78579 CONFIDENTIAL For Restricted Use Only (Not for use by third parties) FINANCIAL SECTOR ASSESSMENT: POLAND April 2001 EASTERN EUROPE & CENTRAL ASIA REGION VICE PRESIDENCY FINANCIAL SECTOR VICE PRESIDENCY BASED ON THE JOINT IMF-WORLD BANK FINANCIAL SECTOR ASSESSMENT PROGRAM 1. As part of the World Bank-IMF Financial Sector Assessment Program (FSAP), a joint mission visited Poland during the period September 1 l-20,2000.’ The principal objectives of the mission were to assist the authorities in identifying potential vulnerabilities in the Polish financial system that could have macroeconomic consequences, to suggest measures to reduce these risks, and to outline development needs in the system and strategies to address these concerns. Follow-up meetings were held in December 2000, during the IMF Article IV Consultation mission. 2. The purpose of this note is to provide a summary of the main findings of the mission, together with the policy priorities identified. ’ A pre-FSAP mission took place during July 4-8,200O and the assessment of the Base1Core Principles for Effective Banking Supervision was initiated in the period July 3 l-August 8,200O and completed during the September mission. The September mission comprised Messrs. Stijn Claessens (World Bank, Team Leader) and Marc Quintyn (IMF, Deputy Team Leader), Mmes. Laura Ard, Daniela Klingebiel and Esen Ulgenerk, Messrs. Peter Kyle, Luc Laeven, Donald McIsaac and Hemant Shah (all World Bank), Ms. Andrea Schaechter and Mr. Mark O’Brien (both MAE), Mr. Peter Doyle (EUl), Ms. Shyamala Gopinath (Bank Supervisor, Reserve Bank of India), Messrs. Stefan Spamer (Bank Supervisor, Deutsche Bundesbank), Martin Andersson (Payments Systems Expert, Riksbank of Sweden), and Ms. Adriana Rota (Staff Assistant, MAE). Mr. Cyrus Sassanpour, IMF Resident Representative in Poland, also attended some of the meetings. MAIN FINDINGS AND POLICY AGENDA 3. The issues facing the Polish financial sector are mostly of development rather than stability nature. Poland has made significant reforms in its financial sector over the last decade, with an acceleration of the restructuring of its banking system in the last three years. As of end-2000, about 2/3 of banking assets have been privatized, mainly to foreign strategic investors. Transition-related portfolio problems have largely been resolved at low fiscal cost. This is not to say, however, that the financial system cannot be further strengthened to better withstand external or domestic shocks. Following the Russian crisis, the increase in domestic interest rates, and a less robust international and domestic environment, the share of non- performing loans of commercial banks increased in the year 1999 by nearly three percentage points. Non-performing loans increased further in 2000 and amounted at the end of the 3’d quarter to some 14.1 percent of total bank loans. The non-performing loans are mainly concentrated in four banks, however, of which two are still state-owned, and in part relate to poorly performing, pre-transition housing and agricultural finance portfolios which are being resolved with government support. Enterprise restructuring has progressed, although there are some weaknesses in corporations’ efficiency as well as unfinished restructuring agendas in some sectors with large state-ownership, implying possible fiscal costs. 4. Risk management capacity in banks has improved with the introduction of global know- how and generally proper regulation and supervision. Some gaps and weaknesses exist, however, mostly concentrated in a few specific areas and specific banks (particularly multi- branch banks either remaining in state hands or recently privatized which lack well- developed risks management systems). Foreign exchange mismatches are generally limited, but interest rate risks are larger. The largest system-wide source of risks relates to credit risks. Most exposed banks can likely manage these risks, in part as they still have large and relatively stable depositor bases. However, liquidity management problems in some banks cannot be excluded, given also the still limited development of the interbank market and the generally very short maturity of financial claims. Although data limitations prevent a complete assessment, vulnerabilities may also exist in the growing offshore borrowing of the corporate sector and portfolio inflows, related to the large current account deficit. The current exchange rate flexibility mitigates some of these concerns as it imposes risks on market participants. The generally low leverage of corporations suggests that even large shocks to domestic interest rates would not affect in a systemic way the solvency of the corporate sector. 5. Structural issues in the banking system relate to the profitability of banking. While most Polish banks are currently relatively well capitalized and profitable, their profitability is in decline with increased competition, triggered in part by the forthcoming full removal of entry barriers for foreign banks. Combined with the still large inefficiencies in many banks and the high costs in building up networks to service the still under-banked population, increased competition will make it difficult for some banks to maintain profitability and capital adequacy positions. Also, in light of the relatively large number and generally small size of Polish banks, further consolidation should be encouraged. Development issues in the banking sector primarily concern extending the access, particularly to SMEs and for housing, and -2- broadening the diversity of financial services. This extension will largely depend on market developments and the overall competitive environment for financial services, although certain legal and regulatory enhancements are also needed, as discussed in the next section. 6. From low bases, other financial services are developing rapidly. Given their small size, sectors such as insurance and pension do not pose any significant threat to the stability of the system, but vigilance is warranted, particularly in light of the formation of financial conglomerates. In order to avoid the build-up of problems, proper attention should be given to instilling better corporate governance, in particular in the pension fund and insurance sectors. Further development of securities markets will largely depend on fundamental factors, including a prolonged decline in interest rates, more rapid privatization and flotation of stakes in state-owned enterprises, and the buildup of an institutional investor base. In the pension fund industry, there is an urgent need to allow for consolidation. In the insurance sector, early reduction of the large role of the state should enhance the industry’s competitive structure. 7. Regulatory and supervisory frameworks have improved in Poland and in many areas and most subsectors of the financial system are approaching best practices in advanced emerging markets. A number of issues nevertheless need to be addressed to increase the robustness and improve the functioning and efficiency of the Polish financial system. Common issues to be addressed in the near term in all subsectors of the financial system include the need for additional staffing and proper compensation to keep up with the growing and more sophisticated sectors, and to avoid the tendency to over regulate and micromanage the sector, in particular in the pension industry and, to some extent, the securities markets. There is also a general need to provide legal backing to supervisors to instill better corporate governance in financial institutions. 8. In the banking sector, additional issues concern consolidated supervision, independence of supervisory agencies, and tools and institutional setup for crisis prevention and management. These issues should be addressed as they can undermine the authorities’ capacity to respond to potential threats to the sector’s stability. While the regulatory framework in the capital markets is generally sound and supportive, improvements can be made in the enforcement and protection of minority rights. As the governance capacity and oversight of pension fund managers is enhanced, a review of the investment policies and other regulations will be necessary, to enhance the role and functioning of the pension industry and to avoid excessive demand for domestic assets. With the growing sophistication of Poland’s financial markets and their integration in the global financial markets, it is all the more important that all supervisors focus fully on assessment of institution-specific risks, away from compliance driven inspections. -3- FINANCIAL SECTOR POLICY PRIORITIES 9. Poland has completed the larger part of the transition-related reform agenda in the financial sector. While some portfolio problems still remain, the outstanding issues are mainly to improve the efficiency of financial intermediation, broaden the access to financial services, widen the diversity of financial instruments, and complete the privatization agenda. This will require sustained macroeconomic stability, enhancements in the legal and overall framework for financial intermediation, improvements in regulation and supervision, and continuation with complementary structural reforms, particularly privatization. While the overall stability of the financial sector does not appear to be a concern at the moment, enhanced oversight of risk management systems of financial institutions and improvements in crisis prevention and management procedures are necessary. Macroeconomic Environment 10. The Polish authorities should remain focused on preserving market confidence and reducing the risk of contagion. Macroeconomic stabilization and structural reform in the past decade have contributed to growing financial sector stability, although risks remain. Looking forward, the macroeconomic policy agenda should consist of containing risks to financial sector stability potentially coming directly or indirectly from three sources-the exchange rate, the macroeconomic policy mix and the growth in credit to newer, potentially more risky sectors, such as SMEs and households-while the removal of the remaining capital controls is not expected to create stability problems.2 11. The first source of risk is exchange rate volatility. Exposure of the nonfinancial sector to exchange rate risks is hard to gauge at this point. However, informal assessment suggests a certain degree of unhedged off-shore borrowings by corporations and it is important that the authorities improve the data collection on these exposures to facilitate monitoring while markets for hedging deepen. The second is the current account deficit. The size of the deficit is shrinking but needs further vigilance, especially in light of recent uncertainties about the global economic environment. In a context where disinflation is also a priority, this can be best achieved through appropriate fiscal policies. Reduction and consolidation of the government deficit and containment of quasi-fiscal and contingent liabilities will be essential to achieve both goals. The third is the rapid growth of credit in the past few years to potentially more risky segments of the private sector (SMEs and households). While a positive tendency, this is having some negative impact on the quality of the banks’ lending portfolio. Although credit growth rates have declined lately, credit growth patterns and risk management skills of individual banks should continue to be monitored closely. 2 Only modest controls remain and their abolition, when the current account deficit has declined sufficiently, should not affect financial system stability. -4- Legal Framework 12. The legal framework for the financial sector is solid, aided by the move to harmonize the framework with EU legislation. As such, it does not pose any threat to financial sector stability, although rapid progress with updating financial sector laws is recommended. Attention should be given, however, to the lack of experience in the judicial system in dealing with financial transactions, particularly bankruptcy, which imposes delays and extra costs. Enforcement of judgments is often complicated and uncertain, and encourages undesirable rent-seeking activities. While information availability has generally improved, some deficiencies still exist in accounting standards and reporting formats and frequencies, and the availability of credit information on (‘potential) borrowers is limited. 13. There are some particular changes that would help increase the access to financial services and reduce inefficiencies. Thefiameworkfir secured lending could be further enhanced by improvements in bankruptcy and collateral procedures, particularly in the functioning of bankruptcy courts and the registering of pledges, including those of the state. The tax systemfir$nanciaZ transactions can be rationalized, including allowing for less restrictive expensing for tax purposes of loan write-offs and specific loan loss provisions by banks, and harmonizing the tax treatment of similar financial instruments. 14. To further facilitate the access to financial services, it is important that the access of lenders to information on borrowers is enhanced with not only negative but also more extensive positive information, such as through the recently established credit bureau. This, in turn, will help increase the quantity and quality of financial intermediation, particularly to SMEs and households. Accounting standards need to be extended to leasing activities and leasing companies and cover all financial products. It is essential that supervisory agencies retain primary responsibilities for the development of accounting standards in their respective areas. The potential financial liabilities ofauditors can be increased to improve the quality of auditing practices. To allow for more effective market discipline, disclosure practices can be enhanced by clearer procedures for remedial actions by supervisory agencies in the event of delays or misreporting. General Regulatory and Supervisory Frameworks 15. There has been very substantial progress in establishing modem regulatory and supervisory frameworks for the different subsectors and increasing transparency. Regulatory frameworks in Poland are increasingly being brought in line with EU directives. Supervisory staff are professional and in touch with developments in the markets. Supervisory agencies have also undertaken efforts to increase transparency, which should underpin financial sector stability. The vast majority of good transparency practices of the IMF’s Code of Good Practices on Transparency in Monetary and Financial Policies are observed. 16. Areas where further strengthening is needed are similar across agencies: disclosure of relationships with financial agencies abroad; disclosure of accounting practices and qualifications; the need to have financial audits of public agencies done by external auditors; -5- to the extent it supports the effectiveness of the respective agency, disclosure of internal procedures and guidelines; and the implementation and publication of standards for the conduct of personal financial affairs and legal protection of officials. 17. To strengthen the authorities’ regulatory and supervisory capacity to respond to crisis situations and threats to systemic stability and to increase the efficiency of the financial sector, the following areas should be addressed for all supervisors. CZoser coordination among supervisory authorities and streamlining of the respective regulatoryfiameworks is needed to avoid supervisory or regulatory inconsistencies or gaps when facing increasingly sophisticated financial markets. The independence of the supervisory authorities should be enhanced and guaranteed, including through fixed terms for the respective chairpersons and financial autonomy, with appropriate accountability. Corporate governance of financial institutions should be further enhanced. Supervisors should have the regulatory tools to hold management and supervisory boards of the supervised institutions explicitly responsible and accountable for prudent management and policies. Over the medium-term, authorities should evaluate the costs and benefits from a move to more integrated supervisory agencies, especially in the area of institutional investors. Regulation and Supervision of the Banking Sector and the Safety Net 18. With the aid of an assessment of compliance with the Base1 Core Principles for Effective Banking Supervision, the following areas have been identified as crucial for banking sector stability and efficiency. The move to consolidatedjinancial reporting and supervision is long overdue. Its absence could pose a threat to financial sector stability given the increased role of financial conglomerates in Poland. Related to the previous point is the need to establish contact and exchange information with other supervisory agencies. Authorities are encouraged to establish more informal or formal agreements such as Memoranda of Understanding with domestic and foreign supervision authorities.3 Enforcementpowers should be complemented with effective remedial actions. At the moment, these powers can only be used after a long list of preliminary actions has been implemented, often by multiple agencies, which can delay reactions to a crisis situation. Supervisors should be given tools to intervene in cases of untruthful and inaccurate reporting. More generally, reporting by banks should be improved and brought to higher standards. The supervisory authority should also strengthen its capacity for encouraging and overseeingproper risk management by banks, including by adopting rules for market risk measurement; for identifying large credit exposure, including definition of groups; and for valuing collateral. 3 Amendments to banking laws currently in the legislative process would address the issue of consolidated supervision and achieve compliance with EU-regulations. In addition, rules with regards to the accounting treatment of financial conglomerates are being prepared in connection with the new accounting law that is expected to go into force next year. Amendments will also further facilitate the conclusion of Memorandum of Understandings with supervisory authorities and the exchange of supervisory-related financial information. -6- 19. Throughout the 1990s the authorities have used a combination of policies and tools that enabled them to build up a sound financial system, while at the same time avoiding banking crises of the types that were seen in some other emerging markets. In the process, the authorities also started building up the features of a financial safety net. This safety net should be further strengthened to improve the incentives in the system for prudent risk-taking and to prevent a crisis. To achieve this, lines of coordination between the agencies involved (National Bank of Poland (NBP), Ministry of Finance, Bank Guarantee Fund (BGF) and the Commission for Banking Supervision (CBC)) should be defined more clearly, not only at the management level but also at the operational level. 20. A number of specific recommendations should also be considered. NBP should assure that its liquidity support is only available for solvent institutions. The current possibility of NBP lending indirectly to insolvent institutions should be discontinued. BGF’s role in lending to troubled institutions should be discontinued to avoid moral hazard problems. BGF’s assistance for restructuring and mergers of banks should be integrated as part of its overall menu of support for bank resolution based on “least cost principles�. To deal promptly with any bank failures and pay out depositors, BGF should consider some “ex ante “funding. Systemic Liquidity and Payments Infrastructure 21. There are no stability issues involved in the set of monetary policy instruments the NBP is using. Transmission of monetary policy impulses is weakened by some factors, but this is not a threat to the stability of the system. Enhancing the efficiency of the transmission could be achieved by creating a more competitive environment for the largest remaining state- owned bank, PKO BP SA, in the market for household deposits; and by hardening budget constraints on public enterprises to stimulate their response to interest rate adjustments. 22. The payments system based on gross settlement largely complies with the Base1 Core Principles for Systemically Important Payments System. Areas that need to be addressed with some stability implications are the following. The presence of the zero-hour rule creates legal uncertainty in the RTGS system. It will be important to quickly adopt the drafted legal amendments. To ensure the smooth functioning of payments systems, rapid progress with the establishment of an intra-day liquidity facility for participating banks will be important. The lack of clear oversight responsibility over the retail payments systems is an issue that could hamper the functioning and stability of these payments systems. These systems are also surrounded by uncertainty because multilateral netting is not recognized under the bankruptcy law. Stability of the Banking System 23. Except for several larger banks that have not yet, or were only very recently privatized, banks’ risk management practices have evolved with the increasing complexity of financial transactions. The legislative framework is generally supportive of good risk management practices by banks. Improvements in the regulatory framework are needed, however, -7- regarding monitoring and reporting requirements for derivatives and supervisory oversight of financial exposures can be strengthened. The main areas of concern at present relate to the management of credit and to a lesser extent interest and operational risks. The slow restructuring of two banks owned by the Treasury currently does not pose direct systemic concerns, but does lead to growing costs for the public sector. 24. Although stress tests performed did not reveal immediate threats to systemic stability, they did point out the remaining fragilities in the system. Most important among these is credit risk. Recent experience confirms that the risks of asset quality deterioration are significant. Classified loans of all banks as a group rose significantly from 10.5 percent of total loans at end-1998 to about 14.1 percent at end-September 2000. Second is interest rate risk, where, due to mismatches at various maturities, some exposure exists as the duration of assets exceeds that of liabilities. Risks arising from increases in interest rates are reduced, however, as interest rates on deposits are currently not very sensitive to changing market conditions. The direct exposure to foreign exchange risk was much more limited for the banking system as a whole reflecting the very conservative foreign exchange positions that most banks maintained, although banks are also exposed indirectly through the unhedged liabilities of corporate borrowers. For a few banks, a combination of increased non- performing loans, higher interest rates and currency depreciation could lead to significant losses relative to their capital. While the most exposed banks have relatively stable deposit bases, such losses could nevertheless give rise to complications in the payments system. The authorities should therefore closely monitor these banks and have in place contingency plans for any such eventuality. 25. Faster restructuring and privatization of the large state-owned bank PKO PB SA would avoid a further deterioration of this bank’s financial results and provide competitive impetus to the sector. While the bank’s large depositor base will limit any direct adverse liquidity impacts, there is a need to enhance its restructuring program by accelerated branch and staff retrenchment and some asset and liability restructuring. Rapid progress in the privatization of the smaller agricultural banks, BGZ SA, with strong shareholder financial commitment, is critical for the viability of the bank. Developmental and Structural Issues in the Banking Sector 26. Extending the access to and broadening the diversity of financial services, and achieving sustainable profitability will mainly depend on market-driven factors. Specific legal and regulatory enhancements, which will enhance financial intermediation by banks and lower costs, are the following. Growing competition for the corporate sector will encourage banks to seek to increase their lending to SMEs and households. Improvements in accounting practices, credit culture of borrowers, and credit history are necessary to allow for this access, reduce the cost of financial intermediation, and limit any risks of poor allocation. The current contractual savings housing finance models may not be viable once their preferential tax treatment is eliminated, could be regressive and inefficient, and may have embedded liquidity risks. Development of a sustainable primary, and in turn secondary, housing finance market in Poland will largely depend on the enabEing environment and the housing finance -8- in&structure, including clarifications regarding the legal status of pledged property, improvements in credit history information, and better, independent property evaluations. Securities Markets 27. Securities regulation complies with almost all IOSCO objectives and principles. The Polish Securities and Exchange Commission (SEC) is generally regarded as a fair and tough regulator, with adequate resources. The authorities should nevertheless consider the following improvements. Over time, more responsibilities could be given to the self- regulating organizations in the system. A better functioning criminalprosecution of white- collar offenses is necessary to ensure effective enforcement and changes in the public prosecutor’s office may be necessary. The mechanisms through which ownership positions can be identified can be enhanced to help in enforcing large ownership limits, tender and takeover rules, insider transactions, and minority protection more generally. 28. The most important contribution to Polish equity market development is rapid privatization. While it has grown considerably in market capitalization and liquidity, the Polish equity market is still relatively small. To enhance the supply of investable securities, the authorities could consider floating tranches of large state-enterprises, provided it would not sacrifice the prospects of a future sale to a strategic investor. Concurrent development of institutional investors would increase the supply of investable funds and enhance the quality of investments. The authorities should also facilitate the integration of trading systems in Poland with global systems. 29. While government bond market development has accelerated since 1999, improvements could be made by establishing a competitively determined yield curve across maturities that provides a benchmark for corporate long-term debt. Development could also be spurred by committing to a regular issuance up to a certain maturity and maintenance of a yield curve up to that maturity; developing a trading mechanism that permits non-bank institutional investors access on equal footing with banks and that does not segment the retail market completely from the wholesale market; and the planned establishment of a primary dealer network with some obligation to ensure a continuous market and smooth price determination. The active cooperation of the National Depository of Securities (NDS) will be essential. 30. The corporate bond and otherjixed-income markets are still small and their further development will take time. Market development will mainly be influenced by fundamental factors, including prudent macroeconomic policies, improvements in the functioning of the government bond market, the growth of institutional investors, and to some extent asset securitization. Institutional Investors 3 1. The institutional investor base (insurance companies, pension funds and mutual funds) is still relatively small in Poland. This mainly reflects the overall reform and privatization -9- strategies pursued. A specific factor is the very recent establishment of a mandatory funded pension scheme. 32. The insurance sector has developed well in recent years, with an influx of foreign investors. To further develop the market, policies for the sector need to address the following issues. Concentration in some segments in the industry remains high, particularly in group- life insurance; low profitability is a concern for some property and casualty services; and PZU’s early and transparent privatization will be important to the development of a competitive market. There are also some issues in regulation and supervision limiting the development of this sector. In particular, the supervisory agency should have adequate powers to intervene weak companies. On-site inspections should gradually shift away from checklist-driven approaches to a risk-based approach to detect isolated or systemic risks at an early stage. As supervisory resources are further built up, the frequency of inspections should be increased. There is considerable concern that insurance premiums in property and casualty areas are not adequate. The ongoing review by the supervisor will be useful to determine whether competition has pushed prices to an inadequate level. 33. Following the recent comprehensive reform of the pension fund sector, a number of important issues need to be further addressed. Pension funds will become an important source of institutional investment in Poland in the near future and may dominate net investment in the capital markets. The functioning of the pension industry is at the moment, however, hampered by problems in the Social Security Administrator (ZUS) and low scale of operations of some funds. Other measures that need to be considered include the following. The voluntary component of the pension system (Pillar II0 should be brought into operation to complete the pension reform program by clarifying the regulatory framework. Regulations should be liberalized to allow the sector to grow more efficiently and offer beneficiaries the right products. In this context, pension funds should be allowed to invest more in foreign assets, a more flexible approach should be taken towards mergers in the sector, multiple financial products and outsourcing of asset management be allowed, and the scope for cross- selling of products should be expanded. Over time, as the governance framework for pension funds is improved, investment regulations on domestic assets should be relaxed and the minimum rate of return guarantee should be evaluated. The Superintendency of Pension Funds’ (UNFE) procedures, governing matters such as licensing and processing of requests for mergers, should be publicly disclosed in order to ensure adequate transparency of its activities. Supervisory activities should focus more on risk managementpractices and solvency instead of on compliance. -lO-