Chapter 3: Rural Financial Services Supply-The Formal Sector

The supply of rural financial services in the Lao PDR, as with most developing countries, can be broken down into the formal, semiformal, and informal sectors. For the purposes of this study, the formal sector consists of the commercial banks, which will be covered in this chapter. The semiformal sector comprises project-based interventions to provide rural and microfinance services. The informal sector comprises loans between friends and family members, informal moneylending, and lending through the traditional Lao houay. The semiformal and informal sectors will be discussed in the next chapter.

The Formal Sector–A Brief History ^1-2

The development of the Lao banking system can be divided into distinct phases. During the first phase (1975–1988), the Government instituted a mono-banking system comprised of the State Bank of Lao PDR (SBL) as the country's only bank. The introduction of the New Economic Mechanism in 1988 ushered in the second phase (1988– 1992) by creating a two-tiered banking system. SBL's commercial banking activities were placed in three stateowned commercial banks (SOCBs), and BOL was created as the central bank. Four additional SOCBs were created in 1990–1991, but all seven of the resultant SOCBs remained under the management control of BOL. ^2-1 Moreover, the legal and regulatory framework was weak, bank supervision was limited, and bank performance was poor.

The third phase (1992–1995) was characterized by further growth in the number of banks in the Lao PDR. Following the issuance of Prime Minister's Decree No. 3 on the Management of Commercial Banks and Other Financial Institutions (1992), branches of foreign banks (five Thai and one Malaysian) were established, along with a joint venture bank. And, importantly for the evolution of the rural finance system, APB was created as a policy bank by another Prime Minister's Decree in 1993 to make subsidized loans for agriculture. Performance of the SOCBs remained weak, with nonperforming loans (NPLs) reported at 35% in 1994. To satisfy capital adequacy requirements, the Government then proceeded with a first round of recapitalization of the SOCBs.

The fourth phase (1996–2002) was marked by improvements in the legal and regulatory environment, with the issuance of several prudential regulations that applied to the SOCBs and other banks and a revised Decree on the Management of Commercial Banks. However, continued weak performance of the SOCBs led to a program to consolidate them–by the end of 2002, their number had been reduced to two SOCBs, along with APB. ^3-2 However, as of end-2002, all three banks maintained high NPLs, surpassing 80% in one case.

A fifth phase can be considered to have begun in early 2003 under the Government's Banking Sector Reform Program. Under this program, two of the three state-owned banks (Banque pour le Commerce Exterieure du Laos [BCEL] and the Lao Development Bank [LDB]) have operated under governance agreements designed to improve corporate governance and reduce NPLs through enhanced loan collection and improved credit decision making. Similarly, under this program, APB has adopted a new corporate mandate and restructuring plan to become a sustainable, market-oriented rural finance institution, operating free of subsidies and phasing out all policy lending. APB is due to receive further support for its reform program under the Government's Rural Finance Sector Development Program, due to begin in 2006. All three banks are due to be recapitalized, contingent on satisfactory performance.

Formal Sector Participants

The commercial banking industry in the Lao PDR has three principal groups:

• Three SOCBs, namely: BCEL, LDB, and APB. All are wholly owned by the Government, with BCEL focused on foreign trade, LDB serving commerce, and APB serving the agricultural sector.
• Three joint-venture commercial banks (JVCBs), namely: the Joint Development Bank (JDB), Vientiane Commercial Bank (VCB), and Lao-Viet Bank (LVB). The JVCBs mainly service customers in the country's principal cities. JDB was established in 1989. VCB began operating in 1995. LVB started operations in 1999. JDB is a joint venture between the Government of the Lao PDR (30%) and private Thai interests. VCB is a joint venture between Lao private investors (25%), and private Australian, Taiwanese, and Thai banking interests. LVB is a joint venture between BCEL and the Bank for Industrial Development of Viet Nam (BIDV).
• Six foreign commercial banks (FCBs), each operating a single branch office in Vientiane, and one other UK bank–Standard Chartered Bank–with a representative office in Vientiane. Five of the six FCBs are Thai– Bangkok Bank (BBL), Krung Thai Bank (KTB), Siam Commercial Bank (SCB), Bank of Ayudhya (BAY), and Thai Military Bank (TMB)–and one, Public Bank (PBM), is Malaysian. The FCBs primarily service their home country clients who have operations in the Lao PDR.

The formal financial sector also has a single insurance company, numerous foreign exchange bureaus, and a social security fund. Overall, the degree of diversity and specialization in the Lao PDR formal financial sector is rudimentary.

Financial Structure

The formal sector banking industry is small and dominated by the SOCBs, which controlled a combined 64% of the estimated KN5.4 trillion ($507 million) in total banking assets as of the end of 2003. Figure 3.1 shows the relative shares of the three banking groups based on total assets.

In the SOCB group, BCEL with KN2.1 trillion ($194 million) in total assets is the largest, followed by LDB with KN1 trillion ($95 million), and APB with KN0.4 trillion ($33 million). The relative shares of the three SOCBs are shown in Figure 3.2 [ PDF 75.4KB | 1 pages ]

The JVCBs hold 21% of the assets in the banking industry. As shown in Figure 3.3, LVB is the largest bank in the group with KN680 billion ($64 million) in total assets. VCB is the next largest JVCB with total assets of KN250 billion ($24 million) and JDB follows with KN189 billion ($18 million).

The six FCBs comprise the remaining 15% of banking assets. BBL is the largest FCB with KN327 billion ($31 million) in total assets. As highlighted in Figure 3.4, the relative positions of the remaining FCBs in terms of total assets are PBM (KN165 billion or $16 million), SCB (KN145 billion or $14 million), KTB (KN103 billion or $10 million), BAY (KN97 billion or $9 million), and TMB (KN1 billion or $94,000).

BOL prudentially regulates and supervises all commercial banks. Supervision of APB according to the prudential regulations applicable to other SOCBs began only in 2005.

The commercial banking industry has experienced considerable growth over the past few years. Between 2002 and 2003 alone, total banking assets grew by 28% in nominal terms. ^4-2 As a consequence of this growth, as well as continuing supervisory weaknesses, NPLs in the industry have also grown. Ongoing restructuring efforts at the SOCBs and BOL are intended to address these problems.

The commercial banks' attention toward rural areas and populations in the country is very limited. BCEL handles foreign trade and as such does not concentrate on rural areas. LDB, with its focus on commerce, has interest in financing small- and medium-sized enterprises (SMEs), some of which are in rural areas (though they are principally in provincial capitals and Vientiane Municipality). APB, with its mandate to promote agriculture, is the SOCB most engaged in rural areas but, in practice, the majority of its clients are located in urban areas. The JVCBs and FCBs do not service rural areas with the exception of financing investments in ruralbased dams, mines, and the like.

Branch Networks

APB has the largest branch network in the Lao PDR. It has a head office branch in Vientiane Municipality and 17 other branches in the 17 provincial capitals. APB also operates 55 subservice units located at the district level.

LDB has its head office in Vientiane Municipality and operates 17 branches, one in each province. LDB also has 29 sub-branches at various district locations. LDB has the second largest branch network in the country, but its network may decrease as it intends to close some sub-branches.

BCEL has its head office in Vientiane Municipality and six branches in the major population centers of Champasak, Khammouane, Luang Namtha, Luang Prabang, Oudomxay, and Savannakhet. For the most part, BCEL does not consider rural populations to be its client base.

The remaining commercial banks have very limited distribution networks. LVB has its head office in Vientiane Municipality and a single branch in Champasak. JDB has its head office branch in Vientiane Municipality and no other branches; it reports no intention of opening any new branches. VCB has a single branch in Vientiane Municipality, but intends to open new branches in Savannakhet and Champasak. The FCBs each have a single branch–all located in Vientiane Municipality–with no plans for new branches.

Hence, the population in Vientiane Municipality has the greatest access (in terms of physical proximity) to commercial banks, followed by residents of the large urban centers, and then by residents in the other provincial capitals. As would be expected, residents of rural areas are most removed from commercial banks and the services they provide.

Savings Products

All commercial banks offer basic saving products in kip, US dollars and Thai baht–current accounts, savings accounts, and fixed-term deposits. The SOCBs and JVCBs offer fixed term deposits out to 24 months in tenor, but the FCBs do not offer fixed-term deposits past 12 months in duration. LVB also offers Vietnamese dong savings accounts out to 12 months in tenor.

All commercial banks' savings products are voluntary in nature except for LDB and APB who have compulsory savings in addition to voluntary savings products. Compulsory savings are associated with group guarantee loan products. As the name suggests, borrowers are required to place funds in noninterest-bearing current accounts as a loan conditionality.

APB offers additional, more specialized saving products such as daily deposit accounts, lottery payout deposit accounts, and 5-year certificates of deposit. These products were developed to improve deposit mobilization at APB. From a large deficit position in the mid-1990s, APB is now close to fully funding its loan portfolio with customer deposits. As shown in Table 3.1, most commercial banks can fund their loan portfolios with funds from their savings products–indeed, many banks have excess liquidity in the form of low loan-to-deposit ratios.

Of total deposits in the commercial banking industry, the SOCBs hold the dominant market share position of 75% as shown in Figure 3.5. Within the SOCBs, BCEL has the most deposits with 61% of the total amount. LDB held about 33% of the deposits in this group, while APB held about 6%.

Interest Rates on Savings

On 31 December 2003, interest rates on kip-denominated deposit accounts of different maturities varied between the commercial banks. The SOCBs offered savings deposit rates at or slightly above the inflation rate. As shown in Figures 3.6 through 3.9 [ PDF 77KB | 1 pages ], the SOCBs offer progressively higher rates at longer maturities.

However, BCEL and LDB did not seem to need these deposits as their aggregate deposits exceeded their outstanding loan portfolios almost threefold at 31 December 2003. APB was the only exception as its deposits almost equalled its loan portfolio. The deposit rates offered by BCEL and LDB appear to be more policy than commercially directed, e.g., as a tool to manage the money supply.

With the exception of LVB, the JVCBs offered deposit rates at a much lower level across the time horizon. JDB and VCB appeared to have sufficient liquidity to finance their current and projected loan portfolios. LVB is similar to the SOCBs in pricing its deposit products. This is expected as the bank is a joint venture between SOCBs of the governments of the Lao PDR and Viet Nam. LVB's deposits and borrowings exceed its loan portfolio need by almost two times.

The FCBs, except PBM, do not offer rates at or above the rate of inflation for their savings deposits. For longerdated maturity deposit products, the rates offered range between 8–10 percentage points below the rates offered by the SOCBs. At their lower pricing levels though, the FCBs appear to be able to attract sufficient funding for their loan portfolios.

All commercial banks also offer deposit accounts in Thai baht and US dollars, some out to 2 years in maturity. The deposit rates offered on these foreign currency accounts are competitive with international rates.

Loans

Loan Characteristics

The commercial banks offer various loan products based on their target market segments and appetite for credit risk. APB lends only in kip, but all other banks offer loan products in US dollars and Thai baht in addition to kip. APB places its dollar and baht deposits with other banks. LVB also offers Vietnamese dong loan products. Loan products are term facilities as well as overdraft facilities.

Loan products for all banks are mainly for working capital purposes (financing short-term agriculture and commercial production) and longer-term financing of capital assets. Consumer loan products such as hire purchase and home purchase loan products are not yet offered in the market. Financial leasing products are still in the development phase.

Collateral in the form of land, buildings, pledged deposit accounts, and precious metal deposits are usually required for individual, SOE, and corporate borrowers. Group guarantee loan products, offered only by APB and LDB, are not secured by physical collateral; instead, they are secured by all members of the borrowing group guaranteeing repayment of the sum total borrowed by all members of the group. Foreclosure and bankruptcy laws are still in development, and a commercial bank's ability to seize and liquidate collateral in the case of default is weak.

While the SOCBs price their loan products at different rates based on the type of business in which the borrower is engaged, the other commercial banks use a single base lending rate approach in line with international practice– additional percentage margins are charged based on an analysis of the borrowers' credit risk characteristics.

BCEL offers loans for short- and medium-term periods to individuals, SOEs, and private companies. The maximum loan tenor for kip loans for individuals and SOEs is 1 year. Companies can borrow out to 3 years. The time limits are put in place to manage perceived credit risk. In general, BCEL requires borrowers to pay interest monthly and principal quarterly.

LDB offers loan products to group guarantee borrowers, individuals, SOEs, and companies at all maturities ranging from short-term to periods greater than 3 years. Like BCEL, LDB generally requires borrowers to pay interest monthly and principal quarterly.

APB's loan products range from the short-term to over 10 years in maturity for some policy-based loans. APB lends to group guarantee borrowers, individuals, SOEs, and companies. Most group guarantee customers borrow for periods of less than 1 year to finance agriculture production, though they can borrow money for up to 3 years for things such as tractors and other agriculture capital assets. APB has numerous repayment schedules for interest and principal based on the particular characteristics of each loan product. The terms of loans have, in the past, often been determined in consultation with donors providing project-specific credit lines.

The JVCBs restrict their loan products to fewer customer segments than the SOCBs. JDB only lends to individuals and companies at short maturities. VCB also lends to individuals and companies, but only for periods of less than 3 years. LVB restricts itself to lending to SOEs and companies at short maturities. In general, the JVCBs all require their borrowers to pay interest and principal monthly.

The FCBs all offer some combination of overdrafts in kip, Thai baht, and US dollars, as well as short-, medium-, and long-term loans in all three currencies.

Because most SOCBs and JVCBs have significant NPL portfolios (this also being the case to a lesser extent for the FCBs), the banks do not aggressively market their loan products.

Credit Portfolios

The three SOCBs (BCEL, LDB, and APB) dominate the industry's loan portfolio. They accounted for 59% of total outstanding gross loans in the banking sector at the end of the first quarter in 2004. Figures 3.10 through 3.14 [ PDF 77.9KB | 1 pages ] illustrate the loan portfolio breakdowns for all of the commercial banks. The SOCBs' lending mandates are evident in their portfolio compositions, which show their respective shares in various economic sectors. ⁵

APB is the principal lender to forestry and agriculture borrowers. Of total industry lending to this sector, APB holds 66% of the total portfolio. On the other hand, BCEL dominates lending to industry (50%), construction and equipment (37%), trade (41%) and handicraft (62%). APB only has a 5% share of handicraft lending.

LDB has a more balanced loan portfolio. It does not dominate any principal loan portfolio category. In most cases, LDB holds a second or third place position in each loan portfolio class.

The JVCBs (JDB, LVB, and VCB) focus principally on the loan market in Vientiane Municipality and, to a lesser degree, the other principal cities. This loan market is mainly focused on construction and equipment, trade and transport, communications, and services lending.

The FCBs (BBL, KTB, BAY, TMB, SCB, and PBM) facilitate the borrowing needs of their home country clients. This fact can be seen in BBL's strong market share (28%) in lending to industry.

As shown in Table 3.2 [ PDF 67.1KB | 1 pages ], the number of borrowers that SOCBs serviced is inversely related to the size of their loan portfolios. BCEL has the largest loan portfolio and the lowest number of borrowers. Its average loan size is KN1. 5 billion ($140,000). APB has the smallest loan portfolio among the three SOCBs and the largest number of borrowers with an average loan size per borrower of KN3 million ($262).

Interest Rates

Table 3.3 [ PDF 67.1KB | 1 pages ] shows the published lending rates as of 31 December 2003 for each bank, according to the type of loan. The JVBs and the FCBs in general price their loan products on the basis of perceived risk, the time value of money, and their underlying costs. They use a single base lending rate approach in line with international practice–the rates shown in Table 3.3 are their base rates. Additional percentage margins are charged based on an analysis of the borrowers' credit risk characteristics. Their final lending rates cover these risks, as well as funding costs, administrative expenses, and loan loss provisioning charges.

The SOCBs price their loans at similar or slightly lower levels, but vary rates by sector rather than by assessments of risk attached to any particular borrower. In addition, APB continues to conduct policy-based lending to agriculture at subsidized rates that are administratively determined.

However, APB is moving away from this practice and part of its loan portfolio is already based on charging market lending rates. Because the SOCBs' practice of pricing across sectors does not factor in an assessment of the risk of an individual borrower, the SOCB loan pricing likely does not reflect the risk of the transactions as accurately as the loan pricing of other commercial banks. It is estimated from the survey that the SOCBs' funding costs are in the range of 10–12%. The current lending rates charged provide a more than 10% margin to cover expenses and loan losses.

Given the level of kip lending rates in the market and the increased probability of default for longer-term loans, most loans are short term in duration.

Other Products and Services

In addition to savings and loan products, the commercial banks offer other credit-based as well as cash management and foreign exchange products. Products include letters of credit (LCs) for domestic and international trade; bank guarantees (BGs) such as bid bonds, performance bonds, and advance payments bonds; international money transfers such as SWIFT payments; domestic money transfers (Dom MT); spot foreign exchange (Spot FX) trades; automatic teller machines (ATM); VISA credit cards; and traveller's cheques. Table 3.4 [ PDF 69.5KB | 1 pages ] summarizes the product offerings of SOCBs and JVCBs. The FCBs are able to offer all these products.

Performance⁷

Generally, a commercial bank's asset structure will consist of three primary categories–liquid assets, fixed assets, and loans and accrued interest receivable. The target level of each category with respect to total assets is determined by central bank regulations and the bank's internal risk guidelines. For liquid assets, the liquidity reserve requirement regulation (cash and readily convertible investment assets held against total deposits) will specify the minimal level of liquid assets acceptable. The international norm for commercial banks is that liquid assets range between 5% and 10% of total assets. Fixed assets, including a bank's physical distribution network, are usually about 10% of total assets. The remaining 80–85% of assets are loans and interest receivable.

As shown in Table 3.5 [ PDF 115.4KB | 1 pages ], commercial banks in the Lao PDR have much larger percentage holdings of liquid assets and lower percentage holdings of loans and receivables than the international norm. A possible explanation for the high degree of liquidity may be a general lack of profitable lending opportunities resulting from an excessive degree of credit risk in the overall economy. It is also possible that the banks retain large liquid asset holdings to provide depositors with additional confidence in terms of the banks' ongoing sustainability. In the case of the SOCBs, large liquid assets may reflect their use as an instrument for managing the money supply, with high deposit interest rates used to increase deposits and reduce the money supply to keep inflation in check.

A contributing factor to the lack of lending opportunities at the banks may be the low degree of investment the banks have made in their physical distribution networks as highlighted by the low percentage of fixed asset holdings.

Most central banks require commercial banks to have equity of at least 8% of their risk-weighted assets; this is the case in the Lao PDR too. The remaining 92% of funding capital will be deposits and borrowings. Deposits will usually be vastly greater than borrowings as they represent much cheaper fund sources.

As the current three SOCBs are the direct result of mergers between the previous seven SOCBs, the current SOCBs have inherited the financial difficulties that caused these consolidations in the first place. ⁸ The SOCBs' problems relate mainly to significant NPL portfolios and corresponding capital impairments. As of 31 December 2003, the capital of the three SOCBs was significantly negative, amounting to-36% of total assets. The SOCBs are currently undergoing restructuring and performance-based recapitalization programs to address these problems.

Of the total NPLs in the system, the SOCBs hold the vast majority. At end-2003, the aggregate NPL rate in the SOCBs was 58%. The JVCBs hold a much lesser degree, and the FCBs with their limited loan portfolios and focus of foreign currency lending to clients from their home countries have the least percentage. Figure 3.15 [ PDF 64.4KB | 1 pages ] highlights the relative NPL rankings within the industry.

Given their large NPL portfolios, the SOCBs also have the largest share of protective coverage against their impaired loans. The Government of the Lao PDR aims to increase this level of loan loss provisioning further through the restructuring of the SOCBs. The SOCBs' loan loss provision percentages are similar percentages as their NPL holdings as shown in Figure 3.16 [ PDF 64.4KB | 1 pages ].

The FCBs hold a larger percentage of loan loss provisions relative to their NPL position than the other commercial banks. This situation illustrates their general practice of prudently providing more than the total amount of their NPLs, provisions on average being about 190% of actual NPLs. The SOCBs currently have four-fifths coverage over their NPL portfolios, while the JVCBs have about one-third coverage. The JVCBs and FCBs have substantial equity positions, averaging about one third of total liabilities and equity, reflecting the high minimum capital requirements for nonstate-owned banks in the Lao PDR in relation to the overall size of their balance sheets. They are also more reliant upon borrowings to finance their assets than the SOCBs.

This is typical for FCBs with just one branch location. Normally, these types of operations are financed with a substantial loan from the parent commercial bank (quasi equity) located in another country. The JVCBs' borrowing percentage is skewed somewhat by a large borrowing of LVB, from its parent development bank in Viet Nam. For JDB and VCB, borrowings are less of a funding source as deposits provide 87% and 65% of their capital funding, respectively. All SOCBs, one JVCB, and a few FCBs recorded losses in fiscal year 2003. Loan loss provision expenditures to cover NPL portfolios were the primary reason for the losses. The other commercial banks reported positive earnings. Their return on equity (ROE) varies between 2% and 11%.

Comment(s)

There are [0] comment(s) for this entry. Post a comment.