Bosnia and Herzegovina
Financial System Stability Assessment

This paper discusses key findings of the Financial System Stability Assessment on Bosnia and Herzegovina (BiH). Economic and financial activity in BiH remains stuck in a low gear since the global financial crisis, reflecting weak external demand, tighter funding conditions, and deep-seated structural issues. Aggregate solvency and liquidity indicators appear broadly sound, but significant pockets of vulnerability exist. The banking system is more than 80 percent foreign-owned banks. The average regulatory capital adequacy ratio exceeded 16 percent as of end 2014. Decisive and timely actions to deal with weak banks are critical for preserving financial stability.

Abstract

This paper discusses key findings of the Financial System Stability Assessment on Bosnia and Herzegovina (BiH). Economic and financial activity in BiH remains stuck in a low gear since the global financial crisis, reflecting weak external demand, tighter funding conditions, and deep-seated structural issues. Aggregate solvency and liquidity indicators appear broadly sound, but significant pockets of vulnerability exist. The banking system is more than 80 percent foreign-owned banks. The average regulatory capital adequacy ratio exceeded 16 percent as of end 2014. Decisive and timely actions to deal with weak banks are critical for preserving financial stability.

Macrofinancial Setting and the Financial System Structure

A. The Crisis Response and Recent Experience

1. The banking sector weathered the global financial crisis relatively well. Fueled by a benign global environment and ample lending supported by foreign banks, bank credit to the private sector in Bosnia and Herzegovina (BiH) grew at an average annual rate of around 25 percent over 2003-07, taking the credit-to-GDP ratio from around 35 percent to 45 percent. Although it was the smallest expansion in the region, and banks relied on traditional lending activities rather than investment in riskier assets, the associated vulnerabilities became clear during the 2009 crisis when capital inflows came to a halt.

2. The authorities’ response to the crisis shored-up depositors’ confidence and helped to safeguard financial stability and sustain the currency board arrangement (CBA).1 The Central Bank of Bosnia and Herzegovina (CBBH) swiftly responded to the crisis by lowering banks’ reserve requirements in several steps. The negotiation of the 2009 SBA with the IMF, participation in the European Bank Coordination Initiative (EBCI) or “Vienna Initiative,” and an increase of deposit insurance coverage to KM 50,000 (€25,000) helped to preserve market and depositor confidence. Moreover, a formalized coordination framework across the agencies through the Standing Committee for Financial Stability (SCFS) was established.2

3. Nonetheless, the economy and financial system are still dealing with the aftershocks of the global financial crisis and underlying vulnerabilities. The past strong economic growth relied increasingly on robust domestic demand and ample capital inflows, delivering GDP growth rates of around 5 percent on average over 2001–08. However, growth has since remained sluggish as foreign demand has been weak and domestic demand is being held back by stagnant wages, high unemployment, tight macroeconomic conditions, and slow credit growth. In the absence of foreign capital inflows, banks have had to become more reliant on domestic deposit funding, and the legacy of lax underwriting standards has been high NPLs and weakened profitability.

Figure 1.
Figure 1.

Bosnia and Herzegovina Economic Developments

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

4. Recent data suggests that the economy still is struggling. Reflecting the effects of severe flooding in May 2014, real GDP growth is estimated to have slowed to 1 percent in 2014, consumer prices fell by 0.9 percent in 2014, and the unemployment rate remains at above 27 percent. Credit to the private sector continues to grow slowly (averaging around 3 percent since 2010), although credit expansion is more rapid among some banks that are attempting to gain market share.

5. Although corporate and household debt levels seem manageable, there are signs of credit constraints. Corporates largely rely on bank credit for financing, although intercompany debt has been growing recently. At end-2013, corporate sector debt stood at around 69 percent of GDP, in line with peers. Household debt has remained steady at around 30 percent of disposable income, but there are signs of increased reliance on short-term debt in the form of credit card or general consumption loans, suggesting stretched incomes and increasing debt service liabilities.

Figure 2.
Figure 2.

Corporate Sector Debt

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Sources: European Central Bank; National Bank of the Republic of Macedonia; National Bank of Serbia; APIF; AFIP; and CBBH.

B. Financial Sector Structure

6. The financial system is fragmented. BiH is divided into two semi-autonomous political entities—the Federation of Bosnia and Herzegovina (FBiH) and the Republika Srpska (RS). Both entities have their own parliament, government, judicial system and stock exchange. Similarly, regulatory and supervisory responsibilities for banking, insurance, and capital markets lie at the entity level by Constitution.3 Banks and insurance companies registered in each entity often have branches in the other. In addition, there is a central (“state”) level administration but with few enumerated powers. In this context, the CBBH and Deposit Insurance Authority (DIA) reside at the state level.

7. The financial system is dominated by a moderately concentrated banking sector. The banking sector accounts for 87 percent of financial system assets, equivalent to 84 percent of GDP as of end-2013. There are twenty seven banks operating in the country (17 in FBiH and 10 in RS, with a share of 70 and 30 percent, respectively, of the country’s banking system). The five largest banks represent over half of banking sector assets. The banking system comprises mostly foreign subsidiaries—82 percent of the banking sector assets, while domestically-owned and public banks account for 16 and 2 percent respectively.

8. The non-banking financial system is small (Figure 3). Insurance penetration is low at about 2 percent of GDP. The nonlife segment collects over 80 percent of insurance premiums. There is one stock exchange in each entity, but capital markets remain underdeveloped despite advanced infrastructure. The real-time gross settlement (RTGS) system settles high-value credit funds transfers and net balances submitted by the GIRO clearing system (GCS) and card switching network.

Figure 3.
Figure 3.

Financial System Structure and Linkages

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

1/ The size of the IRBRS reflects the total assets of the development bank in RS (IRBRS) consolidated with the 6 development funds under its management.Note: The size of each node reflects the total assets of each institution. Linkages (edges) are bilateral claims and liabilities. Top 20 largest linkages are represented by red edges. Blue solid spheres B1–B17 and B18-27 denote commercial banks in FBiH and RS. The two purple solid squares denote the two development banks in FBiH (RBF) and RS (IRBRS), respectively. The green solid diamond represents insurance companies (IC). The aqua, yellow, and orange solid triangles represent leasing companies (LC), investment funds (IF), and microcredit organizations (MC), respectively, and the lime solid square denotes the other financial institutions (OF).

9. Interconnectedness among banks is limited, but linkages between banks and the insurance sector, as well as the RS development bank (IRBRS), are significant (Figure 3). Insurance companies’ deposits in the banking sector amount to about 40 percent of the insurers’ total assets. The IRBRS plays a major role in the RS banking system through credit lines, deposits, and capital (see paragraph 14).4 Two conglomerates are owners of a few financial institutions.

10. As elsewhere in the region, the largest foreign banks operating in BiH are from Austria and Italy. Foreign banks owned by these two countries constitute almost 60 percent of total banking sector assets in BiH (Appendix Table 6). In terms of direct exposure, BiH banking sector is mostly exposed to Austria and Germany, accounting for nearly 50 percent of banks’ total foreign claims and comprising ⅓ of banking sector regulatory capital, through correspondent accounts.

Financial System Resilience

A. Moderately Concentrated Banking Sector with Pockets of Vulnerability

Snapshot

11. The global financial crisis weakened asset quality and profitability of the banking system. The system-wide NPLs ratio rose from 3 percent in 2006 to 14 percent at end-2014 (9 percentage points are provisioned) and banking sector profitability has also deteriorated, reflecting not only the impact the crisis had on the region but also past lax lending practices. Poor corporate resolution and insolvency frameworks mean that asset quality is becoming an important obstacle for re-establishing bank profitability. Although the average regulatory capital adequacy ratio exceeded 16 percent as of end 2014, the dispersion among banks is wide, ranging from about 7 percent to 48 percent. The recent natural disaster prompted regulatory forbearance for loan classification, but so far has had a mild impact on asset quality.

Figure 4.
Figure 4.

Key Financial Soundness Indicators: Cross-Country Comparisons

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Sources: IMF Financial Soundness Indicators Database and National Bank of Serbia.1/ 2014 data not available.2/ The red bar represents data for 2014Q1.3/ Provisions for credit impairment and other losses are also included in the non-interest expenses.4/ 2006 data not available.

12. Liquidity in the system is high, although also with significant dispersion. Liquid assets stood at 26¾ percent and 46 percent of total assets and short term liabilities, respectively, as of 2014Q4. This is partly reflecting the importance that banks place on liquidity buffers under the CBA. Despite high required reserves (RR), the excess reserves were 150 percent of requirements.5 The funding profile of commercial banks has improved, although the loan-to-deposit ratio stands still at a relatively high 120 percent, underscoring a continued dependence on parent funding. The relatively higher level of liquidity in FBiH compared to RS is partly explained by different interpretation and enforcement of the regulation on maturity mismatch (Figure 5).

Figure 5.
Figure 5.

Liquidity Developments

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Sources: CBHH, FBA, and BARS.Notes: Dom: Domestically-owned banks; For: Foreign banks.

13. While sector-wide indicators appear broadly sound, there are pockets of vulnerabilities among domestically-owned banks. This segment has lower and declining liquidity and capital ratios as well as large concentrations (Figure 6 and stress testing section). In addition, asset quality and profitability of domestically-owned banks are lower than that of foreign banks. The detailed asset quality reviews (AQRs) of the three domestically-owned banks under enhanced supervision that were available to the FSAP team have revealed capital shortages, of which only two had been corrected so far.

Figure 6.
Figure 6.

Key Financial Soundness Indicators: Domestic and Foreign Owned-Banks

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Sources: Banking Agency of FBiH, and Banking Agency of RS, and IMF staff calculations. Foreign-owned banks includes Hypo.1/ The classification of domestic and foreign-owned banks is listed in Appendix Table 6.2/ Net income as percent of average equity capital.

14. A number of domestically-owned banks rely heavily on public sector support and exit plans are undefined. In the RS, the IRBRS holds a sizeable amount of shares and subordinated debt in some domestically-owned banks that otherwise would be undercapitalized. It also has credit lines for on-lending to some banks and deposit placements in four domestically-owned banks. In the FBiH, some public sector entities have stakes in some domestically-owned banks.

Dealing with Weak Banks

15. Strong and timely action is needed to deal with weak banks. A number of banks do not meet the prudential capital requirements and others only do so as a result of public capital support. Since this capital support has been provided in the form of subordinated debt and preferred shares, existing equityholders have not been diluted. This contributes to moral hazard, lacks transparency, and is not conducive to a level playing field. Moreover, most of the weak banks still face significantly higher funding costs and suffer from legacy of loans to sub-par borrowers and related parties. Unless owners are willing to provide significant capital support, phase-out related party loans, and address asset quality issues, these banks will need to be restructured and/or resolved.6

16. The development and full implementation of a comprehensive bank restructuring strategy, including effective communications, is critical to preserve financial stability. Without immediate and decisive actions banks’ financial positions will continue to deteriorate, leading to an increase of potential resolution costs. Therefore, the team recommended that the authorities develop, as a matter of high priority, a thorough plan to either facilitate the recovery of these banks (if practicable) or implement a cost-effective resolution consistent with maintaining the stability of the financial system and protection of insured depositors. This will require additional time-bound AQRs of domestically-owned banks and a strategy to address potential implications. The strategy should explore all options for early action and ensure the technical readiness of the DIA to pay-out depositors promptly. A credible and transparent public backstop may be needed to deal with systemic cases.

Stress Tests and Tail Risks

17. The stress tests focused on the banking system and covered all 27 banks. Top-down solvency stress tests were conducted jointly by the FSAP team and CBBH, using supervisory data.7 These stress tests were complemented by bottom-up stress tests by individual banks—using internal models with macroeconomic scenarios provided by the FSAP team—and coordinated by both banking agencies. In addition, liquidity stress tests and contagion risk analysis, together with complementary sensitivity analysis such as concentration risks, were also carried out.

18. Three macroeconomic scenarios were considered. In addition to a baseline scenario, based on the latest WEO staff projections, two alternative scenarios were designed. Full-fledged five-year macroeconomic projections were quantified (Figure 7 and Appendix Table 8).8

Figure 7.
Figure 7.

Evolution of the Level of Real GDP in the Stress Test Scenarios

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Source: IMF staff calculations.

19. Potential credit risk losses on the loan book represent the most important risk factor (Figure 8). Aggregate stress losses—mainly related to increased loan provisions—although non-negligible, remain broadly manageable.9 However, given the relatively low asset quality and concerns regarding reported capital ratios of domestically-owned banks, the large impact of potential credit losses on these banks confirms the importance of urgent action as described in paragraphs 15 and 16. Top-down stress tests found that loan losses due to credit risk ranged from 1.9 percent of GDP in the first adverse scenario to 7 percent of GDP in the most severe scenario (Appendix Table 9).10 Top-down and bottom-up stress test results are broadly consistent, with difference reflecting mainly the significantly larger provisions for impaired loans in the top-down results and the relatively modest response to macroeconomic conditions in the bottom-up results (Figures 8 and 9).

Figure 8.
Figure 8.

Top-Down and Bottom-Up Estimated Potential Losses for the Banking System

(In billions of KM)

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Sources: Individual banks (bottom-up stress tests), IMF, and CBBH staff calculations (top-down stress tests).
Figure 9.
Figure 9.

Top-Down and Bottom-Up Estimated Capital Adequacy Ratios

(In percent of risk-weighted assets)

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Sources: Individual banks (bottom-up stress tests); IMF and CBBH staff calculations (top-down stress tests).

20. Concentration risks are high in a specific segment of the banking sector. Although the average large exposures remain moderate, a few domestically-owned banks present very large single (and common) name exposures mainly to large state-owned enterprises, confirming the relative severe weaknesses of this segment. Overall, sensitivity analysis shows that potential losses remain broadly manageable at the system level, but up to 11 banks could become insolvent if a few of their largest exposures were to default (Appendix Table 10).

21. Direct exchange rate risk and other sources of market risks appear to be contained. Nearly two-thirds of loans are in, or indexed to a foreign currency, mostly euros, and parent bank funding and relatively large remittance inflows have also contributed to the euroization of deposits.11 However, all banks comply with regulatory limits and exhibit fairly small net open foreign-exchange (FX) positions. In fact, the net open FX positions for the different currencies do not necessarily move in the same direction, providing a natural hedge against currency risk.12 Moreover, given the limited amount of securities on the banks’ investment and trading portfolios, other sources of market risk appear to be contained.

22. However, indirect risks warrant closer monitoring in view of a large number of “unhedged borrowers.” Most banks do not collect information on the denomination of their borrowers’ income or assets. Owing to lack of data, potential losses related to indirect foreign-exchange risk (through credit risk) could not be appropriately quantified. Given the large issuance of FX-linked loans, the team recommends that banks and the supervisors close data gaps in this area and respond as appropriate.

23. With a few exceptions, bank liquidity positions appear to be sound. Liquidity stress tests, based on Basel III Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) type proxies, show that the system as a whole has ample liquidity, with the system-wide LCR exceeding 250 percent (Figure 10). Most banks exhibit sizeable amount of deposits at the CBBH. However, there are a few banks, mainly domestic-owned, that present relatively low liquidity ratios (Appendix Table 11). Overall, the potential liquidity shortfall could be around ¼ percent of GDP. If required reserves were excluded altogether from the banks’ HQLA in the computation of the LCR, the potential system-wide liquidity shortfall would increase to just over 1 percent of GDP.

Figure 10.
Figure 10.

Liquidity Stress Tests Results

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Source: Authorities supervisory data and IMF Staff Calculations.

24. Contagion risks through the domestic interbank market are small. Domestic interbank exposures among banks are less than 1 percent of total regulatory capital.13 While some banks have engaged in overnight over-the-counter transactions of deposits, FX, and cash, system-wide exposures appear to be relatively small.

25. Banks still exhibit notable cross-border exposures.14 Several foreign-owned banks benefit from credit lines from their parent banks, and most banks in BiH hold large amount of deposits in their correspondent accounts abroad, mainly with large global financial institutions. In addition, a few banks, mainly domestically-owned, seem to exhibit a “round-tripping” of cross-border exposures, where both claims and liabilities to a particular counterparty are roughly of the same amount. Furthermore, network analysis,15 using bilateral exposures of BiH’s banks, suggests that the effects (both direct and indirect) on capital adequacy of potential credit and funding shocks from abroad (through deposits in foreign correspondent accounts and parent funding) could be sizeable (Figure 11).

Figure 11.
Figure 11.

Cross-Border Spillovers to BiH’s Banks: Credit and Funding Shocks

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Sources: FBA, BARS, CBBH, BIS Locational Statistics Database, IMF Financial Soundness Indicators Database, and IMF staff calculations.1/ An undercapitalized bank is defined as the CAR falling below the minimum requirement.Note: Two banks are excluded from the exercise because their pre-shock CARs are already below the minimum requirement.

B. Insurance Sector Becoming Increasingly Competitive

26. Although the sector has high sector-wide solvency ratios, a number of insurance companies have thin solvency margins (Appendix Table 4). The system is dominated by non-life companies, since life insurance is still in its embryonic stage, and its solvency ratios may also be overstated owing to the use of Solvency I, which is not risk-sensitive. In addition, for some non-life insurance companies, their combined ratios (claims plus expenses over premiums) exceed 100 percent, which suggests that their profits are dependent on the performance of their investment portfolios.

27. Insurance sector liquidity is appropriately managed, but there are significant exposures to the banking system. Over 40 percent of insurance sector assets are in bank deposits (Table 2). A network analysis suggests that in the severe adverse scenario of the stress tests, the insurance sector would lose about 14 percent of its capital.

Table 2.

Bosnia and Herzegovina: Insurance Sector, Size and Investments 2009–2013

(In KM million)

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Source: FBiH and RS agencies.

C. Payment System Risks

28. Resiliency of the interbank payment system was demonstrated during the recent floods. Contingency arrangements were earlier strengthened with the development of a disaster recovery site located at a distant location from the primary site to ensure the resumption of critical operations in the event of a wide scale disruption.

29. The CBA has helped protect the payment system from credit risks, but liquidity risks remain. There are no credit risks due to pre-funding requirements in the RTGS. Prohibiting the CBBH from extending intraday credit and strict rules on the use and replenishment of RR has established strong discipline within the banking system. Vulnerabilities from liquidity risks arise with the high concentration of payment transaction values (55 percent) across five banks, including two settlement banks.

Resolution of Non-Performing Loans: the Legacy Problem

30. The share of NPLs has increased over recent years and weaknesses in the legal framework have impeded the resolution of NPLs. These have limited the ability of banks to transfer NPLs to other entities.16 Steps are needed to address these, while also ensuring that bank supervisors are able to monitor NPLs that are held by AMCs within a banking group, through consolidated group supervision. In addition, relevant regulations should be amended so that NPLs are maintained on a credit register to enable credit providers to identify the status of applicants for credit and to maintain incentives for borrowers to service their loans.

Table 3.

Distribution of Non-Performing Loans

(In percent)

article image
Source: FBiH and RS agencies.

31. Another difficulty impeding the resolution of NPLs is the absence of an alternative to bankruptcy. There is no satisfactory streamlined process by which a company and its creditors can negotiate a restructuring of debt or the company itself to facilitate a least-cost solution to loan impairment. This results in a more piecemeal liquidation of assets than would otherwise be the case, with a consequential loss in recovery on the impaired loans and potentially greater costs to the economy in terms of loss of economic activity and jobs. Therefore, it is important that a framework be established to provide an efficient mechanism, overseen by the courts, for companies and creditors to negotiate a debt restructuring.

32. The insolvency and judicial framework also contributes to the NPL situation. Litigation, execution, and bankruptcy cases take too long to be completed, and additional resources and training in the courts are warranted.

33. Tax impediments to the resolution of NPLs should be also addressed. A review of relevant tax laws should be commissioned to ensure that issues related to debt-restructuring processes, NPLs, and loan loss provisions encourage creditors and debtors to restructure debts and to sell NPLs to third parties. Consideration should also be given to exempting transfers of NPLs (and associated collateral) from VAT, since this could improve the prospects for developing a secondary market for NPLs.

34. The legal framework governing creditor/debtor relationships is comprehensive; however, neither debt resolution nor bankruptcy liquidation work effectively. For instance, non-possessory pledges are not extensively used because banks do not consider such security as secure. Recovery rates of loans secured with pledges are very low. Several legal issues affect loan recovery rates—in particular, the ineffectiveness of execution procedures. Both the valuation of the asset that will be sold at auction and the reserve prices are problematic.

35. There is no insolvency regime for individual debtors. The insolvency law applies only to legal entities and partners in partnerships. Sole traders, craftsmen or entrepreneurs—making up the vast majority of enterprises—cannot benefit from the insolvency framework.

Financial Sector Oversight

A. Governance and Risk Management Pose Challenges for Weak Banks

36. The system of banking supervision oversight has significantly improved since the last review in 2006, but shortcomings remain. Both supervisory authorities have made progress in enhancing the regulatory framework and supervisory processes.17 The banking agencies are preparing a new Law on Banks that should address a number of deficiencies in supervisory powers, recovery and resolution, and consolidated supervision. These reforms will likely impact the respective laws of the banking agencies, such as by adding more supervisory powers. The regulatory framework has been broadened by the issuance of regulations on corporate governance, credit risk management and capital. Harmonization in regulation between the entities has been largely achieved and joint planning continues.

37. Coordination among the various institutions involved in banking oversight is complex, having potential repercussions in times of financial sector stress. In addition, the key players tend to exchange information guided by specific arrangements and laws, but crucial information on the risk profile of banks is not always shared with relevant stakeholders. This could become problematic in a crisis. The development of an integral banking crisis contingency plan by the SCFS, and individual contingency plans by member agencies, is encouraging (see paragraph 63).

38. The banking agencies have signed MOUs with a number of home country supervisors. However, there are no MOUs with the home supervisors responsible for a number of systematically important banks (Austria, Italy and Russia).18 Also, the existing MOUs do not cover arrangements for cross-border cooperation in times of stress.

39. Supervisory agencies do not have a full picture of several domestically-owned banks. This includes the identification of the ultimate beneficiary owner and its holdings. As a result, related party lending and group exposures are not fully identified. The root cause of this problem lies at the licensing and approval process, which should be more substantive. The review of an application must provide sufficient information not only on direct owners but also parent companies and related parties of the parent companies.

40. Weaknesses in governance and risk management at some banks, coupled with weak supervisory powers, have contributed to the current number of problem banks. Loan concentration levels of some banks exceed regulatory limits. Moral hazard issues are exacerbated by the fact that current owners, who are unable to meet a capital call from the supervisor, are allowed to remain involved in the bank. In response, the banking agencies have recently issued regulations on corporate governance and are in the process of developing bank-wide risk management guidance. In conjunction with strengthened corrective action powers, compliance with the regulations would improve the resiliency of banks and the ability of the agencies to impose early corrective measures.

41. The quality of the financial audits of banks bears improvement. As described earlier, the recent AQRs showed weaknesses that bank audits did not reveal. Currently, most domestic banks have implemented IFRS 2009, but several auditors refer in their audit opinion to the local law instead of IFRS, complicating the comparison between different financial statements and leaving the quality of the external audit open to question. Also, the external auditors are appointed only for a year which may have an adverse effect on the continuity of the auditor and the quality of the audit.

42. Loan loss provisioning is based on International Accounting Standards (IAS) and prudential requirements. The IAS provisioning levels may not be adequate as reflected by the adjustments required by inspectors during onsite reviews. The focus going forward should be on developing supervisory standards to encourage the conservative implementation by banks of factors to be considered in determining incurred losses under IAS and moving away from the current prudential standard.

43. The governance of state-owned banks is a concern. The supervisory boards of state-owned banks provide little strategic direction and do not hold bank management accountable for executing its strategy, for the prudent operation of the bank, or for establishing strong systems and controls. A rigorous oversight of the government’s bank related exposures is warranted by the IRBRS. See the companion development Financial Sector Assessment (FSA) report by the World Bank (WB).

B. Insurance Sector: Further Progress Needed

44. The prudential framework will need to be updated as the market develops. The current framework, which is based on Solvency I, is not risk-sensitive and ill-suited for supervising more complex markets. As more than half of insurance premiums are related to the mandatory Motor Third Party Liability (MTPL) insurance, the framework supporting tariff-compliance needs substantial improvements. Major work is underway to liberalize the MTPL tariffs, with the potential to benefit consumers. However, such step should be preceded by the introduction of early warning systems, stress testing, and a risk-based solvency framework, with a ladder of interventions that could trigger timely prompt corrective action.

45. A few key supervisory powers are missing and the complexity of the institutional setup requires stronger cooperation. The powers to remove members of the supervisory board is missing and the RS-Insurance Supervision Agency (ISA) lacks the power to enforce the voiding of voting rights of qualified shared acquired without its approval. The FBiH-ISA cannot appoint provisional administration without withdrawing license of the insurer. The FBIH-ISA is understaffed and its independence needs to be safeguarded. The staff in both agencies should have stronger legal protection. By merging insurance supervision into the respective banking agencies could yield some efficiency gains and simplify the institutional set-up. Consumer protection and financial literacy are in urgent need of development.

46. Group supervision is lacking and cooperation with banking supervisors is weak. The regulation and supervision of insurance groups needs to be strengthened. In particular, it is important to supervise holding companies, limit intra-group transactions and require fit and proper tests for controlling positions at the holding company. Also, a comprehensive group supervision framework should be implemented. Given the sizeable exposure of insurance sector to the banks, strengthening cooperation between insurance and banking supervisors should be encouraged.

C. Financial Market Infrastructure: Oversight Needs

47. The formal assessment of the real-time gross settlement system (RTGS) suggests that many of the principles are observed, but also points to key areas needing improvement. First, the finality and netting arrangements require greater legal certainty at the statutory level as it cannot be ruled out that a transaction settled in the RTGS can be revoked by a court order in the event of insolvency of a participant. Greater legal certainty could also be achieved by eliminating zero-hour rules in insolvency law. Second, a comprehensive risk-management framework needs to be developed that involves a formal identification of risks, risk mitigation measures, and monitoring. Third, liquidity risk management should be more robust (see paragraph 29). Fourth, operational risk in payment systems is well managed, but a recovery time objective needs to be established to ensure that operations can resume within two hours following a disruptive event. And fifth, efficiency could be enhanced with fee schedule reviews and the setting of minimum service levels.

48. The assessment of authorities’ responsibilities suggests the lack of oversight powers, limited resources and supervisory capacity, and the need to broaden and deepen oversight cooperation with other competent authorities. The CBBH Law mainly establishes its operational responsibilities, but does not give it sufficient powers in the oversight of payment systems. Recommendations for improvements include: (i) clearly establish oversight responsibilities, including powers to designate financial market infrastructures, and to protect finality and netting; (ii) adopt the Principles for Financial Market Infrastructures into the regulatory framework; (iii) establish a new oversight unit within Payment Systems Department, which is staffed with sufficient resources to carry out oversight responsibilities; and (iv) develop a MoU to strengthen the oversight of clearing agents, settlement banks, international payment clearing, and cooperation with relevant authorities.

D. Capital Markets Regulation and Development

49. The legal and regulatory framework for the capital market is sound, but more effective implementation and cooperation is essential. The adoption of the EU directives and protocols has improved the legal framework, but the regulators lack the resources necessary to supervise the large number of listed firms and implement the rules and regulations already in place. BiH could benefit from following a model used within the EU where efforts are made to link-up national exchanges and to harmonize legislation and regulation without member states giving up their stock exchanges or their rights to regulate home markets. In this regard, a so-called “passporting” framework has been implemented that allows for issuers, investors and market intermediaries to operate in each other’s national market, creating a vastly larger common market. The companion development FSA report by the WB provides further details.

E. AML/CFT Issues

50. The MONEYVAL 2009 Mutual Evaluation Report identified strategic deficiencies in the BiH’s AML/CFT framework.19 These are notably with respect to criminalization of money laundering and the implementation of customer due diligence measures. BiH agreed to an action plan to remedy these shortcomings. As significant items of the action plan remained unaddressed, MONEYVAL issued several public statements in 2014, calling upon members to apply enhanced due diligence measures to transactions with persons and financial institutions from or in the BiH. Important progress has since been made, notably with the enactment of a new AML/CFT law and amendments to the Criminal Code, but further delay in addressing the remaining deficiencies may result in additional scrutiny from the FATF, with potentially greater negative repercussions for the BiH. Timely and effective implementation of the action plan is therefore strongly recommended, as well as a national assessment of ML/TF risks and greater coordination and cooperation amongst State and Entity level agencies in charge of AML/CFT.

Macroprudential Framework in its Infancy

51. The macroprudential toolkit is relatively underdeveloped, but is being extended. The main instrument is reserve requirements, which were used actively in response to the pre-crisis credit boom and the subsequent liquidity crunch. However, the CBBH is developing its capacity to monitor systemic risks through the use of top-down stress tests, and is working with the banking agencies, developed a methodology to identify systemic domestic banks. Also, the banking agencies have included elements of Basel III in capital regulation, such as capital conservation buffers and a leverage ratio, and intend to introduce countercyclical capital buffers and capital surcharges on systemic banks. There are also limits for open FX positions. In the insurance sector, macroprudential supervision is limited to market-wide analysis of observed trends affecting the insurance sector.

52. The authorities are encouraged to broaden the macroprudential framework, taking into account the constraints posed by the country’s institutional set-up. This should be underpinned by broader and more focused cooperation among the CBBH, FBA and BARS. The existing MoU among the three institutions could be a good platform to coordinate the work on systemic risk and vulnerabilities, and the calibration of and timing for macroprudential tools. For example, the authorities should examine LTV and DTI levels, household and corporate indebtedness, and debtors’ currency mismatches. The respective institutions should undertake high-level consultations on systemic risks at least quarterly. When the insurance sector develops further, considerations should be made given to introduce a macroprudential supervision framework encompassing the insurance sector.

Key Role of Systemic Liquidity Management Under the Currency Board

53. There are constraints on the ability of both banks and the CBBH to manage liquidity.20 The system lacks a central bank liquidity window, and the secondary market for government securities is also small and illiquid. Despite the existing infrastructure, money market and interbank markets are also relatively small, reflecting both high levels of bank liquidity and the fact that foreign banks’ internal risk management practises aim to minimise exposures vis-à-vis the domestically-owned banks. Given the CBA, the aforementioned limitations call for conservative liquidity management and liquidity buffers for banks.

54. The use of reserve requirements should be better tailored towards prudential purposes. There is scope to amend the system to support systemic liquidity management. First, the CBBH contemplates very harsh penalties for non-complying with RRs. In times of stress, the CBBH could consider increasing the flexibility of RR holdings and introducing daily or period-minimum holding thresholds. This should be combined with higher penalty rates, accompanied by enhanced supervision, before sanctions are applied. Second, for the RR base, the CBBH should consider residual maturities and set a minimum daily requirement. Moreover, some exemptions for non-resident deposits introduced during from the recent global financial crisis should be eliminated. Lastly, the CBBH should consider the adequacy of existing RR levels, since they were significantly lowered during the financial crises.

55. Liquidity regulations should be streamlined and the adoption of the LCR would strengthen liquidity management. For the purpose of maturity calculations of liquidity ratios, it would important to take into account early deposit withdrawal options. The minimum liquidity ratio should be raised above the RR to ensure that it is binding. Upon adoption of the LCR, care would be needed in treating RRs as high quality liquid assets (HQLA), given their uncertain availability to meet liquidity pressures. Also, there could be a need to calibrate the haircut applied to public securities for the purposes of the LCR, given the shallow market, the assumptions for deposits/borrowed funds run-off rates, and the treatment of liabilities maturing after 30 days with a prepayment clause. Given the high level of euroization, currency-specific LCRs should also be considered. The design and calibration of the revised and new liquidity regulations should be also reinforced by a quantitative impact study based on historical data with a special emphasis on stress situations.

Constrained Financial Safety Net

56. A number of key elements in the financial safety arrangements are either not present or not adequately developed. The main areas of deficiency are the lack of a comprehensive remedial action program, the inadequacy of resolution powers, and the inability to provide temporary emergency liquidity support to soundly capitalized and well managed banks.

A. Crisis Preparedness Framework

Correction Action Arrangements

57. The banking agencies have statutory authority to require corrective actions by banks, but enforcement powers are limited. The agencies have developed guidance on the use of corrective powers, including setting out triggers for corrective actions based on breaches of capital, liquidity, and asset quality requirements. However, their authority to impose financial penalties for noncompliance, or to permanently suspend board members and controlling owners is limited, except under provisional administration. Similarly, the authority for replacing or restricting the powers of controlling owners outside of provisional administration is also limited. This leads to regulatory forbearance, which should be avoided unless it is based on sound supervisory judgment and steps to ensure that banks are taking satisfactory remedial measures.21

Deposit Insurance Agency

58. The deposit insurance framework is a relatively well developed paybox scheme. The DIA is funded by member banks with reserves of about KM 285 million (€ 145 million) representing approximately 4½ percent of insured deposits. It is supported by a €50 million standby facility with the EBRD. The DIA has the infrastructure in place required for an effective deposit insurance framework, including MOUs to support coordination with the banking agencies, regular testing of depositor data and procedures for making deposit pay-outs.

59. The formal assessment of the DIA against the IADI standards suggests that the majority of the principles are compliant or largely compliant. The DIA has been constantly improving its legal framework and capacity and developed a sound governance framework and has a well-designed depositor reimbursement system capable of payouts, which includes the regular testing of depositor data.22

60. However, further enhancements of the deposit insurance arrangements would be beneficial. These would include (i) establishing the capacity for making prompt pay-outs to insured depositors, in line with the EU relevant directive; (ii) amending legislation to establish the means for the prompt pay out of depositors and authorize the use of DIA funds to facilitate a purchase and assumption transaction (P&A) under the least cost solution (see resolution section below); and (iii) ensuring that the DIA is involved at an early stage in the problem bank resolution process with bank supervision agencies.

Coordination and Contingency Planning

61. Better coordination is essential. All relevant authorities in the SCFS should ensure that the inter-agency contingency plan includes guidance on the actions required by the relevant SCFS members if a bank is closed, including public communications to minimize contagion. The MoU establishing the SCFS sets out the objectives and principles for bank resolution, responsibilities of the respective authorities and coordination procedures. Broadening the focus of the SCFS to include small banks in circumstances where their distress could have implications for financial stability is recommended.

62. Contingency plans were prepared in 2014 by the relevant agencies and a coordinated contingency plan was developed by the SCFS. While these represent significant progress, the plans need to be revised to incorporate procedures to manage each stage of a crisis, such as systemic impact assessment, diagnostics, assessment and implementation of resolution options, cross-border coordination and communications with relevant stakeholders. Regular crisis simulation testing is also required as part of the contingency planning and capacity-building process.

63. Cross-border cooperation and coordination requires attention. Currently, the banking agencies and other relevant authorities have no specific crisis resolution related arrangements with their respective foreign counterparts. Given the systemic importance of several foreign banks to the BiH financial system, this creates a significant risk of inadequate coordination with the home authorities to achieve a satisfactory whole-of-group resolution that would require the signing of MoUs (see paragraph 38).

B. Crisis Management Framework

Creating a Bank Resolution Framework

64. Building on recent initiatives, further progress is required to strengthen the financial safety net. Although improvements have been made to some of the legal powers for resolution in recent years and the authorities have developed financial crisis contingency plans, significant deficiencies remain in the financial safety net, including in respect of resolution powers, institutional responsibility for resolution, and recovery and resolution planning. As a consequence, the authorities are currently not well placed to implement bank resolution in the form of P&A, bridge bank, or bail-in, in a manner consistent with maintaining financial stability, avoiding public funding and minimizing moral hazard. The high level of NPLs in the banking system and the number of banks in various levels of stress make it imperative that the deficiencies in the financial safety net framework are given high priority.

65. There is a need to establish a resolution authority. At present, FBA and BARS have some resolution powers but are not formally designated as, or equipped, to be resolution authorities. The proposed new banking laws need to establish clear responsibility for bank resolution with appropriate accountability and transparency. Ideally, resolution powers should be vested in the DIA, establishing it as the resolution authority, but this would appear impossible in BiH owing to institutional constraints. Therefore, the team suggested instead to vest resolution powers in FBA and BARS and designate them as the resolution authorities for the banks in their respective jurisdictions. This would enable synergies to be reaped between the supervisor, in its responsibility to exercise early intervention, and the resolution authority, in executing resolution. However, this would require designing governance and accountability arrangements to avoid potential conflicts of interest. And if this option were to be taken forward, it would also be appropriate for the DIA management board to include representatives of the two banking agencies.

66. The scope to draw on the existing deposit insurance fund (DIF) should be broadened for funding bank resolution. Currently, the DIF currently can only pay out insured deposits. The DIF should be allowed to participate in bank resolution subject to it being least cost solution—i.e., up to the amount that would have been expended for insured depositor reimbursement in a liquidation—including P&A transactions. However, DIF resources should not be used to provide open bank assistance.

67. Over time, the safety net could be broadened by establishing a Financial Stability Fund (FSF) under the DIA for open bank assistance. Such assistance in a systemic crisis should be provided only if necessary to preserve financial stability and where there is no new capital forthcoming from private creditors. To protect the taxpayer, the FSF backstop option should be subject to a set of clearly defined criteria. Most importantly, all losses in failed banks should be absorbed up-front by existing shareholders, but also by other creditors according to the hierarchy of claims in liquidation and subject to financial stability considerations. This option should be used under strict conditions that minimize the risk of moral hazard and allow for ex-post recovery from the banking industry.23

Limited and Temporary Emergency Liquidity Assistance in the Context of a Currency Board

68. The CBBH is constrained from performing any Lender of Last Resort (LOLR) functions. Central banks in currency board arrangements usually face limits, but these are especially strict in the BiH: the CBBH Law does not allow the CBBH to grant any credit and engage in money market operations “involving securities of any type.” Moreover, the net excess reserves under the currency board arrangements are usually very limited to provide any meaningful basis for LOLR functions.

69. The FSF described above could also be designed to provide very limited liquidity support to solvent banks in the case of acute liquidity stress. The limited and temporary liquidity support—as an early prompt corrective action tool—should be triggered only after the bank has used all the available liquidity management options, including the interbank market, parent bank funding if available, and its reserve requirements—the framework of which should be amended along the lines recommended in paragraph 54. Moreover, such support should only be available to systemic banks that comply with the supervisory capital requirements, are under sound management, and have sufficient collateral or guarantees to cover credit risks for the liquidity provider.

70. Emergency liquidity support should be accompanied by enhanced monitoring and supervision to minimize moral hazard. The compliance with the terms and conditions of the use of the limited and temporary liquidity support would be monitored by the applicable banking agency, which would take enforcement actions as required. An un-remedied breach of the FSF terms and conditions would be grounds for the relevant banking agency to exercise resolution powers.

71. The FSF could be financed through ex-ante levies on banks and with the capacity for ex-post levies on banks to cover costs and any losses sustained by the fund. The FSF could be also supported by possible financing from an international financial institution (IFI). There could be scope to further support the FSF by switching a portion of potential increases in RR into the FSF. The FSF would be administered by the DIA and separated from the DIF. The FSF should be protected with various safeguards. These would include the objectives of the fund, the purposes for which it may be used, the preconditions for invoking it and the governance arrangements.

Appendix I. Figures and Tables

Appendix Figure 1.
Appendix Figure 1.

Economic Developments

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Sources: Bosnia and Herzegovina Authorities; and IMF staff estimates.
Appendix Figure 2.
Appendix Figure 2.

Banking Sector Developments

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Sources: CBBH, and FBIH and RS Banking Agencies.Note: Prior to 2010, assets classified as loss, alongside the provisions made against them, were held off-balance sheets by banks in BiH. This lowered the reported NPL ratios and coverage of nonperforming loans by provisions. Starting with the December 2010 date in the RS, and the December 2011 date in the Federation, banks recorded on-balance sheet the “loss” loans and related accrued interest and provisions, resulting in a structural break in the series.
Appendix Figure 3.
Appendix Figure 3.

Monetary and Capital Market Developments

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Source: CBBH.
Appendix Figure 4.
Appendix Figure 4.

External Sector Developments

Citation: IMF Staff Country Reports 2015, 164; 10.5089/9781513530611.002.A001

Sources: CBBH and BIS.
Appendix Table 1.

Selected Economic Indicators, 2012-2018

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Sources: BiH authorities; and IMF staff estimates and projections.
Appendix Table 2.

Financial System Structure, 2005-2014

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Sources: Central Bank of Bosnia and Herzegovina (CBBH); Banking Agency of FBiH; Banking Agency of RS; and Agency for Statistics of Bosnia and Herzegovina.

Data of banks are from the supervisory data, and data of non-banking insitutions are from the statistical MFS data.

The foreign-owned banks are subsidiaries of large foreign banks.

One bank’s ownership changed from foreign to domestic in Q3 2014. Another foreign bank (according to CBBH) is classified as a domestic private bank here because the major owners have dual citizenship (BiH and US) and the other shareholders are mostly domestic.

Appendix Table 3.

Financial Soundness Indicators of the Banking System

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Sources: CBBH; Banking Agency of FBiH; and Banking Agency of RS.

Net income as percent of average assets.

Net income as percent of average equity capital.

Appendix Table 4.

Financial Soundness Indicators of the Insurance Sector

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Source: Insurance Agency of BiH.
Appendix Table 5.

Risk Assessment Matrix

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Appendix Table 6.

Banking System Assets, end-March 2014

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Sources: Banking Agency of FBiH; Banking Agency of RS, and staff calculations..

The ownership of this bank changed in Q3 2014 from a mostly foreign bank to a mostly domestic private bank.

This bank is classified as a mostly domestic private bank because the majority owners of this bank have dual citizenship (BiH and the U.S.) and the other shareholders are mostly domestic.

Appendix Table 7.

Stress Test Matrix (STeM) for the Banking Sector: Solvency, Liquidity, and Contagion Risks

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Appendix Table 8.

Macroeconomic Projections in the Stress Test Scenarios

In percent, unless otherwise indicated)

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Source: Authorities historical data and IMF staff calculations.1/ These scenarios are based on projections made in July 2014. Therefore, these numbers (in particular the projections for 2014) need to be interpreted in that context. In addition, the latest baseline projections from the IMF’s Area Department team might differ slightly from those presented here. All numbers are period averages.Note: The moderate adverse scenario illustrates an external shock driven mainly by a further weakening in the economic outlook of euro area countries, combined with a further deterioration of the current geopolitical crisis in Ukraine. The severe adverse scenario shows the external risks in the moderate scenario accompanied by a severe reduction in external funding for banks, compound with a further deterioration in the health of commercial banks and loss of confidence.