Georgian Banking Sector Development: Is There Room for Growth?
The Bank of Georgia (right, 1975), and the proposed Tbilisi Business Centre by Robin Monotti Architects. Photo: Phaidon
The Georgian economy faces many challenges, not least of which are access to finance and the extremely high cost of financing private enterprises. With the cost of borrowing (real interest rate) reaching 17.3% on average in April 2013, businesses find it very difficult to function, let alone invest in innovative technologies, long-term growth and development. These challenges can be directly traced to issues raised in one of the ISET Economist blogs: the Georgian financial industry is still very far from being a well-developed, efficiently functioning system. In one of the recent blogs, financial literacy among the general population was named as one of the culprits for the low levels of financial development. Yet financial literacy remains only one of the many pieces of the development puzzle. What are the other structural obstacles to financial sector development? Here is a partial list of potential problems leading to financial sector inefficiencies and a high cost of finance:
- Small market size and low real sector penetration prevent economies of scale for Georgian banks.
- Moderate country ratings on international markets and a reliance on external sources of funding for commercial banks. Short funding maturities for commercial banks lead to short-term lending.
- Low financial reporting standards among Georgian companies. Low levels of financial literacy among the general population.
- Long-term lending is done almost exclusively in foreign currencies, which creates a FX credit risk.
Let us examine each of these problems in turn.
1. Economies of scale refer to the cost efficiencies (lowering of average costs) the firms industry might realize if the scale of its operations increases. Since the fixed costs associated with operating a commercial bank are quite high (operating branches, loan monitoring departments, etc.), the profitability of the banking sector in particular suffers from the relatively small market size in which banks operate. In Georgia this problem is reflected in the total country GDP and the asset size of the commercial banks.
For example, according to the World Bank, the average private credit-to-GDP ratio in Georgia (2008-2010) was 30.5%, which suggests a low level of financial depth relative to developed economies (as a comparison, the private credit-to-GDP ratio in Germany and France is about 109%). In addition, the loan-to-GDP and deposits-to-GDP ratios are equal to 42.5% and 39.6% (by the end of 2012 Q3) respectively. However, this does not imply low indebtedness of the population, as individual borrowers exhibit quite high debt-to-income ratios stemming from short-term lending.
The problem of the economies of scale is further exacerbated by the fact that the industrial base of Georgia is largely underdeveloped, which prevents banks from diversifying their risk across different industries and regions. The situation results in a vicious circle of low diversification, high cost of finance and, consequently, low industrial development.
This is an example of a situation where private markets are unable to efficiently resolve the problem. Consequently, government involvement might be in order. For example, clear policies to increase and diversify the country’s industrial base could help commercial banks better assess the future direction of industrial development and increase private lending.
2. The level of domestic savings in Georgia is very low relative to the financing needs of the country. As a result, Georgian banks have to rely on external (international) financing to satisfy these needs. Besides the high costs of borrowing internationally for a small developing country such as Georgia, the reliance on external finance poses certain risks (capital flow reversals), especially in times of global crises. Thus far, Georgia’s banking system has managed to secure sufficient financing from abroad, but the luxury of foreign financing comes at a price. Georgian banks can only borrow at relatively short maturities on international markets, which translate into high financing costs and short loan maturities for domestic borrowers. As per the NBG’s data, the average maturity of loans is 15.8 months, while the average lending interest rate is 17.3%. The total loan amount is 5.2 billion USD as of the end of April 2013.
The lengthening of credit maturity and decreasing interest rates would undoubtedly have a significant positive impact on the indebtedness of borrowers and the cost of debt services. For instance, increasing the average maturity to three years and freezing the interest rate at the same level would decrease an average borrower’s monthly payments by 50%. However, only decreasing the interest rates would have a much more moderate impact. For example, decreasing the average interest rate to 16% would lower monthly payments only by 1 %.