Abstract
The government has begun implementing an ambitious program of banking sector and enterprise reform in 1999. A key aspect of this program is the restructuring and privatization of three large state-owned banks. As a by-product of the bank restructuring, the bad assets carved out from the banks will be worked out, together with tax and social security arrears. The Slovak authorities have embarked on an ambitious task to deal with inherited weaknesses of the banking system. Now the challenge is to focus on the institutional improvement in banking supervision.
I. Issues on bank Soundness and Supervision1
1. This chapter discusses the state of Slovakia’s banking sector, with particular emphasis on the need to improve banking supervision. The paper first summarizes the nature and roots of the problems that plagued Slovakia’s banking system before 1999 as well as the main steps that have been taken to deal with those problems (Section A). With this as background, Section B presents the current state of play in the banking system, and Section C discusses the remaining agenda. Section D provides the concluding remarks.
A. Background
Weaknesses of the banking sector prior to 1999
2. One of the main problems faced by the Slovak banking sector prior to 1999 was the low quality of its loan portfolio. The problem was exacerbated by inadequate provisions for most of the loan portfolio and/or overvalued collateral in those cases where loans were covered by real guarantees. This situation—which affected mostly the largest state-owned banks, but was also a feature of the rest of the system—had given rise to a significant amount of accrued losses.
3. The large amount of impaired assets can be explained by a number of factors. First, the largest state-owned banks inherited problem loans from the central planning days, and accumulated more of these loans during the 1994–98 period, in part because of political interference in bank lending practices. Second, Slovak enterprises have tended to run their businesses with high leverage ratios and unhedged foreign exchange or interest rate positions. The reliance on the sometimes implicit state guarantee of state-owned enterprises’ liabilities has encouraged managers to fund projects with debt. Third, the volatile financial environment, characterized at times by significant swings in interest and exchange rates, especially during 1997–98, manifested itself in deteriorating financial performance. Finally, the implementation of banking supervision had been weak, owing to various reasons such as insufficient legal enforcement power, and shortage of qualified supervision resources.
4. These factors contributed to the poor banking sector performance in 1998–99.2 The three largest state-owned banks became dangerously undercapitalized, suffering from poor credit portfolios and substantial losses. The smaller commercial banks also had difficulties, even though in most cases they did not have the heavy burden of the problem loans inherited from the past. Some private banks had foreign shareholders that helped them fare better.
Progress since 1999
5. The government began implementing an ambitious program of banking sector and enterprise reform in 1999, in the context of discussions on Enterprise and Financial Sector Adjustment Loan (EFSAL)—to be considered by the World Bank Board on August 2, 2001.3 The banking sector reforms include: (i) the restructuring and privatization of the three large state-owned banks; (ii) a program to resolve troubled small- and medium-sized banks; (iii) substantial strengthening of the regulation and supervision framework of the banking sector; (iv) better implementation of banking supervision; and (v) a workout of the bad assets carved out of the banks. In addition, the program aims at substantial improvements in the legal environment for enterprises, including insolvency reform, collateral reform, and corporate governance architecture.4
6. A key aspect of this program was the restructuring and privatization of three large state-owned banks. In 1999 and 2000 the balance sheets of Všeobecná úverová banka (VUB), Investičná a rozvojová banka (IRB), and Slovenská sporitel’ňa (SLSP) were restructured through two basic operations: (i) a Sk 18 billion direct equity injection at end-1999; and (ii) a Sk 105 billion (12 percent of 2000 GDP) carve-out of bad assets in December 1999 and June 2000. The bad assets were transferred to the Slovak Consolidation Agency (SKA) and Konsolidačna Banka (KOB), and were replaced by state bonds (with maturities of 5, 7, and 10 years, and a combination of fixed and floating rates) in January and March 2001.5 These operations have restored the capital adequacy ratios of these banks to levels above 12 percent, according to International Accounting Standards. The recapitalization took place in the context of a privatization program, and was accompanied by the imposition of conditions and controls during the pre-privatization period. At the same time, new management teams of the banks proceeded with self-restructuring, incorporating cost reductions, layoffs, and technological improvements. The privatization process is nearing a close with the completion of the sale of the state’s stakes in SLSP and VUB to strategic foreign investors, while the privatization of IRB is to be completed by end-2001.
7. As a by-product of the bank restructuring, the bad assets carved out from the banks will be worked out, together with tax and social security arrears. The government’s workout strategy for SKA and KOB combines sales of pools of loans to private investors, auctioning of individual loans to smaller investors, and the outsourcing of collection through asset/legal management contracts. The legal framework is also being strengthened, in order to facilitate the restructuring of distressed enterprises by investors, and to improve the price received by SKA. With extensive technical assistance by donors, the Government established the ambitious target of completing the transfer of SKA’s claims to private sector ownership or management by end-2002, and two tenders were completed in the first part of 2001.
8. Consolidation of small and medium-sized banks. In 2000 the authorities made progress in resolving problems with the banks which had become insolvent as a result of poor governance and political interference in credit decisions. Three banks have been placed in liquidation, two have been sold to a foreign strategic investor, and one has been merged with SLSP. By the spring of 2001, cases of two troubled medium-sized banks with assets amounting to 4 percent of total bank assets remained to be restructured or liquidated, and the authorities intend to complete the process during the year.
9. Regulatory and supervisory regime of the banking sector. In 1999 the regulatory framework for the banking sector was improved significantly, through amendments to the Banking Act and the Act on the Tax Treatment of Reserves and Provision. The amendments to the Banking Act aimed at strengthening the National Bank of Slovakia’s (NBS) supervisory powers. Recently, a new Banking Act has been drafted incorporating further improvements, and moving the legal framework closer to EU standards and to implementing regulations based on the Basel Core Principles. The revised Act—which should come into force in September 2001—includes improvements in areas such as further reinforcing supervisory powers, enhancing board governance, expanding the definition of special relationships (connected parties), expanding a consolidated supervision, providing legal protection of supervisors, and adding risk management provisions. Recent changes to the NBS Act, effective since May 1, 2001, reinforce the supervisory role of the NBS substantially by reducing the involvement of the Ministry of Finance, especially in the areas of licensing and on-site examinations. The new NBS Act also makes it possible for the NBS to issue secondary regulations which have the power of generally binding legal norms for effective banking supervision. These legislative changes will be complemented by amendments to the Accounting Act and the Auditing Act, aiming at harmonizing accounting standards with International Accounting Standards by 2002, strengthening disclosure rules, and greater independence and legal responsibilities for auditors.
10. Implementation of banking supervision. In order to identify areas requiring improvement, a comprehensive evaluation of bank supervision (based on the Basel 25 Core Principles for Effective Bank Supervision) was jointly carried out by World Bank and NBS staff in mid-2000 (Box 1 summarizes the main findings and needed improvements, and compares current regulations with Basel standards). Using the results of this evaluation, the NBS elaborated a comprehensive supervisory development concept (SDC). The SDC defines the mission and focus of supervision, adopts an improved and more proactive approach to bank oversight through further developing of on-site and off-site functions, and the design of supervisory strategies for each institution. The Slovak authorities have a commitment to fully implement the SDC in 2001 and future years, and will provide the necessary operational independence and the allocation of additional financial and human resources to the supervision function.
Banking Supervision and Basel Core Principles
This box presents the main weaknesses identified by the diagnostic review conducted by the National Bank of Slovakia (in cooperation with the World Bank), as well as needed improvements to align supervision with the Basel Core Principles.1
Legal protection of supervisors: The level of protection afforded to the supervisor by the legal structure is unclear. Needed Action: This legal protection should be explicitly defined by law.
Sharing information between supervisors: Supervisory information is not shared with outside supervisors in practice. Some information restrictions exist between on- and off-site supervisory staff. Needed Action: The overall information access for each supervision department within the NBS and with outside supervisors should be evaluated and addressed.
Setting minimum capital adequacy requirements and defining components of capital: The capital measure is generally consistent with the Basel Accord. However, the Supervisor’s follow-up authority to ensure that adequate capital is maintained is weak. Needed Action: Provide the Supervisor with the explicit authority to act with regard to capital adequacy; application of capital adequacy requirements on a consolidated basis; and charges for market risk, and directions for increased capital charge should be adopted.
Establishing and adhering to satisfactory policies for asset quality: Results of on-site reviews indicate that banks examined are not accurately reporting the level of classified assets in their portfolios. Needed Action: The Supervisor should rigorously enforce the requirement and regulations should be expanded further to ensure this.
Connected lending: The Banking Act addresses many aspects of “special relationships” with the bank. However, the ability of the Supervisor to apply the law is questionable. Needed Action: Provide the Supervisor with explicit discretion by law to make informed judgments about the existence of connected lending; expand the definition of “special relationships” in the Banking Act.
Banks’ risk management process: No regulation on overall risk management and market risk has been established. As a result, the Supervisor does not have the capacity to enforce standards of prudential risk management on a comprehensive basis. Needed Action: Sound risk management legislation should ensure that banks’ systems address financial risks; the risk management process should be periodically reviewed and adjusted.
On-site and off-site inspection: The mix or emphasis of on-site and off-site supervision functions does not reflect the existing conditions. Needed Action: Formalize supervisory cycles and ensure adequate financial and personnel resources are available to support effective on-site and off-site supervision.
Supervision on a consolidated basis: The lack of power to conduct consolidated supervision significantly restricts the Supervisor’s ability to assess the complete risk profile of a bank. Needed Action: Legal provisions should be reinforced to conduct a consolidated supervision; the Supervisor should have access to information that will be adequate to fully understand the overall structure of the banking group.
Corrective action: Supervisory focus on underlying causes of individual violation and the need for a strong response is inadequate. Needed Action: The supervisory responsibilities for timely corrective actions have not been properly fulfilled. Additional remedial measures such as prompt corrective actions should be reinforced.
B. The Banking System Today
11. The restructuring of the large state-owned banks, along with the liquidation of three other small banks and the entry of foreign investors, have all contributed to the stabilization of the Slovak banking sector. The return on assets of Slovak banks improved from -4.0 percent in 1999 to 0.6 percent in 2000, mainly because of the removal of nonperforming loans (NPLs) from their books (Table). The ratio of NPLs to total loans was reduced from almost 40 percent in September 1999 to 15.3 percent in December 2000 based on the NBS criteria. The capital adequacy ratio was 12.5 percent at end-2000.
Slovak Republic: Banking sector indicators, 1997–2000
(In percent, end-year)
Or liquidity ratio: (current assets-inventory)/current liabilities.
Slovak Republic: Banking sector indicators, 1997–2000
(In percent, end-year)
| 1997 | 1998 | 1999 | 2000 | |
|---|---|---|---|---|
| Return on assets | -0.2 | 0.0 | -4.0 | 0.6 |
| Return on equity | -5.0 | -0.1 | -61.2 | 9.2 |
| Ratio of non-performing loans | 27.2 | 31.7 | 23.7 | 15.3 |
| Ratio of classified loans | 31.2 | 35.7 | 29.5 | 21.9 |
| Ratio of classified loans covered by reserves and provisions | 54.4 | 47.7 | 68.0 | 85.0 |
| Capital adequacy ratio | 8.1 | 6.7 | 12.6 | 12.5 |
| Acid ratio 1/ | 47.5 | 38.4 | 56.1 | 86.7 |
| Clients’ loans to clients’ deposits | 72.6 | 73.0 | 65.2 | 55.9 |
Or liquidity ratio: (current assets-inventory)/current liabilities.
Slovak Republic: Banking sector indicators, 1997–2000
(In percent, end-year)
| 1997 | 1998 | 1999 | 2000 | |
|---|---|---|---|---|
| Return on assets | -0.2 | 0.0 | -4.0 | 0.6 |
| Return on equity | -5.0 | -0.1 | -61.2 | 9.2 |
| Ratio of non-performing loans | 27.2 | 31.7 | 23.7 | 15.3 |
| Ratio of classified loans | 31.2 | 35.7 | 29.5 | 21.9 |
| Ratio of classified loans covered by reserves and provisions | 54.4 | 47.7 | 68.0 | 85.0 |
| Capital adequacy ratio | 8.1 | 6.7 | 12.6 | 12.5 |
| Acid ratio 1/ | 47.5 | 38.4 | 56.1 | 86.7 |
| Clients’ loans to clients’ deposits | 72.6 | 73.0 | 65.2 | 55.9 |
Or liquidity ratio: (current assets-inventory)/current liabilities.
12. However, these indicators might give too rosy a picture. Banks’ financial fundamentals, albeit slightly improved, remain modest, as manifested by still high ratios of NPLs and low profitability. Although 67 percent of NPLs are covered by provisions, the amount of NPLs could well be higher if loans were classified in accordance with international standards, thus requiring further provisions.6 Future NPL ratios could increase somewhat more because of “ring-fencing” arrangements with regard to the classification of loans of the large state-owned banks with foreign investors.
13. Although the recent amendments to the Banking Act and the NBS Act have strengthened banking supervision legislation, the regulatory framework still contains weaknesses in some areas. The weak areas include the enforcement powers, rules of bank governance, consolidated banking supervision, the quality of bank accounting and auditing, and related lending. Legislative issues also remain in other areas. Despite some progress in the tax system, loan loss provisions are tax deductible only up to the amount required by the NBS’s required loan loss provisioning.7 While this is an improvement over the previous situation, there is still a tax disincentive for banks to make provisions, should banks want to set up more provisions than those required by the NBS. In addition, banks are still required to accrue interest income for NPLs, unless they have been classified as in default. This distorts the level of performing assets and of reported revenue, and unnecessarily penalizes banks, which must pay taxes on income not realized.
14. The implementation of banking supervision has traditionally been weak, owing to various reasons such as insufficient legal enforcement power, and shortage of qualified supervision resources. While important steps have been taken toward restructuring the large state-owned banks and strengthening the regulatory and supervisory process in the banking sector, many challenges remain. Banking supervision has relied heavily on off-site monitoring based on the quantitative analysis of bank report figures. However, the accuracy of some bank-reported figures may be distorted, owing to insufficient confirmation by on-site examiners of the NBS and weak external audits. In many instances, final figures have not reflected serious problems that may very well have existed for some time prior to reporting.
15. Nevertheless, the current staff resources (13 on-site examiners) have not performed on-site examination with sufficient frequency. In 1999, only one comprehensive on-site examination was conducted, while in 2000 four comprehensive on-site examinations were completed. As of April 2001, four banks had never received on-site examinations from the NBS. One problem with on-site examinations is that they have tended to focus on compliance with various regulations rather than risk assessment of individual aspects of the banks’ activities, or managerial capacity. This problem, coupled with a lack of vigorous use of enforcement actions, has resulted in a more costly and disruptive resolution process.
C. The Remaining Agenda
16. In spite of the substantial improvements to the prudential and supervisory framework, its further enhancement is required through a variety of measures.
Prudential regulations should be strengthened further to enhance the effectiveness of bank supervision and make it consistent with Basel recommendations. The regulations related to the accrual of interest on NPLs should be revised. Banks should not accrue interest income for NPLs. In addition, prudential regulations on capital adequacy ratios should be reinforced by incorporating market risks.
Loan classification criteria and accounting standards need to be further developed. The NBS needs to reinforce loan classification criteria to include the repayment capabilities of borrowers.
proposed expansion of a bank’s investment limits on nonbanking institutions raises concerns. These limits are proposed to be increased from 10 percent to 15 percent of a bank’s capital in the new Banking Act. The total investment limits to all nonbanking institutions will also be increased from 25 percent to 60 percent of a bank’s capital. Expansion to nonbanking operations by banks without proper risk management or monitoring mechanisms could result in banks incurring unexpected risks, which might spill over to themselves.
17. On the effectiveness of implementation, the following issues are key:
On-site examination should certainly complement off-site monitoring of banks in order to ensure the accuracy of reported figures. In this regard, the authorities are making welcome plans to increase the number of on-site examiners up to 48 from 13, to make possible a yearly on-site examination on each bank.
The accuracy of capital adequacy ratio (CAR) calculations will become more important. According to the new Banking Act, the supervision authorities will be obliged to take prompt corrective action based on the predetermined threshold of the CAR. For the effective mobilization of such action, the accuracy of the CAR becomes more important. If loan classifications and loan loss provisions are not maintained properly by banks, the CAR is likely to be meaningless. Under such circumstances, the NBS can not activate the prompt corrective action system effectively. Therefore, it is important for the NBS to reinforce on-site examinations to ascertain the proper asset classifications and to assess the appropriateness of provisioning. The reinforced on-site examinations focused on risks such as credit risk could contribute to early detection of problem banks and could prevent the banking sector from experiencing any recurring incidence of recapitalization.
Efforts to strengthen banking regulation and the enforcement powers will not achieve their objective if they are not supported by improvements in skills, techniques, and resources of bank supervisors. Therefore, the authorities should be fully committed to implementing the Supervisory Development Concept. To this end, the staff-monitored program agreed with the Fund also provides a number of important benchmarks (Box 2). It is equally important to provide the necessary operational independence and the allocation of additional financial and human resources to the supervision function.
Banking Supervision; Commitments Under the Staff-Monitored Program
The implementation of the government’s new proactive approach to banking supervision will be monitored through benchmarks under the Enterprise and Financial Sector Adjustment Loan from the World Bank and the IMF staff-monitored program. The benchmarks under the Fund’s program are:
The government will decide on the institutional location of bank supervision (May 2001). (This benchmark has been observed.)
The bank supervision authority will adopt a proactive approach to bank supervision, through the introduction of a new supervisory policy and procedures in line with the supervisory development plan agreed with the World Bank under the Enterprise and Financial Sector Adjustment Loan (September 2001).
The bank supervision authority will develop an overall staffing plan to implement the proactive bank supervisory approach and make satisfactory progress in implementing the hiring under this plan (20–25 percent). At least four banks will be re-evaluated according to the new procedures, starting with the largest banks that are classified as high risk according to the CAMEL ratings (January 2002).1/
The bank supervision authority will approve a new remedial action policy and corrective action plans in conjunction with supervisory strategies prepared by the four banks identified above with inputs from international supervisory experts (January 2002).
18. Location of banking supervision. The government decided in May 2001 that the banking supervision function would remain the responsibility of the NBS until late-2002, but it may be transferred to the newly established Financial Market Authority (FMA)—which is currently under the Ministry of Finance—from 2003. The location of banking supervision is less important than meeting the conditions for effective supervision: legal, administrative, operational, financial, and political independence. The supervisory authority must have sufficient autonomy, authority, and capacity to be effective, whether the supervision function is conducted by the NBS or the FMA (see Box 3 for the main requirements that the new Authority should satisfy to be effective). Should banking supervision be moved out of the NBS, it will be essential to have an effective transfer of the supervision function, without interruption of activities and bank oversight. To this end, the authorities need to prepare and have approved a transition plan that identifies and assigns specific tasks, responsibilities, accountabilities, and time frames.
Key Conditions of Organizational Structure for Effective Banking Supervision
Independence and accountability: A supervisory agency must be able to make decisions that belong to its sphere of competence without undue outside interference. This agency should have the ability to issue or amend regulations in a timely manner. The need for regulatory independence should be balanced by a corresponding need to ensure that the agency is accountable for its policies and actions. All issues referred to the supervisor’s independence should be established by law.
Operational and administrative independence: The executive management of the supervisory agency must be empowered to structure its organization and activities so that it can achieve its objectives. It must have the authority to require financial institution reporting, to conduct outside examinations and special reviews as needed. The agency should be independent in defining its personnel policy, salaries, organizational design, and information and inspection activities.
Budgetary autonomy: The existence of an earmarked source of funding for the agency and its ability to allocate resources to its own internal priorities are important. Otherwise, efforts to develop an aggressive and effective regulatory body can be stopped by cutting the agency’s budget.
Adequate resources: The supervisory agency needs to have adequate resources to discharge its task effectively. Otherwise, the autonomy, integrity, and independence of the supervising agency could be undermined.
Effective enforcement power: A regulatory agency must possess effective enforcement powers over the full range of entities that it is responsible for regulating. In order to protect depositors and creditors, and prevent the contagion of banking problems, supervisors must have at their disposal adequate enforcement power.
Comprehensiveness of regulations: The regulatory system should be comprehensive and free of regulatory gaps. A central component of comprehensiveness is the practice of effective consolidated supervision. Fragmented supervision may create room for regulatory arbitrage and prevent an overall risk assessment of the institution.
19. Reform of deposit insurance system. The authorities are aware of the need to reform the rules of deposit insurance and bank conservatorship, to avoid abuse, enhance market discipline, and improve the long-run viability of the Deposit Insurance Fund (DIF). These measures are particularly important, given that Slovakia will have to almost triple the level of deposit insurance coverage in the future, in order to comply with the EU directive in this area. The government will elaborate a plan to restore the long-run viability of the DIF, allowing the DIF to repay its current obligations to the NBS and fund its future insurance obligations. To this end, the Government will also amend the Banking Act and the Deposit Insurance Act.
D. Conclusions
20. The Slovak authorities have embarked on an ambitious task to deal with inherited weaknesses of the banking system. With the restructuring and privatization of the main state-owned banks nearing completion, the challenge now is to focus on the institutional improvement in banking supervision and to ensure achievement of better asset quality of the banking system. An upgrading of the quality of banking supervision staff and, in particular, an enhancement of on-site supervision should not be delayed any longer. Any delay in the much-needed improvement of banking supervision could weaken the financial system and necessitate another round of recapitalization. It is thus essential to reinforce all the areas of banking regulation in order to discontinue the culture of regulatory forbearance that has prevailed in the banking system and to build a robust banking sector.
21. Although the tightened legal framework and the arrival of strong strategic foreign shareholders could slowly result in better asset quality for Slovak banks, the improvement of the banking sector will depend on the restructuring of the enterprise sector and the strong enforcement of the recently improved legal framework. Unless enterprise restructuring accompanies bank restructuring, the benefits of bank reform will not be fully realized. The persistent asset quality problem could endanger bank soundness in addition to having future fiscal implications.
22. The authorities need to consider carefully the location of banking supervision. The benefits of changing the current setup should be clear and unambiguous before embarking in it. Should they decide to move it outside the NBS, the change in process needs to be well-managed so as to ensure that there is no serious reduction in existing regulatory capacity. This will be key because of the importance of banking supervision in Slovakia given the centrality of banks in its financial system. The question of regulatory structure should be seen not as an end in itself—regulatory structure by itself is not the primary issue—but as a possible means, together with other measures, to achieving the primary objective: the provision of effective supervision, by a well-staffed, well-resourced, and independent regulatory agency.
Prepared by Costas Christou, Louis Kuijs, and Inwon Song.
See SM/99/60 and SM/00/149 for a more detailed analysis of the financial situation of the banking system.
See the World Bank President’s report on the EFSAL, April 2001, for more details.
See Chapter II of this paper for issues related to the performance of the enterprise sector.
Initially the loans were replaced by loans to the two consolidation agencies guaranteed by the government.
Loan classification rules define five categories for classification based on the period of overdue payment and also on the repayment capabilities of borrowers: “standard,” “special-mentioned” “substandard,” “doubtful and litigious,” and “loss.” NBS regulations stipulate that loans overdue for a period of 180–360 days are to be classified as “doubtful and litigious,” while loans overdue for over 360 days are to be classified as “loss.” However, in accordance with international best practices, loans are to be classified as “doubtful” if loans are overdue for over 90 days. Furthermore, if payments are delayed over 90 days and if loans can not be classified as “substandard” or “doubtful,” such loans should be classified as “loss.”
In 1999, the amendments to the Act on the Tax Treatment of Reserves and Provisions have allowed full deductibility of required loan loss provisions for banks. Previously, banks were not allowed to deduct loan loss provisions from their taxable income. This measure reduced a distortion in the tax system that had led to the taxation of bank profits and inappropriate levels of provisions for loan losses.