54958 OFFICIAL USE ONLY SecM201O-0349 June 8, 2010 FROM: The Acting Corporate Secretary Serbia Financial Sector Assessment 1. Attached for information is the Financial Sector Assessment (FSA) for Serbia, as part of the joint IMF-World Bank Financial Sector Assessment Program (FSAP). 2. Questions on this document should be referred to Mr. Raina (ext. 82900). Distribution: Executive Directors and Alternates President Bank Group Senior Management Vice Presidents, Bank, IFC and MIGA Directors and Department Heads, Bank, IFC and MIGA This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its content may not otherwise be disclosed without World Bank Group authorization. ii REPUBLIC OF SERBIA - GOVERNMENT FISCAL YEAR January 1 - December 31 ABBREVIATION AND ACRONYMS AMLlCFT Anti-Money Laundering/Combating the Financing of Terrorism BCP Basel Core Principle on Banking Supervision BSD Bank Supervision Department BSL Banking Stability Law CAR capital adequacy ratio DDOR DDOR Novi Sad, one of the largest insurance companies in Serbia DIA Deposit Insurance Agency EBRD European Bank for Reconstruction and Development EU European Union FSA Financial Sector Assessment FSAP Financial Sector Assessment Program . FSSA Financial System Stability Assessment FSSP Financial Sector Support Program FX foreign exchange GDDS general data dissemination system GDP gross domestic product GoS Government of Serbia GPW gross premiums written IFRS International Financial Reporting Standards IMF International Monetary Fund IT information technology LOB Law on Banks MOF Ministry of Finance MOJ Ministry of Justice MONEYVAL The Select Committee of Experts on the Evaluation of Anti- Money Laundering Measures of the Council of Europe MOU Memorandum of Understanding MTPL motorist third-party liability insurance NBS National Bank of Serbia NOS National Office of Statistics NPLs non-performing loans ROE return on equity ROSC Report on the Observance of Standards and Codes RRs reserve requirements SBA Stand-by Agreement SC Securities Commission SRR statutory reserve requirement WB World Bank 111 Table of Contents I. Overall Assessment ......................................................................................................... 1 II. Macroeconomic Environment ........................................................................................ 2 III. Stability Assessment .... """ .. """".""""""."""."" .. """ ... ".""."""" .. "." ...................... 3 IV. Stability Policies ........................................ " ................... """"'''' ...................... ""'''''''' 4 V. Developmental Issues ..................................... :.................................... " ........................ 5 A. Bank Regulation and Supervision .............................................................................. 5 B. Corporate Debt Restructuring Issues .......................................................................... 6 C. Insurance .................................................................................................................... 8 I. OVERALL ASSESSMENT 1. The FSAP update team found that the authorities have progressed in implementing the key recommendations from the initial assessment. 2 The 2005 FSAP team revealed a number of vulnerabilities, including (i) high credit growth, largely financed by foreign banks, which resulted in rising nonperforming loans (NPLs), and (ii) poor management and low capital of several systematically important state-controlled banks. The Basel Core Principle on Banking Supervision (BCP) assessment identified a number of deficiencies in banking supervision. The update team found that the authorities took action to address the issues highlighted by the 2005 FSAP. In particular, they adopted prudential measures to slow credit growth, including higher risk weights for foreign currency loans to unhedged borrowers, and exposure limits to households. Two systemic state-controlled banks were privatized. Finally, a new banking law was enacted that significantly strengthened supervision on consolidated basis and improved corporate governance and transparency. 2. Serbia weathered the global financial crisis, although not without costs. The economy suffered from depreciation of the dinar, vis-a-vis the euro, soaring sovereign spreads, and weak export demand. This caused a 4 percent contraction in real gross domestic product (GDP) in the first half of 2009. Confidence in the banking sector was also affected, as reflected in substantial withdrawal of household deposits from banks. 3. The banking sector is still highly capitalized and liquid, but increasing NPLs and decreasing profitability especially of smaller banks are of concern. At an aggregate level the sector is well capitalized and liquid, and stress tests show that, under the most severe scenario, even a substantial increase in NPLs would not result in significant undercapitalization of the system. However, NPLs increased substantially in the first half of 2009, and the profitability of the banking system has dropped significantly, especially for smaller banks. Therefore a prolonged recession could further decrease profitability and lead to eventual undercapitalization especially of the smaller banks. 4. The insurance sector remains underdeveloped. While the Serbian insurance sector is adequately capitalized relative to its overall risk exposure, it remains one of the most underdeveloped in the region. 5. The key conclusion of the FSAP update team are: 3 · In the context of weak asset growth and rising NPLs, the high level of required reserves should be reassessed; · Despite an upgraded regulatory and supervisory framework since the 2005 FSAP, the authorities could consider streamlining prudential rules; formalizing 2 See Appendix I for the status of the key recommendations of the 2005 Assessment. 3 The full FSAP update documents on which this FSA is based include: (i) the Aide Memoire, summarizing the team's findings and recommendations; (ii) technical background notes on selected topics, namely: Stress Tests of the Banking System, Liquidity Management, Crisis Framework Management, Deposit Insurance, Insurance Sector, Corporate and Household Debt Restructuring; (iii) update of the observance of the Basel Core Principles for Effective Banking Supervision. 2 cooperation agreements with significant home supervisors; and continuing to build capacity of the Banking Supervision Department; · The proposed legal amendments to introduce "least cost restructuring" of problem banks and to declare a systemic crisis situation under predefined circumstances represent a welcome step forward; To facilitate the resolution of NPLs and corporate debt restructuring, the authorities could: (a) introduce a corporate workout framework with appropriate incentives for stakeholders; (b) establish a centralized registry for bills of exchange and amend pledge laws to protect prior interests in cash collateral; (c) strengthen enforcement procedures and establish a regulated profession of enforcement officers; and (d) establish a task force to propose solutions to corporate fraud as it affects the banking sector; · To support the development of the insurance sector, the authorities should consider (a) promoting the development of life insurance; (b) encouraging the final settlement of liquidated insurers' claims; (c) mandating the separation of life and non-life parts of the business for all companies; and (d) promoting the liberalization of the local reinsurance market. These recommendations are summarized in Appendix II. II. MACROECONOMIC ENVIRONMENT 6. The Serbian economy was hit hard by the global financial crisis. In the period from October 2008 to February 2009 the dinar depreciated by 20 percent vis-a-vis the euro, and 18 percent of households' deposits were withdrawn from banks. These developments, along with weak trading partner growth, led to a sharp contraction in trade and production, and the real GDP contracted by about 4 percent in the first half of 2009. Owing to weak demand and consumption, tax collections have plunged, and, notwithstanding spending cuts and nominal freezes, the fiscal deficit is expected to rise to about 4Yz percent ofGDP by end-2009. 7. To respond to the crisis, the Government requested a precautionary Stand- by Agreement (SBA) with the IMF and introduced various regulatory and monetary measures. In addition to the IMF program, and as the crisis unfolded, the authorities introduced a comprehensive Financial Sector Support Program (FSSP) featuring a combination of commitments by banks and a set of incentives by the National Bank of Serbia (NBS). Foreign parent banks have committed to maintain their exposure to Serbia at the end-2008 level throughout 2009-10, and to keep their subsidiaries sufficiently capitalized and liquid. Incentives by the NBS included access to new liquidity facilities and the softening of some regulatory requirements. The FSSP has helped to restore confidence. 8. Going forward Serbia faces three key risks to its macroeconomic and financial sector stability: · Prolonged weakness of the real sector and deterioration of banks' balance sheets. The crisis has already translated into almost doubling of the banks' NPL ratio since September 2008. Going forward, besides direct impact on private 3 sector profitability and growth, persistence of this trend could adversely impact the sentiment of foreign investors and parent banks, leading to renewal of external financing and foreign exchange (FX) market pressures. · An unsustainable fiscal position could lead to renewed FX market pressures by putting at risk support from the IFIs as well as banks' commitments under the FSSP. Given the expectation of only a modest economic recovery, high spending needs, and low tax receipts, fiscal deficits would hover around unsustainable levels of 5-6 percent of GDP in the medium term. To make the fiscal position more sustainable, the authorities announced ambitious plans to reform public administration, education, health, and pension systems. · Adverse external environment. Slow economic recovery in the region is likely to dampen domestic activity, especially exports. This would weaken investor interest, leading to renewed FX, financial, and fiscal pressures. III. STABILITY ASSESSMENT 9. The banking sector remains highly capitalized, but increasing NPLs are a source of concern. The capital adequacy ratio (CAR) for the entire banking system is 21 percent, and all banks maintain CAR above the 12 percent prescribed minimum. The additional capital buffers largely reflect the impact of prudential regulations which aimed to slow credit growth in the pre-crisis period. However, the asset quality of the banking sector has worsened markedly in 2009. The NPL ratio reached 16Yz percent in June 2009, up from 11.3 percent in 2008, due to the macroeconomic deterioration and exchange rate depreciation. 10. Profitability of the Serbian banking system, which is low by regional comparisons, exhibited a substantial drop in 2009. Low profitability is due to high capital and reserve requirements (RRs). Net income halved in 2009 due to large loan losses. As a result, return on equity (ROE) plunged to 4.1 percent (annualized) from 9.3 percent in 2008. Net interest margin remains the main source of banks profits and has been relatively stable with respect to total loans despite the stiff competition for deposit market share. Alongside, some 13 banks (with a total of 16 percent market share) are currently generating significant losses. Hence, it will be difficult for these banks to rely on profitability to offset credit losses. 11. However, stress test results suggest that the Serbian banking sector, as a whole, can withstand severe shocks. The test confirmed that credit risk poses the largest threat to the system. Nonetheless, under the most severe scenario, even a substantial increase in NPLs would not result in significant undercapitalization in the large banks; some banks' CARs fell below the minimum requirement of 12 percent, but most stayed above 8 percent. The recapitalization needed to restore CAR to the minimum 12 percent did not exceed 1.2 percent of GDP in the worst case scenario, which did not take into account profit buffers. 4 IV. STABILITY POLICIES 12. In the aftermath of the crisis, the authorities undertook measures to enhance market confidence and to enhance supervisory and contingent funding mechanisms. Amongst others, these included: signing of a Memorandum of Understanding (MOU) on Agreement of Cooperation for the Preservation of Financial Stability between the Ministry of Finance (MOF), the NBS and the Deposit Insurance Agency (DIA), to layout a framework for coordinated decision making and a clarification of roles and responsibilities; an increase in the amount of deposits insured; the launch of the FSSP; and the introduction of potential bank recapitalization measures. 13. The authorities plan to replace provisions introduced in the wake of the crisis with a Banking Stability Law (BSL) whose measures can be triggered in the event of a systemic crisis. The proposed law provides for the NBS and the MOF to be able to announce the measures for enhanced deposit or liability coverage in banks, and mechanisms for enhanced government financial assistance to be authorized by an extraordinary session of the Parliament. The Government of Serbia's (GoS) equity, acquired as a result of providing financial assistance to troubled banks, would be divested within a year. To enhance lender-of-Iast-resort facilities available in normal times, the NBS would be able to request that the GoS issue a guarantee to solvent banks with insufficient collateral or to significantly undercapitalized systemic banks. During a systemic crisis, the GoS is required to report on measures undertaken to the Parliament once per month. 14. The proposed BSL therefore provides an adequate crisis management legal framework in case of systemic crisis. Once invoked, the systemic crisis situation is expected to be revoked by the GoS upon suggestion by the NBS or the DIA. Thus, upon its enactment, the new law should in future enable the exit of the enhanced emergency measures mentioned above, once the stability is restored. 15. To introduce a complete bank resolution toolkit, a number of laws are proposed to be amended. As a forward looking policy rather than an immediate need, since there are no problem banks currently in the system, legal amendments are being proposed to the following five laws: the law on deposit insurance, the law on deposit insurance agency, the banking law, the mortgage law, and the law on bankruptcy and liquidation of banks imd insurance companies. The objective of the amendments is to set up a framework for bank restructuring, which will give the authorities maximum flexibility in dealing with problem banks, based on least cost resolution principle. The overall responsibility of restructuring open banks will rest with the NBS, while liquidation of closed banks will stay with the DIA. However, given that the two phases are strictly interconnected, and also in light of the several roles performed by the DIA as liquidator and deposit insurance agency, the two entities should act in close coordination, including in the exchange of information. 16. The separation of the resolution authority and responsibility between the NBS and the DIA is not ideal but is a pragmatic option under the circumstances. In smaller countries, there could be a problem of building up' and maintaining the competence of dealing with problem banks in a separate agency, especially when the 5 bank failures may be infrequent. The options seem to be to either to give the responsibility to the DIA, to set up a specialized and independent unit within the NBS, or, when there is a systemic crisis, to establish a specialized agency. 17. To avoid conflict of interest because of overlapping supervision and restructuring functions, it is recommended that the NBS establish a specialized and independent unit. As the NBS is expected to identify a problem bank, appoint receivers, monitor the progress of any bank restructuring, and verify when the restructuring has been finalized that the bank has been properly restructured, there is a potential for a conflict of interest. It can be argued that the NBS is assessing its own work if it is in charge of both bank supervision and ban1e restructuring. Thus, it is recommended that the NBS establish a unit reporting to the governor in case of restructuring of either large or multiple problem banks. V. DEVELOPMENTAL ISSUES A. Bank Regulation and Supervision 18. Following the previous FSAP, the Serbian authorities have undertaken a major effort to upgrade the legal and regulatory framework for banking supervision. The 2005 Law on Ban1es (LOB) envisaged harmonization of the legal framework with international standards, ED Directives and BCP. For instance, the new law introduced a two-step licensing procedure, a lowering of the bottom threshold for obtaining prior regulatory approval for acquiring direct or indirect ownership in banks, and the establishment of consolidated supervision. The NBS also enhanced the risk management standards in the banking sector by issuing various regulations requiring banks to set up risk management systems. 19. A relatively strict supervisory policy has helped the banking sector to withstand the financial crisis. Substantial solvency buffers have served Serbia well in mitigating the impact of the recent financial turmoil. In addition, the NBS has applied risk weights that, for some asset categories, are conservative, compared to other countries in the region. Faced with rapid foreign currency lending in the run-up to the 2008 crisis, a special 125 percent risk weight was applied' to unsecured foreign currency-related lending. Also, risk weights for housing loans are relatively conservative compared with a number of regional peers. By contrast, the highest risk weights for loans to banks and loans to governments are lower than for countries that have introduced the European Capital Requirements Directive. 20. Despite upgraded regulatory framework and supervisory practices, a number of important challenges remain, including (a) streamlining the framework for loan classification and provisioning; (b) clearing the fiscal impediments necessary for the formalization of cooperation agreements with a number of significant home supervisors; and (c) further capacity building of the Bank Supervision Department (BSD). 21. The loan classification system and the criteria appear to be comprehensive and prudent, but also rather complex. The present banking regulation is broadly characterized by a combination of general principles and precise benchmarks. The 6 former, especially, leaves ample room for a judgment in loan classification. Discussions with banks and NBS staff indicated fundamental differences in classification standards and approaches. Moreover, by setting rather broad brackets for provisioning over each class of exposures, the present regime additionally broadens the scope for a divergent interpretation of the global risk provisioning framework. 22. NBS should consider defining a more precise set of classification criteria. In particular, the classification framework for days past due and provision levels should be more clear-cut, taking into account the needs of both supervisors and banks with respect to prudence, clarity, and transparency. In the same vein, the NBS could consider whether it is still justified in both requiring exposures in foreign currency to be automatically downgraded and simultaneously charging them with a higher weight for CAR purposes. Moreover, in the event of loan restructurings, which are duly followed up on, the requirement to automatically downgrade these loans without taking other considerations into account could be revisited. 23. The NBS is actively cooperating with foreign supervisors in supervising local subsidiaries but has had limited success in entering into formal MOUs with some of the critical EU home supervisors. The NBS has signed bilateral MOUs with most countries in the region and with several EU home supervisors. In practice, international cooperation in ongoing supervision seems to work quite well, such as through the participation of the NBS in supervisory colleges, the practice of joint inspections, and multilateral MOU agreements. However, its domestic obligations to share information with the Serbian tax authority, which raises confidentiality concerns on the part of the home supervisors, has suspended the finalization of MOUs with France, Austria and Germany, which for Serbia are three important home supervisors. A reconsideration of this obligation is recommended to authorize the NBS to duly formalize its cooperation with these three supervisors. 24. The current staffing and budgeting for the BSD appear to be adequate, but some specific competences are still lacking. Shortages of experienced staff make it difficult to adequately fill in some key positions. In addition, the staff shortage is severe in a number of specialized areas, notably information technology audit. Staffing constraints are likely to become more pressing over the next years in view of the expected future growth and increasing complexity of the Serbian financial sector and the challenges posed by the implementation of international regulations and standards. Therefore NBS is advised to give priority to capacity building for the BSD. B. Corporate Debt Restructuring Issues 25. To resolve the escalating levels of non-performing loans and corporate distress,. the authorities should adopt a corporate debt restructuring framework with incentives to encourage stakeholders to participate. As of June 2009, NPLs in the banking system constituted 16.5 percent of total loans, owing primarily to the corporate sector, which underscores a troubling trend. Corporate debt restructuring mechanisms are insufficient to cope with the increasing levels of corporate distress and NPLs. The NBS's decision to relax provisioning rules to encourage debt rescheduling is an important step in promoting restructuring of corporate debts. Banks can reschedule a 7 borrower's debt and reclassify it as performing after 6 months, provided it is a first time rescheduling and the debtor is not delinquent more than 30 days within the 6-month period. Debt rescheduling alone is an impartial solution to the problem, however, and a deeper restructuring of companies will likely be needed for already over-leveraged or financially distressed companies, especially if the recession is protracted. A properly designed corporate restructuring framework can encourage parties to reach consensual agreements that are better for all parties. Typical features of a corporate restructuring framework include a temporary moratorium on debt enforcement, disclosure obligations by the debtor, access to priority financing and provision for use of cash collateral (for example, cash subject to blocked accounts), rules governing inter-creditor arrangements and voting, favorable provisioning and tax treatment for restructured debt, and accelerated approval. 26. Registering bills of exchange and clarifying treatment for competing blocked account requests would create greater transparency in lending practices, reduce risks to the banking system, and promote corporate restructuring. Most banks laud the blocked account procedure as one of the most efficient and best ways of recovering an overdue debt. Some banks react deliberately to defaults taking stock of the client relationship, the cause of the default and the potential for rapid resolution. Others reportedly exploit the process to improve otherwise weak collateral positions. Financial deterioration and materially adverse change clauses in loans, combined with cross-default provisions, enable banks to accelerate their debt so as to submit their own blocking request, compounding problems for financially distressed companies and complicating restructuring efforts. The Law on Payment Transactions should be amended with respect to blocked account provisions to accommodate a corporate workout framework, allow use of cash collateral and cash management accounts, and address concerns about a fair distribution among creditors holding bills of exchange with similar rights. Changes to the law should be taken into account in the design of the corporate restructuring framework. 27. Enforcement procedures should be further streamlined to improve efficiency. NPL resolution and loan loss mitigation is hampered by a still evolving but uneven collateral and enforcement framework that complicates restructuring and leads to delays and lower recoveries in execution procedures. In recent years, a number of laws have been adopted or amended strengthening creditor rights, including Mortgages (2005), Pledges of Movable Assets (2003, amended in 2005 and 2006), Financial Leasing (2003, amended 2005), Enforcement Procedure (2004, undergoing revision), and Corporate Bankruptcy (2004 and 2009). Most of these laws largely comport with international norms, although clearly there is some scope for improvement based on practice and interpretation. For example, auction procedures could be amended to further streamline the auction process. Foreclosure on real property under the old system had to be done through the courts, and could be easily delayed. The current non-court auction procedures under the new Mortgage Law are improved but contain unnecessary restrictions that add little value and delay the process, such as the requirement of multiple auctions with minimum bids pegged to prescribed reduction amounts. Some court proceedings still take longer than necessary, and debtors frequently engage in tactics to avoid enforcement, causing enforcement to take two to three years. Loopholes allowing delays should be closed. 8 28. An expanded and regulated profession of execution officers would also improve the efficiency of the enforcement process. A new Law on Enforcement Procedure was enacted in November 2004 with great promise. The new law strengthened rights of creditors in seeking enforcement in a number of ways, by including: (i) new protective measures (such as, injunctions); (ii) summary execution procedures for commercial matters; (iii) clearer rules and time-bound procedures for appeals; and (iv) procedural enhancements to streamline the handling of claims for movable and immovable property. Despite improvements to the Law on Enforcement Procedure, the enforcement process largely fails now due to a severe shortage of trained enforcement officers. 29. Corporate insolvency mechanisms impose high costs on petitioning creditors, discouraging access to the system, and fail to adequately protect a creditor's collateral rights in bankruptcy. Recent amendments to the bankruptcy law should correct some of these problems. In particular, a petitioning creditor should not be obliged to finance the bankruptcy proceeding, which is too costly for a single creditor and discourages use of the system. Other amendments include new provisions elaborating procedures to approve a prepackaged plan of reorganization. The proposed amendments could be further refined to improve the efficiency of the prepackaged process by excluding from the process creditors whose claims are not being affected or changed. This will make the accelerated restructuring quicker, less complicated, and less costly, and could provide a useful complement to the out-of-court workout process. 30. A task force should be established to examine and propose solutions to corporate fraud as it affects the banking sector. Corporate debt resolution is complicated by a pattern of corporate misconduct designed to circumvent a creditor's legitimate enforcement rights. This is particularly acute in response to account blockages. In an effort to survive, business owners frequently engage in a pattern of corporate fraud to avoid their legitimate obligations by creating alter ego or shell companies through which to conduct their ongoing business activities, with all funds passing through the new legal entity. That entity is free from debt and can open bank accounts, engage in contracts, and carryon business as usual using the corporate assets of the prior legal entity under cleverly disguised lease or contractual use obligations. In most modern economies, such practices constitute fraud or fraudulent transfers that can carry stiff penalties, including loss of business privileges. Other reported abuses include applying for voluntary dissolution during which the owner or a friendly receiver continues to operate the business for years in an "apparent" wind-down of the business, while ignoring creditor claims. Strong penalties and sanctions for such abuses would discourage such behavior. C. Insurance 31. The insurance sector remains small and underdeveloped. With insurance consumption of 76 and 10 per capita per year, for non-life and life insurance, respectively, Serbia lags behind most of its neighbors in Southeastern and Central Europe. In 2009, the industry accounted for only 4.6 percent of total assets and 5.6 percent of total capital of the financial sector. By mid-2009, there were 25 insurance companies, out of which 18 were foreign-owned. The insurance market is privately 9 owned with the exception of one government-owned company, accounting for less than 28 percent of total market share. 32. The Serbian insurance sector is well capitalized, and its overall underwriting performance is satisfactory for tbe sector as a whole. From 2005-2009, the solvency ratio of the sector was close to 200 percent. The adequacy of the industry's surplus capital can also be gauged from the size of the premium leverage ratio, which is 1.7-1.9 in the Serbian market, versus 2.5-3 internationally, demonstrating a rather healthy capital safety margin. During the last few years, the quality of the industry's balance sheet has improved considerably, as can be seen from the growing share of highly liquid assets and declining share of receivables relative to total assets. Despite a small deterioration in the industry's underwriting performance in 2008, the industry still managed to keep its overall underwriting losses and expenses below the annual premium intake. 33. Because the local regulatory requirements prohibit direct placements of reinsurance with foreign companies, the insurers' net risk retention has been unusually high by international standards. For example, in 2008, over 92 percent of gross premiums written (GPW) were retained by insurers versus 50-60 percent typical for more developed markets. Until recently reinsurance placements for all market players, except Delta-Generali (which has its own captive reinsurer), could be effected only through Dunav Re. Since Dunav Re effectively operates as a fronting company for foreign reinsurers, the Serbian insurers appeared to have been reluctant to incur additional intermediation fees. without getting direct access to highly rated reinsurers. However, the situation is likely to improve somewhat with the recent entry into the market of Wiener Re, a fully-owned reinsurance subsidiary ofVIG. 34. The regulatory framework and its vigorous enforcement by the NBS contributed to a large extent to a robust insurance sector. The Insurance Supervision Department currently employs 42 staff, covering (a) Off-site Supervision; (b) On-site Supervision; (c) the Actuarial and Statistical Division; and (d) the Legal Division. The NBS strategic plan for 2006-2009 envisages a progressive evolution from compliance- based to risk-based supervision. In addition, the NBS introduced licensing requirements for insurance agents, improved market transparency, commenced proactive on-site and off-site market supervision, and created a consumer protection unit. It is also developing an "early-warning system" to allow the NBS to intervene in companies' affairs before cases of financial or managerial weakne~s become irreversible. 35. Recommendations to further strengthen the insurance regulatory framework and to develop the insurance sector include the following: · Liberalization of domestic reinsurance market. Given the additional cost burden· and the unusually high premium retention rate for the Serbian insurers, it is important to review the current reinsurance requirements to introduce a competition among the local and international reinsurers in the Serbian insurance market. · Separation of life and non-life insurance. Serbia does not require separation of life and non-life insurance. The existing status quo creates opportunities for management of insurance companies to use often sizeable life insurance reserves as a substitute for risk capital (in lieu of reinsurance) in considerably more volatile non-life catastrophe 10 insurance business, which creates the potential for systemic risk in the sector. Hence, separation of all aspects of life and non-life insurance should be considered an immediate policy priority, and applied without any further delays to all new and old insurance companies by end-2009. · Moving toward a risk-based supervision. The NBS should consider starting the preparation work for the early adoption of a risk-based supervision regime envisaged under the Solvency II regime, which would allow the industry to realize a significant reduction in its risk capital and hence become more efficient and attractive for investors over time. The development of risk-based supervision, however, will require allocation of additional· internal resources and technical assistance from abroad. · Tax incentives for non-life and life insurance. Given the lack of real growth in the non-life insurance sector, it would be advisable, at least temporarily, to eliminate a 5 percent tax currently levied on non-life insurance premium. Furthermore, to ensure a level playing field for all long-term savings products, life insurance should receive tax treatment similar to that allowed under the current pension legislation for individual contributions to a voluntary pension scheme. · Funding MTPL Claims. Currently, there are EUR 2004 million of officially recorded MTPL liabilities from bankrupt companies, which will be serviced by the Guarantee Fund. Although, until now there have been no problems in servicing the MTPL liabilities of bankrupt insurers by the Guarantee Fund, the situation may change for the worse if the speed of claims processing by the bankruptcy court picks up in the future. In that case, the Government should implement necessary measures to ensure adequate funding of unsettled claims as envisaged under the law. 11 Appendix I. Follow-up on Key Recommendations of the 2005 FSAP Adopt a time bound corrective action plan to address deficiencies in compliance with BCP. Ensure provide the NBS accurate asset NBS lllcancm adopted. classifications on their loans. Expand NBS data gathering capabilities to capture NBS Done in NBS Decision 51, June 2005. all foreign currency and foreign currency indexed loans. banks to monitor and assess borrower's NBS Done in NBS Decision 51, June 2005. exposure to exchange rate risk and to reflect their assessment in the loan classification. Revise the criteria for loan loss provisions to NBS Implemented in by-laws pursuant to the Law on minimize the number of reductions in the required Banks. provisions that are allowed. Undertake full-scope examination of the largest NBS Two large state-owned banks were state banks and ensure that recommendations recapitalized in 2006 by the EBRD and are now arising from examinations are adopted. under majority ownership of EBRD and the state. Plans to merge the remaining majority state-owned banks are evolving. Two are . planned to be merged into a third bank, and 'the . fourth one will seek a Bring forward the privatization agenda for the two MOFIDIA One of the banks was sold into foreign large state-controlled banks. ownership. The other is still state-controlled, but with EBRD also as a shareholder. Discussions are being held toward Strengthen all state controlled banks' reporting MOF/DIA Done. requirements. Revise NBS chart accounts to to NBS Done. International Financial Reporting Standards (IFRS) Require bank boards to have audit committees NBS The LOB requires that banks have an audit comprising a majority of independent members. committee of at least three members, at least two of which are members of the bank's board of directors, and with at least one independent member 79 and Require to disclose to NBS Done in NBS Decision, December 2005. of foreign exchange fluctuations on their debt service costs. limits for exposure to large borrowers NBS with respect to state-controlled banks. Require that all state banks' directors are subject to NBS Done in new LOB for new directors of all NBS "fit and proper" criteria. banks (Articles 71 and 72). banking to authorize the NBS to The new LOB "",."",·., the mandate of the NBS supervise banks on a consolidated basis. Reduce significant ownership level criterion for NBS prior approval by the NBS from 15 percent to 5 percent, or lower if significant influence will be uired. 12 Responsible Recommendations Status Seek explicit statutory protection for the NBS and Done in new LOB (Article 121). its officers and staff when perfonning banking . supervision in good faith in accordance with the ' law. Establish limits for a bank's aggregate exposures to NBS Done in new LOB (Article 33). related parties. Require bank boards of directors to accept NBS · Done in new LOB (Articles 73 and 141). responsibility for establishing and overseeing 111t,~"r'Mp,rl risk Include IT specialists within the NBS examinations NBS In progress. staff. Define the powers of the courts in the Banking Law MOJINBS The new LOB calls for limits on the powers of to review the substantive or technical decisions of the courts to review NBS decisions (Article 9). NBS. Increase the statutory reserve requirement NBS The SRR for enterprises has raised to 38 (SRR) ratio on enterprises' foreign-currency percent in December 2005 and unified with the rl"r.r.oito and commercial banks' SRR for households. Introduce a single, fully collateralized lender of last ; NBS Three lending facilities were unified into one resort facility priced at a multiple of the market lending facility, which is linked to the repo rate. rate. Lower the daily minimum requirement of 80 NBS The NBS has lowered the minimum to 50 percent of the SRR. percent during 2008. Link the ceiling and the floor of the interest rate NBS . In November 2005 the ceiling of the corridor corridor with market conditions. , was linked with the repo rate. the process of NBSINOS Done. As of May 2009, Serbia has become a in the GDDS. Increase transparency of ownership and control of SC traded companies. Require publication of the full IFRS audit report, NBS Done new LOB. supporting schedules and auditor's opinion. Strengthen the responsibili OF Done in new LOB. supervisory boards. Increase shareholder protection during capital MOF Enforcement has been strengthened; no increase and takeovers. legislative changes. Ensure IFRS and NBS accounting rules are fully NBS NBS accounting rules are being fully applied to applied to insurance company fixed assets and accounts receivable. receivables. Commence NBS on-site examinations at two large NBS Done. socially owned insurers. Require DDOR Dunav each to submit their DIA DDOR has privatized in 2007, while business plans and appoint financial advisors to privatization of Dunav is yet to be initiated. and execute a Develop a strategy third-party liability NBS The new MTPL Law was adopted the insurance under the guarantee arrangement. Parliament and became effective on October 2009 Phase out restrictive trade regarding NBS done. mandatory reinsurance cessions and long-term nrr,np.IT\/ insurance contracts. 13 ; i i Responsible Recommendations Entity Status of Implementation Implement the corrective action plan for AMLlCFT i APML recommendati ons put forward in MONEYVAL i . . ~~pgI!.:. . . . . · .........................,. .....................................................................,!.. ....... Strengthen the Securities Commission (SC) legal SC Institutional capacity enhanced by authority and institutional capacity. I reorganization and introduction of new remuneration guidelines in July ~QQ?: Develop regulatory framework for investment SC A new Law on Investment Funds was funds in line with EU Directives and international submitted to Parliament in September 2005. J:JlaUU;t;. Finalize and implement the law on voluntary MOF A new Law on Voluntary Pensions was passed pensions. in September 2005. Constitute the MOF Commission to adopt certified MOF Done. auditors and accountants. Modify accounting and auditing legislation in line MOF/NBS Accounting legislation has been brought into with the recommendations of the Accounting and full compliance with IFRS standards. Auditing ROSC. 14 Appendix II. Detailed Recommendations of the FSAP Update Recommendations Priority ,~<, ....... .. '" ............., ......· . . . . . . . . .. i·. .'Bankifig~~gtliation al1d~l~J)˘tyisioJl . ...... .. ' '. ......... ....i ......' ...... Set precise loan classification and provisioning levels, rather than broad ranges subject to Immediate interpretation. Monitor rescheduled and restructured loans. Immediate Relax provisioning and asset classification requirements related to FX loan and the reclassification of Immediate restructured loans that have been performing. Ensure adequate staffing in the BSD through competitive salary structures, training opportunities, and Short-term career prospects . . . . '. . . . . . . . . . . .]. . . . . . . . . . . . .·. . . . . . . . . . . . / . . . . ;. ,. '............t'.~.~.~.~.!~J..~.!:..~. . ~. . 'i" ,,...~~~";,r;.<·.(l;··j.···i. . (·· ..x.'·...; . . ···.. . . . . . Streamline the reserve requirement regulations and reassess its level, although any changes to the Immediate level should be gradual. Reduce the number of NBS repo auctions to one per week. Short-term Prepare alternative liquidity draining channels to allow a scaling down of the NBS repo. Medium-term Explore the introduction of primary dealership to promote the development of the secondary market. Medium-term . . i ..................... .iĞ:::l'islsiVraI1~g~llleptli'..a:nIewo.. k .·.... . . ............... .... .. ..... ..... '. ..... ' Introduce a comprehensive crisis management framework by approval ofthe necessary legal Immediate amendments. Develop crisis memoranda of understanding with relevant home countries. Medium Term .....<.. ....." ··· ·(i········· ·.·.;'J.....··...ii.(·..}:.-g~~~_ -.; ··· -:: ... ·..·'i:;('/X .·· .·.·.i·..:)(·.· .·· .·. ··1>.· ..... ·....."···;.. . . . . · .'. Introduce broader problem bank restructuring options under the NBS for an open bank. Short-term Issue NBS regulations to separate problem bank resolution functions from the BSD, including Short-term setting up an independent problem bank restructuring unit when needed, reporting directly to the governor. Consider putting in place mechanisms for emergency government financial assistance for bank Short-term restructuring costs. i:.·· ·.···· . ··.··;. . . . ;·.· · .·.· ·\ . .· . ·.··.\·,i··r·.··.· · ·· ·.··,i· . ·. ·. ,.·. ·. . . . . . )')eposi~~~sdta.~I,;~S~g.e.nte·..··. ..f " . : . . / ·....... ..), ';. . ...........·.. Enhance the operational capacity of the DIA to ensure timely payout of insured deposits. Short-Term Put in place contingent financing mechanisms between the MOF and the DIA for emergency Short-Term drawdown needs. Evaluate and adjust insured deposit coverage when crisis is over and system is stable. Medium Term Prepare a medium-term strategy for the DIA, including role, responsibilities, and funding. Medium Term ... <' ·. . . . ..... ...... y' .' .vit.... '., q()rp()r~#~·il~.il.·.~(J~~~ltQt~:n~b!· .. ............... . . . ...J.... .. . . . .... . i.····· Establish corporate workout guidelines to facilitate restructuring ofNPLs and address corporate Immediate distress. Introduce mandatory registration of bills of exchange in a centralized registry. Short term Amend pledge law to clarify priority and protection of cash collateral (exempt from blocked Short-term accounts process). Establish a task force to review and propose solutions to the problem of corporate fraud as it affects Short-term the banking sector. I ·· X>.·,·· ....···················· . . . . . ·.. ii·.....>...<·~lllsdran(;~'S~ctQ.F·.·· · ·f . . . . . . . . . . . . . . . . . . . . . . . . . . . , ................................................... . · ',i;/i i:'·'.·. Separate life and non-life insurance companies in all aspects. Short-term Adopt comprehensive measures to promote the insurance sector. Short-term Liberalize the local reinsurance market. Short-term