This note compares patterns of domestic investment in Serbia with those in other central and eastern European countries, noting the relationships with external balances. The structure of participation and employment rates suggests a need for analysis of the impact of labor market institutions on youth and women. A further focus on redeployment services would be appropriate. The Serbian banking system, the implications of the structure of Serbia’s economy, the operational framework of monetary policy, and the adoption of an inflation targeting regime have been discussed.

Abstract

This note compares patterns of domestic investment in Serbia with those in other central and eastern European countries, noting the relationships with external balances. The structure of participation and employment rates suggests a need for analysis of the impact of labor market institutions on youth and women. A further focus on redeployment services would be appropriate. The Serbian banking system, the implications of the structure of Serbia’s economy, the operational framework of monetary policy, and the adoption of an inflation targeting regime have been discussed.

IV. The Banking System9

A. Introduction

1. This note examines recent developments in the Serbian banking system and the implementation of FSAP recommendations.10 It also discusses issues arising in the context of the transition to a flexible exchange rate regime and competition in the banking system.

2. The 2005 FSAP mission concluded that the rapid move from a limited statecontrolled to a dynamic market-driven financial sector has created important benefits, but also new policy challenges. The rapid credit expansion, largely fueled by foreign banks, whose share in total assets has risen to over 70 percent, is contributing to Serbia’s long-term economic recovery. However, it has also complicated efforts to reduce inflation and the high current account deficit. In addition, the FSSA noted emerging signs that rapid credit growth had started to erode systemic financial stability by contributing to an increase in NPLs.

3. The main potential threat to financial stability is high and rising indirect credit risk. With 80 percent of all loans being either fx-indexed or fx-denominated, the exposure of unhedged borrowers to an unexpected depreciation of the currency is significant. Thus a decline in the profitability of foreign banks seeking to gain market share, coupled with an adverse shock—especially an unexpected depreciation—could ultimately result in a credit crunch with adverse implications for the economy at large.

4. The FSSA also noted that these risks were exacerbated by weaknesses in banking regulation and supervision. The Basel Core Principles assessment undertaken in April 2005 identified significant gaps in the banking law and regulations and found that weak enforcement has further reduced its effectiveness.

5. Rapid expansion of bank credit contrasts sharply with the nascent state of other financial market segments. In particular, the FSSA noted the lack of development of capital markets, the poor state of the insurance sector, weaknesses in bankruptcy legislation, and difficulties in taking and executing security. The transfer and pledging of real estate was difficult in the absence of an effective land registry. Finally, accounting and auditing practices are undeveloped and corporate governance is weak.

B. Developments Subsequent to the FSAP

6. Much has been achieved in the relatively short time since the FSAP was concluded and the legal framework of banking regulation and supervision now meets international standards. The new banking law that was adopted in November 2005 is largely in line with the Basel Core Principles (BCPs) and EU Directives. Deficiencies of the previous legislation underlay much of the noncompliance with the BCPs found in the FSAP. In particular, the new law provides for:

  • Consolidated supervision of banking groups.

  • Strengthened “fit and proper” requirements.

  • Protection for the NBS and its staff in the execution of their duties.

  • Limits on lending to parties connected to the bank, its directors and shareholders, in line with EU requirements.

  • Improvements in corporate governance by making directors responsible for risk management and requiring banks to appoint audit committees.

  • Obligation to publish financial statements compiled in accordance with International Financial Reporting Standards (IFRS).

7. The NBS has also adopted most of the by-laws that are necessary for the detailed implementation of the new banking law. All but two of these by-laws (NBS decisions) were issued before the legal deadline of 30 June, 2006. As the by-law on consolidated supervision will only take effect from end-2006, it was decided to use additional time for consultation. The by-law on competition in the banking sector is subject to further discussions on the institutional division of labor with the Competition Council. The by-laws provide for enhanced powers for the NBS to require banks to classify assets and provide for any diminution in value, taking account of the risks involved in fx-lending to unhedged domestic borrowers. Other relevant by-laws include implementation rules relating to licensing, capital adequacy, external audit, risk management, the conduct of supervision, including the enforcement of NBS recommendations, and ‘know your customer’ requirements. These decisions are in line with the law and international best practice, in particular EU requirements, and provide a sound basis for the implementation of the law.

8. The NBS has responded to the rapid expansion of credit risk involved in extending fx-denominated or fx-indexed loans to unhedged borrowers. From September 30, 2006, such loans in excess of CSD 10 million will receive a 125 percent weight in the capital adequacy calculation. Moreover, to contain lending to households, which grew by 96.2 percent in the twelve months to June 2006, the NBS has limited banks’ exposure to households to 200 percent of capital, effective October 1, 2006.11 Moreover, the credit bureau, set up by the Association of Serbian Banks in 2004, is now fully functioning in respect of personal lending. It includes information about credit outstanding as well as default information. Coverage of business lending is expected by the end of 2006.

9. In addition, the NBS has stepped up its efforts to strengthen banking supervision. It has reorganized the supervision function—with World Bank assistance—so that the supervision strategy for each bank and its implementation, on-site and off-site, is the responsibility of a ‘portfolio manager’. This has contributed to improvements in the supervision of asset quality and enforcement of compliance with minimum supervisory standards. Moreover, auditing and disclosure requirements have been improved and some progress has been made in dealing with breaches of statutory limits on connected lending.

10. Progress in bank privatization was substantial. Five banks were privatized since end-2004 and the privatization of another two banks—including Vojvodanska Banka, one of the two remaining systemically important state-controlled banks—is expected to be completed by end-2006, leading to a major diminution in systemic risk. Moreover, the EBRD has acquired a 25 percent interest in Komercijalna Banka, the other systemically important state-controlled bank, and appointed two members of the Managing Board, which is expected to improve governance and strengthen management. While the timing of the eventual privatization of Komercijalna Banka has not yet been determined, the government has expressed a clear preference for a public offer in the Serbian market.

C. Remaining Steps

11. The new legal framework needs to be swiftly implemented. The NBS is working on internal guidance to its staff on the implementation of its requirements set out in the law and the Decisions, in order to ensure consistency and effectiveness of their application. This process will inevitably take some time. It will also require some time for the banks to familiarize themselves with the provisions of the new law and changes in the supervisory processes. Moreover, the Decisions do not yet provide for capital requirements in respect of market risk. Now that the most important market risk, foreign exchange position risk, is subject to a capital charge, the NBS regarded subjecting other forms of market risk to a capital charge as less urgent and has postponed proposals in this area.

12. The brisk pace of credit growth has led to increases in the already high share of nonperforming loans (NPLs) in total loans. While the overall NPL ratio has declined from 22.2 percent at end-2004 to 20.7 percent at end-March 2006, this decline reflects large writeoffs in state-controlled banks prior to their privatization. In contrast, the NPL ratio of foreign banks increased from 10.0 percent to 16.1 percent during the same period.12 However, the NBS noted—and major foreign banks concurred—that this increase reflects to a significant extent stepped-up enforcement of prudential provisions, in many cases involving the reclassification of loans whose quality may have deteriorated before 2005. In the same vein, foreign banks saw little evidence in their portfolio of a deterioration in the quality of underlying assets during 2005 and 2006 so far.

13. Looking forward, however, greater caution is warranted. Over the last few years, banks and their debtors benefited from high economic growth and the limited volatility in the exchange rate implied that unhedged borrowers were de facto shielded from effects of unexpected exchange rate changes. In addition, the credit cycle in Serbia is still at an early stage, given that the dramatic pick up in the pace of credit growth is only a relatively recent phenomenon.13 Against this background, and taking into consideration uncertainties with respect to the capacity of the banks’ risk management systems to deal with their borrowers’ exposure to exchange rate risk, asset quality may become an even larger concern in the not too distant future.

14. The transition from compliance- to risk-based supervision is in its early stages. Risk-based supervision requires staff who understand financial risks and can, therefore, initiate a dialogue with banks, both during on-site examinations and at other times, on the nature and extent of the risks that the bank exposes itself to, and the methods by which the bank prices, manages, mitigates, and controls those risks. The supervisors must be able to identify poor risk management and specify measures to correct these deficiencies.

15. The NBS is considering the adequacy of its supervisory staff in light of the transition to risk-based supervision. At present, the NBS relies on recruiting university graduates, mainly with economics or law qualifications, but almost always without much practical experience in commercial banking, accounting, or information technology. Salary levels in the NBS are low compared to market salaries for individuals with the skills needed which makes it difficult for the NBS to compete despite the job security. While this is a problem that almost all supervisory authorities face, it is particularly acute in Serbia. The decision to grant bonuses of 25 percent to supervision staff during on-site inspections was a first step in the right direction, but it may need to be complemented with a more flexible pay structure and other benefits that can reward scarce skills and strong performers.

16. Consideration could also be given to other transitory remedies. E.g., the NBS could hire experienced individuals at the end of their careers, who are interested to pass on their experience and knowledge to younger staff. Another common technique is to “outsource”part of the supervisor’s activity to accounting and other specialist firms. Where the supervisor feels a bank does not have good quality systems it can require it to commission a consultant to undertake an investigation and to recommend remedial action. The firm would be hired and paid for by the bank, but the terms of reference would be for the supervisor to specify.

17. Risk-based supervision also requires changes in organization. In particular, these could comprise a flatter structure and improved horizontal as well as vertical communication. The appointment of portfolio managers responsible for the total supervisory effort in respect of each supervised institution was an essential step towards modern supervision where onsite examination is used to verify implementation of approved polices in a continuous iterative process. But again it requires highly skilled and experienced individuals to keep abreast of new developments in risk management, a necessary condition for providing effective supervision. This puts a high premium on training, both internally and externally.

18. A major unresolved issue remains in relation to financial reporting, where NBS requirements differ from IFRS. The difference is particularly pronounced in the valuation of assets. This has led some foreign banks to prepare and publish two sets of accounts. The first, in accordance with NBS classification and provisioning rules, which is also used by the tax authorities for the computation of corporate income taxes, and a second set, prepared in accordance with group accounting policies and audited as part of group financial statements. For 2005 the latter has resulted in lower provisions and thus higher profits. An associated issue is the fact that no progress has been made in establishing a national accounting and auditing standards body as provided in the recently passed law on accounting and auditing.

19. Despite recent reforms, there remains some uncertainty for banks in using legal remedies. Considerable steps have been taken to enable banks to make more informed credit assessments, to take and enforce collateral, and to collect from troubled borrowers. The credit bureau now provides full information about potential individual borrowers with details of credit outstanding and payment performance. The system is at present being extended to corporate borrowers—although some large lenders have been reluctant to share proprietary information with potential competitors—and the Association of Serbian Banks expects the scheme to be implemented with full coverage. Improvements have also been made in land registries facilitating the taking of mortgages on both commercial and residential real estate. A separate pledge registry has also been set up enabling banks to take a lien over movable property. Legislative changes improving banks’ ability to recover debts and improvements in bankruptcy legislation have also been enacted. However, many of these changes are very recent and it is too soon to say whether the rights of creditors have been sufficiently enhanced to provide the protection available to banks in other countries.

D. Competition

20. Banks are energetically establishing themselves in a small—if rapidly growing—market. With 38 banks remaining, many with ambitions to increase their market penetration, competition for market share has become quite intense. Margins, especially for large corporate business, have been declining once account is taken of the recent increases in reserve requirements on fx-liabilities. Indeed any profit on relationships with major multinationals’ Serbian affiliates may now derive from added services rather than the margin on lending. Competition for SME lending seems to have had less effect on margins, but such business requires significant costs in establishing branch networks and relationship managers. The boom in less price sensitive consumer lending can partially compensate for these developments. But to some extent, the credit bureau is reducing barriers-to-refinancing-by-borrowers by enabling them to switch more easily to banks with which they do not have a prior credit relationship. And the advent of a similar service for corporates should also strengthen banking competition in that sector.

21. But overall profitability has been sufficient to maintain the banks’ appetite for rapid credit expansion and their capital strength. Although 2005 was a good year, some foreign banks claim to have made a loss after credit costs, at least on Serbian accounting standards. Some of these costs, however, reflect NBS adjustments to provision levels and relate to a deterioration of asset quality in previous years rather than a deterioration during the year itself. In fact, major foreign banks claim to have detected little deterioration in asset quality so far. Indeed, they report higher profits on an IFRS basis. But, evidence of strengthening profitibility notwithstanding, at some point, exposure limits set by foreign parent banks could become a binding constraint on further expansion, particularly as in Serbia these exposures are not limited to the equity investment in their Serbian subsidiaries, but also include their funding of a large part of the lending book. Moreover, it can be expected that more of the smaller banks will find it difficult to maintain profitability, and if so their position will be eroded and their franchise will decline in value. Most observers expect, therefore, some further consolidation, which could also involve the withdrawal of one or more of the bigger players.

E. The Challenges Ahead

22. The Serbian banking system faces additional challenges from high euroization. Reflecting recent experience with hyperinflation and high uncertainty with respect to future economic policies, virtually all deposits except transactions accounts are fx-denominated. Banks report that attempts to sell dinar-denominated term deposit products meet with very little interest and they have little incentive to push such products given the lack of demand for dinar-denominated financing apart from NBS repo operations. Indeed, about 80 percent of credit to the nongovernment sector is fx-denominated or fx-indexed, implying a high share of borrowers without a foreign currency cash flow.

23. The NBS has used reserve requirements on fx-liabilities to drive a wedge between funding costs and lending rates. This has led some banks to increase lending rates. At present, statutory required reserves are 40 percent for fx-denominated deposits and banks’ foreign borrowing with maturities over two years, and—since May 2006—60 percent for banks’ foreign borrowing with maturities up to 2 years. Assuming a cost of funds of 5 percent and that banks are unwilling to shift to dinar-denominated deposits—with a reserve requirement of only 18 percent—and associated dinar-denominated lending, this implies a wedge of about 3.3 and 7.5 percentage points, respectively. While several banks claim that the increased reserve requirements have already started to constrain lending, the strength of credit growth suggests that expected profitability is generally still sufficient. This may partially reflect a restructuring in the banks’ credit portfolio in favor of loans to households which—at least so far—have exhibited a low interest rate elasticity of credit demand.

24. Looking forward, however, the use of reserve requirements to contain rapid credit growth has clear limitations. The current reserve requirements may already be leading to disintermediation—as suggested by the strength of direct corporate borrowing—and further increases can only accelerate that trend. Looking forward, shifting lending to less comprehensively regulated segments of the financial markets may pose risks to the maintenance of financial stability. Foreign banks can easily use their parents to book loans offshore, either by lending to the parent company of the Serbian company or by booking a loan to a purely domestic borrower elsewhere. The euro-indexation of the bulk of new lending renders this process even easier. Banks have also been using leasing companies as a way of avoiding the burden of reserve requirements, but the advantage of extending loans through leasing subsidiaries declined since their foreign borrowing recently became subject to a reserve requirement of 20 percent.

25. At some stage, the moratorium on new “green field” bank licenses will need to be raised. Now that bank privatization is drawing to a close and the new banking law is enacted, it is appropriate to consider a policy for new entrants. It is unlikely that many major international banks will want to enter what they may now perceive to be a crowded market. But one or two may wish to follow their corporate customers to Serbia. More likely would be applicants from banks in Eastern Europe or the former Soviet Union. Such applications will need to face a rigorous ‘quality’ standard, including strict application of the “fit and proper criteria provided in the new banking law.

26. The gradual transition to a flexible exchange rate regime may exacerbate prudential risks. The limited exchange rate volatility through early 2006 created incentives for borrowers to underestimate exchange rate risk. In the same vein, banks have not fully internalized indirect credit risk. The gradual transition to a flexible exchange rate regime should help raise the awareness of these risks. However, given that the regime change has so far resulted in an appreciation of the dinar, it is uncertain whether the banks give sufficient priority to upgrading their risk management systems with a view to fully internalize indirect credit risk. The NBS will thus need to tighten its grip in supervising the banks’ risk management systems. The introduction of a 125 percent risk weight for loans to unhedged borrowers in the capital adequacy calculation is in principle a step in the right direction. However, it will need to be complemented with an intensified assessment of banks’ internal procedures.

27. High reserve requirements help moderate liquidity risk. Liquidity risk is enhanced by these reserve requirements given that the NBS cannot create liquidity in euro. It is, therefore, imperative that banks are required to ensure that they maintain access to foreign markets or at least limit their funding risk. At present, banks are subject to a stock liquidity requirement but there is no requirement limiting the extent to which banks indulge in maturity transformation. Although the NBS collects maturity information it is not disaggregated by currency so the supervisors would not necessarily be aware of mismatches.14 This could cause problems if there is a significant deterioration in asset quality and assets do not mature as soon as expected. The problem is not currently serious so long as the banks have to maintain large required reserves at the NBS, which can mitigate the lack of a ‘lender of last resort’ in euro. In the longer term, a flexible exchange rate regime should help the development of a foreign exchange market with more depth and breadth. In addition a forward market and a market for short dated swaps could help provide a term structure to the dinar money market and help the process of transmitting the NBS’s repo rate to dinar interest rates.15

28. Despite the impressive recent improvements in the legal framework, the Serbian banking system remains vulnerable. The new regulatory framework needs to be swiftly implemented to contain the risks emanating from rapid credit growth and the rising exposure of unhedged borrowers to exchange rate risk—even more so in the context of the transition to a flexible exchange rate regime. Given the limited history of default in recent years and the rapid growth of the customer base, deterioration may well creep up on lenders without much warning. Although margins have been relatively good and demand strong, competitive pressures are mounting. While many banks have earned respectable profits so far, the situation could change and further consolidation occur. The NBS now has adequate powers to deal with the problems that will no doubt arise but the supervisory capacity will need to be strengthened further to detect early warning signs.

9

Prepared by Peter Hayward and Andreas Westphal.

10

The main findings of the Financial Sector Assessment Program (FSAP) team, whose two main missions to Belgrade were in March and April 2005, are reflected in the Financial System Stability Assessment (FSSA), which was discussed by the Fund’s Executive Board on February 6, 2006. It is available at http://www.imf.org/external/pubs/ft/scr/2006/cr0696.pdf.

11

Some categories of household loans are exempt from this provision, most notably mortgage loans subsidized from the budget.

12

To eliminate the impact of changes in ownership, this calculation is based on an assumed constant ownership structure as of March 2006.

13

The 12-month growth rate of credit to the nongovernment sector has exceeded 40 percent since August 2004 and 50 percent since January 2005.

14

Banks are, however, required to prepare liquidity management policies, dealing, inter alia, with liquidity on a currency by currency basis. These policies must include contingency plans.

15

Currently the inter-bank market is small and mainly consists of overnight lending, and—as such lending is largely unsecured—not all banks with surplus liquidity are prepared to lend to all those who need funding.