A major challenge faced by Kosovo after the end of the conflict was to choose a monetary framework, reestablish a secure payment system, and rebuild its financial sector. The confiscation and freezing of foreign exchange deposits in the early 1990s, the severe episode of hyperinflation in 1993–94 (2 percent per hour at its peak), and the intensification of ethnic strife obliterated confidence in the banking system, leading to a virtual cessation of all noncash transactions. In response to the massive flight to the safety of foreign exchange cash holdings and the vanishing of the Yugoslav dinar as a medium of transaction, UNMIK legitimized the use of the deutsche mark and other foreign currencies, which, in turn, led to a rapid euroization of the economy.
To address this challenge, a three-pronged strategy was adopted early on. First, a monetary framework anchored by the use of the euro presented itself as a natural choice, given the task at hand and the initial conditions. The pervasive euroization would have been hard to reverse, and trust in a new currency would have been difficult to establish, in light of the unresolved political status. The use of the euro would help maintain macroeconomic stability, rebuild people’s trust in the financial sector, and support an outward-oriented development strategy. Second, a Banking and Payments Authority (BPK) was established to foster an efficient and safe payment system and to nurture the development of a sound financial sector in a fully liberalized setting, with no restrictions on interest rates, no compulsory or directed credit, and no restrictions on the movement of capital.1 Last, and to jump-start commercial banking, its founding nucleus was launched through active policy intervention. The very first bank was created by European development agencies,2 in January 2000, and another one was started by an American development agency in November 2001. The latter was sold, in early 2003, to a private foreign bank. These two banks continue to dominate the banking system, with assets equal to two-thirds of total banking assets.3
Four years on, the strategy is producing significant payoffs. Following a bout of double-digit inflation in 2000 fueled by massive foreign inflows, inflation has decelerated sharply and is now below the euro area average. The financial sector’s assets have grown steadily, from virtually zero in early 2000 to 39 percent of GDP at end-2003. The banking system, which represents over 80 percent of the sector, is profitable and appears to be healthy.4 Banks are adequately capitalized, the quality of their assets is good, their earning indicators are strong, their liquidity is ample, and their exposure to market risk is limited (see Box IV.1).
Notwithstanding these achievements, there are widespread concerns, both in government and in the business community, that financial intermediation is lagging. Although the banking sector has been very successful at mobilizing domestic deposits, less than half of the deposits have funded domestic credit—the rest has been invested abroad. Domestic credit is dominated by short-term trade loans. Long-term lending to the manufacturing sector is negligible. In addition, despite some recent decline, loan interest rates continue to hover around 14 percent, and spreads are still wide (about 12 percentage points). Most business surveys point to the limited access to, and high cost of, bank financing as some of the main impediments to private sector development. All in all, there are concerns that the financial sector has not provided enough support to Kosovo’s development.
Financial Sector Developments and Banking System Soundness
Kosovo’s financial sector has been growing rapidly over the past few years. At the end of 2003, total assets of financial institutions stood at €694 million (approximately 39 percent of GDP), up from €108 million at end-2000. The financial system includes seven commercial banks, eight insurance companies, six pension funds, and 17 microfinance institutions (Statistical Appendix Table 24). All five domestically owned banks were licensed in 2001. They have less management depth than foreign banks, but some of them also have minority foreign shareholders who have been providing technical support.
Available data suggest that the banking sector is healthy and profitable (Statistical Appendix Table 25). In particular:
Banks are adequately capitalized. The average capital adequacy ratio (ratio of capital to risk-weighted assets) was 16.6 percent in December 2003. This ratio has been declining over the past 2 years, reflecting the growing share of loans to the private sector in banks’ portfolios. All banks are also complying with the minimum required amount of capital, which the BPK increased to €4 million at end-December 2003 to bring it more in line with EU directives.
The quality of banking assets is good. The ratio of nonperforming loans (NPLs) to total loans was 1.6 percent in December 2003 (down from 2.5 percent in December 2002), and aggregate provisions against loan losses were almost twice as high as the amount of reported NPLs. These data on asset quality should, however, be interpreted with caution because bank credit has recently been increasing rapidly.
Earnings indicators are strong. At the end of 2003, the average return on assets was 1.3 percent, and the return on equity was 18.7 percent. Since 2002, only one bank has been reporting net losses, which—according to the BPK—were due to rather significant start-up expenses related to information technology systems and the opening of several new branches.
Liquidity remains sufficient. Although the share of liquid assets in total banking assets has been declining in recent years, reflecting an increasing share of bank credits, it still represented 58 percent as of December 2003.
The exposure of banks to market risk is limited. The use of the euro substantially reduces the exchange rate risk, as only 1 percent of total loans and less than 3 percent of total deposits are reported to be denominated in foreign (other than euro) currencies. Interest rate risk also remains moderate, given the short length of maturities of banks’ assets and liabilities.
Individual bank-by-bank data also do not raise any immediate concerns. All banks are sufficiently capitalized and liquid. Several small banks, however, report relatively high ratios of NPLs to total loans (up to 4.6 percent), and the loan loss provisions of two of these banks are also lower than their NPLs.
The regulatory and supervisory framework is adequate but remains largely untested. The legislation governing the functioning of the BPK and other Kosovar financial institutions is new. The legislation was drawn up on the basis of international best standards and practices. However, in some instances, the BPK has faced undue political pressure, undermining its operational independence.
Following a review of monetization and financial intermediation trends since the end of the conflict, this chapter aims to contribute to an analysis of the perceived weaknesses. We analyze in turn the reasons behind (i) the relatively lagging financial deepening, (ii) the high cost of financial intermediation, and (iii) limited maturity transformation. The chapter concludes with a summary of the main findings and draws some conclusions about possible ways to enhance the role of the financial sector in Kosovo’s development.
Trends in Monetization and Financial Deepening
The rapid expansion of the financial sector has been driven mainly by the impressive growth of bank deposits. Since the end of the conflict, these have increased at a brisk pace, almost surprisingly rapidly, given the history of bank failures under the former regime. Deposits grew at an average annual rate of 67 percent in euro terms during 2001–03 and reached a level estimated at about 32 percent of GDP (€600 million) at end-July 2004 (Figure IV.1). The growth of deposits is still running at about 30 percent year-on-year as of end-July 2004 (Statistical Appendix Table 26).
Bank Deposits, 2000–04
Sources: Banking and Payments Authority of Kosovo; and IMF staff estimates.1Adjusted for euro cash changeover effect.Bank Deposits, 2000–04
Sources: Banking and Payments Authority of Kosovo; and IMF staff estimates.1Adjusted for euro cash changeover effect.Bank Deposits, 2000–04
Sources: Banking and Payments Authority of Kosovo; and IMF staff estimates.1Adjusted for euro cash changeover effect.The growth of the deposit base reflected a sustained increase in the demand for broad liquidity and a dramatic shift from cash holdings to bank deposits. Broad liquidity increased steadily at an average annual rate of 10 percent per annum during 2001–03, well in excess of output growth5 (Figure IV.2). The cash changeover to the euro and the series of measures taken to encourage the use of bank accounts played a catalytic role in the shift from cash to bank deposits.6 Deposits more than doubled in the run-up to the cash changeover in December 2001, as cash conversion was permitted only for small amounts, and large cash holdings had to be converted into bank deposits. Despite an initial decline in deposits in early 2002, the smooth changeover—which reinforced the public’s trust in banks—permanently expanded the banks’ deposit base and raised the currency-to-deposit ratio. The latter, which may have been as high as 6 in 2000, is estimated to have declined to about 1.
Broad Liquidity, 2000–04
(In millions of euros)
Sources: Banking and Payments Authority of Kosovo; and IMF staff estimates.Broad Liquidity, 2000–04
(In millions of euros)
Sources: Banking and Payments Authority of Kosovo; and IMF staff estimates.Broad Liquidity, 2000–04
(In millions of euros)
Sources: Banking and Payments Authority of Kosovo; and IMF staff estimates.These developments place Kosovo at a higher level of monetization than countries with similar income levels. As reflected in Figure IV.3, the regression line shows that a level of monetization that would have been in line with other low-income countries’ levels would have been a ratio of Broad Money–to-GDP of about 40 percent. In fact at 56 percent, the M2-to-GDP ratio in 2003 compares favorably with the 37 percent average in transition countries and the 52 percent average in the emerging-market economies of Asia and Latin America.
Kosovo and Selected Economies: Financial Depth and Level of GDP, 2002
Sources: Banking and Payments Authority of Kosovo; and IMF staff estimates.Note: Kosovo-1 relates to 2003 GDP per capita. In Kosovo-2, GNDI is used instead.Kosovo and Selected Economies: Financial Depth and Level of GDP, 2002
Sources: Banking and Payments Authority of Kosovo; and IMF staff estimates.Note: Kosovo-1 relates to 2003 GDP per capita. In Kosovo-2, GNDI is used instead.Kosovo and Selected Economies: Financial Depth and Level of GDP, 2002
Sources: Banking and Payments Authority of Kosovo; and IMF staff estimates.Note: Kosovo-1 relates to 2003 GDP per capita. In Kosovo-2, GNDI is used instead.Supported by the strong buildup of bank deposits, financial intermediation has progressed at a vigorous pace. Starting from close to zero at end-2000, loans had reached €328 million by end-July 2004, equivalent to 17 percent of GDP, with growth still running at 90 percent year-on-year as of end-July 2004 (Figure IV.4). Whereas initially banks were accumulating foreign assets as their deposit base was expanding, this trend started to reverse in 2003, with banks repatriating some of their foreign asset holdings to lend domestically (Figure IV.5 and Statistical Appendix Table 26).
Bank Loans, 2000–04
Source: Banking and Payments Authority of Kosovo.Bank Loans, 2000–04
Source: Banking and Payments Authority of Kosovo.Bank Loans, 2000–04
Source: Banking and Payments Authority of Kosovo.
Banks’ Main Balance Sheet Items, 2000–04
(In millions of euros)
Source: Banking and Payments Authority of Kosovo.Banks’ Main Balance Sheet Items, 2000–04
(In millions of euros)
Source: Banking and Payments Authority of Kosovo.Banks’ Main Balance Sheet Items, 2000–04
(In millions of euros)
Source: Banking and Payments Authority of Kosovo.Notwithstanding this rapid expansion, the level of financial intermediation is low compared with other transition economies and Kosovo’s own level of monetization. At 16 percent of GDP, the loans-to-GDP ratio is among the lowest in the world.7 The average loans-to-GDP ratio in emerging economies in Asia and Latin America is about 63 percent, and over 120 percent in developed countries. Furthermore, 5 years after the start of the transition, much faster progress has been achieved in many other transition economies than in Kosovo (Figure IV.6). Also, whereas informal credit plays a significant role in other countries, it is believed to be negligible in Kosovo. The loans provided by the 17 microfinance institutions add only 11 percent to the size of market.
Ratio of Loans to GDP, Transition Countries
(In percent; five years after the beginning of the transition process)
Source: Roberto Zahler, see footnote 11.Note: Bulgaria, Estonia, and Latvia have currency boards.Ratio of Loans to GDP, Transition Countries
(In percent; five years after the beginning of the transition process)
Source: Roberto Zahler, see footnote 11.Note: Bulgaria, Estonia, and Latvia have currency boards.Ratio of Loans to GDP, Transition Countries
(In percent; five years after the beginning of the transition process)
Source: Roberto Zahler, see footnote 11.Note: Bulgaria, Estonia, and Latvia have currency boards.Reasons for the Relatively Lagging Financial Deepening
Relatively shallow financial deepening along with high monetization reflect (i) the still high preference for cash and (ii) the relatively small share of deposits invested in domestic assets. Basically, whereas monetary assets represent about 60 percent of GDP, only about half are bank deposits, and only about half of these are used to fund domestic loans. It is interesting to compare this picture with that in a country at the other extreme of banking sector financial intermediation. In Germany, for example, monetary assets are equivalent to 140 percent of GDP, of which 133 percent of GDP equivalent is bank deposits, and bank loans are equivalent to 160 percent of GDP. In that case, both monetization and intermediation are high—with intermediation even higher than monetization—because banks capture almost all monetary assets and mobilize additional resources to fund their domestic loan portfolios.
What explains this still relatively limited degree of financial deepening, considering high and growing monetization? Elements of an answer can be found in the following: (i) an analysis of balance of payments developments, as the counterpart to low domestic lending has been reflected in an accumulation of net foreign assets by the banking system; (ii) an analysis of savers’ behavior, which may explain their high preference for cash; and (iii) an analysis of banks’ behavior, which may shed light on the relatively low propensity of the banking system to lend domestically.
From the perspective of balance of payments, the accumulation of foreign assets may be seen as a positive response of the economy to the massive external inflows and to the shift in the composition of monetary assets toward deposits. First, as explained in Chapter II, the flows of foreign assistance and private transfers, which were massive, led to a clear overheating of the economy. This was evidenced by double-digit inflation, which persisted until late 2001. If a larger share of these inflows had financed higher spending, overheating would have been more severe, and wage and price pressures would have inflicted greater damage to competitiveness. In this sense, the accumulation of foreign assets—which was tantamount to a sterilization of excessive inflows—was an opportune and welcome response. It built reserves on which the economy can draw in the future to mitigate the impact of negative shocks. Second, some of the increase in bank deposits and, consequently, some of the rise in banks’ foreign assets simply reflected cash coming from “under mattresses” and its being deposited in banks. As such, it represented a transfer of foreign asset holdings from the household sector to the banking sector, which, fortunately, had a neutral impact on the net foreign asset position of the consolidated economy.8
Regarding savers’ strong preference for cash, it may be explained by the size of the “gray” economy, the less-than-full trust in the banking system, a lingering sense of insecurity, and the low-opportunity cost of holding cash.9 Surveys of depositors revealed that they are less concerned about the return on their deposits than about the safety and security of their savings. Also important is the lingering sense of insecurity, which may cause people to want to hold onto cash in case of possible emergencies. Fairly low returns on euro deposits, which diminish the opportunity cost of holding cash, may also be playing a role, even if only marginally.
In a sense, the strong preference for cash prevents the full realization of the potential for financial deepening from high monetization. Kosovo’s currency-to-deposit ratio, of about 1, is one of the highest in the world (Figure IV.7). The average in transition countries is less than 0.4; in emerging economies in Asia and Latin America it is about 0.15, and in developed countries it is below 0.05. If confidence in banks continues to strengthen and ways to economize on the use of cash can be realized, a decline in the currency-to-deposit ratio to 0.25 could generate additional loanable funds of €234 million—which is equivalent to about 70 percent of outstanding domestic credit.
Regarding the banking system’s seemingly low propensity to lend domestically, the problem is multifaceted, involving capacity for credit risk management, enforcement of creditors’ rights, liquidity management, and the demand for creditworthy investment projects. This constellation of factors has played out differently for different banks, with a clear demarcation between the largest bank and the other banks. Indeed, the average loan-to-deposit ratio of 44 percent masks a large difference between the largest bank, with a ratio of 25 percent, and the other banks, with ratios hovering around 60 percent (Figure IV.8). Whereas other banks expanded their deposits and lending activities at equal speed from the beginning, the largest bank—given its dominant position—initially took a much more guarded attitude toward domestic lending, choosing instead to invest most of its assets in foreign securities. Starting in 2003, the bank has stepped up its domestic lending activities and has even started to unwind its foreign asset position to fund a larger domestic loan portfolio (Figure IV.9).
Loan-to-Deposit Ratio, 2001–03
Source: Banking and Payments Authority of Kosovo.Loan-to-Deposit Ratio, 2001–03
Source: Banking and Payments Authority of Kosovo.Loan-to-Deposit Ratio, 2001–03
Source: Banking and Payments Authority of Kosovo.
Share of the Largest Bank in Deposits and in Loans, 2000–03
Source: Banking and Payments Authority of Kosovo.Share of the Largest Bank in Deposits and in Loans, 2000–03
Source: Banking and Payments Authority of Kosovo.Share of the Largest Bank in Deposits and in Loans, 2000–03
Source: Banking and Payments Authority of Kosovo.Banks’ lending (excluding the largest bank) is, at the moment, close to the liquidity risk ceiling encouraged by the BPK, namely, that loans not exceed 65 percent of deposits. The rationale behind this prudential limit is threefold.
First, such a limit is meant to ensure that the speed at which credit expands is in line with banks’ risk management learning curve. Rapid credit expansion may have stretched to the limit some banks’ capacity to assess risk, raising concerns about the quality of their loan portfolios. Even though the indicators of the quality of banking assets are good (see Box IV.1 and Statistical Appendix Table 25), these indicators are to be interpreted with caution, as they are backward looking and may not capture potential problems, especially in an environment of rapid credit expansion.10 The situation is aggravated in Kosovo by the primitive financial accounting and cashflow forecasting of many borrowers. This means that assessment of amounts recoverable on loans depends largely on past payment experience and could be overvalued.
Second, the limit is also meant to ensure that the speed at which credit expands is in line with the gradual buildup of the capacity of the judicial system to enforce creditors’ rights. At the moment, court performance is weak, and appeals and adjournments are easy to obtain—a situation that might encourage a culture of nonpayment, given the lack of effective sanctions for noncompliance.
Third, the need for a prudent approach to managing liquidity risk is justified by the absence of a lender of last resort, the very limited ties of domestic banks to the international financial market, the absence of an interbank market in Kosovo, and the untested stability of banks’ predominantly short-term deposits. Banks’ exposure to liquidity risk is heightened by the fact that a substantial share of bank deposits belongs to one large public enterprise.
In contrast to the practice of the smaller banks, the largest bank’s business strategy has focused on providing a reliable payments system and on securing its depositors’ savings. By doing so, it has adopted a much more prudent lending strategy and has the strongest financial soundness indicators. As mentioned above, the bank has recently started to play a more active role in the domestic loan market. The argument often cited by the bank’s managers—that the low level of lending is explained by the lack of bankable projects and the low profitability of investment—may in fact reflect its relatively large lending potential compared with the volume of profitable lending opportunities. At the same time, the volume of profitable projects also reflects the high lending interest rates.
Reasons for the High Cost of Financial Intermediation
Despite some decline, loan interest rates and spreads remain high. Loan interest rates continue to hover around 14 percent, while deposit rates are around 2½–3 percent (Figure IV.10). A flattening of the yield curve in the past 3 years has led to a small increase in short-term interest rates and a more significant decline in longer-term rates. Meanwhile, the deposit interest rate structure has remained fairly stable. Loan interest rates are higher than in most transition countries and in the Balkans, even considering the time spent in transition.
Loans’ Nominal Interest Rate
(In percent)
Source: Roberto Zahler, see footnote 11.Loans’ Nominal Interest Rate
(In percent)
Source: Roberto Zahler, see footnote 11.Loans’ Nominal Interest Rate
(In percent)
Source: Roberto Zahler, see footnote 11.The high cost of financial intermediation reflects the interplay between large inefficiencies and a high risk premium in an overly concentrated sector (see Table IV.1). In a recent study, Zahler decomposed the 13½ percent estimated cost of financial intermediation into costs related to loan loss provisioning, overhead costs, and capital requirements and returns on capital.11 The results reveal the following:
Cost of Financial Intermediation
(In percent of loans)
Cost of Financial Intermediation
(In percent of loans)
| Domestic Banks | Foreign Banks | ||
|---|---|---|---|
| Total cost (percent) | 13.5 | 13.5 | |
| Due to: | |||
| Loan loss provisions | 4.5 | 4.0 | |
| Overhead expenditure | 7.0 | 4.6 | |
| Return on capital | 2.0 | 4.9 | |
Cost of Financial Intermediation
(In percent of loans)
| Domestic Banks | Foreign Banks | ||
|---|---|---|---|
| Total cost (percent) | 13.5 | 13.5 | |
| Due to: | |||
| Loan loss provisions | 4.5 | 4.0 | |
| Overhead expenditure | 7.0 | 4.6 | |
| Return on capital | 2.0 | 4.9 | |
Loan loss provisioning for both domestic and foreign banks account for 4–4½ percentage points of the cost of financial intermediation. The average loan loss provisioning is 200 percent of NPLs—far in excess of prudential requirements—owing to the perceived high macroeconomic risks and overall political uncertainty.
Overhead costs account for 7 percentage points of the overall cost of financial intermediation for domestic banks and 4½ percentage points for foreign banks. High overhead costs probably reflect the high cost of information due to the small size of the market, the predominance of small and medium-sized enterprises, the absence of a collective credit information bureau, and weak competition. These costs are compounded in domestic banks by overstaffing and overbranching.12
Prudential capital requirement and the high return on capital—made possible by fairly high concentration13—explain the remaining cost. The BPK requires a minimum capital of 12 percent of risk-weighted assets, whereas rates of return on equity demanded by banks range from 40 percent to 10 percent, with a system average of 20 percent. The relative efficiency of foreign banks and their dominant market position are captured as higher ex post rates of return on equity (5 percentage points of their overall cost of intermediation), which, ex ante, reflect a higher risk premium.
Reasons for the Limited Maturity Transformation
Despite some recent lengthening, loans are still predominantly short term and maturity transformation is limited, most notably for domestic banks. For the banking system as a whole, 40 percent of all loans have a maturity shorter than 1 year, another 40 percent between 1 and 2 years, and the remainder over 2 years. For domestic banks, the share of loans up to 1 year is as high as 70 percent, and only 3 percent of loans are over 2 years; for foreign banks, meanwhile, the share of loans up to 1 year is only 16 percent, and the share for over 2 years is 50 percent. On the liability side, demand deposits represent about 55 percent of the total, and the bulk of savings deposits have maturities of up to 1 year.
The limited maturity transformation reflects the prudence with which liquidity risk has been managed. There are three main reasons for this prudence. First, with only 4 years of history to go by, it is difficult for banks to determine the level of “core deposits,” that is, those sight and short-term deposits that are constantly renewed or prolonged and that, hence, could largely be assumed to be permanent.14 The uncertain political and economic outlook adds to the difficulty in ascertaining the level of core deposits. Second, 45 percent of deposits are held by firms, with a high degree of concentration among a few large ones. These institutional deposits are generally regarded as more volatile than individual deposits, because they are mostly current accounts and tend to be much larger. Economic difficulties in any one of the large firms may significantly drain banks’ liquidity. Third, the lack of a lender-of-last-resort facility and the weak links with international financial markets necessitate a more prudent management of liquidity risk, and explain why domestic banks, which have virtually no access to any potential source of short-term liquidity, have been constrained in their ability to offer longer-maturity loans.
Conclusions and Ways Forward
The following key findings emerge from this analysis and make it possible to draw a few conclusions about the way forward.
First, the choice of a monetary framework anchored around the use of the euro has served Kosovo well. The use of an external anchor for domestic policies imposed financial discipline—securing a low-inflation environment—and is likely to have played a major role in achieving a high level of monetization and a rapid expansion of financial assets. It did so by avoiding uncertainty and the lack of confidence and credibility problems that would have been associated with the old or a new domestic currency. The use of the euro deprives the economy of one stabilization policy. But for long-term growth and development—which is the main challenge facing Kosovo today—the benefit from financial stability promoted by the use of a stable currency plus the benefit from trade facilitation with Europe that is promoted by the use of the euro are likely to outweigh the costs of having one less stabilization instrument. If Kosovo is to improve this trade-off and mitigate the loss from the absence of an independent monetary policy, it must preserve and further enhance the flexibility of the labor and goods markets.
High monetization and a healthy and stable banking system provide a solid foundation for further progress in financial intermediation. Safeguarding the soundness and stability of the financial system will continue to sustain a robust growth in banking assets by strengthening, inter alia, incentives to move from cash to bank transactions. Together with improvements in investment opportunities, the buildup of financial assets will provide a basis for further financial intermediation. To a large extent, the accumulation of foreign assets by the banking system in the past 4 years was not a sign of weakness but a welcome response of the economy to the large external inflows and the sharp drop in currency in circulation. If the increase in bank deposits had been used to extend domestic credit, Kosovo’s current account deficit would have been larger, inflationary pressures stronger, and damages to Kosovo’s competitiveness greater. Through the banks’ accumulation of foreign assets, the economy built up a valuable reserve it can use to mitigate the impact of negative shocks in the future.
Most of the perceived shortcomings in the performance of the financial sector reflect, to a large extent, its short life span. The absence of institutional history meant that there was practically no institutional capacity and business experience to draw from. A faster expansion of domestic credit would have compromised the quality of banks’ loan portfolios, given banks’ growing but still weak risk management capacity, the accounting and corporate governance structure at the level of enterprises, and the judicial procedures and practices used in applying a new set of laws. A more aggressive push for maturity transformation would have been imprudent, given the untested stability of bank deposits, the still high overall uncertainty, and the absence of a lender of last resort and of ties to international financial markets.
To enhance the financial sector’s contribution to Kosovo’s development, the authorities should remain focused on maintaining a sound financial system and establishing a legal system conducive to a healthy credit culture. The BPK’s perseverance in strengthening effective and proactive bank supervision will ensure that the financial sector remains healthy and profitable. Continuing to strengthen the legal environment to protect creditors’ rights and nurture a credit culture will support further growth in domestic lending and a decline in interest rates. Indeed, when the legal system is not supportive, banks try to avoid legal recourse and, hence, either are more cautious in extending loans to new and untested clients or charge a higher risk premium. The recently launched credit information bureau should help reduce information costs and facilitate risk evaluation. Strengthening the regulatory framework for external auditing and accounting standards is also important. If the largest bank in Kosovo were to increase its lending activity, its greater efficiency would help bring down the cost of financing intermediation. However, this might price some local banks out of the market, and the authorities should stand ready to encourage mergers among those banks. Enforcing the anti–money laundering law would reinforce the public’s growing trust in banks.
Because Kosovo’s unresolved political status creates negative externalities that individual banks and financial institutions cannot absorb on their own, some policy intervention could be justified. Political uncertainty adds to the credit and liquidity risks that banks have to deal with; it affects the growth of a stable and long-term deposit base and complicates long-term investment decisions. Moreover, because Kosovo has no sovereign rating, banks are unable to obtain an institutional rating and, hence, cannot borrow from outside. To address this market failure, various policy options may be contemplated, and the authorities are encouraged to carefully weigh the pros and cons of those or of alternative policies. The following are some possible options:
Providing credit guarantees to local banks to access international capital markets or to mobilize additional domestic long-term funds could help lengthen maturities and would promote the development of long-term domestic savings instruments.
Providing a limited guarantee to banks’ mortgage loans could help jump-start mortgage loans, which, in turn, could promote labor-intensive investment in housing.
Auctioning off to domestic banks medium-term loans from the government or from some donors could also help lengthen maturity. These funds may be tied to lending to small and medium-sized enterprises, if these enterprises were found to be more prone to choose labor-intensive investment.
Finally, the BPK could explore the possibility of obtaining a contingency credit line. It could use this line to provide short-term liquidity to banks if and when it is required; it may also want to help banks establish linkages with international capital markets, which could yield significant efficiency gains through better liquidity management, exposure to foreign expertise, and market discipline acquired through greater transparency.
In 1999, the BPK was charged with providing payments services and bank supervision. Later, its role was enhanced and expanded to include licensing, supervision, and regulation of all financial institutions (including insurance and pension funds).
In late 2001, the European Bank for Reconstruction and Development and the International Finance Corporation became additional shareholders.
In addition to these two foreign-owned banks, there are five mainly domestically owned commercial banks, all licensed in 2001.
It should be noted that, to date, the Fund has not performed formal prudential or supervisory assessments of the Kosovar banking system. However, available data suggest that the banking system remains healthy and adequately capitalized.
Based on staff team’s estimates of currency in circulation (Appendix I).
The introduction of an interbank clearing system in 2001 marked an important early step in the authorities’ systematic efforts to promote noncash payments. Subsequently, the authorities eliminated cash in the bulk of their transactions. For instance, about 97 percent of government employees currently receive their salaries through their bank accounts, and the government-sponsored basic pensions are all paid to the recipients’ bank accounts.
There are about 50,000 bank loans and microfinance credits, which is equivalent to 25 loans for each 1,000 people. This is another indicator of low financial intermediation.
The above reasoning serves to dispel the widespread notion in Kosovo that the accumulation of foreign assets by banks and by the BPK (on account of budget surpluses) reflects an export of Kosovo’s savings to finance investment in the rest of the world. Such a notion fails to recognize that on a net basis Kosovo has run large current account deficits and has benefited from savings in the rest of the world to sustain a level of consumption 30 percent higher than its domestic income.
These factors also help explain why there are very few deposits with maturities longer than 3 months, despite interest rates as high as 4½ percent offered by some domestic banks.
In such an environment, few good companies are likely to have outstanding loans with several banks, as most banks would regard them as “best credit risks.” Thus, the likelihood of systemic risks would increase if these few firms were to fail.
Roberto Zahler, “Financial Sector’s Role in Economic Development in Kosovo,” unpublished (Zahler Co, Santiago, Chile, 2004).
Bank assets per employee in domestic banks average 8190,000, against 8600,000 in foreign banks in Kosovo, and bank assets per branch in domestic banks average 81.7 million, against 815 million in foreign banks.
The Herfindahl index, which is equal to the sum of the square of each bank’s market, is 2.8. An index higher than 1.8 is usually regarded as describing a highly concentrated market.
In mature banking systems, banks usually count on 75–85 percent of sight and short-term deposits to be constantly renewable and, hence, stable.
