Baseline Diagnostics

32. Significant improvements have been made in the area of banking regulation and supervision since the 2012 FSAP. Several new regulations have been issued covering almost all aspects of supervision; the CBK has introduced a risk-based, forward-looking supervisory approach; Basel III (except the liquidity standards) becomes effective in January 2020, as does International Financial Reporting Standards (IFRS) 9; and the Law on Banks, Microfinancial Institutions, and Nonbank Financial Institutions (LB) is being updated to include provisions relating to recovery and resolution of banks, consumer protection, and amendments to some existing provisions.¹² Also, the problem identified in the 2012 FSAP, whereby the CBK could not adequately supervise banks in Northern Kosovo for political and security reasons, has been partially addressed.

33. In broad terms, regulatory structures in Kosovo coincide with international norms. There is a strong legislative base, the CBK carries out the main functions of supervision (licensing, onsite/offsite supervision, AML/CFT surveillance, etc.) and is staffed by dedicated and knowledgeable persons, although some gaps in expertise exist, as discussed hereunder.

34. Banks meet capital adequacy requirements and are reasonably profitable with low levels of NPLs. The aggregate capital adequacy ratio is about 16 percent and has been at that level since 2016, at least. Almost all capital is composed of Common Equity Tier 1 (CET1).¹³ The return on equity has been about 5–6 percent since 2015 and the NPL ratio is currently 2.6 percent, having fallen steadily from 5.9 percent in 2016. The reason for the favorable NPL figure is attributed to a very effective collection system, better underwriting by banks and a strengthening of banking supervision. However, a significant part of the increase also relates to the denominator effect (rapid credit growth) and write-offs.

35. Banking business in Kosovo is traditional in nature. It largely comprises the acceptance of deposits and granting of loans. Virtually all banking business is conducted in euros, and there is no cross-border activity except for placements from and with foreign banks and parent bank groups of Kosovo banks. Placements from groups banks are restricted to 20 percent of total deposits, and placements with them are restricted to 10 percent of Tier l capital as such placements are regarded as related-party transactions.

36. The CBK should review as a matter of urgency its staff complement in terms of both number and expertise. The mission was impressed by the professionalism, knowledge, and dedication of the supervisory staff. However, they seem overstretched and will be even more so in the future. It is acknowledged that the CBK operates an effective training program with frequent attendance at relevant courses abroad. However, the burden of regulation, both in terms of policy and practical supervision, has become more complex and technical with the advent, for instance, of Basel III and IFRS 9. Accordingly, the CBK should very carefully consider the implications of these and other requirements on staffing levels and expertise. Also, there is currently no practice of seconding staff between the Banking Supervision Department (BSD) and the Licensing and Standardization Department (LSD). Such practice would be of benefit to both departments.

37. There is no provision in law for the public disclosure of reasons for the dismissal of CBB members, as is stipulated in the BCP.

38. The CBK should remove any remaining doubt concerning the protection of staff against defending their actions and/or omissions made while discharging their duties in good faith. The CBL (Article 78) provides that “The Central Bank shall indemnify a member of the Central Bank’s decision-making bodies or its staff, or an agent of the Central Bank against costs incurred in the defense of a legal action brought against such person in connection with the discharge or purported discharge of official tasks within the scope of his employment or engagement under this law, provided that no such indemnification shall apply if such person has been convicted of a crime arising out of the activities that are covered by such legal action.” It was noted in the 2012 FSAP, however, that then recent cases showed delays and challenges to reimbursement of legal defense costs. In response to this finding, the CBK introduced an internal rule on the indemnification of costs in legal proceedings. However, such indemnification is conditional; most notably, even where the CBK Human Resources Division recommends payment of such costs, the Governor may reject it. The CBK should consider amending the rule to more accurately reflect the provision in Essential Criteria 9 of BCP 2, namely that the supervisor and its staff are adequately protected against the costs of defending their actions and/or omissions made while discharging their duties in good faith.

39. The CBK should review the list of regulations to ensure that all necessary risks and issues are dealt with. The CBK has issued supervisory regulations that cover almost all relevant matters. However, there are gaps, e.g., limits on the use of capital conservation buffer, countercyclical buffer, country and transfer risks, cybercrime and certain aspects of market risk. The CBK should review the list for completeness and revisit existing regulations, many of which date from 2012–2013, to ensure that they reflect current thinking.

40. The CBK should consider updating its list of activities that can be undertaken by banks (permitted activities). Article 44 of the LB sets out the list of permitted activities. However, this list was devised in 2012 when the law was enacted and takes no account of developments since then, particularly those driven by technology. During discussions with external sources concerns were raised about, for example, the absence of specific reference to digital money services and the fact that the law provides that communications with bank customers in certain circumstances must be made via letter, thereby ruling out the use of more advanced technology for such communications, e.g., the use of electronic signatures. (It is noted that permitted activities are being addressed in the current draft of the new law on banks. Inter alia, the proposed new law elaborates on existing activities, and provides for new activities, e.g., provision of insurance or reinsurance services and pension company services. It also specifically provides for the implementation of electronic money services.)

41. In relation to the application process for a banking license, some information relating to the applicants is incomplete. For instance, in seeking details about the professional and business history of directors and senior management of the proposed bank, the CBK requires such information only for the previous 10 years, rather than for the entire career of the applicants.

42. The CBK has not been invited by the ECB to participate in the supervisory college of Raiffeisen. Nor is the CBK party to its resolution and recovery plans. Raiffeisen is the largest bank in Kosovo, with a market share of almost 25 percent, and is a subsidiary of an Austrian bank. As a systemically important financial institution, it is supervised by the ECB in conjunction with the Austrian Supervisory Authority. While the local operations in Kosovo may be relatively insignificant in group terms, they are of major significance in the Kosovo financial market and economy. Accordingly, the CBK should have every opportunity to be party to group regulatory deliberations. Also, the CBK should continue its efforts to sign a memorandum of understanding (MoU) with the Austrian authorities, notwithstanding the apparent reluctance of the latter to do so.

43. The CBK should limit the period of tenure for directors of banks. Currently, bank directors are appointed for terms of not more than four years and may be reelected for subsequent terms. However, there is no limit to the number of times a director may be reelected. Best practice (as, for instance, set out in the joint guidelines of September 2017 on the assessment of the suitability of members of boards of banks and investment firms by the European Banking Authority and the European Securities and Markets Authority (ESMA) (Article 91)) would suggest a maximum period of 12 years in this area; any longer could result in the independence of independent directors, in particular, being compromised. The joint guidelines do not automatically exclude such a person from being an independent director, however, it requires the bank/investment firm in question to justify to the supervisor the reasoning why the members’ ability to exercise objective and balanced judgement and to take decisions independently are not affected by the situation.

44. While the law provides for the CBK to meet the external auditors, such meetings rarely take place. They do not seem to be regarded as necessary as generally no issues of concern to either side tend to arise. However, even in the absence of specific problems, it is regarded as good practice for the regulator and external auditor to meet on a regular basis to discuss issues of common interest. This could happen either at the planning stage of the audit or after the auditor has completed the audit, or both. Moreover, the CBK should instigate meetings with the external auditing profession as a group to discuss issues of common concern to both.

45. The CBK banking supervisory process is well documented and comprises integrated offsite and onsite activities, while the Executive Board is the decision-making body for corrective measures against banks. The RBS manual organizes and formalizes guidance to the CBK’s bank examiners, in order to ensure a consistent application of supervisory procedures. The offsite manual, although not yet into force,¹⁴ is very comprehensive in establishing the offsite supervision role and provides guidance on its conduction. Supervision is conducted both on a solo and consolidated basis. Onsite supervisors from banking and nonbanking areas may perform joint examinations when special expertise is needed. The Reporting and Analysis Division of BSD is responsible for offsite activities of all institutions in Kosovo’s financial sector and produces micro- and macrofinancial analysis reports.

46. The Payment System Department (PSD) is responsible for the oversight of banks’ intraday liquidity procedures. Exchange of information on banks’ liquidity status between supervisors and PSD staff is adequate for each other’s needs and effective in both directions, although on an informal basis. PSD is not formally responsible for reporting to BSD in the event of a bank not complying with its intraday liquidity needs. Neither the PSD nor the BSD requires banks to assess stress scenarios forecasting disturbances to payment and settlement systems.

47. Banking supervision in Kosovo has not yet experienced periods of financial stress. The short history of Kosovo’s banking supervision and the absence of a financial crisis during its life time have not given supervisors the practice to conduct banking supervision under stress. BSD’s emergency decision-making processes and the role of supervision in the event of a bank request for ELA, for example, need to be formalized and periodically tested.

48. The CBK keeps and administers the CR to collect and distribute credit information to financial institutions. All credit providers are required to report to the CR of Kosovo all credit applications and credits extended to their customers, and they may assess a client’s information upon his/her authorization. BSD makes use of CR information to assess whether the risk classification of a specific client is consistent among credit providers. A more thorough assessment of credit risk in banks and the credit market based on CR granular data has not yet been developed.

49. Regulation requiring Basel III minimum standards for liquidity risk are still in an initial stage of elaboration. The current regulation on liquidity risk management requires banks holding the ratio of liquid assets against short-term liabilities at the minimum level of 20 percent by currency, and of 25 percent in total currencies. All banks are well above these limits.

50. The banks’ liquidity risk may be underestimated by supervisors, while they rely on the current regulatory ratios for its assessment. Liquidity buffers may be overestimated in case a bank relies on assets that could not be easily settled to cover its liquidity need, such as Government of Kosovo (GoK) securities, due to the absence of active secondary markets in Kosovo. Besides, the ratio metrics do not take into account cash outflows that may occur in stressed situations, such as the early withdrawal of term deposits. The absence of legal impediments for a customer to withdraw term deposits prior to maturity may bring unexpected outflows not considered by the current ratios. Thus, in order to cover these gaps, in particular as long as Basel III liquidity requirements are not yet in place, offsite supervision should improve monitoring tools to have a better comprehension of banks’ liquidity risk exposure. Methodology should explore banks’ vulnerabilities and identify whether their contingency buffers are sufficient to support the liquidity needs derived from stressed scenarios.

51. Except for two branches, Kosovo banks would not face difficulties complying with the liquidity coverage ratio (LCR). However, while being a minimum requirement, this ratio is also a comprehensive liquidity stress test and should be used for a more thorough assessment of banks’ liquidity capacity. For example, estimations show that in a scenario where GoK securities are not included in the high-quality liquid assets (HQLA) buffer due to the absence of a liquid market for these securities, one bank would breach the minimum LCR while two others would experience a relevant reduction in their liquidity ratio levels.¹⁵

52. The CBK is experiencing delays in the implementation of repo operations longer than the intraday lag with the market. The CBK provides intraday liquidity facilities to banks, through repo operations collateralized by government securities. However, these operations cannot exceed the intraday lag. The CBK has already drafted regulation to regulate repo operations with market participants maturing beyond the intraday term, but there is no provision for its implementation.¹⁶ The stage of development for the facility’s framework, in terms of an IT solution, at the CBK is also unclear. This facility is very relevant to improve the liquidity capacity of Kosovo’s government securities and opens the door for the development of a secondary market for them. The Regulation on Liquidity Risk Management already treats these assets as liquid for the computation of the required liquidity ratios.

Main Recommendations

53. The authorities should prioritize a review of the staffing requirements within the three supervisory Departments: Banking Supervision; Licensing and Standardization; and AML. To this end, the authorities need to:

• Undertake an in-depth analysis of the staffing requirements that are currently needed and will be needed in day-to-day supervision and policy, particularly as a result of the upcoming implementation of new requirements such as Basel III and IFRS 9. These new requirements require highly specialist and expert staff with a detailed understanding of their subject matter. Improved IT infrastructure and greater support for data analysis should also be part of the review.

• Provide for the secondment of staff between the BSD and the LSD.

54. Other areas that the authorities should address include:

• Remove any remaining doubt concerning the protection of staff against the costs of defending their actions and/or omissions made while discharging their duties in good faith. Specifically, amend the CBK’s internal rule on the Indemnification of Staff Costs in Legal Proceedings by providing unconditional support for staff in these circumstances.

• Provide for public disclosure reasons for the dismissal of CBK’s Board members.

• Review list of regulations to ensure that necessary risks and issues are dealt with (e.g., country and transfer risks, cyber risk, and certain aspects of market risk) and re-examine existing regulations to ensure that they reflect the latest thinking.

• Update list of activities and procedures that can be undertaken by banks to reflect, inter alia, technological developments in banking.

• In relation to the applications for banking licenses, require full details of the business and professional history of directors and senior management, as well as for principal shareholders of the proposed bank (rather than only for the past 10 years).

• Intensify efforts with the ECB to participate in the Raiffeisen supervisory college and to be party to its resolution and recovery plans.

• Limit the maximum period for which directors can be elected to the Boards of banks to 12 years unless the bank in question can justify to the supervisor the reasoning why the members’ ability to exercise objective and balanced judgement and to take decisions independently are not affected by the situation.

• Introduce a formal regime for regular meetings with the banks’ external auditors;

• Integrate stress tests exercises with the financial stability work of the CBK and communicate the results to the banks.

• Approve and implement the Offsite Supervision Procedures Manual for Banks.

• Establish supervisory procedures that would be required during periods of stress.

• Conduct periodic tests on the operational procedures for granting of ELA with participation of the banking industry.

• Periodically review the procedures and integration of onsite and offsite supervisory functions.

• Require banks to notify BSD in advance of any substantive changes in their activities, structures and overall condition, or as soon as they become aware of any material adverse developments.

• Develop tools for a more thorough assessment of credit risk based on granular data from the CR.

• Improve offsite assessment of trends in risk concentrations, risk mitigation strategies, and risk build-up across banking sectors.

• Formalize responsibilities and procedure for information exchange between BSD and the PSD.

• Require banks to define scenarios forecasting disturbances to payment and settlement systems, for the purpose of operational risk management.

• Improve offsite monitoring tools, in order to have a better comprehension of banks’ exposure to liquidity risk. Methodology should explore banks’ vulnerabilities and identify whether their contingency buffers are sufficient to support the liquidity needs derived from stressed scenarios. At a minimum, scenarios should take into account the absence of secondary markets in Kosovo for the estimation of the banks’ liquid assets buffer, and the absence of legal impediments for early withdrawal of term deposits for the estimation of liquidity needs.

• Implement Basel III liquidity standards.

• Finalize the implementation of repo facilities between the CBK and financial institutions, maturing over the intraday lag.

Baseline Diagnostics

55. The findings of this review of the insurance sector in Kosovo are broadly similar to those of the 2016 MCM TA mission in which concerns were expressed regarding the solvency and viability of the insurance industry, including under-provisioning. The CBK has moved forward in one key area since then, in that it has now employed an actuary, the lack of which was a key concern of the 2016 TA mission. The 2016 TA mission resulted in a recommendation to set up a qualified and experienced actuarial function. While employing one actuary is a positive step, enhancing this function further is necessary as detailed below. The industry does not appear to have fundamentally adjusted its collective balance sheet so the concerns of the 2016 TA mission about the viability of the industry remain as detailed below. The 2016 TA mission found the new insurance legislation and regulations to be in line with Solvency I EU directives, which were superseded by Solvency II. This was a positive development but as the state of the insurance industry in 2019 shows, regulatory reform is not enough on its own. Supervision processes at all levels of intervention (not just taking extreme enforcement measures such as liquidations) should also be enhanced. It is notable that the 2016 TA mission also commented on the low loss ratios and extremely high expense ratios as detailed below.

56. The insurance market in Kosovo is undeveloped, particularly with respect to life insurance. There are currently 13 insurance companies in Kosovo (1 entered liquidation during the mission, at end-April 2019). The original 14 companies consisted of 12 non-life and 2 life insurance companies. At end-2018, gross non-life premiums amounted to €89.1 million, of which 67 percent was mandatory third-party liability business, while life insurance gross premiums amounted to €3 million, resulting in an insurance penetration of 1.37 percent of GDP.¹⁷ This is reasonably in line with the average for Central and Eastern Europe (1.92 percent) but well below that of Western Europe (7.28 percent).¹⁸

57. The insurance industry statistics may lack reliability and seem distorted compared with international benchmarks. Figures provided to the IMF show combined ratios of less than 100 percent industry wide but with very high expense ratios. Loss ratios usually range between 60 and 75 percent, and expense ratios between 25 and 40 percent. However, for 2018, Kosovo insurers showed loss ratios of 46.6 percent and expense ratios of 48.1 percent for their domestic business, and 32.8 percent loss ratio for non-resident MTPL with an expense ratio of 59.6 percent. The low loss ratio may be a result of underestimating claims, particularly those going through the courts, suggesting that technical provisions are understated while the financial position is overstated. The high expense ratios may be the result of incentives provided to agents and brokers or directly to clients given the inability of insurers to compete on price as premiums are set by the CBK for the most important product, MTPL. The high expense ratios prevail even though the CBK has apparently issued a regulation limiting expenses to 35 percent of premiums, something that is only adhered to by the leading companies in the market. It is acknowledged that there are review processes in place at the CBK, as well as audits by external auditors; yet there seems to be no viable explanation for such low loss ratios and high expense ratios.

58. Losses caused by uninsured drivers are being transferred to the insurance industry through the compensation fund run by the Kosovo Insurance Bureau. The requirement to have MTPL is administered through the requirement for registration of motor vehicles. There is a significant prevalence of unregistered and therefore uninsured motor vehicles in Kosovo. The Insurance Association of Kosovo estimates that claims from uninsured drivers are between €3.5 million and €5 million per year, corresponding to about 10 percent of claims. This is a significant drag on the profitability of the insurance industry.

59. Premium rates for MTPL are set by the CBK but have not been adjusted since 2011. Current premiums are set based on previous World Bank TA. Since 2011, premiums have not been adjusted for market developments such as inflation in medical expenses, changing driver behavior due to technology, or changing risk profiles due to court awards of damages. It is not clear whether losses from uninsured drivers were taken into account in setting the rates. Hence, it is imperative that the MTPL premium rates be reviewed and a process established to review those rates on application of insurance companies. Since 2011, the insurance industry has twice requested increases in premiums but both applications have been rejected. In 2015, CBK regulations were changed, with some prescribed claims payment amounts increasing 10 times, yet there was no adjustment in premiums.

60. The liquidation of an insurance company during the mission and the possible escalation of measures vis-à-vis other insurance companies are positive developments, although they also have some negative consequences. Shutting down failing insurers provides positive signals to the remaining insurance companies that the supervisor is willing to act to prevent losses to policyholders or the industry in general through the compensation fund. It may enhance the behavior of the industry if the failing insurers were competing in unsustainable ways. However, liquidations of insurance companies are detrimental to the image of the insurance industry among the population, in particular in a country where insurance industry development is a priority. In the past, a number of insurance companies have been operating in an under-capitalized state. More recently, the CBK has been more active in taking measures against companies that do not meet solvency requirements or have only minimal buffers.

61. The practice of installing CBK employees as administrators and liquidators compromises the independence of CBK as the supervisor of the industry. CBK supervisors are obviously highly qualified employees and have skill sets likely to be suited to the role of administrator or liquidator. However, the CBK risks its appearance of independence and its general reputation from such appointments. While these individuals cease their formal employment relationships with the CBK once appointed, there may be informal agreements for them to return to the CBK once the administrator role is complete. The commercially determined level of remuneration for administrators is particularly a concern in terms of incentives and CBK reputation. The appointment of an ex-CBK employee in an unsuccessful administration process could become a reputational issue for the CBK.

62. Market conduct by the insurance industry, particularly the willingness to use the court system to delay claim payments, is a concern. Most Kosovar citizens only engage with the insurance industry through the MTPL contract. There is a culture among the insurance industry and claimants (possibly driven by the legal profession) to resolve disputes in court rather than using the CBK dispute resolution mechanisms through the complaints process. Courts have been willing to award claims that exceed prescribed amounts by the CBK. The CBK is attempting to address this by proposing legislation that will put the CBK claim payment amounts in the legislation rather than in CBK regulations, which have not been adhered to in courts. Overall, the practice of delaying claim payments through the court system may engender public distrust in the insurance industry and is a likely factor behind the low penetration of insurance in Kosovo.

63. The lack of a range of investment opportunities and liquid secondary markets for financial instruments constitute significant concerns for the development of the insurance market. In addition, CBK mandates limits on certain investments and requires that at least 10 percent of assets are invested with the CBK. Insurance companies predominantly invest in bank deposits, with some investments in government bonds and real property. Efficient financial markets facilitate the assessment of the financial and risk positions of insurers and the execution of their investment and risk management strategies. In the absence of efficient financial markets, the assessment of risk becomes more challenging for both insurers and supervisors, something that needs to be taken into account in the design of regulations, supervisory practices, and insurer risk management.

64. The powers and capacity of the CBK to undertake adequate surveillance of market conduct of the insurance industry should be further strengthened. CBK insurance supervisors do not appear to be able to obtain an understanding of how insurance companies are interacting with policyholders and potential policyholders. Apart from not being able to conduct so called “mystery shopping”¹⁹ campaigns due to legal limitations of the CBK, there are also other conduct of business supervisory tools that do not appear to be applied by the CBK (e.g., consumer surveys).

65. Market-conduct issues and prudential solvency concerns seem to be highly intertwined. The behavior of insurers in attempting to delay claim payments through court processes, as well as possible incentive schemes to compete in a market with regulated premiums are concerns that have direct prudential impact. The delay of claim payments could be a sign of under-reserving and hence attempt at delaying the representation of losses. The use of incentive schemes could result in high expense ratios.

66. The CBK has not yet adapted Solvency II. The current prudential regulatory framework does not place as much emphasis on the risk management of insurance companies and risk-based capital requirement calculations as the current EU Solvency II framework. The CBK is beginning to look at how it can move toward implementation of Solvency II over the medium term.

67. Onsite supervision of insurers appears to be adequately frequent but may not be delving into risks with enough intensity. Insurance supervisors seem unaware of the basis of the high expense ratios in the industry. There are suspicions that this may be hiding the incentives used by the industry to compete in a rate-regulated environment, however these suspicions have not been verified, suggesting a need for improved onsite supervision techniques.

68. The U.S. Treasury Financial Service Technical Assistance has helped develop an RBS manual. This manual is currently being reviewed within the CBK. The implementation of this manual should lead to positive changes in the nature of supervision.

69. The availability of sufficient skilled staff within the CBK to undertake supervision is an ongoing challenge, particularly with respect to actuarial expertise. CBK has one qualified actuary, leading to significant key person risk in terms of peaks in workload, risk of unavailability due to illness, and the possibility this person may leave the CBK for more lucrative employment in the industry. It also implies a concentration of professional expertise without adequate peer challenge. The nature of the MTPL product, the need for review of the premium rates and the challenges of the Kosovo insurance industry all point to the need for enhanced actuarial expertise within the CBK. In the short term, carefully constructed outsourcing arrangements with international professional services firms may allow access to additional actuarial expertise. In the long term, sponsoring the education and professional development of students and graduates to attain actuarial qualifications and work for the CBK would be desirable.

70. Many fees and taxes are applied to the insurance industry, threatening its viability when also combined with other regulatory requirements placed on insurers. There is a 5 percent tax on premiums rather than the usual corporate tax applied in Kosovo. According to the Kosovo Insurance Association, the industry paid approximately €4.5 million in taxes in 2018, compared with €230,000 had the usual corporate taxation rate been applied. The CBK is aware of this issue and has taken steps with other government authorities to seek amendment to this law. The industry has been required to pay a 1 percent of premium contribution to the Red Cross, a requirement that has recently been declared unconstitutional by the Constitutional Court. The industry is also required to pay claims related to uninsured drivers. CBK applies a fee of 1.35 percent of premium. There are restrictions on investments, marketing expenses, and on overall expenses that do not appear to be enforced, and restrictions on premiums that can be charged for the major product. Overall, this does not appear to be a regulatory framework conducive to attracting new entrants to the market or ensuring the viability of current industry participants.

Main Recommendations

71. These recommendations are framed with an awareness of other TA that is being provided, particularly by the U.S. Treasury and in the past by the World Bank. The CBK needs to:

• Update the pricing of the mandatory MTPL product and develop a process to regularly review the pricing of this product as risk factors evolve.

• Assess the viability of continuing to apply the various taxes and fees, as well as obligations to pay for claims related to uninsured drivers.

• Enhance the supervision of market conduct of insurers.

• Reconsider crisis management processes for the insurance industry, particularly the practice of installing CBK employees as administrators and liquidators.

• Implement the RBS manual for insurance that has been developed.

• Enhance onsite supervision practices for insurance.

72. The IMF is best placed to provide TA on the last four of those priorities. With respect to setting MTPL premiums the CBK may seek independent professional advice or assistance from say the World Bank, which previously provided TA in this area.

73. The transformation of the industry, its regulation and CBK’s supervision of the industry is a medium- to long-term project that needs buy-in from CBK management, the insurance industry and the GoK in general. IMF TA can only be effective with that buy-in. As a result, the observations made during the mission on CBK governance must be addressed as a precondition for the provision of IMF TA. It would be advisable to engage with other TA providers such as the U.S. Treasury and the World Bank to create a coordinated program of TA within an overall plan over an achievable timeframe and with credible milestones.

74. The CBK along with other relevant government authorities need to develop consumer education and awareness of the benefits of insurance and seek to counter any negative public perceptions of the insurance industry due to the liquidation of one or more insurance companies. Increased involvement in market-conduct supervision will necessarily involve more outreach to consumers in general and policyholders in particular. An education campaign to make the public aware of the benefits of insurance along with improved conduct by insurers should result in increased penetration of insurance in the economy. A stable and viable insurance industry that provides necessary protection and investment products can enhance economic development and financial stability.

75. Solvency II implementation is important for potential integration into the EU system but should not be seen as an immediate priority. Solvency II has been designed for the sophisticated EU insurance market with well-resourced supervisors. The implementation of Solvency II, which was prepared over more than a decade, has improved risk management and governance of the insurance industry in the EU, but its implementation has also come at some cost. As Kosovo looks toward integration with the EU, Solvency II implementation is an important medium-term goal and can provide an excellent framework for the development of insurance regulation and supervision in Kosovo provided that the implementation sufficiently takes into account proportionality and the local circumstances of the insurance industry in Kosovo. In particular, the relative development of the industry, the resources of the CBK and the need to develop those resources, the availability of adequate investment options and the reliability of secondary markets to provide market prices of investments and other inputs to valuation would need to be taken into account, among other considerations. The development of capital markets, as discussed below, will be important in successfully implementing a modern prudential regulatory framework such as Solvency II.

Baseline Diagnostics

76. Capital markets do not currently exist in Kosovo to any meaningful extent. There is no stock exchange. The financial sector is dominated by banks, which focus on plain-vanilla banking activity. The only securities in issuance are government bonds, for which there is no active secondary market. Neither banks nor insurance companies offer investment products. Corporates rely on bank loans for their funding needs. Aggregate credit growth is high but households’ ability and willingness to consider capital markets as an alternative to banks is questionable.

77. Auctions of government securities are typically held every two weeks by the CBK.²⁰ The primary dealers consist of banks and the KPST, the state-run pillar II pension fund. Insurance companies and a few large corporates also buy government bonds through their bank. Auctions are often oversubscribed although two auctions failed in mid-2018 when the CBK signaled it would no longer buy GoK securities in the secondary market. The maturity of the issues is gradually being extended, as exemplified by the issuance of the first 10-year bond in 2018. However, the CBK believes that the limits of the domestic investor base will soon be reached.

78. The KPST is the main domestic institutional investor but its investment portfolio is heavily weighted towards foreign assets. The Governing Board of KPST invests the assets in line with prudent investment principles set by law. Current assets under management amounted to €1.8 billion as of end-April 2019. Currently, €1.4 billion of assets are invested in a selection of investment funds managed by major global asset managers, giving exposure to a diversified set of instruments. The remainder of the portfolio is split between Kosovo government bonds (€255 million) and cash deposits at domestic banks (€130 million). Extensive information on the performance of the portfolio is provided on the KPST website, including in the form of a Key Investor Information Document prepared in line with relevant EU legislation.

79. All Kosovo citizens are obliged to contribute 5 percent of their salaries to the KPST, and employers must match that contribution. Employees can choose to contribute more than 5 percent of their salary to a different pension fund. However, in practice there is only one other scheme—the Slovenian-Kosovo Pension Fund—the assets of which are a mere 0.5 percent of total pension assets. KPST is considering creating two separate portfolios within the pension fund: a default portfolio for all contributors with a balanced risk profile, and a more conservative portfolio for imminent retirees.

Main Recommendations

80. The CBK should consider the development of capital markets as a medium-term goal. As the CBK considers how best to implement the recommendations from the FSSR, and as it looks ahead to implementation of the substantial TA Roadmap, there are strong arguments for focusing in the first instance on other priorities. This would recognize that development of capital markets will in any case take some time and would allow scarce resources to be targeted to other areas of more pressing urgency. The recommendations below should be read in the context of this broader message.

81. Establishing an investment fund sector in Kosovo should be subject to several other key building blocks being put in place first. Investment funds require a diversified pool of potential investments, a sufficient number of investors who are willing and able to place their money, and the presence of key service providers. To achieve this, progress should be made in the following four areas:

• Establish a cross-agency task force for the development of capital markets in Kosovo.

• Draft key pieces of capital markets legislation in order to provide a sound framework.

• Develop expertise on capital markets at CBK.

• Ensure existence of pre-conditions for capital markets activity. More detail on each of these recommendations is provided below.

82. While it would be possible to allow the creation of investment funds in Kosovo in the short term through finalization and adoption of the draft investment funds law, this should rather be seen as a long-term goal that would complement the development of capital markets more generally. Any investment funds established in the near future would lack eligible assets in which to invest. The relevant legislation could be drafted in such a way that the funds could invest in assets abroad, but this is unlikely to foster development of capital markets activity in Kosovo itself, nor would it provide financing to local companies. In addition, such an approach could risk triggering capital outflows. Moreover, it is doubtful that investors in Kosovo would be in a position to make informed investment decisions on products to which they have not had exposure thus far. Similarly, it would be imprudent to assume that Kosovars would have access to reliable advice on investment products from existing financial institutions. It is also important to note that this initiative is being taken amid a saturating market for domestic sovereign debt securities.

• The CBK should ask the government to establish a cross-agency task force on the development of capital markets in Kosovo.

83. A national task force should be created to identify the key building blocks that are needed to foster the development of capital markets. This should involve (at least) the CBK, the MoF, the KPST (as the main institutional investor in Kosovo at present), a range of financial market participants (notably banks and insurance companies), and representatives of retail investors. The task force should indicate which aspects it considers most important. The task force should be put in place by the end of 2019 and deliver its report by mid-2020. The IMF can help guide the discussions of the task force, although this would not constitute formal TA.

• The CBK should provide assistance to the MoF in drafting key pieces of capital markets legislation.

84. Capital markets activity cannot occur without an appropriate legal framework being in place. The CBK, working with the MoF, should prepare draft laws on capital markets that are compatible with the EU acquis. This should include legislation on primary issuance of securities, secondary market trading of securities, transparency, market abuse, and prudential/conduct of business requirements for investment services providers, as well as completion of the laws on investment funds and repos. While the EU legislation should be taken as a basis given the provisions of the Stabilization and Association Agreement, it will be important to consider both: (i) proportionality, taking into account the specific circumstances of Kosovo; and ii) international best practice. The IMF can provide TA in the form of comments and input on the draft legislation. It can be expected that the development of a comprehensive package of legislation will take about three years.

• Develop expertise at CBK on capital markets.

85. In the absence of any meaningful capital markets activity in Kosovo, it is understandable that CBK staff currently lack the appropriate knowledge or expertise to supervise such activity. Leveraging on the existing knowledge within the Asset Management Department of the CBK, staff should be given access to training on capital markets in parallel with the development of the framework legislation. This does not preempt the eventual decision on whether a separate authority for capital markets should be created. Bodies other than the IMF are likely to be better placed to provide this training. This will be an ongoing process with no specific deadline.

86. Kosovars’ exposure to financial services is currently limited. Many citizens (48 percent according to World Bank data) do not have bank accounts, and those that do have access only to simple banking products. Kosovo citizens do have indirect exposure to capital markets through the KPST, which provides extensive information on its investments. However, it is not clear to what extent the average citizen makes use of this information or is able to understand it. It is therefore important that the financial literacy initiatives include a capital markets segment, which would provide basic information on financial markets and investment products.

• Ensure existence of preconditions for capital markets activity including improved

financial reporting, corporate governance, disclosure, and external audit.

87. Healthy capital markets require certain preconditions to be in place if they are to function effectively and inspire confidence among potential investors. Based on discussions with stakeholders during the FSSR mission, this is not currently the case in Kosovo. For example, evidence suggests that, while significant progress has been made, there remains room for improvement on financial reporting. Similarly, compliance with corporate governance standards is patchy, with limited separation between owners and management in many companies. As far as disclosure is concerned, the CBK should increase its focus on disclosures provided by banks to their clients with a view to enhancing the quality of such disclosures; this would act as a stepping stone towards the preparation of adequate disclosures once investment products appear on the market. Finally, standards on external audit should be tightened. Feedback from market participants suggests that external audits are only robust when provided by a small handful of providers, and that local auditors are often under pressure not to give qualified opinions. The KFRC is making significant efforts to strengthen its oversight of the audit industry, but it will take time and resources before meaningful progress is made. The IMF will liaise with the World Bank to determine how best to provide TA on these topics.

88. Steps should be taken to develop the interbank money market and repo market and to deepen the secondary market for government bonds. The IMF (MCM) has already provided comments on a draft law on repo, while other TA providers (the U.S. Treasury, European Bank for Reconstruction and Development (EBRD)) have also made recommendations in this context. Similarly, other TA providers are either better placed to provide input on how to deepen government bond markets or have already provided such input.

89. It is also important to underline that the development of a healthier insurance sector based on the recommendations set out elsewhere in the FSSR will be beneficial to development of capital markets. For example, insurers could play a larger role in providing secondary market liquidity for government securities (now) and other securities (in future), while healthier insurers would be able to offer investment products of their own (thereby providing competition for banks and other capital markets players).

Institutional Arrangements

92. An effective macroprudential policy framework requires robust institutional arrangements. These arrangements must incorporate important principles of good governance that ensure sound decision-making underpinned by strong mandates and powers. They must also facilitate the regular exchange of information between agencies so that a system-wide appreciation of risks can be assembled. Sufficient staff must be in place with the right expertise so that this information can be reviewed using a full range of analytical methodologies.

93. In terms of mandates, the CBK is well-served from a broader financial stability perspective. The CBL specifies that the primary objective of the central bank is to “foster and to maintain a stable financial system including a safe, sound and efficient payments system.” Because Kosovo is a fully euroized economy, the objective of price stability is set as an additional, but subordinate objective. There is no reference to macroprudential policies in the primary legislation; but the purpose, scope, and application of macroprudential policies were approved by the Executive Board in accordance with its powers under Article 36 of the CBL. Nevertheless, CBK recognizes that there is merit in further strengthening its macroprudential policy mandate by making an explicit reference to this role within primary legislation.

94. The CBK is well-equipped in terms of policy instruments. The LB provides CBK with a full array of policy instruments for microprudential purposes. The CBK is of the view that the LB provides sufficient flexibility for these instruments to be used also for macroprudential purposes. Nevertheless, the CBK is cognizant of the need to provide macroprudential policy with a stronger legal foundation and is proposing to do so through amendments to the LB and associated regulations. However, since the amended law will apply only to banks, and macroprudential policies must have system-wide application, it would be preferable for the CBK to derive its enabling powers by way of an amendment to the CBL.

95. The current institutional arrangements in support of macroprudential policy should be strengthened. The establishment of MPAC was an important step forward in terms of governance around macroprudential policy. However, decision-making itself is reserved to a small Executive Board consisting of the Governor and two Deputy Governors, neither of whom have executive responsibilities for macroprudential oversight. The mission believes there is a strong case for reviewing the governance arrangements within the CBK to ensure that they are suitably aligned with the central bank’s primary mission in support of financial stability and its role as macroprudential authority. In doing so, the CBK is also encouraged to review the resourcing of the financial stability function to make sure that it is keeping pace with the expanding workload that comes from operationalizing a macroprudential policy framework. This is not only about staff numbers, but also about ensuring that staff time is used productively.

96. An effective financial stability framework gains from a collaborative relationship between the central bank and the MoF. In Kosovo, as the CBK regulates all financial institutions, collaboration with the MoF primarily concerns issues of crisis management. Still, it is important that the MoF is regularly briefed on the outlook for the financial sector and is not taken by surprise by unfolding events. These briefings will be formalized with the establishment of an inter-agency National Financial Stability Committee, which will meet semi-annually from late 2019 and onwards.

Systemic Risk Monitoring

97. To fulfil its macroprudential responsibilities, the CBK must be able to monitor systemic risks in Kosovo. This is not easy as “systemic risks” are difficult to define and quantify in practice. They most obviously exist, for example, in the shape of a broad-based breakdown in the functioning of the financial system, potentially including a large number of financial institution failures. However, an effective policy framework must function preemptively, so that systemic risks are addressed and mitigated before crystallizing in a way that damages the financial system and the real economy.

98. Developing an early warning system in Kosovo is a challenging task. Credit penetration remains low by regional standards and financial deepening is an important policy priority. Therefore, evidence that credit is growing at an annual rate in excess of 10 percent facilitated by low interest rates, an easing of credit standards and the use of the KCGF to support lending to MSMEs is to be welcomed. However, differentiating between healthy financial deepening and potentially excessive credit growth is not easy. The CBK lacks the type of information on nonfinancial sector balance sheets that would allow it to form a more-forward looking assessment of systemic risks. The CBK is currently unable to assess whether the surge in credit is increasing the leverage of households and corporates and testing their debt-servicing capacities. Of particular concern is the opaqueness of property markets in Kosovo.

99. Stress testing plays a key role in macroprudential analysis. The CBK undertakes regular stress tests to assess the financial system’s resilience in terms of solvency and liquidity in response to plausible, adverse outcomes. Currently, the EAFSD and BSD undertake their own stress tests using separate scenarios. The BSD stress test is a micro-focused exercise using individual bank data while that of EAFSD is a macro-focused exercise. While some information sharing takes place between the BSD and the EAFSD, the stress tests themselves are undertaken independently and both largely take the form of static sensitivity analysis. BSD also receives stress test results from the commercial banks but does not specify the scenarios nor validates their stress testing methodologies. Neither department undertakes any detailed network analysis to identify the potential for financial contagion in Kosovo.

Operationalizing the Macroprudential Policy Framework

100. While the CBK has a macroprudential policy framework in place, it has yet to implement any specific policy measures. The MPAC is briefed on a quarterly basis on systemic risks and the outlook for the financial system. So far, it has found no compelling reasons to recommend to the Executive Board that macroprudential policy actions should be taken. However, persistent credit growth and signs of a tightening in liquidity conditions suggest to the mission that it might be timely to consider the use of some of the instruments in the macroprudential policy toolkit.

Institutional Arrangements

101. The current institutional arrangements are not well aligned with the CBK’s primary objective within the CBL of fostering and maintaining financial stability. Decision-making, which is reserved to the Executive Board, is decoupled from the process within the CBK for monitoring and assessing systemic risks and formulating an appropriate macroprudential policy response. The mission is of the view that the CBK’s financial stability mandate would be strengthened by establishing a decision-making Financial Stability Committee, chaired by the Governor and composed of executives and non-executive members with relevant expertise. An alternative approach would be to broaden the composition of the existing Executive Board.

102. More resources should be dedicated to financial stability analysis. The CBK must be confident that it has sufficient staff with the right training and expertise to fully support the financial stability mandate. The deliverables of the EAFSD should be reviewed to ensure that they are targeted and precise. The Financial Stability Report should be further streamlined.

103. The CBL should be amended to explicitly provide for a macroprudential policy function. Currently, the intention is to anchor macroprudential policies within the amended law on banks, but since macroprudential policy must have system-wide application, provision within the CBL is to be preferred.

Systemic Risk Monitoring

104. The CBK should complete a full review of macroprudential data gaps and develop a strategy to close them. The most pressing gap relates to property where meaningful information on construction, transactions, and prices is not readily available. In order to speed up progress, the mission team recommends the formation of an Interagency Real Estate Working Group consisting of the CBK, the MoF, the KAS, and the Ministry of Environment and Spatial Planning. It should also involve representatives from the Real Estate Industry Association. The Working Group should review all information that is currently available on real estate, identify the information and data gaps, determine how best to address them, and—by doing so—determine what specific IMF TA might help close them.

105. The CBK should explore ways to better harness the information collected by the CR. There is scope to make use of the existing data for calculating default rates and loss-on-default. The CBK could use the CR data to compute loan-to-value (LTV) and debt-to-income (DTI) ratios for macroprudential policy purpose. The CBK could also use the CR information to derive aggregate borrowing statistics (loan by type of legal entity, region, and purpose and activity type, average principal amount, average interest rate, currency composition, average maturity, etc.) and make them available to the public and financial institutions.

106. The CBK should more closely monitor developments in nonfinancial sector balance sheets. Excessive leverage in household and corporate sector balance sheets increases the dangers of excessive credit growth. However, the large size of the informal sector in Kosovo limits the amount of information that can be drawn from the national accounts. For that reason, the CBK should explore the use of surveys in consultation with the KAS, including the current Household Budget Survey and the forthcoming Statistics on Income and Living Conditions in Households survey. STA provides TA on developing sectoral financial accounts and balance sheet statistics, including for the nonfinancial sector.

107. The CBK needs to enhance its stress testing competencies. Collaboration in this area between EAFSD and BSD needs to be intensified. EAFSD should take ownership of the scenario design, building on its systemic and macroeconomic perspective, with BSD contributing bank-specific knowledge to help assess the sensitivity of loan portfolios to macroeconomic conditions. EAFSD would benefit from some assistance on the use of macrofinancial modelling to help generate and quantify adverse scenarios. Both departments would benefit from some guidance on the effective use of stress testing models, moving beyond static, single period, sensitivity analysis.

108. The CBK is encouraged to deepen its network analysis. While inter-linkages within the financial system are currently quite limited, this will increase over time as the nonbank sector, particularly pensions, grows in size. It is also important that the CBK deepens its analysis of the flow of funds between financial sector and nonfinancial sector balance sheets, including government.

Operationalizing the Macroprudential Policy Framework

109. The CBK should use macroprudential policies to reinforce the quality of consumer lending. Consumer credit has been growing strongly in recent years at an annual average rate of about 11 percent. However, the CBK has very limited insight into household sector balance sheets that would enable it to assess changes to leverage and debt-servicing capacity. There may be merit in introducing LTV, DTI or debt-service-to-income (DSTI) limits to ensure that banks’ credit management systems are conservatively aligned to the opaque nature of Kosovo’s credit environment.

110. Liquidity risks need to be contained. References to ample liquidity can be misleading given the lack of an active secondary market for domestic government securities. Any changes in liquidity conditions of the banking system need to be very carefully monitored. The CBK is to strengthen the liquidity management of banks by introducing the LCR and the net stable funding ratio as part of its planned implementation of Basel III requirements. Ultimately, the CBK needs to foster the development of an inter-bank repo market in Kosovo; a useful step in this direction will be the planned introduction of a central bank repo facility.

111. Having taken the steps to formally identify domestic systemically important banks, the CBK should follow through with a capital surcharge. For banks that already have capital well in excess of minimum requirements, this adjustment will have no immediate effect. But it will help better align regulatory requirements with CBK’s assessment of the contribution made by the larger banks to overall systemic risk.