Issue 5, 2012. October-November



Georgia is currently ranked in 64th place in the world according to Transparency International's Corruption Index 2011, and has made progressive steps towards to diplomatic and economic relations with the United States and Western European Countries. These positive trends are reflected In the Georgian banking and financial sector.

Besik Sanaia

Increased investor protections, strong economic fundamentals, low corruption, government reforms, significant progress in economic and business development processes had a positive impact on the Georgian economy and banking sector.

Georgia's strong economic recovery is reflected in its standing among the various financial rating services. Georgia's sovereign debt is rated BB- by Standard & Poor's Financial Services LLC and B by Fitch Inc. S&P raised its rating to BB from B+ in November, 2011, and Fitch raised its outlook from stable to positive in March, 2011. Moody's Investors Service Inc. first assigned a Ba3 rating in October 2010. The ratings echo a reduction in both the budget and current account deficits, an improvement in the financial sector's health and easing of political risk.

Positive trends, potential risks and financial stability

Since 2004, the Georgian banking sector has achieved remarkable growth due to economic reforms, foreign investments and aggressive lending. However, consistent with most small economies, the Georgian financial sector was negatively affected by the 2008 global financial crisis. The negative effects resulted from losses and asset reductions banks experienced during the third and fourth quarters of 2008. Banking assets decreased 6.5 percent in 2009. Nevertheless, the banking sector rebounded from the global financial crisis, with assets growing 27.4 percent in 2010 and 20 percent in 2011.

Significant growth in assets of certain Georgian banks has resulted in having two so-called systematically-important banks in Georgia. The Bank of Georgia, the second-largest bank in the Caucasus by assets, and TBC Bank, which represented 62.9 percent of banking sector assets in 2011. The question is, are there banks in Georgia that are too big to fail?

The advantage of banks becoming bigger is that in a global economy there is a need for financial institutions with scale and global capacity. Large banks can offer their customers products, services and infrastructure that smaller banks simply cannot match, from multicity branch networks to global coverage. These factors act to lower costs to the customer.

However Simon Johnson, a former chief economist for the International Monetary Fund, who is now a professor at the MIT's Sloan School of Management and a contributor to Bloomberg View, believes that in line with the current developments in regulations of financial services firms (Dodd-Frank Wall Street Reform and Consumer Protection Act, Basel III, etc.) there should be regulatory limits on the size of bank assets. Johnson points out that size limits "provide protection against both the systemic risk and the competitive distortions created by financial institutions that are too-big-to-fail, which are not adequately addressed by existing regulations. We believe these limits should work out to no more than four percent of GDP for all banks and two percent of GDP for investment banks, but that is a debate we are willing to have." If we analyze the Georgian banking sector on the basis of Johnson's calculations, we get the following picture: Total assets of the Bank of Georgia as of Dec. 31, 2011, amounted to 22.5 percent of Georgia's GDP in 2011 and TBC Bank's total assets amounted 15.9 percent of GDP for the same period. Please note that everywhere GDP is used in this publication, it represents GDP at current prices and not real GDP, unless explicitly mentioned otherwise.

As Fitch ratings noted in 2012, "Georgia is one of few emerging markets with zero government ownership of banking system, which is very important for the banking sector".

Given the unique nature of the Georgian banking sector and its strong economic fundamentals, we believe that currently too-big-to-fail is not an issue of concern for the local banking sector. However, the NBG must monitor the expansion of asset bases of these two banks in order to avoid what happened in small developing economies (e.g. Iceland) and what became one of the major criticisms of developed countries (United States, United Kingdom, Switzerland, etc.) in 2008.

The point is that once cumulative numbers of several big banks exceed the country's GDP, those banks may become too big to save.

Total assets of the Georgian banking system have grown from approximately 31 percent of GDP in 2006 to more than 52 percent in 2011, which is significant, but not out of line with small countries that have become international financial centers, such as, Hong Kong, the Netherlands, and Switzerland).

By comparison, total assets of the Azerbaijan banking system as of December, 2011, was 28.5 percent of GDP, and total assets of the Armenian banking sector was 54.7 percent of GDP for the same period.

Standard & Poor's, in its publication "Banking Industry Country Risk Assessment: Georgia," which was published in July 2012, lists the following major strengths of the Georgian Banking Industry.

- Strong long-term macroeconomic growth prospects.

- Advanced regulation compared with regional peers and recent progress in structural economic reforms.

- Sound banking-sector governance and high transparency because of high foreign ownership.

- Low private-sector leverage.

Standard & Poor's reviewed the Georgian banking sector under its updated Banking Industry Country Risk Assessment (BICRA) methodology, and Georgia ranks in BICRA group 8, along with countries such as Argentina, Azerbaijan, Kazakhstan, Latvia, Nigeria and Tunisia.

Small economies are exposed to the risk of what economists refer to as multiple equilibria, meaning that concerns about a country's potential financial meltdown could lead to massive withdrawals out of a small country's assets, which would then lead to a financial meltdown, even if their banking systems' fundamentals are strong. Normally, this is the result of traders' speculative actions by betting on the country's default and driving its credit default swaps, or CDS, spreads artificially.

However, Georgia's linkage to the world financial markets is not that significant. We have not been able to identify any financial institutions who sell CDS on Georgian sovereign debt. Therefore, we believe that the probability of Georgia being exposed to this risk is remote.

Premium listing on London Stock Exchange

In June 2012, the Bank of Georgia, became the second foreign bank to have a premium listing on the London Stock Exchange. The bank became a part of FTSE 250 and FTSE 250 All Shares index, a step widely assessed to be a move toward strengthening the liquidity position of the bank and increasing its recognition in financial markets.

Georgia, regional banking hub

According to Fitch ratings officials, overall, the Georgian banking sector is well capitalized and comfortably liquid, pre-impairment performance is strong, and asset quality is stable.

The sector is undergoing substantial liberalization. It has already become a regional banking hub, which was evidenced by interest expressed in the Georgian banking sector by international financial institutions.

In general, the investor protection index is significantly higher in Georgia compared to other countries in the region. According to the World Bank's "Doing business in Georgia – 2012," Georgia is ranked 17 out of 183 economies for the strength of its investor protection index. While the indicator does not measure all aspects related to the protection of minority investors, a higher ranking does indicate that an economy's regulations offer stronger investor protections against self-dealing in the areas measured.

Georgia's path from ex-Soviet state to noticeably developing economy can be explained by a general liberalization of the economy, privatization, globalization — with significant investments made by international financial institutions in the Georgian banking sector — and well-educated young people who often receive schooling abroad and are trained in a financial market that is disproportionate to the size of the country. The result has been an increased optimism and a positive trend in the Georgian financial and banking industry. The above analysis of Georgia's banking sector suggests that it has the potential to be transformed from one that is focused primarily on its domestic markets to one providing financial services in the region, into Europe and, perhaps, the rest of the world.

Besik Sanaia is a senior associate at KPMG Georgia. The opinions expressed are his own.