Abstract
EXECUTIVE SUMMARY Economic and financial activity in Bosnia and Herzegovina (BiH) remains stuck in a low gear since the global financial crisis, reflecting weak external demand, tighter funding conditions, and deep seated structural issues. A high system-wide NPL ratio—14 percent at end-2014, about two thirds of which are provisioned—reflects the impact of the crisis, low growth since then, and a history of lax lending policies. Bank governance problems, related-party loans and inadequate corporate resolution and insolvency frameworks are obstacles to addressing asset quality problems and re-establishing bank profitability. Institutional fragmentation is delaying much-needed financial sector reforms. 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. However, the dispersion among banks is wide, ranging from about 7 percent to 48 percent. Vulnerabilities are concentrated within domestically-owned banks, some of which are struggling to meet capital requirements, while some others are relying on public support. Stress tests indicate that these banks have large concentration risks and low liquidity ratios. While the insurance sector is small, a number of companies have thin solvency margins. FSAP team access to supervisory data—at the individual bank level, aggregated along group of banks, and system wide level—was exceptionally good. Decisive and timely actions to deal with weak banks are critical for preserving financial stability. A comprehensive strategy—backed by a credible diagnostic assessment—is needed soon to either facilitate the recovery of these banks (if practicable) or to resolve them in a cost-effective manner that is also consistent with maintaining the stability of the financial system and protecting insured depositors. The timetable for these steps should be spelled out clearly and effectively communicated, and consideration should also be given to a credible and transparent public backstop to deal with potentially systemic cases. Banking and insurance oversight improved since the 2006 FSAP, but a number of important shortcomings remain that have contributed to the vulnerabilities of the financial sector. Cooperation among the various oversight institutions is complex, having potential repercussions in times of stress. Lack of adequate governance and risk management has contributed to the current number of problem banks. The administrative powers of the agencies to sanction and fine supervisory board members and significant owners are inadequate. Moreover, the identification of ultimate beneficial owners of banks is problematic and related-party lending and group exposures are obscure. There is a need to further strengthen the supervisory board selection process and internal audit functions of state banks. The prudential framework for the insurance sector should be updated to improve its risk sensitivity. Consumer protection and financial literacy in the insurance industry are weak and should be improved. The legal framework governing creditor/debtor relationships is comprehensive; however, neither debt resolution nor bankruptcy liquidation work effectively, impeding NPL resolution.
The authorities of Bosnia and Herzegovina appreciate the informative and candid exchange of views with the mission team during the FSAP. Despite the domestic political, economic and social challenges and external headwinds, the country has maintained macroeconomic and financial stability. Deeply rooted economic rigidities still exist, however, and the new government is committed to give a new impetus to structural reforms by improving public confidence in the reform process and strengthening the utilization of donor support.
Amid high uncertainty, the Currency Board Arrangement (CBA) continues to be the cornerstone for domestic policymaking. The CBA has proved its sustainability both during the boom prior to the crisis and in the cyclical downturn. The strong commitment to the CBA among all domestic political players will remain an important buffer against shocks. Bosnia and Herzegovina’s authorities firmly believe that the CBA remains the appropriate anchor for all its policies in the long run and until the potential EU accession and eventual euro adoption. That said, the CBA needs to be continuously supported by strong macro and macroprudential policies.
In general, Bosnia and Herzegovina’s financial system has successfully navigated during the global financial crisis. As the FSSA report highlights, the major financial institutions continue to be resilient to risks, even those arising in a severe stress scenario. Nonetheless, the authorities remain vigilant, because the economy and financial system are still dealing with the aftershocks of the global financial crisis and underlying vulnerabilities arising from sluggish growth, tight macroeconomic conditions, slow credit growth, high NPLs and weakened profitability of financial institutions. They agree that, given the circumstances, small domestic banks have been more adversely affected by the downturn.
The International Financial Institutions, including the Fund, will continue to play an important role in ensuring financial stability and growth sustainability in Bosnia and Herzegovina. The authorities remain attentive to the Fund’s advice and recommendations, but emphasize that the highly uncertain and volatile environment, both external and domestic, poses challenges. This makes it difficult to achieve the desperately needed broad political and social consensus for smooth and timely policy implementation. The authorities, however, are committed to prudent macroeconomic and financial policies. They have expressed interest in a successor arrangement with the Fund, and discussions have started.
The authorities welcome the FSSA findings and recommendations, especially the mission’s attempt to tailor its advice to the constitutional and institutional specifics of the country. They are also well aware that the model of financial supervision set at the entities level is unique among the world supervisory practices and that its efficiency and effectiveness need to be strengthened. The authorities have established a high-level Standing Committee for Financial Stability (SCFS) to coordinate, and especially to better sequence and synchronize the financial sector oversight and supervision, given that there is currently no single body that has the mandate for financial supervision and crisis preparedness across all institutions and markets in Bosnia and Herzegovina.
In the current juncture, one of the most pressing issues for the authorities remains the creation of a credible, transparent and effective bank restructuring and resolution mechanism. Given the constitutional specifics and differences in restructuring and resolution practices that have been implemented at the entity level so far, the authorities and staff examined, during the FSAP process, various options to come to a better integrated and more efficient mechanism, which is closer aligned with the best international practices. Initially, staff and the SCFS considered that a centralized restructuring and resolution authority and the respective funds at the state level are optimal, but later on, views of some of the SCFS members diverged. The current consensus option is to establish the resolution mechanism institutionally within the existing banking supervisors at the entities’ level. At the same time, the new autonomous resolution fund will be managed by the state deposit insurer.
The financial safety net in Bosnia and Herzegovina remains incomplete without the creation of an emergency liquidity facility to support resolution of troubled banks and provide the necessary liquidity for solvent but illiquid banks. At this initial stage, the creation of a Financial Stability Fund needs to be supported by the IFIs, and the authorities stand ready to fully implement the suggested framework for emergency liquidity support, including enhanced monitoring and supervision, to minimize moral hazard. The authorities will further develop systemic liquidity management in a conservative manner and strictly observe the limitations of the legal framework underpinning the CBA. They will also steadily improve the use of reserve requirements for macroprudential purposes and introduce a liquidity coverage ratio in line with staff’s advice.
The authorities concur that the 2014 Contingency plan needs to be updated and its scope should be broadened to include restructuring and resolution of small banks with financial stability implications. In line with staff’s advice, the plan will be further revised to incorporate the necessary procedures for managing different stages of possible crisis, and to establish a model for crisis simulation exercises. The authorities also work on signing Memoranda of Understanding (MoUs) with the remaining home country supervisors of the systemically important banks, and on extending the coverage of existing MoUs. The authorities are committed to steadily increase the institutional capacity of all supervisors and their enforcement power.
Going forward, the authorities agree with staff that the existing legal framework for resolving debtor-creditor disputes in Bosnia and Herzegovina needs to be strengthened, while the growing number of NPLs needs to be tackled in a cost-effective way. They are open to staff’s recommendations for a more systematic and country-specific approach to this end. Given the uncertain low-growth environment, the Banking Supervisory Authorities have highly appreciated the joint work with staff on stress-testing, and they stand ready to sustain and further develop the capacity of the banking system and individual credit institutions to withstand shocks. They will also finalize the remaining asset quality reviews (AQRs) of distressed banks later this year. The AQRs of all other banks are considered too, and additional technical assistance from the Fund will be needed to implement a credible methodology compliant with the best international practices.
The achievements so far provide a sound base to further extend and develop the country’s macroprudential toolkit, and to integrate financial sector oversight. The authorities have made important progress with addressing the AML/CTF issues through the enactment of a new AML/CFT Law and amendments to the Criminal Code. To enhance implementation of the existing AML/CTF action plan, the authorities envisage improvements in coordination and cooperation among the various agencies at the state and entity levels.
Finally, the authorities would like to express again their gratitude to the IMF FSAP team, headed by Ms. Munoz, for its dedicated work and good advice.