REPUBLICAN STATE INSTITUTION
"NATIONAL BANK OF THE REPUBLIC OF KAZAKHSTAN"		RESOLUTION OF THE BOARD OF DIRECTORS

On Approval of the Principles of the Mechanism for Providing Last Resort Loans by the National Bank of the Republic of Kazakhstan

In accordance with the Law of the Republic of Kazakhstan dated March 30, 1995 "On the National Bank of the Republic of Kazakhstan", with the aim of defining the principles for providing last resort loans by the National Bank of the Republic of Kazakhstan, the Board of Directors of the National Bank of the Republic of Kazakhstan RESOLVES:

1. Approve the attached Principles of the Mechanism for Providing Last Resort Loans by the National Bank of the Republic of Kazakhstan.
2. Assign the Department of Financial Stability (S.T. Khakimzhanov) to ensure the publication of this resolution on the official Internet resource of the National Bank of the Republic of Kazakhstan.
3. Entrust control over the implementation of this resolution to the Deputy Chairman of the National Bank of the Republic of Kazakhstan M.E. Abylkasymova.
4. This resolution enters into force from the day of its adoption.

Chairman

of the National Bank E. Dosayev

Approved

by the Resolution of the Board of Directors

of the National Bank

of the Republic of Kazakhstan

dated "9" July 2019 No. 53

Principles

of the mechanism for providing

last resort loans

by the National Bank of the Republic of Kazakhstan

Preamble

This document is developed with the purpose of disclosing the general principles and approaches of the last resort lending mechanism operated by the National Bank of the Republic of Kazakhstan (hereinafter – the National Bank), which has been in effect since 2019.

In 2018, the National Bank initiated amendments to the legislative acts of the Republic of Kazakhstan, which came into force on January 1, 2019, with the aim of improving the last resort lending mechanism. Thus, the principles of the last resort lending mechanism were included in the Law of the Republic of Kazakhstan dated March 30, 1995 "On the National Bank of the Republic of Kazakhstan". In order to implement the changes introduced into the legislative acts and to define the procedure for providing last resort loans by the National Bank to second-tier banks (hereinafter – bank) and organizations classified as systemically significant infrastructure financial organizations, the Rules on Last Resort Loans Provided by the National Bank were developed, approved by the Resolution of the Management Board of the National Bank dated September 27, 2018 No. 227, registered in the registry of state registration of normative legal acts under No. 17691 (hereinafter – the Rules).

The Principles were developed taking into account international experience and recommendations of the International Monetary Fund.

The improvement of the last resort lending mechanism is aimed at harmonizing borrowing conditions and requirements for potential borrowers, which will contribute to increasing the efficiency of the last resort lending process, as well as motivating banks to improve the efficiency of internal liquidity management processes and contributing to strengthening the stability of the financial system.

Goals and Objectives of the Last Resort Lending Mechanism in International Practice

In international practice, liquidity provision by the central bank occurs systematically through open market operations within the framework of monetary policy implementation (hereinafter – MP) and selectively within the mandate for ensuring financial stability by providing last resort loans to individual solvent banks experiencing acute liquidity shortages.

The goal of providing emergency liquidity is to eliminate a market failure manifested in the panic withdrawal of deposits from a solvent bank and the associated loss of ability to fulfill obligations to clients. The possibility of a liquidity shortage arises because, in a fractional reserve system, bank liabilities are generally shorter than claims. For efficiency reasons, banks hold only a small volume of liquidity sufficient to meet expected net outflows for funding and credit operations. However, in the event of simultaneous deposit withdrawals or refusal to renew them, a bank can only satisfy the first claims received. The fear of being late and ending up among depositors whose claims will not be satisfied causes panic at the first signs of mass fund withdrawals from any given bank.

In a fractional reserve system, the threat of simultaneous deposit outflows is exposed not only to insolvent banks but also to solvent, well-capitalized banks. Deposit outflows can be triggered by events that do not directly affect the bank's sustainability but affect the expectations and behavior of its depositors. Such a liquidity shock is commonly referred to as idiosyncratic to highlight the specificity of triggers and the selective nature of their impact on specific banks.

Providing emergency liquidity by the central bank in response to such idiosyncratic shocks allows, if not eliminating this threat completely, then at least significantly reducing each individual bank's exposure to unjustified panic and preventing its spread.

Analysis of Problems with the Last Resort Lending Mechanism

The possibility of providing emergency loans to banks at any time is similar to the principles of liquidity insurance by the central bank. Similar to insurance, lender-of-last-resort lending is associated with the risk of abuse by borrowers, the risk of adverse selection of borrowers, and credit risk.

The risk of abuse by borrowers is expressed in the low motivation of banks to build more responsible internal liquidity management processes, as banks are confident in the availability of loans. At the same time, banks tend to increase high-risk operations to obtain greater income. In this case, preferential lending conditions only exacerbate the situation. Banks turn to the lender without urgent need and may use funds for unintended purposes.

By increasing high-risk operations, banks risk their financial sustainability. The probability of these banks turning to last resort loans is higher. Meanwhile, good banks experiencing an idiosyncratic liquidity shock and genuinely having the right to a last resort loan are disincentivized from turning to the central bank for help due to reputational risks (stigma risk). In the absence of adequate monitoring of the borrower's financial condition by the supervisory authority, the probability of adverse selection of borrowers increases.

The absence of clear principles for providing such loans by central banks does not contribute to minimizing these risks. The lack of regulation of borrowing conditions and requirements for the borrower, the definition of a clear role for last resort loans in the overall central bank policy on liquidity provision reduces transparency, predictability, and consistency in the actions of the central bank. Public trust, and consequently, effective financial stability assurance, decreases.

Therefore, all principles of last resort lending must be transparent. Defining market conditions and requirements, uniform for all banks, contributes to minimizing the lender's credit risks and the risk of the bank using the loan for unintended purposes, such as asset stripping, and also contributes to increasing banks' motivation to create efficient processes for managing their own liquidity. Clear functional separation of last resort loans from other liquidity provision mechanisms operating in the central bank, such as operations within the framework of MP, settlement (resolution) of problematic banks, makes the central bank's policy logical, understandable, and consistent.

The National Bank, with the aim of improving the efficiency of the last resort lending mechanism and minimizing the aforementioned risks, implements the last resort lending mechanism based on the Principles defined in this document.

Principles of the Last Resort Lending Mechanism in the National Bank

Principle 1. Last resort loans for the purpose of ensuring financial stability

The National Bank provides last resort loans within the task of ensuring the stability of the financial system of Kazakhstan. Last resort loans are not a tool of MP.

Principle 2. Targeted use of last resort loans

The National Bank provides last resort loans to banks only to cover idiosyncratic liquidity shocks. Borrowed funds are not intended to increase the bank's capital and assets.

Principle 3. Solvency of the borrower

Only a solvent bank that is unable to cover an idiosyncratic liquidity shock through other sources of financing may receive a last resort loan.

Compliance of the bank with the requirements and conditions for last resort loans does not imply automatic provision of a last resort loan.

The National Bank also has the right to provide last resort loans to systemically significant infrastructure financial organizations.

Principle 4. Security for the fulfillment of obligations under the last resort loan

The National Bank provides last resort loans fully secured by the bank's assets and accepts liquid market assets, as well as quality credit portfolios and real estate, as collateral. A quality credit portfolio and real estate of the bank are accepted as collateral only after a preliminary assessment conducted within the framework of collateral pre-positioning.

Principle 5. Market conditions for providing last resort loans

The National Bank limits the amount of the last resort loan to the size of the bank's liquidity deficit and the amount of acceptable collateral.

The term of the last resort loan is from fourteen to ninety days with the possibility of extension up to three times, where the total term of providing the last resort loan does not exceed one year.

The reward rate for the last resort loan is not lower than the official rates of the National Bank.

The currency of the last resort loan is the tenge.

Principle 6. Monitoring and Control

For the purpose of effective implementation of the last resort lending mechanism, regular monitoring of bank solvency is carried out.

Explanations to the Principles of the Last Resort Lending Mechanism in the National Bank

Principle 1. Last resort loans for the purpose of ensuring financial stability

The National Bank provides last resort loans within the task of ensuring the stability of the financial system of Kazakhstan. Last resort loans are not a tool of MP.

Last resort loans are a tool for supporting the liquidity of an individual bank in an emergency situation for it, with the aim of minimizing systemic risks and ensuring financial stability. The National Bank does not use last resort loans as a tool for maintaining the necessary level of liquidity in the system.

One of the causes of systemic risks is the mass outflow of depositors and the lack of sufficient liquidity reserves at the bank to simultaneously fulfill its obligations to them. At the same time, panic among depositors of one bank quickly spreads to depositors of another bank, creating a risk of systemic contagion throughout the financial sector. In this situation, the National Bank provides a last resort loan for the timely and full performance of the bank's obligations to clients (excluding related parties), preventing the growth of panic among the population.

Principle 2. Targeted use of last resort loans

The National Bank provides last resort loans to banks only to cover idiosyncratic liquidity shocks. Borrowed funds are not intended to increase the bank's capital and assets.

The bank uses the last resort loan only to maintain uninterrupted fulfillment of its obligations to clients. The National Bank may restrict the bank from conducting certain operations in order to prevent the use of borrowed funds for unintended purposes.

Principle 3. Solvency of the borrower

Only a solvent bank that is unable to cover an idiosyncratic liquidity shock through other sources of financing may receive a last resort loan.

With the aim of minimizing credit risk, the National Bank provides last resort loans to banks that are not classified as banks with unstable financial position or category of insolvent banks[1]. Financial instability of the bank is grounds for refusing to issue last resort loans. In this case, other more decisive measures for the settlement and rehabilitation of the bank are provided.

Compliance of the bank with the requirements and conditions for last resort loans does not imply automatic provision of a last resort loan. The National Bank has the right to refuse to issue a last resort loan for a number of objective reasons, such as the identification of a high share of the bank's transactions with related parties, if the liquidity deficit arose due to inefficient management by the bank's management. The need to satisfy the claims of individual large creditors and depositors of the bank is not grounds for issuing a last resort loan by default.

The National Bank also has the right to provide a last resort loan to systemically significant infrastructure financial organizations due to their high significance and influence on the financial system.

Principle 4. Security for the fulfillment of obligations under the last resort loan

The National Bank provides last resort loans fully secured by the bank's assets and accepts liquid market assets, as well as quality credit portfolios and real estate, as collateral. A quality credit portfolio and real estate of the bank are accepted as collateral only after a preliminary assessment conducted within the framework of collateral pre-positioning.

As collateral, the National Bank accepts the bank's liquid market assets on condition that there is no related party relationship with the issuer of securities.

Also, the National Bank may accept non-market assets, such as a quality credit portfolio and real estate of the bank (except for unfinished construction objects), as collateral for the last resort loan only in the absence of collateral acceptable for attracting liquidity in the money market.

The purpose of expanding the list of acceptable collateral is to increase access to last resort loans for solvent banks in the absence of market assets provided by the bank as collateral.

Due to the duration of the process of assessing the cost of this type of assets, it is necessary for the bank to conduct corresponding preliminary procedures. Thus, if the bank does not exclude the possibility of applying for a last resort loan in the future and offering non-market collateral as security for the fulfillment of obligations under the last resort loan, it undergoes the procedure of collateral pre-positioning.

Collateral pre-positioning is a preliminary procedure for determining by the National Bank and the bank of the bank's assets acceptable for acceptance by the National Bank as collateral in the event of providing a loan by the National Bank, with the conclusion of an agreement on collateral pre-positioning.

Collateral pre-positioning includes a preliminary (before applying for a last resort loan) assessment of the cost of non-market assets by an independent subject of appraisal activity[2] and coordination with the National Bank of these assets regarding their acceptability as collateral in the event of the need to provide a last resort loan.

Non-market assets are accepted as security for the fulfillment of obligations under the last resort loan only if they have previously undergone collateral pre-positioning procedures and have been approved by the National Bank as acceptable as collateral.

The assessed value of market and non-market collateral, taking into account applicable discounts[3], must fully cover the amount of the last resort loan and rewards for it.

Principle 5. Market conditions for providing last resort loans

The National Bank limits the amount of the last resort loan to the size of the bank's liquidity deficit and the amount of acceptable collateral.

The term of the last resort loan is from fourteen to ninety days with the possibility of extension up to three times, where the total term of providing the last resort loan does not exceed one year.

The reward rate for the last resort loan is not lower than the official rates of the National Bank.

The currency of the last resort loan is tenge.

The amount of the last resort loan is limited by the current and forecasted size of the bank's liquidity deficit according to the National Bank's assessment and the bank's funding plan, and by the amount of acceptable collateral taking into account the discount applied to the collateral.

The maturity of the last resort loan is determined by the nature of the liquidity deficit, which is temporary if the bank is solvent. The last resort loan is a tool for allocating short-term liquidity and does not represent a mechanism for funding the bank with long-term maturity. The bank's need for liquid funds on a longer-term basis indicates the likelihood of deep structural and/or systemic problems related to its activities and management methods. Moreover, the provision of long-term last resort loans motivates the use of last resort loan funds outside their target purpose.

The bank has the right to petition for the extension of the loan no more than three times. At the same time, the total term of the loan should not exceed one year. The decision to satisfy the petition by the National Bank will proceed from the expediency of further lending to the borrower. Thus, in the event of deterioration of the borrower's financial condition as a result of regular monitoring, or when liquidity problems are exhausted and there is no further need for borrowing, the National Bank will not extend the loan.

The National Bank sets the reward rate for the last resort loan at a level not lower than the market cost of borrowing. Taking into account the emergency nature of the situation, an unreasonably high penalty interest rate imposes an additional burden on the borrower. At the same time, low interest reward rates stimulate banks to apply for last resort loans without necessity. Taking into account the above principles, the National Bank sets the reward rate for the last resort loan at a level not lower than the official refinancing rate of the National Bank with the possibility of applying an additional percentage reward established by the National Bank.

Principle 6. Monitoring and Control

For the purpose of effective implementation of the last resort lending mechanism, regular monitoring of bank solvency is carried out.

Monitoring of the bank's financial condition is conducted on a continuous basis with the aim of minimizing the risk of adverse selection of borrowers, credit risk, risk of abuse by banks, and prevention of asset stripping by the bank. Monitoring of the bank's financial condition will allow for the timely application of appropriate measures in case of deterioration of the bank's condition.

1. In accordance with Articles 61-6 and 61-7 of the Law of the Republic of Kazakhstan "On Banks and Banking Activity in the Republic of Kazakhstan" ↑
2. Subject of appraisal activity, attracted for carrying out independent assessment of cost and updating the assessment of pledged property. ↑
3. The size of the discount for the cost of collateral is established by the National Bank depending on the risk of reduction in the cost of collateral accepted by the National Bank, changes in market conditions, the size of expenses related to the realization of pledged property, and the discount that will be provided to the potential buyer of these assets in the event of default on the last resort loan. ↑