Republic of Kosovo
Financial System Stability Assessment
Author: International Monetary Fund. Monetary and Capital Markets Department
Publication Date:
12 Apr 2013
eISBN:
9781484328408
Language:
English
Keywords:
ISCR; CR; central bank; return on equity; financial system; bank assets; interest rate; reserve fund; banking law; deposit base; insolvency regime; loan-to-deposit ratio; bank leverage ratio
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This article summarizes the financial performance and crisis management of the Republic of Kosovo. Kosovo’s economic condition shows stability in systematic risks, but it also has vulnerabilities. Kosovo banks are exposed to macrofinancial risks because of its open economy, but the Central Bank of the Republic of Kosovo (CBK) has immensely promoted the growth and stability of the banking sector. CBK should also monitor certain interest rates, tax rates, and foreign rates. The current system should allow the growth of microfinance institutions to reach the competition in the global banking sector.

Abstract

This article summarizes the financial performance and crisis management of the Republic of Kosovo. Kosovo’s economic condition shows stability in systematic risks, but it also has vulnerabilities. Kosovo banks are exposed to macrofinancial risks because of its open economy, but the Central Bank of the Republic of Kosovo (CBK) has immensely promoted the growth and stability of the banking sector. CBK should also monitor certain interest rates, tax rates, and foreign rates. The current system should allow the growth of microfinance institutions to reach the competition in the global banking sector.

I. Structure of the Financial System and Recent Macro-Financial Performance

1. Kosovo’s financial sector, which is dominated by banks, has expanded rapidly since 2000. Financial system assets as a share of GDP more than doubled from 33 percent in 2003 to about 74 percent as of June 2012. There are presently eight commercial banks, which account for more than 75 percent of total financial system assets and around 60 percent of GDP (Table 2). Six banks are locally incorporated and two are foreign branches. The three largest locally incorporated banks are subsidiaries of European banks and together account for more than 70 percent of bank assets. One of the three medium-sized banks is also foreign-owned.

Table 2.

Kosovo: Financial System Structure (2007–2012)

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Source: Central Bank of Kosovo and IMF staff estimates.

2. The nonbank sector is represented by pension funds, micro-financial institutions and insurance companies. After banks, pension funds are the largest financial intermediaries. Their role is to complement the pay-as-you-go government funded system and their investments represent about 20 percent of total financial assets. There are also 14 small micro-financial institutions managed by nonprofit organizations, which are not deposit-takers. The insurance sector is represented by one life and 10 non-life insurance companies that together comprise about 3 percent of total assets.

3. Kosovo is one of the smallest insurance markets in Europe. Gross non-life premiums, including personal accident and health, amount to about €67 million, of which about €1 million are life insurance premiums. Despite a very low market penetration rate of about €38 per capita, in 2011 the overall real growth of the market measured by gross premium written (GPW) was under 5 percent. Moreover, 70 percent of premiums come from the compulsory third party motor liability insurance (MTPL).1

4. Although small, the microfinance sector is a key lender to small businesses, agriculture, and low income households. It accounts for 4 percent of the total loan portfolio of financial institutions. The average loan size amounts to €1,400 and lending to agriculture accounts for 46 percent of total lending to the sector. Two providers dominate the MFI market, with about 50 percent of assets.

5. The CBK is the single supervisor for all financial intermediaries. It issues banking and insurance regulations, as well as prudential rules for the pension funds. In spite of the fact that microfinance institutions are not deposit-takers, they are also supervised by the CBK.

6. Kosovo has unilaterally adopted the euro as its legal tender in 2002. While this supports stability by providing a strong monetary anchor and has generally served the economy well, it places a premium on disciplined macroeconomic policies, makes fiscal policy the main instrument for domestic demand management, and imposes limitations on the central bank’s ability to act as lender of last resort.

7. Kosovo’s economy was affected by the global financial crisis of 2008/09 through a weakening of private sector demand driven by a drop in transfers from Kosovo workers abroad. During 2008–09, economic conditions in host countries of Kosovo’s diaspora rapidly deteriorated; by 2009, the Kosovo’s economic outlook turned sharply weaker. GDP growth fell to 2.9 percent, from 6.9 percent the year before, and countercyclical fiscal expansion, financed largely from one-off dividends receipts and drawing down cash buffers, mitigated the impact of the private sector contraction.

8. While Kosovo’s economy recovered somewhat after 2009, broadly in line with the host countries of Kosovo’s diaspora, growth has recently faltered. During 2010–11, real GDP grew on average by 4.5 percent, driven primarily by private sector demand. Consumer prices reversed from deflation of 2.4 percent in 2009 to inflation of 5.4 percent in 2010–11, triggered by higher prices for imported food. The trade deficit widened from 39.7 percent of GDP in 2009 to 41.1 percent of GDP in 2011, reflecting mostly higher imports. Strong current and capital inflows, primarily from the Kosovar diaspora, funded the deficit. There have been indications of a weakening in domestic demand in early 2012. Staff projects real GDP growth of 2.7 percent in 2012. Consumer price inflation is expected to average 2.5 percent in 2012, compared with 7.3 percent in 2011 (Table 3).

Table 3.

Kosovo: Selected Economic Indicators

(in percent, unless otherwise indicated)

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Sources: Kosovo authorities; and IMF staff estimates and projections.

See Box 2 in the IMF Country Report No. 12/100, April 2012, International Monetary Fund, Washington DC.

Total foreign assistance excluding capital transfers.

September 2012.

Series updated with the 2011 census.

II. Financial Institutions Resilience to Risks

A. Banks

9. Kosovo banks are exposed to external and domestic sources of macro-financial risks. Kosovo banks are exposed to shocks from abroad because of the openness of the economy and financial cross border exposures:

  • Growth is significantly influenced by external factors. Domestic demand is mainly funded with transfers from Kosovars living abroad equivalent to about 40 percent of GDP. Moreover, these transfers are direct determinants of bank credit quality and liquidity since they are used to service loans and fund deposits.2

  • Inflation is mainly driven by the volatility of imported food items, affecting real income and real interest rates.

  • Credit growth is influenced by developments in foreign countries since the three largest banks are foreign-owned. They have parent banks in Germany, Austria and Slovenia and two of these are embarking in significant deleveraging plans outside their home markets in order to restore their capital adequacy ratios.

  • Liquid assets are mainly foreign assets. Banks fund themselves with local deposits and do not depend on funding from their parents but invest around 22 percent of total assets abroad, largely in the euro area. These investments include sovereign bonds and placements in parent and other (mainly European) banks. Placements in parent banks are limited to 15 percent of Tier 1 capital while there are no limits to placements in other banks. Sovereign bonds (mostly highly rated) are the equivalent of about 70 percent of Tier 1 capital while balances with other banks (including parent banks) are 100 percent of Tier 1 capital (Figure 1).

Figure 1.
Figure 1.

Kosovo: External Bank Exposures

Citation: IMF Staff Country Reports 2013, 099; 10.5089/9781484328408.002.A001

Source: National authorities and Fund staff estimates.

10. Risks also come from specific economic and institutional features of the domestic environment in which banks operate:

  • Kosovo is a small and concentrated economy and this limits banks’ ability to diversify their risks. Banks have limited possibilities to diversify across sectors. Kosovo’s export sector has remained small (about 7 percent of GDP) and concentrated on low valued-added products, especially base metals; imports represent about 52 percent of GDP. About a third of all bank loans are to the trade sector while another third are loans to households. High levels of informality and flaws in commercial legislation and judiciary procedures limit acceptable clients to a reduced number of corporations and individuals, promoting also name concentration on banks’ asset and liability sides.3

  • There are limited cushions to compensate for potential macroeconomic instability. Due to the unilateral adoption of the euro, the authorities have limited instruments to conduct macroeconomic stabilization policies and to provide a safety net to banks. Local interbank and other financial markets are almost nonexistent.4

11. The economic slowdown has had an impact on credit quality and bank profitability but the banking system still appears adequately capitalized and liquid (Table 4).

  • The banking system NPL ratio nearly doubled from 3.3 percent in 2008 to 6.5 percent at end June 2012. This trend is largely attributable to a large increase of NPLs in the trade sector. NPLs appear well provisioned by regional comparisons and based on relatively conservative classification requirements (Figure 2). On aggregate, banks’ June 2012 return on equity was 10 percent, down from 19 percent at end-2010. Some medium-sized and small banks reported losses in the first half of 2012. As of June 2012, the banking system CAR was 17.2 percent, down from 18.8 percent at end-2010. Most banks maintained CARs above the 12 percent regulatory minimum.5

  • Deposit growth remained relatively flat during the first half of 2012, which has somewhat increased banks’ loan-to-deposit ratios as credit still expanded at an annualized rate of around 8 percent for the system (and higher for small and medium-sized banks). The recent deposit slowdown could be attributable to lower capital inflows associated to the Kosovar diaspora and large withdrawals of public enterprise deposits. Liquid assets however remained high (29 percent of total assets) covering about 34 percent of total deposits. The high liquidity ratio is to some extent the result of moral suasion by supervisors targeting an 80 percent loan-to-deposit ratio, which banks meet while investing the rest abroad.

Table 4.

Kosovo: Financial Soundness Indicators

(in percent)

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Source: Central Bank of Kosovo and IMF staff estimates.
Figure 2.
Figure 2.

Kosovo: FSIs. Country Comparison

(In percent)

Citation: IMF Staff Country Reports 2013, 099; 10.5089/9781484328408.002.A001

Source: IMF FSI Database1/ NPLs net of specific provisions to capital.
uA01fig01

Kosovo: Sectoral Concentration and Nonperforming Loans 1/

Citation: IMF Staff Country Reports 2013, 099; 10.5089/9781484328408.002.A001

1/ Size of bubble corresponds to size of the sector in total credit.

12. Stress tests were based on the potential channels of risk transmission and vulnerabilities identified in paragraphs 20–21. Staff assessed the impact of further euro-zone deterioration on the Kosovo banking system.6 The crisis was assumed to impact the banking system through a decline in remittances and FDI, a decline in the value of banks’ holdings of European sovereign debt, higher counterparty risk from exposures to euro-zone banks, and a reduction in credit due to deleveraging by foreign-owned banks. Specifically, under this scenario GDP would decline by 2 percent, yields on European sovereign bonds held by banks would increase on average by 130 bps, and there would be an average increase in the default probability of European banks to which Kosovo banks are exposed of 140 percent (Figure 3 and Table 5).7

Figure 3.
Figure 3.

Kosovo: Euro-Zone Recession Baseline and Alternative Scenarios

Citation: IMF Staff Country Reports 2013, 099; 10.5089/9781484328408.002.A001

Source: Central Bank of Kosovo and IMF staff estimates.1/ The cyclical strength index is defined as the ratio of German labor costs over Kosovo CPI, multiplied by the ratio of nominal imports to nominal exports. Higher values of the index correspond to higher remittances and lower default rates.
Table 5.

Kosovo: Euro-Zone Recession Scenario—Assumptions

(In percent unless indicated otherwise)

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Source: National authorities and IMF staff estimates.

GDP growth for 2011 is an estimate.

The cyclical strength index is defined as the ratio of German labor costs over Kosovo CPI, multiplied by the ratio of nominal imports to nominal exports. Higher values of the index correspond to higher remittances and lower default rates.

13. The macro stress tests found the banking system to be generally resilient to further euro-zone deterioration but there are pockets of vulnerability among small and medium-sized banks and in one large foreign subsidiary (Table 6).

  • The two largest banks would remain above the regulatory minimum since the impact of higher losses on the capital ratio is partially mitigated by the projected reduction in risk-weighted assets driven by banks’ deleveraging schedules to satisfy supervisory requirements abroad as well as by lower demand for credit due to the fallout from the euro-zone crisis. The remaining four locally incorporated banks are more vulnerable and their capital ratios would fall below the 12 percent minimum. The capital injection needed to restore their CARs to the minimum requirement would be about 0.2 percent of GDP.

  • One large foreign bank subsidiary was viewed as more vulnerable, especially given the weaker state of its parent bank. If this subsidiary failed, other banks would not be directly affected due to limited domestic interbank linkages. However, the largest pension fund could be affected through its large deposit in the bank, which amounts to around 3 percent of its total portfolio.

  • This analysis points to the need for supervisors to monitor credit growth and strengthen provisions in the more vulnerable banks, taking particular account of exposures to parent companies. Enhanced information exchange and coordination with relevant foreign supervisors may also be necessary.

Table 6.

Summary Stress Test Results—Solvency

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The two foreign branches are excluded from the calculation of the recapitalization needs since they are not supposed to meet the minimum capital requirement. One branch’s CAR is below 8 percent before the stress tests.

Adjusted by the mission team to account for shortfalls in required provisioning.

A shock to the default rate in the housing and construction sector, which also applies a 20 percent reduction in collateral valuations due to a decline in home values.

All systemic risk scenarios do not consider banks’ profits as a buffer and assume zero credit growth. The two largest net borrowers in the domestic interbank market default on exposures to other local banks. The capital of the two banks and their liabilities to other banks are written down to zero.

All subsidiaries are assumed to increase their exposure to parent to the limit of 15 percent of Tier 1 capital, which is the maximum permitted by regulation.

Includes a failure of a parent on its exposure to the subsidiary in Kosovo, which is equivalent to 36 percent of its capital.

A parent declares bankruptcy and the capital of the subsidiary is written down to zero. The total loss to the banking system is assumed to be equivalent to the subsidiary’s capital and liabilities to other institutions.

The pension fund is assumed to lose its deposit in subsidiary.

The year with maximum impact on CAR over the estimation period (2012-2016).

Haircut corresponding to the 50th percentile of historical bond yields using a duration approximation formula and a 5-year duration assumption.

Haircut corresponding to the 50th percentile of historical bond yields plus a 5 percent decline in equity valuations.

Haircut corresponding to the 90th percentile of historical bond yields plus a 20 percent decline in equity valuations.

In addition to the macro effects of the adverse European scenario a parent is assumed to default on its liabilities to subsidiary in Kosovo.

14. Sensitivity tests found that banks are vulnerable to their highly concentrated portfolios and to interest rate risk while exchange rate risk is negligible.

  • Large concentrations are present despite the fact that some large corporate clients borrow from several banks. Such exposures to common borrowers could induce correlation risk in the system and the CAR of one bank with a 10 percent market share would fall below 12 percent if the five largest common borrowers in the system defaulted. Some banks would also be vulnerable to a further deterioration of loan quality in the trade sector. This assessment points to the need to ensure that the new regulation on large exposures is enforced in the planned schedule, and to avoid exceptions to the large exposure limits.8

  • Interest rate risk is driven by maturity mismatches between interest-sensitive assets and liabilities. A parallel shift of 200 basis points in interest rates would bring two banks representing more than 25 percent of the system below the 12 percent CAR minimum. Supervisors should therefore start monitoring interest rate risk and its potential impact on earnings and asset values.9

  • Direct and indirect exchange rate risks are low because banks on average maintain small open foreign exchange positions and loans in foreign currency are less than 2 percent of total assets.

15. Liquidity stress tests show that current liquidity arrangements could cope with mild to medium-severity deposit runs (Table 7).10 Current liquidity arrangements include a targeted loan-to-deposit ratio of 80 percent imposed by supervisors by moral suasion, which most banks meet while investing most of the remaining deposits abroad, and the Emergency Liquidity Assistance (ELA) fund described in section V.

  • The outcome of the systemic liquidity tests suggests that cumulative deposit outflows of 15 percent of total deposits, combined with a 10 percent haircut on liquid assets, would be enough to deplete banks’ excess liquidity, bringing the liquid assets of the banking system slightly below 20 percent of total deposits.11

  • A 30 percent outflow, combined with a 20 percent haircut on liquid assets, would nearly deplete the liquid assets of the banking system. The total liquidity assistance needed to enable the banks meet these withdrawals would be equivalent to 2.2 percent of GDP. Liquidity assistance of up to 1 percent of GDP can be covered by the ELA fund and up to 2 percent of GDP, if CBK equity and reserves are included. This outcome does not take into account the fact that some foreign-owned banks may be able to borrow from their foreign parents if needed and that haircuts to liquid assets could be much lower if the runs were triggered by local factors.

  • Available ELA funds would be able to fully cover liquidity needs of the two smallest banks (which hold 2 and 5 percent of total deposits respectively) in the event of a run that would affect just these banks.

  • Deposit concentration appears significant. A simultaneous withdrawal of the ten largest private deposits in each bank, which overall account for around 10 percent of total deposits, would reduce the ratio of liquid assets to total deposits of the banking system from 34 percent to around 27 percent. One small bank would run out of liquid assets and the total amount of liquidity needed to meet the withdrawals would be around 0.3 percent of GDP. Supervisors should use information on deposit composition by size to identify potential vulnerabilities arising from deposit concentration.

Table 7.

Summary Stress Test Results—Liquidity

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Source: Central Bank of Kosovo and IMF staff estimates.Note: (*) indicates approximately the maximum deposit run that could be covered by the emergency liquidity assistance fund (ELA) and the Central Bank’s other available resources (e.g. capital and reserves), which together amount to around 2 percent of GDP.

Number of banks with insufficient liquid assets to meet the withdrawals.

Liquidity assistence needed by the banking system to meet the withdrawals.

Cumulative outflow of total deposits, haircut on liquid assets.

An outflow of approximately 5 percent of total deposits.

An outflow of approximately 6 percent of total deposits.

An outflow of approximately 8 percent of total deposits.

An outflow of approximately 10 percent of total deposits.

B. Nonbank Financial Institutions

16. The two pension funds are still vulnerable to a sharp correction in equity markets. The 2008–2009 crisis negatively affected the investment performance of the two pension funds: Kosovo Pension Savings Trust (KPST, a mandatory defined contribution scheme) and Slovenia-Kosovo Pension Fund (SKPF, a voluntary scheme). KPST was predominantly invested in equities and suffered a considerable decline in portfolio market valuations in 2009. Since then, it has reduced its equity holdings. However, a correction in stock market valuations of around 20 percent would result in a decline in the value of the funds’ portfolios of around 14 percent. Sovereign bond holdings are also significant.12 Market risks are born by pensioners but the funds bear liquidity risks in case redemptions exceed expectations. So far, this has not happened, as the funds have limited liabilities due the young age of the population. Interlinkages with other institutions are limited to deposits with banks, which are collateralized by pledged securities.

17. Although insurance companies do not pose systemic risks, given limit linkages to the banking sector, its financial fundamentals are very weak. Specifically, four out of 10 nonlife companies are technically insolvent when assessed against EU Solvency I rules, and three have insufficient liquid assets to cover their current technical provisions, which in turn appear to be considerably understated. Despite the existence of a minimum Motor Third Party Liability (MTPL) premium and a maximum agents’ commission rate, fierce competition often forces insurers to resort to discounts and rebates to clients and additional compensation to agents. As a result, in 2011, most companies recorded negative underwriting income from this large line of business and the average return on equity (ROE) was 2 percent. Risks also arise from the underestimation of technical provisions by many insurers, and the insufficient amount of liquid assets available in the market to support existing provisions.

18. In case of insolvency of insurance companies, outstanding claims will have to be paid by the Motor Compensation Fund (MCF).13 This fund currently has about €2 million in capital. As the Fund annually collects over €10 million in premiums from the sales of “border policies,” it is unlikely to experience financial difficulties from covering outstanding claims against one or even two bankrupt companies. However, in the medium term, with the disappearance of the “border policy” revenue following Kosovo’s joining the Green Card system, the ability of the MCF to pay claims could be jeopardized.14

19. The insurance industry is also facing growing reputational risk due to a poor record of claim payment. This will likely hamper growth and development in the near future. CBK should enact and implement a regulation to introduce an out-of-court insurance dispute resolution mechanism (e.g., private arbitration with binding decision powers), in order to address the growing volume of consumer complaints against insurers and the lack of technical capacity of local courts to properly address insurance related disputes

20. After almost a decade of fast growth, microfinance institutions (MFIs) have contracted in recent years. Total MFI assets are now about 2 percent of financial system assets, down from 5 percent in 2007. The main reasons include governance concerns resulting in CBK putting the largest MFI under official administration and freezing its lending activities; reluctance of MFIs investors to increase capital due to regulatory uncertainty; fraud cases in some of the largest MFIs that resulted in credit losses; and a refocus of the MFIs on smaller loans. As of June 2012, the current level of loan impairment (loans past due 30 days or more) was 9.2 percent while returns on assets (ROA) and on equity (ROE) were 0.6 percent and 0.4 percent respectively. As of June 2012, annualized profitability was significantly negative. MFIS have their accounts with commercial banks, and in some cases, commercial banks have granted credit lines to MFIs for onlending purposes. However, most of MFI funding comes from external sources. Given the size of MFIs, none of these transactions appears to pose systemic risk.

III. Financial Sector Oversight

A. Banking

21. The assessment of the Basel Core Principles found an uneven level of compliance with international standards, primarily due to resource constraints.15 Key areas that should be addressed include: upgrades to the legal framework; development of a risk-based forward looking supervisory program; consolidated supervision and closer coordination with foreign supervisors and a continuation of the capacity building in supervision. As established in the CBK Law, the CBK is responsible for the regulation and supervision of commercial banks, microfinance companies, insurance companies and other financial service providers.

22. Some areas of banking legislation and regulation would need to be completed or modified to ensure consistency. The CBK was established in 2008 after the declaration of independence of Kosovo, as the successor to the Banking and Payments and the Central Banking authorities of Kosovo, which had been created in 2000. In order to build the necessary institutional capacity, many public institutions in Kosovo have been recipients of intensive and prolonged—and sometimes contradictory—international technical assistance. While this assistance has permitted the establishment of many key institutions in a very short period of time, it may have also overburdened the capacity of local officials to carry out the necessary critical analysis to make the regulatory framework fully consistent and sufficiently comprehensive.

23. Banking supervision has to be conducted under very challenging—and sometimes even hostile—circumstances resulting from the political and security context of the country. The fact that the declaration of independence of Kosovo has not been universally recognized internationally poses significant challenges to the CBK, as it tries to exercise its authority in certain areas of the country. For example, two commercial banks licensed in the Republic of Serbia that have operations in the northern part of Kosovo (Mitrovica, a Serbian-majority enclave) are not as intensively supervised as the banks operating in the rest of the country.16

24. The political tensions and the fact that banks operating in northern Kosovo are not regularly supervised by either banking authority have a direct bearing on the CBK’s effectiveness as a bank supervisor. Consequently, the ratings for the principles on permissible activities, ongoing supervision of banks and enforcement of corrective actions reflect the bank and supervisory standoff in Mitrovica. There is no evidence that either the Serbian or the Kosovo banking supervisory authorities are conducting the necessary supervision on these institutions. While the CBK tried to undertake an on-site examination of the bank, and reportedly even requested assistance “for security reasons” to Eulex Kosovo, in the end it had to accommodate to ad hoc arrangements that, while reasonable, are only second-best solutions for this situation. In this regard the assessors want to highlight the importance of the issue given its potential for escalated tensions in the region in the event a bank was to experience liquidity or other difficulties.

25. The Anti Money Laundering (AML) law has significant gaps that could affect the effectiveness of AML activities in the banking sector. An UN Interim Administration Mission in Kosovo (UNMIK) regulation on AML was in effect until 2010, when the Assembly of Kosovo approved the Law on the Prevention of Money Laundering and Terrorist Financing. As reported to the assessors, this Law presents several technical deficiencies, including the lack of specific provisions giving authority to the CBK or the Financial Intelligence Unit to carry out compliance inspections in several types of institutions, most notably banks. Furthermore, this Law provides insufficient protection to bank officials filing reports to the FIU in the discharge of their responsibilities.17

26. Notwithstanding some progress, supervision of banks is still largely based on the review of the level of compliance with existing rules, and not on the risk profile of the entities. The supervisors use the Capital-Assets-Management-Earnings-Liquidity-Sensitivity to market risk (CAMELS) internal rating system, and this approach has been helpful to identify problems. However, important challenges need to be addressed before a truly risk-based supervisory system is in place. Except in the assessment of the credit risk embedded in banks’ loan book, which currently receives sufficient attention, especially during on-site examinations, the supervisory process does not sufficiently address some risks that are already very important to the banking sector of Kosovo.

27. Implementing a risk-based supervisory regime in Kosovo is needed, especially for the three systemic banks. The supervisory process has to be substantially enhanced to ensure that the risks of the foreign banks are sufficiently understood and monitored by the CBK on a regular basis, so timely action can be initiated, to the extent possible. In addition, operational, interest rate and liquidity risks are prevalent in the system, but have not received the necessary supervisory attention yet. Market risk is currently limited; however it is likely to increase its importance in the near future as the securities market develops.

28. Legal protection for banking supervisors and other CBK employees was found to be inadequate. The legal framework explicitly mentions that a member of the Central Bank’s decision-making bodies or its staff shall not be liable for acts or omissions performed in the course of the duties and responsibilities, unless it has been proven that such acts or omissions constitute intentional wrongful conduct or gross neglect. It additionally indicates the obligation of the CBK to indemnify them for the legal costs they have incurred in these cases. However, actual cases demonstrate that in practice employees had to cover all the costs resulting from their legal defense until being definitively cleared of any wrongdoing. Only then were staff entitled to claim the reimbursement of these legal costs from the CBK. Discussions with CBK staff indicated that these defense costs may be substantial and the process of getting definitive acquittal can take a long time. Furthermore, even if the employee is cleared of criminal acts, CBK may challenge the expenses submitted and not reimburse any costs until the claimant gets the official declaration from a Court of Justice compelling the CBK to pay for the expenses borne. The lack of proper coverage appears to be a cross-cutting issue, as it applies to bank and other financial sector supervisors, and to deposit insurance fund employees.

29. The CBK has exercised the substantial authority that the legal framework assigns it as supervisor. In the recent past, CBK has temporarily prohibited the payment of dividends; has required capital injections; and replaced management in banks, as well as closed the branches in Kosovo of an unlicensed bank

B. Nonbank Financial Institutions

30. CBK main insurance regulation suffers from severe technical deficiencies and its adoption in 2007 represented a legislative setback with respect to the previous regulation. Insurance activities are governed by UNMIK Regulation No. 2001/25 which covers licensing, supervision and regulation of insurance companies and insurance. The main regulation issued by the CBK, as the insurance market regulator, is the Regulation on Deposit of Assets as Security, Capital Adequacy, Financial Reporting, Risk Management, Investment and Liquidation, which came into effect on January 1, 2007, and replaced EU Solvency I. Another important pillar of the insurance regulatory framework is the new MTPL Law No 04/L-018 on Compulsory Motor Liability Insurance, which was passed in 2011.

31. EU Solvency I framework should be reinstated as the main legal basis for monitoring, supervising and enforcing minimum solvency margin requirements. When assessed against IAIS ICP principles, the existing regulatory framework is incomplete and inadequate. Despite numerous solvency and capital requirements, the current regulation falls short of establishing an adequate solvency and minimum risk capital supervision framework, which prevents the CBK from effective monitoring and supervision of the market and, at the same time, allows companies to operate with considerably less surplus capital or solvency margin than would be required under the previous Solvency I regime. Among gaps in the existing regulations are the minimum requirements for calculating technical provisions; requirement of mandatory annual actuarial audits to be conducted by accredited and licensed actuaries; requirements for actuarial accreditation; and specification of potential liabilities for erroneous or misguided opinions. A new insurance law should also be approved to supersede all existing UNMIK regulations and provide a comprehensive legal foundation for insurance activities in Kosovo.

32. The supervisory approach for MFIs is not related to the risks and sophistication of MFIs. Both MFIs and NBFIs are non deposit taking institutions, regulated and supervised by CBK. The scope of permitted activities is broader for NBFIs than for MFIs, which can only lend to SMEs and low-income households. However, NBFIs do not have capital and licensing requirements, and have fewer restrictions on their activities while MFI regulations mimic that of banks. The legal framework should be amended to create a level playing field between MFIs and NBFIs. CBK should develop reporting requirements and supervisory processes appropriate to the risks posed by these institutions and ensure that regulatory requirements can promote growth in both sectors.

C. Payment System

33. There is only one payment system in Kosovo. It is a hybrid interbank payment system called the Electronic Interbank Clearing System (EICS), which is operated by the CBK and clears all priority payments, retail credit transfers, and retail direct debits. All commercial banks are participants in EICS, as is the CBK (both for itself and on behalf of the government). The system provides payments for large and low-value transactions. The CBK has initiated—with World Bank assistance—the implementation of a Real-Time Gross Settlement (RTGS) payment system for large-value transactions, which is expected to be completed by 2014.

34. Non-cash payment instruments including checks are still not widely used. The use of payment cards is still low, but their number as well as the number of transactions made by them has increased significantly over the past few years. All banks have their own networks of the Automated Teller Machines (ATM) and Point of Sale (POS) terminals. However, there is a limited cooperation among them for sharing their networks. The CBK has planned to tackle this area by initiating the establishment of a national card switch system to reduce costs and improve efficiency. Once implemented, the RTGS and the card switch system will significantly reduce settlement and systemic risks

35. Implementation of earlier Fund technical advice on payment system oversight is mixed. The recommendations on Legal and Regulatory Issues were taken into account by redrafting the Draft Law on the Payment Systems before sending it to the Government and the Parliament for further discussions. There are several recommendations on the organization of the oversight function that are being implemented at present by the CBK because they do not depend on the passing of the Payment System Law. For example, the oversight function has been separated from the operation function by establishing two divisions in the Payment System Department. The hiring of an expert to head the oversight unit is proposed in the budget plan for the 2013. Other recommendations are still in the process of implementation, which mainly depends on the passing of the Law on Payment System. Detailed steps towards TA recommendations provided by the Fund to the CBK in 2011 on Payment System Oversight are presented in Appendix III.

IV. Issues in Macroprudential Oversight

36. The CBK lacks an integrated framework for formulating and implementing policies to fulfill its primary responsibility for maintaining financial stability. Such a framework would help counter potential macro instability that may arise from the opening of the economy and the lack of monetary policy instruments.

37. The CBK should link a regular internal review of financial indicators to decisions on macroprudential policy, and strengthen policy transparency and accountability. To do this, it is recommended that:

  • The CBK should establish a Macroprudential Policy Advisory Committee (MaPaC), including participation of the Executive Board, the Financial Stability and Supervision Departments, and other relevant departments. The MaPaC should meet on a quarterly basis to review key indicators of macro-financial stability and evolving risks. On the basis of this assessment, the MaPaC should recommend policy measures to the Executive Board, which would then take decisions.

  • Accountability and transparency arrangements should include a pre-announced schedule of meetings to decide on policy measures; press releases on decisions taken; publication of the Financial Stability Report, appearances by the Governor before the Assembly Budget and Finance Committee, as well as briefings for banks, press and analysts.

38. To make macroprudential policy operational, the CBK will need to establish a set of primary indicators for assessing different aspects of financial stability and assign instruments to be used to manage those risks. For these purposes it is useful to distinguish between structural vulnerabilities—structural characteristics of the financial system which may accentuate the potential for spillovers or contagion of shocks—and cyclical vulnerabilities which refer primarily to vulnerabilities which vary substantially over time, generally reflecting the state of the business cycle and risks in the real economy.

39. Cyclical vulnerabilities include both those associated with excessive credit expansion and with liquidity risks. To address these, the CBK will need to select a few key indicators that can be monitored on a regular and timely basis, to serve as intermediate policy guides. For leverage or credit vulnerability, the CBK could consider focusing on broad indicators for the banking system such as a bank leverage ratio or, possibly, a credit/GDP ratio. For liquidity, CBK might focus primarily on a bank loan/deposit ratio (LDR).

40. A principal challenge is to determine indicator values, or ranges, which are judged to be consistent with financial stability, and values that should trigger policy action.

  • Stress testing may have an important role to play in such analysis. In this regard, it is recommended that stress tests be based on macroeconomic analysis.

  • The CBK should also monitor a range of additional indicators in each of the main vulnerability assessment areas which will assist in interpreting developments in the primary indicators.

  • The use of such ancillary indicators and stress tests should be particularly useful in distinguishing between developments affecting the financial system in general as opposed to specific institutions, and between developments which are likely to be self-correcting and more persistent trends calling for policy actions.

41. Data limitations make the task of determining appropriate indicators particularly challenging. The lack of timely, good quality macroeconomic data and the fact that the structure of the economy and financial system has evolved significantly over the past decade makes it difficult to distinguish between cyclical and structural movements in macroprudential indicators. Clearly, an important priority will need to be the improvement of basic macroeconomic indicators, as well as research on indicators of the business cycle in Kosovo.

42. The CBK will also need to determine a set of instruments to be used in response to financial stability risks. For example, for excessive leveraging or credit growth, instruments might include limits on loan-to-value or debt- or debt service-to-income ratios for households, analogous measures for firms, and adding a countercyclical element to bank capital requirements. With regard to liquidity, the CBK could consider introducing a countercyclical component to its reserve requirements for banks. A rules-based approach, in which instrument settings are adjusted systematically in response to risk indicators, facilitates policy consistency over time, helps preserve policy independence, and helps overcome inertia in policy making. Such policy rules, however, may need to be supplemented by judgment and should only serve as a starting point in decision making, which generally requires taking into account a broader range of information.

V. Financial Sector Safety Nets and Crisis Management

A. Emergency Liquidity Assistance

43. Emergency Liquidity Assistance (ELA) was introduced in 2010 for solvent banks and insolvent but systemically important ones. The new Central Bank Law (CBL) and a regulation on ELA enable the CBK to provide liquidity assistance for solvent but illiquid banks up to 100 percent of Tier 1 capital. The CBL also grants the CBK power to provide emergency liquidity to banks that may be insolvent, if their failure may have adverse implications for financial stability. Initially, ELA can be granted for up to 28 days. Any extension beyond three months requires a program to be approved by the CBK’s executive board specifying remedial actions to be taken by the bank.

44. Staff does not support the use of ELA for insolvent banks, even in the case of systemic importance. If this feature is maintained, this type of ELA should be subject to very strict conditions. These should include at least a previous declaration of systemic crisis and a guarantee issued by the Government in writing securing the repayment of the loan.

45. Resources available for ELA operations amount to approximately €90 million. This is equivalent to about 5 percent of bank deposits subject to reserve requirement, or 2 percent of GDP and would seem adequate to contain liquidity problems in one or two small banks.18

46. Since banks are the beneficiaries of ELA, it is appropriate for them to bear at least part of the costs. ELA serves, in effect, as a collective insurance for the industry, so that each bank does not have to fully self-insure. Currently this insurance is provided free, distorting behavior in favor of greater maturity mismatching. Introducing a premium, based on each bank’s deposit base subject to reserve requirements, could both help maintain the current size of the fund relative to deposits and improve incentives for bank funding strategies.

47. An ELA premium, equivalent to 0.3 percent annually of bank deposits subject to reserve requirements would ensure that ELA funds would remain relevant. A premium of this size applied to the current deposit base subject to reserves, would amount to around €5.3 million and would be consistent with growth of the deposit base by about 6 percent per year. If growth of the deposit base differed significantly from this, it would be appropriate to recalibrate the premium. ELA premiums would be pooled in the SRF.19

48. If a significant increase in ELA funding is judged appropriate, a reserve pooling arrangement could be considered. Reserve pooling has been adopted by Ecuador, and is being considered in Panama and El Salvador and typically involves allocating a portion of each bank’s required reserves to a pool administered by the central bank, and which could be made available for ELA purposes to other banks.

49. Collateral requirements for ELA appear too restrictive. Acceptable collateral for ELA include government of Kosovo securities, securities of EU countries and of banks registered in the EU, as well as liquidity reserves at CBK. These collateral requirements may impair the scope for the CBK to respond in the event of a systemic crisis, and consideration should be given to also include certain types of loan portfolio, subject to appropriate haircuts.

50. No operational procedures have been established for ELA yet. In case of sudden surge in deposit withdraws, banks might need immediate access to ELA, which should be fully operational. To do so, detailed operational procedures are required, such as draft contracts, designation of tasks and responsibilities, as well as a solvency analysis. CBK should develop a remedial program when ELA is initially granted—and not just upon ELA renewal. This should be paired with enhanced monitoring by the Supervision Department.

B. Resolution of Problem Banks

51. The CBK is the resolution authority and the recently approved Banking Law provided it with new resolution tools, which include:

  • The appointment of an official administrator, following specific triggers, who takes over the powers of the bank’s shareholders and management.

  • The official administrator must prepare a resolution plan within 60 days of appointment. The official administrator can propose that assets and/or liabilities be transferred to another bank under a Purchase and Assumption (P&A) transaction before the bank license is revoked; or liquidation can be initiated. If the bank is not rehabilitated within one year, the bank’s license will be revoked (Article 61). CBK can also revoke a license directly and transfer assets and/or liabilities by initiating receivership. The liquidator is appointed by the CBK. Payment of insured deposits takes place after the bank license is revoked and receivership is initiated.

  • The possibility of creating a bridge bank.

52. The Government should amend the banking law to address shortcomings in the bank resolution framework. The legal definition of P&A should include the transfer of liabilities and assets (articles 68.4 and 73.22 of the Banking Law). To minimize litigation risk, P&A should only be performed after the license is revoked. To reduce resolution costs the option of creating a bridge bank should be limited to systemic banks. A clearly formulated least-cost test should be introduced to guide the choice among resolution options, including between liquidation and P&A. CBK should be tasked with performing this test. CBK should also formalize existing policies and procedures in a bank intervention and resolution manual.

53. CBK decisions can be challenged in court, but cannot be overturned. Decisions by CBK or its agents cannot be overturned in court but can warrant compensation in case actions are found to be unlawfully, arbitrary or capricious. This is a good feature since it ensures prompt resolution of problem banks. However, there are consequences for the protection of CBK staff that are discussed in paragraph 39.

C. Deposit Insurance

54. The DIFK was created by Law in 2010 and became operational in 2011. Several amendments to the Deposit Insurance Law (DIL) are currently before Parliament (expected to be passed by end-2012) to improve and clarify the DIL structure and operations.

55. DIFK is an independent agency with legislated objectives to protect small depositors and contribute to financial stability. It is governed by a Management Board appointed by CBK and comprises of (i) the CBK Governor; (ii) one representative from the Ministry of Economy and Finance; (iii) the DIFK Managing Director; (iv) a deposit insurance expert; and (v) an expert certified auditor. The Law is silent on the term of the Managing Director.

56. DIFK is an ex-ante scheme with initial funding provided by the government (which, in part, from a World Bank loan), and the German donor agency KfW. The current fund size is a little over €13 million (including initial disbursements and bank premiums already collected). This represents approximately 4.6 percent of insured deposits in the banking sector. DIL should clarify whether the initial contribution from the Government and KfW and funds raised through bonds can be used for insured deposit payouts since the current drafting is unclear on this matter.

57. As a narrow mandate (“paybox”) scheme, DIFK is responsible for collecting periodic premiums from banks, accumulating and investing these premiums, and reimbursing insured depositors in the event of a bank failure. DIFK has no supervisory or resolution powers; although it is permitted to (and does) assess risk-based premiums, which, in conjunction with CBK’s supervisory regime, helps mitigate moral hazard. Amendments to Article 12.1 require DIFK to begin repayment of insured depositors “…as soon as possible…but not later than 30 days of the insured event” (reduced from 60). Given Kosovo’s special bank insolvency regime, and assuming advance preparation by both DIFK and CBK, repayment could easily start within three to seven days.20 Although the law permits DIFK to borrow in the market (but not from member institutions), with Government guarantee, and to issue bonds, there is no formalized emergency back-up funding arrangement in place. The Government should put in place a “fast track” limited line of credit in case of need to reimburse insured depositors when the reserve fund is depleted. Replenishment of the fund should be made through premiums paid by the banks, using the emergency premium power to the extent permitted.

58. Staff calculations indicate that the current target reserve level of 5 percent of total insured deposits should be raised to a range of 8–9 percent. Typical rules of thumb suggest that for a banking sector comprising 20 to 40 banks, the reserve fund should be adequate to cover 4 to 6 small, or 2 to 3 medium-sized bank failures. However, this benchmark is inadequate for Kosovo, given its relatively small banking sector and composition. Therefore, in this case it is recommended a fund size that could compensate insured depositors in the event of two small or one medium-sized bank failures.

59. Deposit coverage should grow in line with the growth of the DIFK. A basic tenet of deposit insurance is that the level should cover fully a great number of depositors, but a relatively low amount of deposits by value The DIFK estimates that the €2,000 level fully covers approximately 90 percent of depositors and around 14 percent of the total value of insured deposits in the banking sector; therefore meeting this best practice. Accompanying the DIL amendments is a proposal to increase the deposit insurance coverage level from €2,000 to €5,000. Given that the current target is considered too low and there is no legitimate back-up funding arrangement in place, it would not be appropriate to introduce such expansion of coverage now. DIFK staff estimates that the proposed €5,000 level would fully cover approximately 93 percent of depositors, i.e., coverage of depositors would increase by only 3 percent; but it would increase DIFK’s exposure by about 80 percent (from approximately €300 million to around €529 million). A higher fund size could support higher coverage and help to gradually close the gap with deposit insurance coverage in the euro area.21

60. Banks’ premium should not be reduced or discontinued even if the fund’s current target size has been reached, except in cases in which a bank becomes less risky, justifying an adjustment to its risk-based premium. The amendments that are currently before Parliament are silent on the issue of whether banks should stop contributing to the fund once the target is reached, while the current law gives power to the DIFK to do so. The core principles for deposit insurance establishes that the cost of bank failures be borne by the banking industry. This requires a deposit insurance fund to be funded primarily with bank contributions while at present most contributions to DIFK have been made by the government. At some point in the future, when the target reserve fund achieves a significant buffer above its exposure, DIFK should consider repaying government contributions.

D. Institutional Framework and Coordination Arrangements for Systemic Risk Monitoring and Crisis Management

61. Albeit incipient, the existing coordination mechanism between the CBK, MoF, and DIFK provides the foundation for a comprehensive crisis management framework. A tri-party MoU on financial stability cooperation was signed at end-2011 between the CBK, the MoF and the Assembly Committee on Budget and Finance (ACBF). The MoU determines the role of each authority, as well as basis for cooperation to protect financial stability. The MoU also established the Financial Stability and Crisis Management Committee (FSCMC), which is a consultative forum on financial stability issues with no decision power. Coordination between the CBK and the DIFK primarily occurs through the Governor of the CBK, within his capacity as a Board Member at the DIFK. The CBK and the DIFK recently signed a MoU for information sharing. The Government should consider creating a Crisis Management Executive Committee (CMEC) comprising the MoF, the CBK and the DIFK with decision making power regarding the declaration of a potential systemic crisis upon proposal by the CBK

62. Kosovo has not developed a process for contingency planning. A contingency plan ensures that all practical arrangements for actions that need to be undertaken in case of crisis are in place, so that the authorities can respond promptly. The contingency plan should be tested through simulation exercises. Large banks should also be required to prepare their own contingency plans for meeting periods of prolonged stress.

E. Legal Framework for Crisis Management

63. The existing framework—consisting of ELA and provisions for creating bridge banks—should be completed with other legal arrangements to address potential crises. A robust crisis framework should also include extraordinary funding arrangements for the DIFK (¶68) and an option for the CBK to avail of government guarantees to extend ELA to systemic banks that may be insolvent (¶55). Moreover, the possibility of setting up a bridge bank should be limited to cases in which a systemically important bank is involved

64. A comprehensive framework should also name the authority responsible for the identification of systemic scenarios, provide the legal basis for the enhanced legal tools, and identify the potential source of funding. More specifically, this framework should grant power to: (i) the CMEC to declare a potential systemic crisis upon proposal of the CBK; (ii) the DIFK to increase deposit coverage; and (iii) the Government to issue guarantees as a condition to extend ELA to systemic banks that may be insolvent as well as in these cases to lift the limit of 100 percent of Tier 1 capital. To minimize the cost of a crisis, it is crucial that the authorities have the power to undertake these actions without getting upfront Parliamentary approval or, if approval is required, this should be obtained in a single extraordinary session of Parliament to take place the same day of the crisis declaration. Whether the proposed legal provisions should be included in one law or be introduced by amending a number of laws is a matter of legal drafting. Various countries have followed different routes and such decisions really rest on the legal drafting tradition of each country.

VI. Financial Sector Development

65. Access to financial services is mixed. With 60 percent of all households (and 52 percent of all low-income households) having access to a bank account, the country compares well with—even above—some other countries in the region. Use of electronic payment services is limited due to high informality. ATM and branch penetration is low by regional standards. Lending activity is limited, except to salaried individuals and established businesses. Loans of less than €10,000 to small businesses account for under 7 percent of the total loan portfolio while loans for up to €30,000 account for about 14 percent. Loans for the for agricultural activities account for only 2.4 percent of total loans provided by commercial banks.

66. The interest rate spreads and margins are high when compared with the region. The average weighted differential between deposit and lending rates in Kosovo have exceeded 1000 points since 2008. In 2011, the differential was 1060 basis points, falling to 1016 in 2012. The spread is high when compared with the region, where the average is less than 400 basis points. The net interest margin to loans ratio has remained robustly above 8 percent since 2009.

67. Profitability and pricing resilience suggest that more competition is needed, but the new banking law reduces potential for banks and MFIs to compete. The law effectively reduces the overlap and contestability between the lower reach of banks and the top end of the client base of MFIs. The legislative thresholds limiting MFIs to clients whose income is less than the taxable threshold, and the limit on the total annual debt servicing cost, means that most—if not all—MFIs are now in violation of the law.

68. Regulatory uncertainty and the complexity of CBK regulatory framework constrain the MFI sector growth and development. While it is generally understood in the sector that MFIs can operate as an NGO or as a Joint Stock Company (JSC), gaps remain for the interpretation and effective application of the Law and there is concern that MFI NGO may need to convert to MFI JSC to continue operating. MFI regulation does not seem to reflect the business reality of most MFIs. The greater part of the sector has neither the scale nor the sophistication to implement these regulations. Moreover, given that these institutions are not deposit takers, the need for such a tight regulation is not clear. CBK should create a Financial Inclusion Task Team, comprising of Ministry of Trade, Finance and Justice and businesses associations, to address obstacles to MFI growth discussed in this report.

Appendix I. Kosovo: Risk Assessment Matrix

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Appendix II. Kosovo: Stress Test Matrices

Stress Test Matrix for Solvency

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Stress Test Matrix For Liquidity Risk

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Appendix III. Kosovo: Follow up of Recommendations on Payment System Oversight

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