Bosnia and Herzegovina
Financial Sector Assessment Program - Banking Sector Supervision Core Principles Implementation Update—Technical Note

This Technical Note presents an update on Banking Sector Supervision Core Principles Implementation in Bosnia and Herzegovina. 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 since the 2006 Financial Sector Assessment Program. The banking agencies are in the process of preparing a new Law on Banks that should address deficiencies in the supervisory powers, resolution tools, and consolidated supervision. Comprehensive regulations on risk management have been drafted that will address remaining deficiencies that are highlighted in this assessment.

Abstract

This Technical Note presents an update on Banking Sector Supervision Core Principles Implementation in Bosnia and Herzegovina. 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 since the 2006 Financial Sector Assessment Program. The banking agencies are in the process of preparing a new Law on Banks that should address deficiencies in the supervisory powers, resolution tools, and consolidated supervision. Comprehensive regulations on risk management have been drafted that will address remaining deficiencies that are highlighted in this assessment.

Introduction4

1. In 2006 Bosnia and Herzegovina (BiH) underwent a Basel Core Principles (BCP) assessment based on the 1999 version of the BCPs. Individual assessments were conducted for the Federal Banking Agency (FBA) in the Federation of Bosnia and Herzegovina and for the Banking Agency of Republika Srpska (BARS). Since the assessment, the BCPs were revised in 2006 and again in 2012.

2. The revisions to the BCPs reflect changes in the guidelines issued by the Basel Committee on Banking Supervision (BCBS) and also increased the level of detail and required verification to document the authorities’ practices in monitoring compliance by banks with regulatory requirements and effecting corrective action.

3. In preparation for the current FSAP, the FBA and BARS prepared self-assessments to determine their level of compliance with the current version of the BCPs. Since 2006, the authorities have been upgrading their supervisory processes and regulatory framework and in the current FSAP a principle-by-principle review was conducted to determine the level of progress in meeting the BCP standards. The scope consisted of an analysis of the self-assessments, and responses to detailed questionnaires completed by the authorities and a review of documentation concerning corrective action, reports of inspection, offsite analyses and other key risk areas. However, compliance grades were not assigned since the review did not include verification of all essential criteria.

The 2012 Revised Core Principles

The revised BCPs reflect market and regulatory developments since the last revision, taking account of the lessons learnt from the financial crisis in 2008/2009. These have also been informed by the experiences gained from FSAP assessments as well as recommendations issued by the G-20 and FSB, and take into account the importance now attached to: (i) greater supervisory intensity and allocation of adequate resources to deal effectively with systemically important banks; (ii) application of a system-wide, macro perspective to the micro-prudential supervision of banks to assist in identifying, analyzing and taking pre-emptive action to address systemic risk; (iii) the increasing focus on effective crisis preparation and management, recovery and resolution measures for reducing both the probability and impact of a bank failure; and (iv) fostering robust market discipline through sound supervisory practices in the areas of corporate governance, disclosure and transparency.

The revised BCPs strengthen the requirements for supervisors, the approaches to supervision and supervisors’ expectations of banks. The supervisors are now required to assess the risk profile of the banks not only in terms of the risks they run and the efficacy of their risk management, but also the risks they pose to the banking and the financial systems. In addition, supervisors need to consider how the macroeconomic environment, business trends, and the build-up and concentration of risk inside and outside the banking sector may affect the risk to which individual banks are exposed. While the BCP set out the powers that supervisors should have to address safety and soundness concerns, there is a heightened focus on the actual use of the powers, in a forward-looking approach through early intervention.

The number of principles has increased from 25 to 29. The number of essential criteria has expanded from 196 to 231. This includes the amalgamation of previous criteria (which means the contents are the same), and the introduction of 35 new essential criteria. In addition, for countries that may choose to be assessed against the additional criteria, there are 16 additional criteria.

While raising the bar for banking supervision, the Core Principles must be capable of application to a wide range of jurisdictions. The new methodology reinforces the concept of proportionality, both in terms of the expectations on supervisors and in terms of the standards that supervisors impose on banks. The proportionate approach allows assessments of banking supervision that are commensurate with the risk profile and systemic importance of a wide range of banks and banking systems.

Overview of the Institutional Setting and Market Structure

4. Bosnia and Herzegovina is divided into two semi-autonomous political Entities—the Federation of Bosnia and Herzegovina and the Republika Srpska.5 Both FBiH and RS 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, while their respective laws and regulations are harmonized to a degree. In addition, there is a central, or “State” level administration but with few enumerated powers. In this context, the Central Bank of Bosnia and Herzegovina (CBBH) and the Deposit Insurance Authority (DIA) reside at the national level.

5. The financial system in Bosnia and Herzegovina is dominated by a moderately concentrated banking sector. The banking sector accounts for 86 percent of the financial system assets, which are equivalent to 84 percent of GDP as of end-2013. 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. Twenty seven banks operate currently in the country (17 in BiH and 10 in RS, with a share of 70 and 30 percent of the banking system). The five largest banks represented about half of banking sector assets in 2013.6 The interbank linkages are limited. Interconnectedness between banks and the insurance sector, as well as between the banks and the RS development bank, is more significant.7

6. As elsewhere in the region, the largest foreign banks operating in Bosnia and Herzegovina are from Austria and Italy. Together with Slovenia these banks make up ¾ of banking sector assets in FBiH and half in RS.8 While most of the foreign subsidiaries have taken a cautious position after the recent crisis, a couple of new foreign banks, albeit small, have been relatively aggressive in expanding their market share.

7. The rest of the non-banking financial system is small. It is distributed among insurance companies (5 percent of financial system assets), leasing companies, investment funds, and microcredit organizations (3 percent of financial system assets each). The share of nonlife insurance (in terms of assets) is below 2 percent of GDP, while life insurance accounts for only 0.3 percent of GDP. There is one stock exchange in each Entity, but capital markets remain underdeveloped. 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. It also handles large-value payments that stem from the capital markets and international payment clearing services.

Preconditions for Effective Banking Supervision

A. Sound and Sustainable Macroeconomic Policies

8. The banking sector weathered the global financial crisis relatively well. Fueled by a benign global environment and ample lending supported by foreign parent banks’ funding and capital in subsidiaries, bank credit to the private sector grew at an average annual rate of around 25 percent over 2003-07. While the level of credit-to-GDP rose from around 35 to 45 percent over this period, this represented the smallest expansion in the region. However, the associated vulnerabilities became clear during the 2009 crisis when capital inflows came to a halt. A traditional banking sector model and the absence of riskier mortgage and foreign exchange-related instruments in the currency board arrangement (CBA) helped to mitigate the impact of the global financial crisis on the banking sector.

9. The authorities’ response to the crisis shored-up depositors’ confidence and helped to safeguard financial stability. The CBBH swiftly responded to the crisis by lowering bank high reserve requirements in several steps to free-up liquidity. The FBA and BARS closely monitored liquidity and the soundness of the banks. The negotiation of the 2009 SBA with the IMF, participation in the European Bank Coordination Initiative (EBCI) or “Vienna Initiative,” and the two-step increase of deposit insurance coverage to KM 35,000 (€17,000) to all banks,9 helped to preserve market and depositors’ confidence. Moreover, a formalized coordination framework across the agencies through the Standing Committee for Financial Stability (SCFS) was established.10 However, the CBBH is also, according to the Law on the Central Bank, in charge of the coordination of activities between the two banking agencies.

10. The crisis weakened asset quality and profitability of the banking system.11 System-wide NPLs ratios stood at 15.5 percent at end-June 2014, compared to just 3 percent at the onset of the global financial crisis, reflecting the impact the crisis had on the region. Banking sector profitability has deteriorated, partly due to weak economic environment and the region in general, partly due to high regulatory provisioning requirements related to high NPLs (the provisions to NPL ratio is at 68 percent). Owing to poor corporate resolution and insolvency frameworks, asset quality is becoming an important obstacle for re-establishing bank profitability. The sector-wide regulatory capital is at over 17 percent of risk-weighted assets as of end-June 2014, and banks maintain low leverage ratios. The recent natural disaster prompted regulatory forbearance measures for loan classification, but so far had relatively mild impact on asset quality. According to the authorities, only about 1 percent of total loans have been restructured so far, even though more loans could be restructured.

11. BiH has adopted a strategy to safeguard financial sector stability and plans to adopt banking laws in line with Basel II. The global financial crisis and its aftermath have revealed significant shortcomings in BiH’s supervisory and regulatory frameworks, including the supervisors’ lack of control over excessive and lax bank lending prior to the crisis. Supported by the SBA, the authorities of BiH have adopted a number of measures to boost their contingency planning and crisis preparedness toolkit. A detailed asset quality review is being conducted for six banks under the enhanced supervision regime.12 Moreover, CBBH and both banking agencies, with assistance from IMF and EU, have made progress in drafting new banking laws.

12. Key risks to the financial sector derive from slow NPL resolution, high dependence from parent banks, and potential weak demand. The balance of financial stability risks has changed since the 2006 FSSA. In particular, credit risk increased dramatically due to lax lending conditions in 2005-8, leading to high NPLs. Owing to poor resolution and insolvency frameworks, asset quality is an important obstacle for reestablishing bank profitability. In terms of macroeconomic risks and inwards spillovers, the overall situation is similar to the 2006 FSAP. Foreign bank subsidiaries are still reliant on parent bank support, which renders the system vulnerable to external developments. Moreover, renewed weakness in the euro area, compounded with deterioration in the health of commercial banks, could result in depositors’ confidence loss. Monetary and financial conditions have tightened, reflecting lower credit growth and liquidity in the system, as well as less risk appetite.

B. Well Established Framework for Financial Stability Policy Formulation

13. The macroprudential toolkit is underdeveloped and relies mostly on required reserve management. The required reserves levels were used to mitigate the credit boom as well as the following liquidity crunch before and after the global financial crisis. The CBBH is also conducting top-down stress tests on the main financial risks and, jointly with the banking agencies, has developed a methodology to identify systemic domestic banks. The annual Financial Stability Report, prepared by the CBBH contains a broad range of information on the macroeconomic environment, household and legal entities, financial intermediaries, including the aggregate results of stress test, FSIs, and on financial infrastructure.

C. Well-Developed Public Infrastructure

14. Weaknesses in the legal and judicial frameworks have impeded the resolution of NPLs. One of these is the legal impediment (in the Law on Obligations and the Law on Protection of Consumers, the latter being applicable to loans to natural persons) that impedes banks from transferring non-cancelled NPLs to an entity other than a bank. These laws have been a significant obstacle in the ability of banks to resolve NPLs, given that one of the preferred mechanisms for doing so is the sale of NPLs to either a company formed for the purpose within the bank’s group or to an external party which specializes in impaired debt collection.

15. Legal impediment need to be addressed by amending the relevant laws in each entity to enable all NPLs to be transferred to non-bank entities, subject to appropriate safeguards. These safeguards would include the ability of the banking agencies to continue to monitor NPLs where these are located in an AMC within a banking group through consolidated group supervision. In addition, NPLs could be maintained on a credit register to enable credit providers to identify the status of applicants for credit.

16. Another difficulty impeding the resolution of NPLs is the absence of an alternative to bankruptcy. Under BiH laws, 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 more companies being placed into bankruptcy than might otherwise be required, 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. It also results in a large backlog of cases in the courts awaiting decisions.

17. Current monitoring and enforcement arrangements do not ensure that the quality of financial statements meet the standard of IFRS. The audit public oversight systems are nascent, and audit quality assurance systems have only performed preliminary work. It will take at least three to five years of constant effort to implement these systems effectively. In addition, provisions of the new EU audit regulation relating to the monitoring of audits of PIEs will necessitate that the institutions responsible for audit public oversight directly monitor audit firms responsible for PIEs statutory audits and are completely independent from the audit profession. These requirements will imply additional constraints on the capacity of the entities to implement these systems. Financial sector regulatory agencies (under BARS and FBA) have increased their monitoring of financial statements compliance with IFRS and need to continue these efforts by hiring specialized staff or training existing staff in IFRS and at a minimum ISA 700, the standard that governs the audit report.

18. Preliminary results in implementing statutory audit quality assurance systems in both Entities point to a decrease in audit quality and numerous instances of non-compliance with ISA and IFRS. Some of the roots for low audit quality are the constant downward pressure on audit fees, rapid rotation, and late appointment of statutory auditors.

D. Clear Framework for Crisis Management, Recovery, and Resolution

19. Building on recent initiatives, further progress is required to strengthen the framework for recovery and resolution. 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, recovery and resolution planning, and resolution funding.

20. There is a need for the establishment of a resolution authority and resolution funding. At present, the FBA and BARS have some of these 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. Currently, there is no resolution fund in BiH, other than the deposit insurance fund. Given that open bank resolution of systemically important banks may require funding for various aspects of resolution and that this goes beyond the scope of a deposit insurance fund, a new source of funding will be necessary in order to reduce fiscal risks and moral hazard.

21. The CBBH has no LOLR facility—prohibited by CBBH law—and there are gaps in the banking crisis resolution framework. The framework has benefited from a series of reforms over recent years. These include improvements to some statutory powers for crisis resolution, the development of contingency plans by a number of the agencies responsible for crisis resolution, and the establishment of a formalized coordination framework across the agencies through the SCFS.

E. Appropriate Level of Systemic Protection

22. The deposit insurance framework is relatively well developed. The DIA has responsibility for administering a pay-box form of deposit insurance where the deposit insurance fund is financed by annual levies on banks, supported by a €50 million standby facility with the EBRD. Since its establishment, the DIA has made good progress in developing much of the infrastructure required for an effective deposit insurance framework, including MOUs to support coordination with the FBA and BARS, regular testing of depositor data and procedures for making deposit pay-outs. The current level of funding is sufficient to cover all insured deposits in the small domestically-owned banks.

23. Information sharing and coordination arrangements between the DIA and other safety-net participants need to be strengthened. The DIA requires timely information on problem banks to prepare promptly for pay-out cases and manage its liquidity needs accordingly. The current MoU with the banking agencies is more than ten years old and information is not exchanged automatically. To achieve further flow of information between financial safety-net participants, all problem banks in BiH should be regularly discussed in the SCFS.

F. Effective Market Discipline

24. While sector-wide indicators appear broadly sound, there are pockets of higher vulnerabilities among domestic banks. The domestic banking segment has lower liquidity and capital ratios as well large concentration risks. The asset quality of the domestic banks deteriorated more substantially than that of the foreign banks. As a consequence, the profitability of domestic banks dropped more than that of foreign banks and capital ratios declined faster. The detailed asset quality reviews (AQRs) of the five domestic banks that are under enhanced supervision have revealed capital shortages, of which only two have been corrected. To results of the AQRs performed by reputable external auditors on two domestic banks are long overdue.

25. A number of domestically-owned banks rely heavily on public sector support. In the RS, the development bank (IRBRS), along with the six development funds under its management, holds a sizeable amount of shares and subordinated debt issued by some of the domestically-owned banks that otherwise would be undercapitalized. It also has large credit lines for on-lending to all commercial banks in RS and two in FBiH, and place deposits in four domestic banks. In contrast, the relatively small development bank in the FBiH does not play a similar role. However, some public sector entities have stakes in some domestically-owned banks. Furthermore, some small domestically-owned banks hold each other’s shares, although only up to limited amount. Conglomerates also hold a significant amount of the shares issued by the small domestically-owned banks through their controlled companies engaging in both real and financial sectors.

26. The solvency of a number of domestic banks is under severe pressure and action is needed to deal with weak banks in the near future. There are signs that the business models of the weakest banks have been unsustainable for some time. They faced significantly higher funding costs and had been compelled to cater mostly to sub-par borrowers, with negative impact on asset quality. Without significant capital support from the owners coupled with profound changes in business models, these banks may face difficulties surviving the contested banking market. A number of them have already benefited from public sector capital support without diluting existing shareholders, thereby contributing to moral hazard. Without imminent and decisive actions the banks’ financials will continue to deteriorate leading to a rapid increase of potential resolution costs over time. Therefore, the authorities are advised to develop, as a matter of high priority, a thorough planning process to either facilitate the recovery of these banks (if practicable) or to implement a cost-effective resolution consistent with maintaining the stability of the financial system and protection of insured depositors. As part of the resolution planning process, all resolution options should be carefully assessed, including ensuring the technical readiness of the DIA to pay-out depositors promptly.

G. Anti-Money Laundering and Terrorist Finance Issues

27. The 2009 Mutual Evaluation Report conducted by MONEYVAL identified strategic deficiencies in the BiH’s AML/CFT framework, such as deficient and inconsistent criminalization of the money laundering offense across state and entity level legislation and a lack of effective implementation of customer due diligence measures. BiH agreed to an action plan to remedy these shortcomings. Although important progress has been made, notably with the enactment of a new AML law, significant deficiencies remain. Failure to implement the action plan in a comprehensive way has resulted in MONEYVAL issuing public statements on BiH in June and September 2014, calling upon members to apply enhanced due diligence measures to transactions with persons and financial institutions from or in the BiH. Further delay in addressing key AML/CFT deficiencies may result in additional scrutiny from the Financial Action Task Force (the standard setter on AML/CFT), with potentially greater negative repercussions for the BiH, notably on correspondent banking relationships.

28. Timely and effective implementation of the action plan is recommended, notably through the enactment of the necessary amendments to the Criminal Code. Staff also recommends that the authorities conduct a national assessment of the ML/TF risks and develop a national strategy in line with its findings. Staff further encourages the authorities to promote greater coordination and cooperation amongst State and Entity level agencies.

Main Findings

A. Main Findings in the Federation of Bosnia and Herzegovina

Responsibilities, Objectives, Powers, Independence, Accountability, and Cooperation (CPs 1-3)

29. The system of banking supervision oversight is significantly improved since the last review in 2006, but further enhancements are necessary. The current Law on Banks has been strengthened after 2006 with regard to transfer of significant ownership, anti-money laundering, consumer protection and provisional administrator. The FBA is in the process of developing a new Law on Banks that should also address some deficiencies in the supervisory powers, recovery and resolution, and consolidated supervision. These reforms will probably also impact the Law on the Banking Agency. With regard to the regulatory framework, this 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 for the implementation of additional regulations and operational improvements.

30. There are clear checks and balances for independence of both supervisory agencies, but the context in which both entities operate could become difficult. The political economy could be behind the opaque ownership structures of domestic banks. At the same time banks and the FBA have trouble identifying the ultimate beneficiary owners of the banks and their holdings which leads to opaque ownership structures. There are also examples where the parliament proposed amendments to the LOBA that could compromise the operational independence of the supervisor.

31. The framework for appeals by financial institutions against supervisory actions should be strengthened. Currently, it is possible that after an appeal the court may temporarily suspend the decision of the FBA, or delay its execution. This could be very damaging for the banking sector that is sensitive to early and timely intervention.

32. Cooperation and coordination in BiH is very complex due to the administrative set-up of the country and may have potential repercussions in times of financial sector stress. For instance, the SCFS on the state level and the Committee for Coordination of Supervision of the Financial Sector at the level of the RS seem to have overlapping mandates. This could become problematic in case of a crisis. In addition, the key players exchange information to certain extent guided by specific arrangements and laws, but crucial information on the risk profile of banks (i.e., the CAMEL rating) is not always shared with relevant stakeholders (the other banking agency, CBBH, and the DIA) which creates information asymmetries. It is therefore important to strengthen the coordination and in exchange of information. The development of an integral contingency plan is encouraging in this respect.

Ownership, Licensing, and Structure (CPs 4-7)

33. FBA does not have a clear picture of the ownership structure of several domestic banks in BiH. 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. Root cause of this problem lies at the licensing and approval process (including transfer of significant ownership and major acquisitions), that has been mostly formal instead of substantial and without imposing prudential conditions, if needed. This means that the assessment of the licensing criteria for newly established banks are not comprehensive and focus mostly on describing the prescribed content, rather than assessing criteria of safety and soundness that covers suitability ownership structure, (group) governance (including fit-and-proper of board members and senior management), strategic and operational plans, internal control, risk management and projected financial conditions (including capital base). The same counts for the approval of major acquisitions or investments. The assessment prior to approval focuses mostly on required documentation and the impact on the capital position. There is no explicit assessment whether the new acquisition or investment expose the bank to unnecessary risk, impedes efficient supervision, nor whether the bank has sufficient resources to manage the acquisition or investment.

34. The LOB does not have clear distinctions between bank subsidiaries, branches, representative offices and other operational offices and the activities they can engage. There are different articles in the LOB that give some kind of direction but these are not comprehensive.

Methods of Ongoing Banking Supervision (CPs 8-10)

35. Ongoing bank supervision is conducted through a blend of onsite and offsite activities that are detailed in supervisory manuals. Annually a supervisory plan is developed for each bank that addresses planned activities, both onsite and offsite. The scope of the supervisory plan reflects the bank’s risk profile which is determined by considering the following: results of the offsite analyses and onsite inspections, the assigned CAMELS rating, the bank’s annual business plan, early warning system (EWS) risk indicators, Uniform Bank Performance Report (UBPR) and any other public or confidential information available. Onsite inspections focus on evaluating loan portfolio quality, implementation of corrective action, effectiveness of risk management systems and internal controls. Offsite monitoring performs quarter analyses on banks and the system as a whole. The offsite department also has the ongoing responsibility for monitoring banks’ compliance with corrective action which in 4/5 rated banks includes regular meeting with bank management.

36. Banks’ risk profile is graded based on an aggregation of risks under the CAMELS categories; Capital, Assets, Management, Earnings, Liquidity and Sensitivity to market risk. A rating for each category is assigned and an overall rating is assigned to the bank. The scale of the ratings is 1-5 with 5 being the highest risk. The criteria considered for rating each risk category and assigning a numerical rating have been detailed in a regulation and published in the Official Gazette. A number of prudential ratios are analyzed under each category and also qualitative factors such as; as quality of risk management. Comparison to system averages is also factored into the rating to highlight areas where the bank appears to be an outlier. Currently the “S” is not rated pending issuance of the market risk decision.

37. FBA conducts collects, reviews and analyzes prudential reports and conduct several controls to ascertain the accuracy of the information. Key controls are formal IT controls, substantive controls by off-site, on-site inspections (since 2009 together with IT inspectors) and assessments of the compliance with law and regulation by the external auditors. Noticed is that the prudential returns are not comprehensive yet. FBA does not receive prudential reports on consolidated basis (see CP 12 Consolidated supervision) nor does she receive reports on pillar 2 capital (see CP 16 Capital), country risk exposure (see CP 21 Country risk) or market risk except foreign exchange positions (see CP 22 Market risk). In addition, the supervisory board nor the external auditor have to attest the prudential returns.

Corrective and Sanctioning Powers of Supervisors (CP 11)

38. The FBA has a number of enforcement tools to require banks to effect corrective action but authority to fine individual supervisory board members is limited. The FBA can impose fines, issue orders requiring increases in capital, cease and desist unsafe and unsound practices, impose temporary management and revoking the license. However, the fines that may be currently applied under the administrative procedures are insignificant. The banking law is currently being re-drafted.

39. The FBA has not developed a remedial action program that aggregates all the tools, describes circumstance when they may be applied and outlines benchmarks for applying a hierarchy of actions. While FBA decisions and the banking law address situations that may be subject to sanctions and enforcement action, a comprehensive remedial action program would enhance transparency, ensure consistency in application, provide clear internal guidance and facilitate timely corrective action.

40. Problem banks may remain in that status for extended periods without defined prospects for recovery or resolution. Supervision of problem banks is labor-intensive and resolution costs tend to increase the longer the unstable situation is permitted to exist. Recovery or resolution options should be evaluated early and executed. Allowing banks that may no longer be viable to continue to operate results in increased risk as the bank may undertake transactions to raise funds or increase capital with back-to-back operations with other banks that may result in double gearing. Currently authorities face constraints in resolving banks due to inadequate sources of market capital, a weakened economy that limits opportunities for banks to recover and a lack of confidence by depositors that may trigger system-wide deposit runs if a bank is resolved.

Consolidated and Cross-Border Banking Supervision (CPs 12-13)

41. Consolidated supervision as a concept and practice has not been implemented by FBA. There are no prudential requirements both quantitative and qualitative for the supervision of consolidated supervision. Furthermore, the supervisory agencies do not have the supervisory power to intervene in groups. This will also emphasize the need to have excellent cooperation and information exchange with Austria, Italy and Russia (beyond formal arrangements). Since these countries are the (grand) parents of D-SIB in both the FBiH and the RS. Recently, both FBA and BARS received a confirmation from the Austrian supervisor (FMA) that there are no hindrances anymore to formalize and sign the Memorandum of Understanding (MOU). At the same time both agencies should stay realistic what the value of the MOU is. Furthermore, the current arrangement with the supervisors of Slovenia and Turkey don’t address cross border cooperation and coordination in times of crisis.

Corporate Governance (CP 14)

42. The FBA has issued Decisions on the Diligent Behavior of Members of Bank’s Bodies (corporate governance} and Suitability Assessment of Banks’ Bodies (fit and proper). Bank compliance would be enhanced by providing additional guidance to banks on FBA expectations for issues to be addressed in a risk appetite statement: quantitative metrics such as value-at-risk, leverage ratio, range of tolerance for problem loan levels, and acceptable stress test losses. And in strategic plans: a comprehensive assessment of current and expected risks, state the business objectives of the bank and express how achieving the objectives will affect the risk profile of the bank.

Prudential Requirements, Regulatory Framework, Accounting, and Disclosure (CPs 15-29)

43. Major improvement has been made to the regulatory risk management requirements. Areas in need of attention are: market and country risk, interest rate risk in the banking book and guidance on holistic risk management requirements for banks. As part of Pillar 2 and the Internal Capital Adequacy Assessment Process (ICAAP) implementation the authorities plan to address these issues. A risk management decision has been drafted that provides a bank-wide view and introduces broader risks such as strategic risk. The risk management decision will also address areas not currently regulated.

44. The process of enhancing the capital requirements continues with the adoption of the Decision on Minimum Standards for Capital Management of Banks and Capital Hedge (Capital Decision). Being phased-in, the enhancements incorporate elements of Basel II and III such as: capital conservation buffers, leverage ratio, elimination of Tier III capital, amortizing revaluation reserves, limiting loan loss reserves to 1.25 percent of Tier II, and stricter definitions of capital elements. Currently credit risk weighted assets are calculated in compliance with most Basel I requirements, while weighted operational risk is being calculated according to the basic indicator approach, which is to a significant extent in compliance with Basel II. In 2014, amendments and addenda were executed to the Decision on Capital, with the objective of strengthening the structure of capital, introducing protective layers for capital conservation, restraining the rate of financial leverage, and the highest possible level of convergence with the requirements of Basel III (and adoption of deadlines for harmonization with new requirements). Adoption of this decision is a transitional solution until full implementation of Basel II/III, as per banking agencies’’ strategy.

45. Adequacy of provisioning levels in some banks is questionable and IAS requirements from FBA need to be strengthened. Onsite inspections and independent reviews of provisioning identify improper classification of loans and valuation of collateral. Issuing requirements on haircuts for real estate collateral and guarantees (particularly given the restrictions of the guarantor protection law) and on the assumptions for defining impairment would enhance identification of impaired loans and enforcement by FBA.

46. Related party lending, similarly to concentration risk, is an issue of concern at many domestic banks. Onsite inspections often disclose violations of related and connected party lending limits. The violations reflect internal control deficiencies and poor governance.

47. The outcome of the AQR raises questions on the quality of the financial audits of banks that fit a broader context. Currently, several domestic banks implement IFRS 2009 since, this is the last version translated into local language. In addition, some external auditors of domestically owed banks base their opinion on the Law on accounting and auditing instead of IFRS. This makes it difficult to compare financial statements across the banking sector and brings uncertainty to the quality of the external audits. Furthermore, the quality assurance of the financial audit is barely developing. Also, the appointment of external auditors takes place on a yearly base with a maximum of five years. Neither of the agencies have the power to rescind an external auditor. Though they do have the power to consent to the appointment of the external auditor and to refuse the report of an external auditor. There is a risk that changing auditors every year has an adverse effect on the continuity and the quality of the audit. Appointing an external auditor for at least three years, together with the power to rescind, will alter the incentives for external auditor by making the m more candid about the audits. This could have a positive effect on the continuity of the auditor and quality of the audit.

48. FBA needs to put more effort in identifying the inherent ML/TF risks. Recently, a new law and regulation on AML/TF has been adopted. Also the supervisory processes are aligned with these law and regulation. However, there are some concerns. First, more attention could be paid to understanding the inherent ML/TF risk profile of banks and, accordingly, make the supervisory intensity risk based. Second, the follow-up of findings could be strengthened. Third, there seems to be a poor feedback loop between the FBA and the FID. Fourth, it seems that supervision of branches outside the FBiH, but with head-quarters inside the FBiH, are not being inspected on-site for ML/TF activities.

Table 2.

Federation of Bosnia and Herzegovina: Summary of the Key Findings

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B. Main Findings in Republika Srpska

Accountability and Cooperation (CPs 1-3)

49. The current Law on Banks has been strengthened after 2006 with regard to anti-money laundering, consumer protection and provisional administrator. The BARS is working on a new Law on Banks that should address some deficiencies in their supervisory powers, recovery and resolution, and consolidated supervision. These reforms will probably also impact the Law on the Banking Agency. With regard to the regulatory framework, this 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 for the implementation of additional regulations and operational improvements.

50. There are clear checks and balances for independence for BARS, but the context in which it operates could become difficult. There seems to be a substantive interdependence between the government and the domestic banking sector. This means that in case BARS faces a domestic bank with non-viability problems, the government has a substantive interest in how the problem ought to be solved. It appears that in such a case not only the interest of depositors, the bondholders and the shareholders are important, but also the interests of the government. This could put pressure on BARS how to deal with non-viability in her pursue of save and soundness of the banks.

51. Legal protection is weak. Missing is the legal protection for persons appointed by BARS such as temporary administrators or liquidators. Also missing is the indemnification. The provisions framework for appeal on appeal by financial institutions against supervisory actions should be strengthened. Currently, it seems possible that after an appeal the court can suspend the decision of the BARS. This could be very damaging for the banking sector which is sensitive to early and timely intervention.

52. Cooperation and coordination in BiH is very complex due to the administrative arrangement of the country, having potential repercussions in times of financial sector stress. Therefore, it is very difficult to determine who gets which information and when. For instance, the SCFS on the state level and the Committee for coordination of supervision of the financial sector on the level of the RS seem to have an overlapping mandate. This could become problematic in case of a crisis. In addition, there is an information asymmetry where the banking agencies know what the financial condition of individual banks is, but won’t share for instance the CAMEL rating with each other, the Central Bank, and only partly with the DIA. The development of an integral contingency plan is encouraging in this respect.

Ownership, Licensing, and Structure (CPs 4-7)

53. BARS does not have a clear picture of the ownership structure of several domestic 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. Root cause of this problem lies at the licensing and approval process (including transfer of significant ownership and major acquisitions) that has been mostly formal and without imposing prudential conditions. This means that the assessment of the licensing criteria for newly established banks are not comprehensive. The assessments focus mostly on submitted documentation rather than assessing safety and soundness related criteria that covers suitability ownership structure, (group) governance (including fit-and-proper of board members and senior management), strategic and operational plans, internal control, risk management and projected financial conditions (including capital base). The same applies for the approval of major acquisitions or investments. The assessment prior to approval focus mostly on the required documentation and the impact on the capital position. There is no explicit assessment whether the new acquisition or investment expose the bank to unnecessary risk, impede efficient supervision, nor whether the bank has sufficient resources to manage the acquisition or investment.

54. The LOB does not have clear distinctions between branches, representative offices and other operational offices and the activities they can engage. There are different articles in the LOB that give some kind of direction but these are not comprehensive.

Methods of Ongoing Banking Supervision (CPs 8-10)

55. The building blocks for a comprehensive supervisory process are in place. Through a mix of onsite and offsite activities, the BARS develops a risk profile of the banks and assigns risk ratings. The risk rating, which is based on an analysis of capital, asset quality, management, earnings, liquidity and sensitivity to market risk (CAMELS), is then used as a basis for determining the supervisory activities required to accurately assess the banks’ condition. To help the BARS staff in conducting their activities, process manuals for onsite and offsite supervision have been adopted.

56. BARS updates its supervisory strategies using stress test results provided by the CBBH. BARS coordinates with the CBBH in monitoring the banking system and provides quarterly information and comments on assumptions provided by the CBBH. The results of the stress test are discussed within BARS and supervisory strategies are adjusted based on the stress test results. However, in its supervisory process stress testing of individual banks or risks is not incorporated on a regular basis to enable a more forward looking approach. Regulations have not been issued on banks’ use of stress testing.

57. Close coordination exists between offsite and onsite teams. During annual planning for onsite inspections, the offsite department provides input on risks to be reviewed. Quarterly analytical reports by offsite unit are shared with the onsite inspectors and significant changes in risk are identified by the offsite unit are incorporated into the onsite inspection planning and meetings between the two areas are held at the conclusion of an onsite inspection to discuss findings by the onsite team. Follow-up on corrective action is performed by offsite with frequent reporting to onsite.

58. BARS conducts collects, reviews and analyzes prudential reports and conduct several controls to ascertain the accuracy of the information. However, the prudential reports are not comprehensive yet. BARS does not receive prudential reports on a consolidated basis (see CP 12 on consolidated supervision) nor does it receive reports on Pillar 2 capital (see CP 16 on capital), country risk exposure (see CP 21 on country risk) or market risk except foreign exchange positions (see CP 22 Market risk).

Corrective and Sanctioning Powers of Supervisors (CP11)

59. BARS can demand the controlling owners to inject additional capital. However, when the current owners are unable to inject capital, the options for BARS to insist on alternative channels of capital or resolutions are limited. The ability of banks to sell shares is currently poor due to economic conditions that are not attracting investors and BARS is concerned about resolving even small banks on concerns of system-wide deposit runs. Currently, the development bank has been placing subordinated debt in the banks to improve regulatory capital. When controlling owners remain in place after refusing to inject capital, the risks to the deposit insurance fund are magnified.

60. BARS has available a range of tools to require corrective action from banks but implementation could be enhanced by detailing a remedial action program. Existing regulations should be amended to implement a comprehensive remedial action program and clarify the hierarchy of enforcement actions and introduce new tools. Additionally, enforceable guidance to communicate the expectations of BARS on standards for corporate governance, risk management and other policy areas should be issued to support supervisors’ judgment concerning unsafe and unsound practices and facilitating enforcement.

61. A remedial action program must include well-defined enforcement tools that enable the regulator to apply a wide range of penalties or restrictions that can be adapted to the gravity of the situation. The program must be transparent: BARS should publish the situations under which it would take supervisory action, and describe the supervisory action and the subsequent response should the institution fail to act. BARS’ internal operating procedures should be detailed and prescriptive, identifying the officials authorized to initiate enforcement action, the process to be followed to initiate an enforcement action starting at the field inspector level, through the review process to document and finalize the enforcement action and establishing processing timeframes. In its annual report, BARS should publish the remedial actions taken even if the name of the institution is withheld. Having a transparent, well-defined process with benchmarks and reporting will enhance supervisory accountability. Increased transparency would also aid in defending court cases.

62. The remedial action program would help bring together, in a coherent fashion, the graduated application of remedial measures. Some of these elements are addressed in various documents or regulation, but a compilation of the requirements and policies in a well-defined enforcement program would facilitate the initiation of enforcement action. The published guidelines should establish that banks can expect an action when:

  • Capital falls below a certain level. The action can vary depending on the trigger points and management response. The contingency plan under review introduces enforcement action options at varying capital levels.

  • Recurring inaccurate filings of regulatory reports or delinquencies should result in daily fines until situation is corrected. Currently there are fines but these could be increased based on recurrence and significance of inaccuracy.

  • Bank operating policies and processes are inadequate and may lead to a deteriorating financial condition. For example specifically defining inadequate policies and procedures concerning corporate governance and risk management as unsafe and unsound practices and based on supervisory judgment imposing sanctions and fines.

  • Violations of law are identified. Depending on their gravity, some violations, such as related party dealings, should have automatic fines on the bank and the individual.

  • Bank soundness falls below acceptable levels established by BARS (based on CAMELS rating). In addition to enhanced supervision; banks should have recovery and resolution plans with strict timeframes to avoid extended periods in categories 4 and 5. Banks in the latter stages of deterioration have adverse impacts on the banking system even if not systemic.

  • Financial penalties in significant amounts should be applied by BARS to not only management but supervisory board members and controlling owners. This will require amendments to the law. Strict guidelines for ending temporary administration that may include requirements for clearing problem assets, injecting capital before ending administration and avoid approvals based on future commitments by acquirers/investors.

63. A detailed remedial action program will also enhance accountability, as those involved will need to document why action was not taken in the presence of the situations described above. BARS’ internal audit or internal control system should review the Remedial Action Program and its implementation.

Consolidated and Cross-Border Banking Supervision (CP 12-13)

64. Consolidated supervision as a concept and practice has not been implemented by BARS. There are no prudential requirements, quantitative or qualitative, for consolidated supervision. Furthermore, the BARS does not have supervisory powers to intervene in groups. There is also a need to have strong cooperation and information exchange with Austria, Italy and Russia (beyond formal arrangements). Since these countries are the (grant)parents of D-SIB in both the FBiH and the RS. Recently, both FBA and BARS received a confirmation from the Austrian supervisor (FMA) that there were no more hindrances to formalize and sign the MOU. At the same, expectations for the practical value of the MOU is should be realistic.

Corporate Governance (CP14)

65. BARS has issued the Decisions on Diligence of the Bank’s Management Body (corporate governance} and on the Assessment of Suitability of Members of Banks’ Management Bodies (fit and proper). The regulations are comprehensive. However, additional guidance for developing a risk appetite statement and relating it to the business plan would enhance compliance, particularly given the governance issues in many banks.

Prudential Requirements, Regulatory Framework, Accounting, and Disclosure (CPs 15–29)

66. While significant improvement has been achieved in the regulatory risk management requirements; work remains to be done on market, country, and interest rate in the banking book risks. Issuing a decision on holistic risk management requirements and risk aggregation, and relating it to the risk appetite and business plan would enhance the effectiveness of risk management in banks. The guidance could be developed in conjunction with Pillar 2 and Internal Capital Adequacy Assessment Process (ICAAP) implementation.

67. BARS has adopted a strategy for implementing Basel II/III. Currently, credit risk weighted assets are calculated in compliance with most Basel I requirements, while weighted operational risk is being calculated according to the basic indicator approach, which is to a significant extent in compliance with Basel II. In 2014, amendments and addenda were executed to the Decision on Capital, with the objective of strengthening the structure of capital, introducing protective layers for capital conservation, restraining the rate of financial leverage, and the highest possible level of convergence with the requirements of Basel III (and adoption of deadlines for harmonization with new requirements). Adoption of this Decision is a transitional solution until full implementation of Basel II/III, in compliance with the strategy.

68. The IAS 39 and prudential provisioning and loan classification standards are followed by banks. Although banks are required to follow International Financial Reporting Standards (IFRS), BARS also requires compliance with prudential standards that require a certain level of provisioning based on loan classification categories, defined on prudential concerns (primarily based on time in delinquency status). The prudential requirements serve as a floor to provisioning levels.

69. Onsite inspections frequently identify provisioning deficiencies, raisings concerns about the adequacy of provisioning. Supervisory requirements for collateral valuation, impairment definition and loss assumptions are needed to foment a conservative approach by banks in establishing benchmarks for objective evidence of impairment as well as addressing provisioning levels. Additional training for supervision staff will be required to enforce provisioning and review banks’ assumptions under an IAS environment.

70. Onsite inspections frequently identify related party and concentrations violations at banks. These violations reflect deficiencies in corporate governance and risk management and are early indicators of future insolvency if not immediately addressed. The powers of BARS to effect significant fines on supervisory board members through an administrative process are limited. The misdemeanor channel is cumbersome and court decisions are unpredictable.

71. The outcome of the AQR raises questions on the quality of the financial audits of banks that fit a broader context. Currently, several domestic banks implement IFRS 2009 since, this is the last version translated into local language. In addition, some external auditors of domestically owed banks base their opinion on the Law on accounting and auditing instead of IFRS. This makes it difficult to compare financial statements across the banking sector and brings uncertainty to the quality of the external audits. Furthermore, the quality assurance of the financial audit is barely developing. Also, the appointment of external auditors takes place on a yearly base with a maximum of five years. Neither of the agencies have the power to rescind an external auditor. Though they do have the power to consent to the appointment of the external auditor and to refuse the report of an external auditor. The risk exist that yearly change of auditor has an adverse effect on the continuity of the auditor and the quality of the audit. Appointing an external auditor for minimal three years together with the power to rescind will give a different incentive to an external auditor and could have a positive effect on the continuity of the auditor and quality of the audit

72. BARS need to put more effort in identifying the inherent ML/TF risks. Recently, new law and regulation on AML/TF has been adopted Also the supervisory processes are aligned with these law and regulation. However there are some findings. First, more attention could be paid to understanding the inherent ML/TF risk profile of banks and accordingly make the supervisory intensity risk based. Second, the follow-up of findings could be strengthened. Third, there seems not to be a good feedback loop between the BARS and the FID. Fourth, it seems that supervision of branches outside the FBiH, but with head-quarters inside the FBiH, are not being inspected on-site ML/TF activities.

Table 3.

Republika Srpska: Summary of the Key Findings

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Detailed Recommended Actions

Table 4.

Federation of Bosnia and Herzegovina and Republika Srpska: Detailed Recommended Actions to Improve Compliance with the Basel Core Principles and the Effectiveness of Regulatory and Supervisory Frameworks

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Appendix I. Federation of Bosnia and Herzegovina: Principle-by-Principle Implementation Review

A. Supervisory Powers, Responsibilities, and Functions

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B. Prudential Regulations and Requirements

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