS. Impairment provision model is defined as follow:
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Impairment provision = Net present Value of future cash flow – Total loan exposure Net present Value of future cash flow = Present value of the future cash flow discounted at original effective interest at the reporting date. Total loan exposure = Outstanding balance of loan + acc. interest receivables + penalty income – deduction (guarantees provided by government, central bank and other international financial institutions). Classification In order to identify the classification of the asset, the Bank shall calculate the provision and determine the classification based on the loan loss provision rate under IFRS. BoM classification is determined based on the IFRS provision rate. The scale of the classification of the asset based on the loan loss provision rate is outlined in the regulation as follows:
Classification Performing Special Sub- Doubtful Loss m ention standard Provision loss rate Up to 5% 5%-25% 25%-50% 50%-75% over 75% Reporting Project financing and credit department calculates loan loss provision under IFRS semi-annually and submits to risk evaluation and management department for review. After risk evaluation and management department’s review, loan loss provision is discussed at Credit Committee and credit committee decision is issued. Based on the credit committee resolution, financing and credit reporting division classify the debtors based on the approved loan loss provision and reports to BoM semi-annual basis. Summary The Bank started to follow the BoM regulation starting from 2017 pursuant to the approved regulation dated October 2017. Provision amount is equal to our provision per AQR ECB manual and the classification is allocated according to the loan loss provision rate. T able 46: Overview of Bank’s and our BOM provisions
In mlns of MNT 2017 2016 2015 2014 2013 2012 T he Bank provision under 213,818 192,747 7 5,577 30,893 6,225 - IFRS and BoM Loans to be repaid from 213,818 192,747 7 5,577 30,893 6,225 - corporate Loans to be repaid from ------state budget
Our provision under BoM 430,894 425,331 264,707 241,745 25,388 7,443
Loans to be repaid from 430,894 425,331 264,707 241,745 25,388 7,443 corporate Loans to be repaid from ------state budget Loans to be repaid from the state budget
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BoM regulation states that debtor will be classified as PE with no provision if the debtor is guaranteed by government. As the portfolio is repaid from the state Budget, the portfolio is classified as PE with no provision. Loans to be repaid from corporates - corporates T able 47: Classification analysis of the total portfolio under BoM regulation
Exposure amounts, In 2017 2016 2015 2014 2013 2012 m lns of MNT
Per bank classification
Performing 1,939,942 2,285,754 2,102,889 1,711,661 87 9,128 261,367
Special mention 552,739 579,948 249,084 197,208 - -
Substandard 192,855 286,848 - - - -
Doubtful - - 5,945 - - -
Loss 6,617 5,950 - - - -
T otal loans to be repaid from corporates including 2,692,153 3,158,501 2,357,918 1,908,869 87 9,128 261,367 off balance exposure
Per our classification
Performing 1,952,704 2,467,672 1,989,792 1,550,314 7 52,766 253,924
Special mention 175,617 - - - 126,362 -
Substandard 180,175 161,619 140,929 39,583 - -
Doubtful - 364,185 77,892 178,325 - -
Loss 383,657 165,025 149,306 140,648 - 7 ,443
T otal loans to be repaid from corporates including 2,692,153 3,158,501 2,357,918 1,908,869 87 9,128 261,367 off balance exposure
12.2. Credit risk concentrations T able 48: Concentration risk from the economic sector point of view In mlns of MNT 2017 2016 2015 2014 2013 2012 Manufacturing 807,270 1,034,831 1,193,148 814,931 440,446 88,440 Construction 670,885 629,844 398,700 132,968 67,365 - Financial and insurance 660,753 335,829 - - - - activities
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Mining and 377,460 624,789 612,604 653,770 357,223 141,512 quarrying Electricity, gas, steam and air 77,434 262,409 387,876 - 127,700 2,774 conditioning supply Transportation 24,961 240,705 30,004 - 4,779 7 ,443 and storage Health and social 17,720 - - - - - work Agriculture, forestry and 1,247 - - - - - fishing Mortgage - - 117,018 - - - Railway - - 442,728 417,897 301,953 - Roads ------Utility - - - 227,580 94,614 - Other - - 32,427 - - - Transportation and - - - 13,175 - - communication Real estate and - - - 110,547 101,318 50,774 housing loans Utility - - 406,443 - - 428 Road - - 1,365,643 1,189,527 690,416 202,184 Finance - - - 2,938 - - Power plant - - - 270,942 - - T otal loan and advances 2,637,730 3,128,407 4,986,591 3,834,274 2,185,815 493,556 (before im pairment) T able 49: Concentration risk from the economic sector point of view by percentage: By percent 2017 2016 2015 2014 2013 2012 Manufacturing 31% 33% 10% 21% 20% 18% Construction 25% 20% 13% 3% 3% - Financial and insurance activities 25% 11% 16% - - - Mining and quarrying 14% 20% 9% 17% 16% 29% Electricity, gas, steam and air conditioning supply 3% 8% 8% - 6% 1% Transportation and storage 1% 8% 1% - 0% 2% Health and social work 1% - - - - - Agriculture, forestry and fishing 0% - - - - - Mortgage - - 2% - - - Railway - - 9% 11% 14% - Roads ------Utility - - - 6% 4% - Other - - 1% - - - Transportation and communication - - - 0% - - Real estate and housing loans - - - 3% 5% 10% Utility - - 8% - - 0% Road - - 24% 31% 32% 41%
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Finance - - - 0% - - Power plant - - - 7% - - Total loan and advances (before im pairment) 100% 100% 100% 100% 100% 100% Credit risk concentration from single debtor As at each snapshot dates, the aggregated amount of the top 5 largest corporate debtors before impairment is presented in below table. The amount did not consider on-lending loans and loans to be repaid from state budget. T able 50: Top 5 debtors of corporate portfolio (excluding on-lending portfolio) in mlns Industry 2017 2016 2015 2014 2013 2012 of MNT Debtor 1 Mining and quarrying 336,817 592,860 447,163 497,914 339,161 141,512 Debtor 2 Manufacturing 192,855 185,724 140,929 125,874 102,814 86,462 Debtor 3 Construction 285,327 318,010 278,265 113,775 60,660 - Debtor 4 Construction 174,165 178,461 143,134 134,940 - - Debtor 5 Manufacturing 182,481 - - - - - Debtor 6 Construction - 183,529 - 177,012 - - Debtor 7 Manufacturing - - 129,431 - - - Debtor 8 Manufacturing - - - - 23,548 - Debtor 9 Mining and quarrying - - - - 18,062 - Debtor 10 Transportation and storage - - - - - 7 ,443 Total loan portfolio to corporates 1,976,978 2,101,535 1,458,271 1,218,114 555,728 235,417 excluding corporates Exposure to Top 5 1,171,645 1,458,585 1,138,922 1,049,514 544,245 235,417 largest corporate debtors Percentage of top 5 debtor in total corporate loan portfolio excluding on- 59% 69% 7 8% 86% 98% 100% lending only one debtor exists as at 31 December 2012. As at each snapshot dates, the aggregated amount of the top 3 largest on-lending borrowers before impairment is presented in below table. T able 51: Top 3 debtors of on-lending loans In mlns Industry 2017 2016 2015 2014 2013 2012 of MNT Financial and insurance Debtor 1 63,807 307,081 279,892 278,405 272,745 - activities, manufacturing Financial and insurance Debtor 2 264,739 300,494 178,136 38,934 - - activities, manufacturing Financial and insurance Debtor 3 - 88,954 121,517 137,978 36,247 1,979 activities, manufacturing Financial and Debtor 4 7 0,753 - - - - - insurance
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activities, manufacturing Exposure to Top 3 largest on-lending 399,299 696,529 579,546 455,317 308,993 1,97 9 debtors T otal on lending exposure as at each 1,026,872 781,494 564,503 308,993 1,979 snapshot before 660,753 im pairment Percentage of top 3 debtors in total Corporate on-lending 60% 68% 7 4% 81% 100% 100% loan portfolio excluding corporate loan There were only 1 and 2 debtors as at 31 December 2012 and 2013, respectively. Concentration of the group of connected debtors Connected clients as defined in CRR article 4 paragraph 39. If a debtor belongs to multiple groups of connected clients the major connection should be specified. If there is no major connection then a control dependence takes priority over an economic dependence and should be reported as such. T able 52: Summary of connected debtors (information provided by the bank) Group of connected 2017 2016 2015 2014 2013 2012 debtors Group of connected debtor 1 513,761 7 82,955 457,676 688,756 357,223 - Group of connected debtor 2 317,607 378,982 226,357 32,006 - - Group of connected debtor 3 55,243 - - - - - Group of connected debtor 4 23,678 - - - - - T otal exposure from 910,289 1,161,936 684,034 7 20,762 357,223 - connected clients T otal loan and advances balances from corporates 2,637,730 3,128,407 2,242,605 1,7 82,591 864,565 237,340 (before impairment) Percentage of the group of 35% 37 % 31% 40% 41% 0% connected debtors Excluding loans and advances to be repaid from the state budget
12.3. Off-balance sheet items and the potential impact on the capital adequacy under Basel rules Guarantees The Bank issued a guarantee on behalf of a housing projects amounting to USD 84 mln on the 13 September 2012 with the maturity of 6 years from the loan disbursement. To date the counterparty have not yet provided any funding to the housing project. The Bank has issued three-year guarantee to a debtor with the amount of USD 7 6 mln in May 2013. The guarantee is finalised in 2016 as the construction of a object that was subject to the guarantee is completed and full settlement is made by the project implementing companies. The Bank issued a two year guarantee to a local commercial bank in the amount of USD 35 mln in January 2014. The guarantee is fully settled in 2016 as the debtor fully repaid the loan received from local commercial bank.
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We have concluded that no provision is necessary as guarantees 3600000272 and 3600000735 are settled with no activation while the other guarantee Client 1 is still inactive. We summarised the exposure from the issued guarantees on Table 61. T able 53: List of guarantees in 2012 to 2017 2017 2016 2015 2014 2013 2012 Client 1 In mlns of USD 84 84 84 84 84 84 In mlns of MNT 203,879 209,121 167,662 158,390 138,944 116,936 Client 2 In mlns of USD - - 13 54 7 6 - In mlns of MNT 25,848 101,822 125,546 - Client 3 In mlns of USD - - 5 35 - - In mlns of MNT 10,379 65,996 - -
As a result of additional provision identified during our review, the potential impact on capital adequacy ratio is show in table below. T able 54: Potential impact on capital adequacy
Capital Impact
T ot al T ot al Identified T ot al T ot al Ca pital ca pital ca pital a djustments ca pital ca pital su rplus or prior t o a dequacy du ring ou r following a dequacy deficit over rev iew ra tio prior rev iew ou r review ra tio after regulatory (m ln. t o review (m ln. MNT) ou r review m inimum (m ln. MNT) MNT ) of 10% (%) (%) (%)
2 017 1 ,038,823 3 3.60% -2 17,056 8 21,747 2 6 .58% 1 6.58%
2 016 9 53,557 3 0.50% -2 32,584 7 20,973 2 3.06% 1 3.06%
2 015 2 87 ,402 1 4.22% -1 89,130 9 8 ,272 4 .86% (5 .14%)
2 014 2 46,536 1 3.66% -2 10,852 3 5,684 1 .98% (8 .02%)
2 013 1 43,879 17 .76% -1 9,163 1 24,716 1 5.39% 5 .39%
2 012 6 6 ,992 1 3.65% -7 ,443 5 9,549 1 2.14% 2 .14%
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13. Fixed assets
13.1. Review of valuation of fixed assets through desktop review process This section summarises findings from our review of the Bank’s fixed assets. Fixed assets in this case encompasses DBM’s own use property. T able 55: Fixed assets overview (2012 – 2017)
Year 2012 2013 2014 2015 2016 2017 961 1,361 2,111 28,249 28,999 28,488 Balance sheet value (mln. MNT)
Significant increase in 2015 is due to acquisition of 11th and 12th floor in TDB tower, which currently serves as a DBM headquarters. T able 56: Comparison of Bank’s and our valuation of fixed assets
Bank’s Consultant’s Difference in Asset class Valuation method valuation valuation valuation (m ln. MNT) (m ln. MNT) (m ln. MNT)
Bank’s own use Market approach - property Comparable Valuation 28,488 23,400 - 5,088 Method based on unit of area
For Bank’s own use properties, our valuation is lower than the Bank’s valuation. This difference is due to different valuation approaches applied by the Bank and us. The Bank is valuing their fixed assets at cost whereas our valuation is using a market approach. Approach applied by the Bank creates no issue in relation to valuing fixed assets.
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List of abbreviations
Abbreviation Full description
BCBS Banking Committee on Banking Supervision
DPD Days past due
FCY Foreign currency
FX Foreign exchange currency
IA Internal Audit
ICS Internal Control System
IFRS International Financial Reporting Standard
IVS International Valuation Standards
LCR Liquidity Coverage Ratio
MIK Mongolian Mortgage Corporation
MNT Mongolian Tugrik
NPE Non-performing exposure
NPL Non-performing loan
NSFR Net Stable Funding Ratio
PE Performing exposure
RAF Risk Appetite Framework
RAS Risk Appetite Statement
RM Risk Management
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T able of tables Table 1: Findings and recommendation related to corporate governance framework...... 15 Table 2: List of findings and recommendation related to risk management framework, credit granting and monitoring process, and classification of loans and other assets ...... 24 Table 3: List of findings and recommendations to Credit Risk Management Framework: ...... 27 Table 4: List of findings and recommendation to internal control system and audit function ...... 37 Table 5: List of provided documents that were obtained and reviewed...... 39 Table 6: Components of liquidity risk management subject to review ...... 39 Table 7: Information on the Government support...... 43 Table 8: Summary of funding structure ...... 44 Table 9: Overview of investment structure ...... 45 Table 10: List of procedures, policies and strategies in previous years...... 48 Table 11: FX positions at year end (2012-2017) ...... 50 Table 12: Volumes of provided credits to clients that are able to generate a FCY cash flow ...... 50 Table 13: List of policies related to accounts receivable ...... 51 Table 14: Accounts receivables outstanding balances each year-end...... 51 Table 15: Estimated future liquidity position of the Bank as at Dec 2017 ...... 53 Table 16: List of all funding sources (issued bonds, accepted loans)...... 53 Table 17: Summary of interest income from related parties...... 56 Table 18: Interest expense summary to related parties ...... 56 Table 19: Rates for non-related parties (nominal rates) ...... 57 Table 20: Interest income accrued/recognised but not collected from loan and advances according to credit quality disclosure under IAS 39...... 58 Table 21: Interest income accrued / recognised but not collected from loan and advances according to revised classification of reviewed loan portfolio ...... 58 Table 22: Earnings recognised in statement of profit and loss from fees and commission income and foreign exchange translation gain/losses based on audited financial statements as at each reporting date...... 59 Table 23: Foreign currency positions as at 31 December 2017, 2016 and 2015 based on the audited financial statements and fluctuation in percentage of each currency (official rate in the end of the year and official rate in the beginning of the year)...... 59 Table 24: Income recognised on statement of profit or loss during 2012 to 2017 based on audited financial statements (accounting policy of each stream has been outlined accordingly) ...... 61 Table 25: Balances of prepayments based on audited financial statements...... 61
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Table 26: Impact on statement of profit or loss from derivative valuation based on audited financial statements...... 62 Table 27: FSLIs and valuation techniques ...... 63 Table 28: Data compilation of comparative information...... 63 Table 29: Control scheme of comparative information ...... 64 Table 30: List of missing disclosures ...... 64 Table 31: Breakdown of loan exposure ...... 66 Table 32: Summary of corporate debtors classified as PE ...... 67 Table 33: Summary of corporate debtors classified as NPE ...... 67 Table 34: List of reclassified corporate debtors in 2012 to 2017 (in mln of MNT)...... 68 Table 35: On-lending projects through commercial banks ...... 72 Table 36: Bank’s classification of debtors...... 73 Table 37: On balance exposure breakdown – All on lending projects ...... 73 Table 38: Summary of on-lending debtors classified as NPE ...... 74 Table 39: Summary of selected samples from the State budget loan ...... 76 Table 40: Summary of repayment received from the State ...... 76 Table 41: Summary of final reconciliation act ...... 77 Table 42: Provisioning assessment – Loans to be repaid from corporates ...... 78 Table 43: Provisions by classification – Loans to corporates ...... 79 Table 44: Provisions on individual debtor level – Loans to corporates ...... 80 Table 45: Overview of Bank’s collateral value and collateral value after our review ...... 86 Table 46: Overview of Bank’s and our BOM provisions ...... 87 Table 47: Classification analysis of the total portfolio under BoM regulation ...... 88 Table 48: Concentration risk from the economic sector point of view ...... 88 Table 49: Concentration risk from the economic sector point of view by percentage: ...... 89 Table 50: Top 5 debtors of corporate portfolio (excluding on-lending portfolio) ...... 90 Table 51: Top 3 debtors of on-lending loans ...... 90 Table 52: Summary of connected debtors (information provided by the bank) ...... 91 Table 53: List of guarantees in 2012 to 2017 ...... 92 Table 54: Potential impact on capital adequacy...... 92 Table 55: Fixed assets overview (2012 – 2017) ...... 93 Table 56: Comparison of Bank’s and our valuation of fixed assets ...... 93
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