Financial System Stability Assessment

This paper focuses on the important issues of Montenegro economy which are as follows: microfinancial setting, financial system resilience, financial oversight, resolution of nonperforming loans, and financial safety nets. Montenegro is still dealing with the aftermath of the collapse of the lending boom in 2008. Economic momentum has accelerated in 2015, but there are numerous downside risks. System-wide solvency and liquidity indicators appear broadly sound, but significant pockets of vulnerabilities exist among domestically owned banks. Decisive action to deal with weak banks is critical for preserving financial stability. While the legal, regulatory, and supervisory frameworks for banking and insurance sector have markedly improved since 2006 Financial Sector Assessment Program, further progress is required.


This paper focuses on the important issues of Montenegro economy which are as follows: microfinancial setting, financial system resilience, financial oversight, resolution of nonperforming loans, and financial safety nets. Montenegro is still dealing with the aftermath of the collapse of the lending boom in 2008. Economic momentum has accelerated in 2015, but there are numerous downside risks. System-wide solvency and liquidity indicators appear broadly sound, but significant pockets of vulnerabilities exist among domestically owned banks. Decisive action to deal with weak banks is critical for preserving financial stability. While the legal, regulatory, and supervisory frameworks for banking and insurance sector have markedly improved since 2006 Financial Sector Assessment Program, further progress is required.

Executive Summary

The Montenegro economy is still dealing with the aftermath of the collapse of the lending boom in 2008. The financial crisis hit asset quality, weakening banks’ portfolios. The legacy of pre-crisis rapid increase in indebtedness is adding to banking sector vulnerability. The crisis triggered a prolonged period of balance sheet deleveraging, which has translated into a near uninterrupted credit contraction. Slow economic growth and gaps in the legal framework have hampered banks’ efforts to reduce the overhang of nonperforming loans (NPLs).

Economic momentum has accelerated in 2015, but there are numerous downside risks. The investment-led boost in economic activity, including from the costly highway project, increases growth prospects but exacerbates already sizable public debt-related vulnerabilities. While lending to the private sector has recently shown signs of recovery, credit growth remains subdued.

System-wide solvency and liquidity indicators appear broadly sound, but significant pockets of vulnerabilities exist among domestically owned banks. The financial system is dominated by banks and, in particular, by foreign subsidiaries. Several domestically owned banks have very high NPLs and/or very low provisioning levels; some have received qualified audited reports in recent years. Stress tests indicate that those banks are also vulnerable to shocks, such as protracted economic slowdown, even under the moderate stress scenario. Notable cross-border exposures remain. Increasing competition and the slow economic recovery are weighing on banking sector profitability. Strong competition in the banking sector is compressing interest rate spreads to levels that are threatening the survival of some smaller banks, with higher funding and operating costs.

Decisive action to deal with weak banks is critical for preserving financial stability. An independent Asset Quality Review (AQR) of all banks is recommended to review loan classification and provisioning practices. The authorities are advised to develop, with high priority, time-bound supervisory action plans, including capital injections by shareholders. In parallel, the Central Bank of Montenegro (CBM) should start preparing bank-specific resolution planning to maintain financial system stability, protect insured depositors, and minimize costs to taxpayers.

While the legal, regulatory, and supervisory frameworks for the banking and insurance sector have markedly improved since the 2006 FSAP, further progress is required. The main areas for strengthening banking oversight include identifying, measuring, and managing nonperforming assets; focusing on operational risks; and introducing effective consolidated supervision. A number of key shortcomings should be remedied to complement improvements in the framework for NPL resolution. The oversight agencies should bolster cross-border arrangements with home supervisory and resolution authorities. The recent Law on Consumer Bankruptcy needs to be amended, as it could negatively affect the collection of existing loans and the issuance of new loans secured with mortgages. In insurance oversight, the key policy priorities are moving to a risk-based supervisory approach and gradual introduction of Solvency II.

The financial safety net should be strengthened. The CBM should be confirmed as the resolution authority for the institutions under its supervision. A number of essential resolution powers, such as establishing a bridge bank, should be made available to the CBM. The Deposit Protection Fund (DPF) should be authorized to fund resolution measures and needs to be more closely integrated into crisis preparedness mechanisms. A credible and transparent public backstop is needed to deal with systemic cases in the absence of private sector-funded resolution. Emergency liquidity assistance should be brought under a single framework and follow best international practice.

The macroprudential framework and systemic liquidity management should be enhanced. Euroization is limiting the CBM’s options to manage liquidity and provide liquidity support. In preparation for Basel III, sound liquidity risk management standards should be prioritized as the first line of defense against liquidity pressures. A macro prudential framework should be established and, over time, made fully operational, and underpinned by broader and more focused cooperation among the relevant agencies under the auspices of the Financial Stability Council (FSC) with expanded powers to issue recommendations on macroprudential policy. The macroprudential mandate should be vested in the CBM.

The CBM-managed payment and settlement systems are generally efficient. Some adjustments are needed to minimize any residual liquidity risks, such as facilitating the automatic transfer of balances from the reserves account to the settlement account. The CBM oversight function should be strengthened through the formulation of an oversight policy framework, along with improvements to interdepartmental communication and exchange of information.

Table 1.

Montenegro: FSAP Key Recommendations

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“I-Immediate” is within one year; “NT-near-term” is 1–3 years; “MT-medium-term” is 3–5 years.

Macrofinancial Setting

A. Crisis Legacy and Macroeconomic Outlook

1. The economy has yet to fully recover from the collapse of the lending boom, as balance sheet weaknesses and bank deleveraging have hampered economic growth. In the run-up to the 2008 crisis, sizable capital inflows fueled a demand boom and imbalances, including reckless bank lending, a housing bubble, and rapid increase in public and private debt. The bursting of the asset bubble resulted in a large stock of NPLs, deteriorating bank profitability, and significant debt overhang that has contributed to a sustained contraction in credit and weak investment.

2. In the run-up to the crisis, policy actions to address the lending boom had limited results. By late 2007, the CBM introduced stricter rules for asset classification and provisioning—which were relaxed during the crisis—and increased the capital adequacy ratio (CAR) by 2 percentage points to 10 percent. In early 2008, temporary bank-specific ceilings on credit growth were introduced and the RR rates on certain deposits were increased. In late 2008, the government guaranteed all bank private deposits to dampen deposit outflows.

3. Since the crisis, slow credit growth has been a drag on economic growth. Reliance on foreign direct financing of investment has increased, but empirical work suggests that increased bank lending can provide an important boost to medium-term growth. After almost seven years of near uninterrupted contraction,1 lending to the private sector has showed signs of recovery, and lending to the private sector increased by 2.3 percent (households and the corporate sector expanded by 2.7 percent and 2.2 percent, respectively) in 2015. Credit is expected to expand as aggregate demand increases, but the overall high degree of private-sector leverage makes a credit-led recovery unlikely.

4. Economic activity accelerated in 2015 as large infrastructure projects moved ahead, but risks weigh on the downside (Figure 1). The capital-intensive growth agenda, including the highway project (23.5 percent of 2014 GDP), should boost growth in the near and medium terms; but it comes at the expense of exacerbating already pronounced public debt-related vulnerabilities. Large, general government financing needs (averaging nearly 10 percent of GDP during 2016–20) are an important source of macroeconomic risk. The narrow production base and rigid labor market reduce the capacity to absorb external shocks, and rapidly rising public debt constrains policy space. Lax fiscal discipline could ultimately increase funding costs and lending premiums.

Figure 1.
Figure 1.

Montenegro: Selected Economic Indicators

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

Sources: Montenegro authorities and IMF staff estimates.

Financial System Resilience

A. Financial Sector Structure

5. Banks dominate the fully euroized financial system and account for about 90 percent of system assets, equivalent to about 93 percent of GDP as of June 2015. The Euro is used as legal tender, but Montenegro is not part of the euro area; 14 banks operate in Montenegro, which is up from 11 in 2013. Foreign subsidiaries hold 79 percent of the sector’s assets. Most of the lending is to the trade sector and households (mostly mortgages), each representing about 38 percent of total loans. Loans to nonresidents represent 18 percent of the total.

6. The insurance sector grew steadily at an average annual rate of 3 percent in the past five years. Total premium has kept pace with the growth of the economy and remains at 2 percent of GDP. The life insurance sector is very small: 6 life insurers collected EUR 12 million in premiums in 2014, insuring less than 10 percent of the population. The non-life insurance sector is predominantly compulsory motor third-party liability insurance. Nine of the 11 insurers are foreign subsidiaries, writing 95 percent of total premiums.

7. The rest of the nonbanking financial system plays a minor role. While the nascent stock exchange’s market capitalization is significant, the turnover is very low and the bond market is thin. The total asset size of the five micro-credit institutions (MCIs) is 2 percent of GDP. The leasing market is small and declining since the crisis.

B. Financial Soundness

8. The financial crisis hit asset quality (Figure 2). The crisis triggered a prolonged period of balance sheet deleveraging in banks, which translated into a nearly uninterrupted credit contraction. High NPLs, low profitability, and high private sector indebtedness continue to render banks vulnerable.

Figure 2.
Figure 2.

Montenegro: Main Banking Sector Indicators

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

9. Progress to address the debt overhang has been slow, partly owing to a weak market for real estate, banks’ unwillingness to recognize further losses, and gaps in the debt-resolution framework. Sector NPLs were still high at 14.7 percent of total loans in September 2015, down from 25.3 percent in mid-2011.2,3 NPL ratios vary widely among banks from 5.5 percent to 35 percent. Regulatory provisions, in turn, were slightly above 70 percent of reported NPLs—increasing slowly since 2010–11. Significant variations exist across banks, reflecting potential regulatory forbearance as well as an apparent reluctance on the part of some banks to create adequate provisions due to low profits.

10. Corporate balance sheets remain weak and limited progress has been made in cleaning household balance sheets, although the size of bank debt is comparable to the region (Figure 3). Corporate sector indebtedness has decreased from 2008 only by 11.2 percentage points of GDP to 114.5 percent as of 2014.4 While household domestic liabilities have declined by about 15 percent relative to the pre-crisis peak, banks have been increasing lending activities in the retail segment. High structural unemployment, declining real wages, and limited pension incomes threaten the sustainability of this lending model, absent a sustained robust boost in growth.

Figure 3.
Figure 3.

Montenegro: Corporate and Household Indebtedness

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

11. Overall lending conditions remain tight. Credit growth has been sluggish despite declining lending rates. As balance sheet repair has been modest, existing vulnerabilities cast doubt on prospects for a credit-led recovery. High NPL levels are an indication of significant rigidities in the NPL resolution framework and tightened credit risk management in many banks. Weak credit demand appears to be another important factor.

12. Banks’ reported capitalization appears adequate overall, though with significant variations. The aggregate tier I capital ratio is about 14 percent, with the CAR at close to 16 percent, compared to the regulatory minimum of 10 percent, albeit with wide differences (the highest CAR being 33 percent and the lowest 10 percent). Nevertheless, some banks could have CARs close to or below the regulatory minimum after provisioning adjustments, as assumed in the stress test.

13. Banks’ profitability continues to be very weak, with an aggregate return on assets (ROA) of 0.5 percent and return on equity (ROE) of 3.4 percent in June 2015. Interest rate spreads on new loans5 have declined significantly, putting additional pressure on bank profitability. The small market and increasing competition partly explain the high overhead expenses-to-core income ratio, which, in June 2015, was 76 percent for the sector, with five banks above 100 percent.

14. Bank liquidity is ample. Banks have reduced the loan-to-deposit (LTD) ratio since the crisis to just above 100 percent, albeit with wide heterogeneity across banks. The share of liquidity held with the CBM above the required reserves is high, reflecting possibly higher precautionary balances, sluggish credit demand, and increased risk aversion in lending, combined with limited new bankable projects.

15. Foreign exchange loan exposure is modest as the economy is euroized. As of June 2015, loans in foreign currencies amounted to EUR 171 million (7.6 percent of total loans), while deposits amounted to EUR 152 million (6.3 percent of total deposits). However, the recently adopted law on the conversion of Swiss franc into euro-denominated loans imposes significant costs on one foreign-owned bank subsidiary.6

16. Some domestically owned banks face challenges. As a group, they have weaker profitability and higher operating and funding costs than foreign-owned banks.7 In some banks, the amount of loans past due by more than 90 days disproportionately exceeds the amount of NPLs as classified by the CBM. Intensified competition for a limited number of good-quality borrowers increases pressures on interest rate spreads and banks’ earnings.

17. The viability of weaker banks should be carefully assessed. While the CBM has imposed higher capital requirements on one bank, weaker banks should be subject to more intensive supervision and not be allowed to expand by collecting costly deposits. The CBM should adopt bank-specific, time-bound supervisory action plans, including requiring additional capital to cover the actual and anticipated losses. In the absence of timely compliance, banks should be resolved on a least-cost basis. Delays in enforcement may distort the banking market and increase resolution costs significantly.

18. High NPLs, indications of inadequate provisioning in some banks, and an overall reliance on real estate collateral call for AQRs. External auditors have issued qualified opinions related to inadequate provisioning for several banks in 2013 and 2014, which have not been addressed. The supervisors also lack proper tools to challenge banks’ real estate collateral valuations. An independent AQR of banks is therefore needed to estimate the extent of inadequate provisioning and to inform subsequent supervisory action.

19. Domestic interconnectedness among banks is limited (Figure 4). While there are some cross-exposures between commercial banks, insurance companies, and investment funds, gross claims and liabilities of the banking sector to nonbanks averaged only about 2 percent of total assets. The domestic interbank transaction volume is small: only 0.2 percent of the banking sector’s total assets.

Figure 4.
Figure 4.

Montenegro: Financial System Structure and Linkages 1/

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

1/ The size of each node reflects the total assets of each institution. Linkages (edges) are bilateral claims and liabilities, and the thickness of each linkage reflects the magnitude of bilateral linkages. The data is as of December 2014.

20. The banking sector’s high cross-border exposures reflect the ownership structure, investment and hedging strategies, and search for investment opportunities. Banks’ foreign claims and liabilities account for over 115 percent and 50 percent of total regulatory capital, respectively, as of end-2014. Without viable and safe domestic alternatives, Montenegro banks invest in foreign-government securities and place part of their excess liquidity in EU banks. Some banks have invested in higher yield sovereign bonds in the region, although these exposures are limited. On average, about 20 percent of deposits belong to nonresidents, with a few banks having somewhat higher shares. Nonresident deposits, over a quarter of which are from Russia, have stayed relatively stable (Figure 5).

Figure 5.
Figure 5.

Montenegro: External Exposures of the Banking Sector, end-2014

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

Sources: CBM, IMF staff

21. The insurance sector returned to profitability in 2011, although some insurers still suffer operating losses. While the CAR stood at 735 percent for life and 170 percent for non-life insurers at end-2014, the solvency margins were calculated on a Solvency I type of fixed factors, without taking into account the risk profiles of the assets or liabilities, underestimating risks, and overstating capital.

C. Stress Tests and Tail Risks

22. Top-down solvency, liquidity, and contagion risk stress tests were conducted for the 12 banks that were active at end-2014. The tests were carried out in close cooperation between the mission and the CBM staff, using supervisory data and data submitted by banks. The tests show that capital shortfalls in the banking system could be significant in adverse scenarios.8 The banking system exhibits short-term liquidity resilience, while longer-term liquidity is less resilient and vulnerabilities to elevated funding costs are high.

23. Solvency stress tests accounted for potentially inadequate loan-loss provisioning. Strong indications of inadequate NPL provisioning were found in four banks; for three banks, the external auditors issued qualified opinions for end-2014 financial statements. Consequently, parallel solvency stress tests were conducted based on adjusted capital adequacy levels,9 rendering one of the banks insolvent before any stress was applied and would require a capital injection of 0.7 percent of GDP to reach the minimum regulatory capital requirement.

24. Three one-year macroeconomic scenarios were applied. In addition to a baseline scenario based on IMF staff projections as of August 2015, two alternative scenarios were designed to assess banking system stability under stressed conditions (see projections in Appendix Tables 8 and 9).10

  • Adverse scenario 1: A moderate scenario with an economic contraction driven by a reduction of external demand caused by a protracted euro area economic slowdown, combined with economic deterioration in Russia. The moderate scenario growth projection of -2.5 percent mimics the growth in 2012 (the EU contracted by -0.5 percent). This was combined with a significant drop of output growth in a number of sectors.

  • Adverse scenario 2: A severe scenario with significant financial market deterioration combined with the moderate scenario shocks. Montenegro suffers from reduced investments and faces elevated funding costs due to increased risk aversion. GDP is projected to fall by 5.2 percent (equal to two standard deviations from the historical mean), reflecting reduced external and internal demand. These developments are partially caused by an assumed reduced confidence in sovereign finances, causing increased funding costs for the economy.

25. Credit risk losses had the largest impact on capital adequacy (Figure 6). Due to short data history and a lack of through-the-cycle data on quarterly GDP, top-down stress tests found insufficient statistical significance in the relation between NPLs and macroeconomic variables. Stress tests relied on broad evidence of sensitivities of credit losses to real GDP growth estimated for emerging markets.11,12 Potential loan losses due to credit risk were estimated to range from 1.2 percent to 4.8 percent of GDP in the moderate and severe adverse scenarios, respectively (Appendix Tables 10 and 11).

Figure 6.
Figure 6.

Montenegro: Contribution to the Capital Adequacy Ratio of the Banking System

(In percentage points)

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

Source: IMF staff calculations.

26. Funding risk is sizable in an environment of increasing deposit competition and low profit margins. Low profitability renders banks vulnerable to increased funding costs. Under the adverse scenarios, while banks would largely be able to cover the deposit outflow using cash and liquid assets, profitability would be impaired even by relatively small deposit rate increases. With a high aggregate ratio of nonresident to total deposits, the vulnerabilities to funding cost increases may prove material.

27. Market risks are significant in a number of banks. While banks’ total holdings of fixed income, equities, and real estate on average amount to 3 percent of total assets, the distribution among banks is uneven, as some banks’ total holdings of such assets amount to above 15 percent. This causes vulnerabilities to market risk, and in particular to volatility in credit spreads on domestic sovereign and corporate bonds, as well as in equity and real estate prices. However, banks exhibit little vulnerability to foreign exchange risk.

28. Loan concentration is high in several banks. While the average largest exposure in the system remains below 25 percent of regulatory capital, some banks have exposures to single debtors above the threshold.13 The total capital shortfall resulting from the default of the largest net exposures would amount to 0.3 percent of GDP, while the default of the five largest exposures would cause capital shortfalls of 3.2 percent of GDP (Appendix Table 12).

29. Banks exhibit high short-term liquidity resilience but longer-term vulnerabilities. With an aggregate liquidity coverage ratio (LCR) of 863 percent, banks have ample and, possibly, excess liquidity. The short-term resilience remains even when deposit outflows under the severe adverse scenario are assumed and sovereign bonds and required reserves are excluded from the pool of high-quality liquid assets (Figure 7).14 However, with an aggregate net stable funding ratio (NSFR) of 124 percent and two banks below 100 percent, long-term liquidity resilience is lower. When deposit outflows are assumed, as many as seven banks fall below the 100 percent NSFR threshold, which is caused by relatively low asset quality and the use of funding deemed as unstable.

Figure 7.
Figure 7.

Montenegro: Liquidity Stress Tests Results

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

Source: CBM and IMF staff calculations.

30. A large shock to a country to which Montenegro banks have significant exposures could have both direct and indirect spillover effects on the banking system (Figure 8). Although banks’ direct exposures were relatively small, their indirect impact was large, due to the interconnectedness with countries that have direct exposures to Montenegro. The potential impact of geopolitical events in Ukraine appeared manageable.15

Figure 8.
Figure 8.

Montenegro: Cross-Border Spillovers to Montenegro Banks: Credit and Funding Shocks

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

Sources: CBM, BIS Locational Statistics Databases, IMF Financial Soundness Indicators Database and IMF staff calculations.1/ Bank failure is defined as the capital-to-RWA ratio falling below the CAR requirement.

D. Structural Challenges

31. The authorities suggested that weak credit growth and high lending rates are due to banks’ excessive risk aversion and to insufficient competition in the banking sector. Attempting to redress this situation, the CBM has looked favorably at applications for new bank licenses, and the authorities are also considering imposing lending rate caps to spur credit growth.

32. The mission found the competition in the banking sector not weak, evidenced partly by low concentration and persistent weak profitability. In terms of concentration and market power, there seems to be no evidence of dominance in the market. The Herfindahl–Hirschman Index (HHI) was about 0.12 for assets, deposits, and loans at end-2014. The share of the five largest banks has declined from 85 percent at end-2008 to 68 percent.

33. Staff analysis suggests banks’ high interest rate spreads are mainly driven by costs. A decomposition of interest rates spreads for the period 2007–14 shows that spreads on outstanding loans are driven predominantly by overheads and provisions, while profit margins are mostly negative (Figure 9). Furthermore, competition has compressed spreads on new lending to levels threatening the survival of some smaller banks with higher funding and operating costs and a weaker client base. Anecdotal evidence suggests that cost pressures on the funding side, coupled with declining lending rates in the fight for a few good clients, are driving some banks into a high-danger zone.

34. The authorities were discouraged from introducing caps on lending rates and from increasing the number of banks without a sound business plan and robust capital base. Introducing caps may further restrict credit to small- and medium-size enterprises and consumers, as well as lead to an undesirable mispricing of risks. International experience suggests that interest rate caps have a limited effect on supporting lending while having a negative impact on financial access.16 The increase of number of banks, particularly without solid business plans and strong capital, may lead to costly market disruptions.

35. There are no easy solutions to address the high lending rates that are relatively common in the region. In particular, the high cost of long-term funding (reflected in high sovereign yields), a sluggish economy, and overall high indebtedness and associated high credit risks, as well as the low rate of recovery on NPLs and other structural rigidities in the economy, are all likely to contribute to elevated lending rates and higher risk aversion (Figure 9).17

Figure 9.
Figure 9.

Montenegro: Concentration and Competition

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

Sources: CBM, Bankscope, and IMF staff calculations.

Financial Oversight

A. Macroprudential Framework

36. While responsibilities for financial stability have been assigned, macroprudential policies or instruments are missing. The CBM has a financial stability objective, but lacks the toolkit for mitigating systemic imbalances. Similarly, the FSC aims to monitor, identify, prevent, and mitigate systemic risks in the financial system, but lacks a macroprudential toolkit or enabling clause to authorizing the CBM to introduce macroprudential tools.

37. Within the current institutional framework, the macroprudential mandate should be vested in the CBM. This mandate should build on the existing regulatory and supervisory powers of the CBM, expanding them toward a macroprudential framework, and include powers over macroprudential instruments as part of their ability to act. The identification of instruments (such as loan-to-value, debt-service-to-income, debt-to-income ratios, and capital buffers) is particularly relevant, even if not immediately activated. The FSC, in turn, should retain its mandate over financial stability, expanded with additional powers to issue recommendations on macroprudential policy. To ensure accountability and the willingness to act, these recommendations should be made public. The CBM should continue to chair the FSC and perform technical operations.

B. Systemic Liquidity Management

38. Systemic liquidity management is constrained by euroization. Without the ability to create money, the CBM’s options to manage liquidity and provide liquidity support are limited. Therefore, high liquidity buffers and strong bank supervision are essential for reducing vulnerabilities that may emerge because of those limitations.

39. Surplus liquidity in the system reflects both the banks’ need to maintain liquidity buffers in a euroized economy, with very limited capacity for official liquidity support,18 and sluggish credit demand. Since 2012, banks’ transactional non-interest-bearing balances19 (Figure 10) have increased from 60 percent of required reserves to 80 percent.20 Furthermore, a low euro interest environment and sluggish credit demand have increased idle balances with the CBM, weighing on banks’ profitability.

Figure 10.
Figure 10.

Montenegro: Required Reserves

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

Source: CBM.

40. Ensuring sound liquidity risk management standards is important. The work on Basel III should be complemented by regulatory liquidity ratios to strengthen banks’ short-term resilience. The current design of regulatory liquidity ratios has several shortcomings: the government bond market is shallow and illiquid; high-quality liquid assets (HQLA) are limited; and it is difficult to assess stressed outflows due to limited data series. This puts a bigger onus on the regulator to ensure that the liquidity ratios are dynamic and that they rely on frequent calibration and quantitative impact studies. The CBM should strengthen liquidity risk supervision by focusing on significant currencies, dynamic and structural maturity mismatches, and feasibility of contingency plans, particularly for domestically owned banks. The CBM could also take this opportunity to remove treasury bills from the list of eligible securities to meet RRs as the market for government securities is illiquid.

C. Banking Oversight

41. Laws, regulations, and supervision have improved significantly since the 2006 FSAP to align more closely with Basel and EU requirements. The CBM adopts a risk-based approach to banking supervision. While the approach is conservative in some elements, several important areas for improvement are identified.

42. A more conservative approach by the CBM to the evaluation of business plans and issuance of new licenses is warranted. Three new banks were established in the past year. Each bank submitted detailed three-year business plans that, prima facie, appeared feasible. Nonetheless, in the current business climate, questions must arise about some banks’ viability to survive.

43. While legislation provides for consolidated supervision, the concept is defined narrowly and the application is limited. At present, consolidated supervision focuses narrowly on accounting and reporting issues; supervisors do not focus sufficiently on understanding and assessing group-wide risks, including reputational and contagion risks. Prudential ratios are not calculated on a consolidated basis. The company law does not recognize the concept of a ‘holding company’; if introduced, this would facilitate consolidated supervision.

44. Weaknesses in the broader operating environment are diluting the effectiveness of credit risk management and the CBM’s ability to supervise this risk. These weaknesses include the unavailability or unreliability of borrowers’ audited financial statements and inability to independently verify or establish connectedness among counterparties. There is also scope for excluding or discounting certain exposures while measuring credit risk, and difficulty in quality evaluation and timely disposal of collateral. The need for enhanced supervision in some banks may strain the CBM’s capacity and call for an increase in resources for banking supervision.

45. The prudential framework for identification and measurement of problem assets is conservative in some respects, but has significant gaps. These result in inaccurate presentation of the level and quality of nonperforming assets; enforcement should also be strengthened. This arises mainly because the prudential framework allows banks to reclassify assets on the basis of types of collateral, irrespective of the borrowers’ ability to repay, and lacks adequate clarity and consistency for restructuring or rescheduling loans and their prudential treatment.

46. The implementation of the CBM’s prudential limits for related-party transactions and large exposures is weak. The CBM’s measurement of exposures is at variance with Basel norms and diverts banks’ and supervisors’ attention from the gross exposures that reflect the maximum exposure to loss. The aggregate limit for all related-party exposures is too high at 200 percent of own funds, compared to a level of 25 percent under the Basel Core Principles (BCP). There are also significant gaps in the definitions of “related party” and “related-party transactions.” The CBM should also expand the scope of supervision to address concentration risks, including sector concentration and concentration through collateral.

47. While the legal, regulatory, and supervisory frameworks for risk management are well established, there is scope for improvement. Banks should be required to improve the governance framework for risk management and the CBM should address the concentration of outsourcing activities at the system level to limited service providers; provide additional guidance to banks on monitoring and management of operational risk, concentration risk, funding risk, and interest rate risk in the banking book; and develop appropriate methodologies to supervise these risks.

48. While the CBM has adopted a conservative approach to Basel II implementation by requiring higher minimum capital ratios and higher capital for operational risk and for country risk, gaps in the measurement of capital and risk-weighted assets (RWA) exist. The current framework (1) does not require banks to deduct deferred tax assets and significant investment in the equity of restructured borrowers, (2) allows fixed asset revaluation reserve at full value without being discounted, and (3) assigns a lower risk weight to nonperforming assets and exposures secured by commercial real estate.

D. Insurance Oversight

49. The Insurance Supervision Agency (ISA) should transition from compliance-based supervision to risk-based supervision. While the ISA has made substantial progress in developing the regulatory framework since its establishment in 2008, a risk-based supervisory framework needs to be adopted before implementing the Solvency II regime. At a minimum, the ISA should introduce guidelines on corporate governance and requirements on risk management and internal controls. Offsite supervision must include assessments of the risks of the insurer’s business, the effectiveness of the insurer’s risk management policy, and the adequacy of its capital.

50. The ISA should develop a transition strategy to gradually introduce Solvency II. To help the industry make this transition smoothly, the ISA should develop a phased approach. Before adopting Solvency II, the ISA should improve the existing solvency regime with the following:

  • Establish asset valuation rules for solvency purposes, including the treatment of intangible assets, encumbered assets, and provisions for long-outstanding receivables and doubtful debts. An aggregate limit on investments in and loans to related entities for solvency purposes is important in light of the market dominance of foreign participants.

  • Adopt scenario testing to analyze the financial resilience of the insurer in predetermined scenarios. In the absence of more sophisticated capital adequacy requirements under Solvency II, scenario testing is a good way to identify vulnerabilities.

E. Financial Market Infrastructure Oversight

51. Steps taken since the 2006 FSAP are generally conducive to operations and further development of payment and settlement systems, but more improvements are needed.

  • The CBM oversight function could be further strengthened with an oversight policy framework that is consistent with the newly enacted Payment System Law and international standards, including public policy objectives, the CBM’s standards, the scope, activities, and tools for oversight, and the mechanisms for cooperation with other regulatory authorities.

  • Risk-mitigation measures are required to minimize any residual liquidity risk and any consequential credit risk in the CBM payment system (with RTGS and DNS modules): (1) defining priorities for payment orders that could lead to their immediate rejection in the event of a lack of balances, (2) facilitating the automatic transfer of balances from the reserves account to the settlement account for settling any pending transactions, and (3) automating the intraday liquidity facility on a collateralized basis. Furthermore, the partial unwinding of transactions (especially in the final settlement cycle) in the DNS system should be eliminated.

F. Anti-Money Laundering and Combating the Financing of Terrorism

52. Montenegro is taking active steps to enhance its AML/CFT framework and to reach a better understanding of its money laundering and terrorist financing risks (ML/TF). The most recent assessment in 2014 found significant deficiencies.21 Some progress has since been made, in particular through the AML/CFT law rescinding the previous versions of the law. The new law notably strengthened customer due diligence (CDD) obligations by requiring the reporting entities to verify the identity of a person purporting to act on behalf of a corporate customer, and by allowing the application of simplified CDD in instances of “insignificant” ML/TF risk and no suspicion of ML/TF. Practical steps were also taken to improve the reporting of suspicious transactions (by expanding the indicators of suspicious transactions and conducting training events for reporting entities) and to initiate a national assessment of Montenegro’s ML/TF risks.

53. Significant deficiencies nevertheless remain. The scope of the reporting requirements remains narrow, as it refers to the reporting of “transactions” (rather than “funds”) and of “suspicion of ML/TF” (rather than “suspicions of funds that are the proceeds of a criminal activity”). Information on the beneficial ownership of legal persons created in Montenegro does not appear to be accessible to competent authorities in a timely manner. While reporting entities collect some beneficial ownership information, it does not appear adequate. Enhanced due-diligence measures are insufficient, notably because reporting entities are not required to establish on a risk basis the source of wealth of beneficial owners identified as domestic politically exposed persons (PEPs). In addition, there are no provisions to prevent criminals or their associates from holding or being the beneficial owners of a significant or controlling interest, or from holding senior management functions in certain financial sector institutions. These deficiencies and other significant vulnerabilities identified in the national risk assessment should be addressed as a matter of priority.

Resolution of Nonperforming Loans

A. Nonperforming Loans

54. NPLs remain a difficult legacy reflecting the impact of the global financial crisis and subsequent economic slowdown as well as lax pre-crisis lending standards. If not reduced, NPLs will continue to burden banks’ balance sheets, undermine profits and capital, and suppress banks’ appetite for new lending. Because the bulk of NPLs are backed by real estate collateral, the state of the real estate market—in combination with some banks’ inability and unwillingness to absorb losses—is one of the key impediments to reducing NPLs. The absence of sound estimates for the shortfall in provisions relative to actual losses that would be incurred in more rapid NPL resolution impedes effective policy formulation.

55. Regulatory standards have been loosened over the past several years. This should be reversed in accordance with the recently strengthened supervisory requirements. The CBM has introduced a requirement for banks to prepare a multi-year NPL resolution strategy, including annual operational targets and quarterly reporting against those targets. In addition, the CBM should strengthen regulatory standards and enforcement to establish loss provisions that better reflect expected losses. Where appropriate, banks should be required to raise additional capital to support these provisions and to create headroom to absorb the losses that would be associated with future NPL workouts and write-offs. To ensure compliance with tightened regulatory standards, the CBM should establish a specialized team within the Supervision Department to be a resource to the relationship managers and their teams, and to support the supervision of NPL management practices in all banks. (This team would be distinct from staff responsible for individual bank relationship management and for supervising the credit risk management function.)

56. The CBM should also consider requiring banks to separate certain NPLs into specialized workout subsidiaries. This could improve the management of the transferred NPLs by enabling managers to focus on value recovery and to institute independent governance to support that objective.

57. In order to analyze, regulate, and monitor the NPL problem in its entirety, it is recommended to strengthen reporting requirements for nonbank credit institutions and asset management vehicles. In addition to the EUR 397 million NPLs on banks’ books, about EUR 720 million has been sold predominantly to parent banks and affiliated SPVs. Reporting these exposures to the credit registry should be made mandatory in order to enhance the CBM’s monitoring of NPL dynamics comprehensively.

B. Insolvency and Creditor Rights

58. A number of legal and institutional reforms to improve the framework for insolvency and creditor rights have been undertaken in recent years, but gaps remain. The legal framework governing bankruptcy is comprehensive and security rights are adequately protected in liquidation. Nonetheless, there is substantial variability in the speed and quality of enforcing some legal provisions by the courts. A business rescue culture is not developed. Reorganization “workouts” are not common, and so most bankruptcy cases end up in liquidation. Land titling procedures and cadastral information have been improving, but gaps remain, especially in rural areas.

59. The recently enacted Law on Voluntary Restructuring of Debts should be amended. In particular, eligibility for using the law should be broadened to loans that encompass debtors in serious financial distress or insolvency. Also, the out-of-court debt-restructuring mechanism would be well complemented by a fast-track procedure to confirm workout plans previously approved by a legally defined majority of creditors, making such plans obligatory with respect to all creditors. This would encourage creditors to participate in out-of-court negotiations and limit threatening attitudes from minority creditors who hold out.

60. The recent Law on Consumer Bankruptcy raises several concerns and should be amended or clarified through regulations. The current text does not contemplate adequate safeguards to protect the secured creditors’ rights. For example, the law establishes—depending on interpretation—a radical exemption in favor of a bankrupt debtor’s house, which cannot be sold in bankruptcy, provided that this is “commensurate with the basic housing needs of the consumer.”22 If the exemption is applied to loans that were secured by mortgages created before the law was entered into force, most of the loans would be considered unsecured and their collection hampered.

Financial Safety Net

A. Institutional Arrangements

61. While the establishment of the FSC and its activities is welcome, there is scope for improvement. The FSC was established to maintain financial system stability and avoid financial distress. However, several inter-agency Memoranda of Understanding (MOUs) have not been updated since the FSC’s establishment, and overlapping scopes with the FSC Law and the absence of MOUs between several institutions raise questions about the efficiency of the framework. The DPF should be an FSC member; currently, the DPF does not get invited to FSC meetings, while the FSC Law does permit this. The FSC members should have the formal authority to send representatives to the meetings as the functioning of the FSC in the current framework could be hampered in the case of the temporary absence of a member.

62. There is scope for improving the agencies’ contingency plans and the national contingency plan (NCP). The FSC has adopted the NCP to complement institution-specific contingency plans. However, the FSC does not always focus on crisis preparedness and its management mandate; it focuses on its systemic risk-monitoring mandate. Progress toward the NCP’s implementation is rarely discussed by the FSC and it has yet to organize a system-wide crisis simulation exercise involving all FSC members and the DPF.23 Moreover, none of the oversight agencies have formal cross-border arrangements with home resolution authorities, nor is a cross-border crisis management framework in place.

63. The CBM should be confirmed as the resolution authority for the institutions under its supervision. The CBM is the de facto resolution authority for banks. In light of the size of the banking sector, there is no need to establish a new resolution authority. If the CBM becomes the supervisor of other financial institutions, under new legislation that is under development, the CBM should also be the resolution authority for them. To increase the CBM’s effectiveness, a dedicated full-time, small Resolution Unit should be established, and the unit should have ready access to resources throughout the CBM. Its reporting line to the CBM Board should be separate from the department responsible for emergency liquidity assistance and also from the Supervision Department.

B. Failure Mitigation Regime

64. The CBM is authorized to impose a wide variety of early intervention measures under a range of circumstances, including if, in its assessment, a bank’s financial viability could be threatened. These measures include scaling down or ceasing certain operations, establishing adequate reserves for losses, selling assets, restricting or ceasing dividends, increasing capital, and removing executive directors or board members, among others.

65. The CBM requires banks to undertake contingency planning, including for purposes of restoring capital and liquidity in times of stress. Although full recovery plans, as envisioned under the EU Bank Resolution and Recovery Directive (BRRD) and related European Banking Association (EBA) guidance, are not yet necessary, the banks are required to prepare contingency plans for managing their liquidity in crisis situations. The CBM has issued a detailed document outlining its expectations for the plans. Banks’ liquidity contingency plans are evaluated as part of individual bank supervision. Similarly, as part of its regular supervisory processes, the CBM requires banks to prepare capital plans that must be updated annually.

C. Failure Resolution Regime24

66. The CBM can appoint an Interim Administrator (IA) who has the power to resolve a potentially failing bank. The IA assumes the powers of the shareholders, the Board, and the Executive Directors; he has wide authorities, including to sell assets and to transfer assets and liabilities to another bank. The CBM directs and supports the IA. The outcome is either resolution via recapitalization, the transfer of some or all assets and liabilities to another bank, or bankruptcy.

67. Certain desirable resolution powers are not available. These include establishing a bridge bank and—as a last resort—the power to recapitalize and temporarily fund a systemically important bank (including via the use of a bridge bank) in the absence of a private sector-funded resolution. Some powers are envisioned, however, in draft special legislation that would be introduced in a systemic crisis (the so-called “lex specialis”). The lack of certainty as to whether these legal powers would actually be available when needed complicates resolution planning.

68. The CBM, as the de facto resolution authority, has yet to initiate bank-specific resolution planning. While this is envisioned for the transposition of the BRRD, the CBM can immediately start bank-specific resolution planning, including conducting resolvability assessments to determine the impediments to the resolution of specific banks. This work should be executed by the Resolution Unit, prioritized based on banks’ CAMEL ratings, and coordinated with home authorities—without being dependent on these authorities. If structural impediments to resolvability are identified, the CBM should consider using its powers under the Banking Law to cause the bank to remedy those impediments.

69. Existing resolution funding powers and arrangements are limited and should be strengthened. The liquidity and capital support provisions are insufficient. Although the lex specialis, if adopted, should provide some useful tools to support the effective resolution of a systemically important bank (for example, the ability to establish a bridge bank), and strong liquidity and capital support provisions and related safeguards. The DPF should be able to finance the transfer of insured deposits to another bank through purchase and assumption (P&A).25 The MOF should be given the statutory authority in the lex specialis to borrow and/or use budgetary means up to a specified limit without requiring ex ante parliamentary approval, though with ex post parliamentary accountability.26 The MOF could establish a fee-paid (committed) contingent credit line with a reputable foreign bank or an international financial institution.

70. The rules for the use of public funding in a crisis situation should be clearly defined. Shareholders and hybrid capital and subordinated debt holders should fully absorb losses, and shareholders should be fully written off prior to receiving any government capital support. The objective to follow a least-cost resolution method should be explicitly introduced into the law. To guide the potential provision of such support, the CBM and the MOF should adopt explicit policies that set strict, objective, quantifiable, and measurable criteria for determining whether a bank is so systemically important that its failure would have severe repercussions for the financial system. Any loss incurred in the provision of public funds should be recovered from the banking industry. The provision of public funds should be contingent on, or followed by, formulation of a restructuring plan that ensures long-term viability.

D. Deposit Insurance

71. The deposit insurance system is relatively well developed but some operational improvements are needed. The DPF operates under the narrow mandate of a pay box. The level of funding by banks is sufficient to cover all insured deposits in all small banks; a standby credit line with the European Bank for Reconstruction and Development (EBRD) and a statutory provision for backup funding from the government are available. The Deposit Protection Law (DPL) should be amended, enabling the DPF to finance the transfer of insured deposits to another bank through P&A. In addition, the DPF should be allowed to use other options for payout, including making payments electronically to deposit accounts established by depositors in other banks or using interim or advanced payments in the case of prolonged delays. Furthermore, the payout timeframe should be shortened from 15 working days to 7, and risk-based premiums should be introduced.

E. Liquidity Support

72. Limited resources to finance ELA constrain the CBM’s lender-of-last-resort (LOLR) ability. Due to its inability to create money, the CBM would need to provide financial assistance from its capital. With limited resources, the CBM cannot be expected to act effectively as the LOLR in case of a system-wide liquidity shock. Although in 2009, during the global financial crisis, foreign banks facing liquidity outflows obtained financial assistance from their parents, there is no guarantee that such credit lines would be readily available again.

73. ELA provisions under the CBM Law and the lexspecialis should be brought under a single framework. A formalized emergency liquidity support framework is in place under the CBM Law and also laid out in the lex specialis. The new single framework should include only the components of the existing and draft legislation that reflect best international practices (for example, prescription of eligible collateral, pricing, and haircuts) and should include certain essential safeguards such as the prohibition of financial transactions by the receiving banks with their related parties.

74. To avoid delays in providing ELA and to limit its risk exposure, the CBM should have available a list of acceptable collateral with pricing and haircut methodologies. While it is difficult to prepare for all possible scenarios and types of collateral, the CBM should develop a list of what would constitute “other collateral deemed acceptable,” along with pricing and haircut methodologies, as well as develop its capacity to administer such assets. The list—for internal use only—might include, for example, residential mortgages and corporate loans. To safeguard the CBM’s financial autonomy, alternative sources of funds and additional conditions and restrictions for the CBM ELA should be considered. There could be alternative options—based on international experiences—to expand the envelope of ELA funding. These could include a dedicated MOF subaccount at the CBM for ELA that the CBM could use at its discretion in addition to its own limited resources. Arrangements should be put in place for the MOF to reimburse the CBM for losses stemming from ELA.27

75. Banks requesting access to the CBM ELA must first exhaust all existent sources of liquidity. Further safeguards could include (1) requiring an objective, predetermined solvency test both at the start and the duration of ELA, (2) capping the use of the CBM’s fund for ELA and implementing measures to reimburse the CBM for its ELA-related losses, (3) requiring foreign-owned banks’ parents to present a letter of comfort to provide liquidity in times of stress, (4) prescribing appropriate safeguards for the use of ELA by the receiving bank and enhancing monitoring to minimize moral hazard,28 and (5) allowing banks to draw down the required reserves at the CBM below the minimum requirement for a short period.29

Appendix I. Economic and Financial Soundness Indicators

Appendix Figure 1.
Appendix Figure 1.

Montenegro: Monetary and Capital Market Developments

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

Sources: Montenegro authorities, Bloomberg
Appendix Figure 2.
Appendix Figure 2.

Montenegro: External Sector Developments

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

Sources: Montenegro authorities, WB, BIS, WEO, and IMF staff calculations.1/ Real effective exchange rates are trade-weighted and CPI-based.
Appendix Figure 3.
Appendix Figure 3.

Montenegro: Key Financial Soundness Indicators: Cross-Country Comparisons

Citation: IMF Staff Country Reports 2016, 088; 10.5089/9781475519815.002.A001

Sources: IMF Financial Soundness Indicators Database; Bank of Albania; and National Bank of Serbia.1/ The red bars represent data for 2014Q3.2/ The red bars represent data for November 2014.
Appendix Table 1.

Montenegro: Selected Economic Indicators, 2010–20

(Under current policies)

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Source: Ministry of Finance, Central Bank of Montenegro, Statistical Office of Montenegro, and IMF staff estimates and projections.

Reflects a change in the methodology by Monstat starting January 1, 2010.

A change in classification in off-balance sheet items has resulted in a structural break in 2012; the annual changes for credit growth in 2013 are distorted by the change in methodology.

Includes extra-budgetary funds and local governments, but not public enterprises.

Estimates, as private debt statistics are not officially published.

Appendix Table 2.

Montenegro: Financial System Structure, 2010–2015

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Source: CBM

Latest available.

Appendix Table 3.

Montenegro: Financial Soundness Indicators, 2009–2015

(In percent)

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Source: CBM.

Provisions reflect IFRS impairments. The ratios based on CBM regulatory provisions are higher; the respective ratio was 72.6 percent as of end-June 2015.

Appendix Table 4.

Montenegro: Banking System Assets, End-September 2015

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Source: CBM.
Appendix Table 5.

Montenegro: Summary of Banking System Loan Portfolio, End-2014

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Source: CBM.
Appendix Table 6.

Montenegro: Risk Assessment Matrix

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Appendix Table 7.

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

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Appendix II. Progress on 2006 FSAP Recommendations

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Appendix Table 8.

Montenegro: Macroeconomic Projections for Stress Test

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Source: IMF staff estimates.

Exchange rate is expressed in EUR as the equally weighted average price of USD, GBP, and CHF.

Appendix Table 9.

Montenegro: Financial Projections for Stress Test

(In percent)

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Source: IMF staff calculations
Appendix Table 10.

Results of the Solvency Stress Test without Provisioning Adjustments

(All amounts in millions of euro)

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Source: IMF staff calculations