34441 FOR OFFICIAL USEONLY FINANCIAL SECTOR ASSESSMENT SERBIA NOVEMBER 2005 EUROPE CENTRALASIAREGIONVICE PRESIDENCY AND FINANCIALSECTORVICEPRESIDENCY BASED ONTHE JOINT IMF-WORLDBANKFINANCIAL SECTOR ASSESSMENT PROGRAM BACKGROUND 1. As part ofthe Bank-FundFinancial Sector Assessment Program (FSAP), two missions visited Serbia, one inMarch2005, andthe secondfrom April 12to 26,2005. The purpose of the FSAP was to assess the strengths and vulnerabilities ofthe financial sector andto identify key areas for its further development.' The team met with the Ministryof Finance (MOF), National Bank o f Serbia (NBS), Bank RehabilitationAgency (BRA), commercial banks, insurance companies, and many other officials. The team produced several reports that were reviewedby and deliveredto the authorities'. Our findings are set out inthis Financial Sector Assessment and our policy recommendations summarized inthe Annex. STRATEGIC ASSESSMENT STABILITY AND DEVELOPMENT OF ISSUES 2. The team concludedthat the financialsystem is currently broadly stable, but that there are systemicriskswhich could cometo the fore ifthe rapidpaceof credit growth continues.Credit to companies and households grew by 13 percent of GDP during 2004. The credit surge fosters economic recovery and growth, and was made possible by the authorities' strong reform program, which i s impressiveinthe light o f recent history. However, rapid credit growth brings new risks to financial and macroeconomic stability, especially inthe context o f the very large current account deficit and high inflation. At the same time, the still low level of bank credit and the rather undeveloped non-bank financial sector indicates ample scope for further financial development. ' The FSAP team comprisedMark Stone (IMF, Leader); MichaelEdwards(World Bank, Deputy); Marie ThBrkse Camilleri, Vania Etropolska, InWon Song, Neil Saker, Andreas Westphal, CharmaneAhmed (all IMF); Peter Kyle, Rodney Lester ,SusanMarcus, Angela Prigozhina, Branko Radulovic,SusanRutledge, MartinSlough(all World Bank); Tom Kokkola,RonaldMacDonald, and Walter Zunic (all experts). These were an Aide Memoire, TechnicalNotes, andDetailedAssessments of Compliancewith Standardsand Codes. - 2 - 3. Policiesto support financial stability and developmentshould focus principally on bank supervision and the legalframework. The Base1Core Principles assessmentof bank supervision was unfavorable, despite recent progress. Bank supervision should be improved by consolidating recent enhancementsinthe institutional capacity ofthe Bank Supervision Department, by adoption o f the new banking law, and new regulations that address credit risks by strengtheningenforcement and risk management. Many legal measures are needed to improve governance and ensure that banks do not take actions that could increase systemic vulnerabilities, while developing insurance, pensions and capital markets. Since May 2005 the authorities have implementedmany FSAP recommendations (see Annex). Systemicvulnerabilities 4. Significant systemic vulnerabilities are bank credit riskand the large state-owned banks. The consequences o fthose systemic riskswould overlap and could amplify considerably inthe absence of sound macroeconomic and structural policies. -5.mostofCredit risks arise from the 47 percent nominal growth inbank loans during 2004 which comprises foreign exchange indexedloans to borrowerswith dinar income. Stress test results indicate that credit risk is the most significant risk for the system. To mitigate credit risk, the team recommends better data reporting, newprovisioning requirements,improvedbank governance, and fbrther strengthening ofthe supervision and enforcement functions. 6. The state banksare not competitivewith foreign banks and their performance should be improved substantially ahead of privatization. Their relatively weak financial condition suggests that a major credit shock could put severe pressure on their loanportfolios and capital base, and anarrowing of margins arising from greater competitionwould create losses and induce under-capitalization. The risks should be addressedby resolute enforcement of supervisory examinations; better data reporting, internal controls, risk management and governance; andthe continuationo f rapidprivatization. 7. Banking supervision has improved, especiallydata collection and analysis, but high staff turnover and weak enforcementhave undermined its effectiveness. Weak enforcement has beena legacy of recent history, lingeringstate control of several key banks, gaps inthe legislation, and the vagaries o f thejudicial system. The risk-based approach to supervision has not yet taken hold, and consolidated supervision of banking groups also needs to be introduced. Off-site analysis, AML measures and inter-agency cooperation should also be strengthened. 8. Greater stabilitywould be supported by stronger bank governance. The ability of theNBSto apply "fit-and-proper" criteria for directors andsignificant shareholders should be enhanced, and the threshold for requiringNBS approval for changes inownership tightened. Bank directors should be heldaccountable for material misstatements of financial position and the NBSshould beempowered to apply remedial actions and sanctions incases o f financial misreporting. Internal and external audit provisions relating to banks should be expanded and strengthened. - 3 - Financialdevelopment 9. The team concludedthat financialdevelopmentis unbalanced,reflectinggaps in the legaland regulatoryframework. Foreignbank lendingand leasing are bothgrowing sharply, and state bank privatization i s underway, but non-bank financial markets are either small or nonexistent. 10. Policiesare underwayto removeimpedimentsto the developmentof the nascent insurancesector.The industryis dominated by two large state insurers, which are scheduled for restructuring and privatization. The Insurance Supervision Department has requiredthem to prepare business plans prior to full on-site inspections. The growing life sector is marked by unscrupulous practices and the relevant prudential rules needstrengthening. However, the department has begun an impressive work program and has closed fifteen insurers, while the BRA now oversees insurer liquidation and bankruptcy. 11, Creationof a supportinglegal framework is presentlythe mainissue for capital markets.The authorities are undertaking reforms to modernize the regulatory and institutional framework. Market participants must be requiredto adhere to high standards o f accountability and transparency. 12. Monetarypolicyeffectivenesswould be strengthenedby adjustmentsto the monetaryoperationframeworkand the establishmentof an interestrate corridor. The MFP Transparency Assessment notes that policy effectiveness would benefit from greater public disclosure of the broadobjectives and intermediate targets. The RTGS systemis highly reliable and efficient, and i s fully compliant with the Core Principles for Systemically ImportantPayment Systems (CPSIPS). Legal and businessenvironment 13. The legalframework has inconsistenciesand gaps, but many new lawshave been passed or are underconsideration.New Company, Secured Transactions, and Bankruptcy Procedure laws have beenpassed, but not yet implemented.A draft LandLaw has been drafted. A Law on the Bankruptcy and Liquidation o f Banks and Insurance Companies was approved by the parliament on July 15,2005. 14. Muchwork remainsto be done on the corporate governanceframework. Registration o f new companies has beenmuchimproved, but weaknesses remain inthe transparency o f ownership, financial reporting, board responsibilities, minority shareholder protection incapital dilution and corporate takeovers. The securities regulator suffers from insufficient legal authority and weak institutional capacity. Investment funds remain unregulated and pose a risk for future private pension funds. Revised legislation and a strengthening o f the regulatory agencies are both required. 15. The authoritiesshould eliminatediscrepanciesbetweengeneral-purposefinancial reportingunder InternationalFinancialReportingStandards (IFRS) and regulatory reporting. The Accounting and Auditing Law (2002) requires all enterprises to follow IFRS, but enterprisesmust adhereto standard forms or grids for the regulators which do not comply with IFRS. This fosters a "form over substance" attitude to financial reporting, andprecludes - 4 - measurement o f loan losses. The appropriate solution would be for the authorities to modify the charts of accounts usedfor regulatory reporting by banks, insurance companies and other financial institutions to comply with IFRS. MACROECONOMIC CONTEXT 16. The current state of the financial sector is best understood against the background of the 1990s.The politically distorted and war-influenced management o f the economy duringthose years created large fiscal and external imbalances, resultingin hyperinflation, large public debt and a shrunken financial sector. In 1991, the government took over most foreign currency savings of households, and many households lost their deposits as a result o f large-scale pyramidschemes. Internationalsanctions from mid-1992 until October 2000 ledto isolation and the loss o f official external financial support. 17. Since the fall of the previous regime, Serbia has made good progress in macroeconomic stabilization. The exchange rate-based stabilizationprogramhas helpedto reduce inflation from 115 percent inDecember 2000 to 8 percent at end-2003. The favorable disinflation trendwas supported by a notable reduction inthe government deficit. However, despiteaverage non-agriculturalgrowth of about 5 percent per year since 2002, output is only slightly above halfo f its pre-transition level. 18. Recent macroeconomic imbalances have put at risk earlier achievements. By mid- 2005 inflation had doubled to 17.5 percent, owing to robust domestic demand drivenby rapid wage and credit growth, administrative price increases, and higher oil prices. Owing to strong domestic demand and a large trade deficit, the current account deficit of Serbia and Montenegro relative to GDP widenedfrom 9.7 percent in2001 to 15.5 percent in2004, which i s too high, giventhe rise in foreign borrowing to pay for imports. Total external debt at end- 2004 o f US$14 billion(62 percent o f GDP) was unchanged, despitethe debt reductionby the London Club and other creditors equivalent to 7 percent o f GDP. 19. Re-monetization and a rapid expansion in the market share of foreign-owned banks have contributed to fast credit growth, while rising euroization has also increased vulnerabilities. Buoyant growth inforeign-currency deposits, partially fed by remittances, and the surge inforeign borrowing by commercial banks financed a credit boom in2004 that contributedto the deterioration inthe current account deficit. Euro-indexedlending has increased banks' credit risk resulting from their borrowers' exposure to exchange rate risk. The tighteningo f monetary policy since mid-2004 resulted ina moderate decline inreserve money, but strong broad-money growth has continuedunabated. High euroization undermines the impact ofchanges inpolicy interest rates on bank lendingrates, domestic demandand inflation. To compensate, the NBS has resorted to macro prudential measuresto slow down credit growth with a view to helping contain domestic demandand the current account deficit. 20. Macroeconomic imbalances are rooted in structural problems in state- and socially-owned enterprises which account for 50 percent of GDP. Weak financial discipline inthose enterprises has ledto rapid wage increases, and their low productivity hampers the growth o f exports and GDP, so their restructuringand privatizationshould be accelerated. It i s essential to reduce overstaffing and to initiate bankruptcy procedures against unviable, socially owned enterprises that are unable to attract investors. FINANCIAL SECTOROVERVIEW 21. The financialsector is small and bank-dominated,equivalentto some 48 percent of GDP,which is low by regionalstandards.The 43 licensed banks as of end-2004 represented90 percentofthe financial system, with total assets of S R D 510 billion (6.45 billion), which was 40 percent of GDP. Leasing company assets accounted for 2.1 percent of GDP, while the assets o f non-bank credit institutions were tiny (0.2 percent o f GDP). The insurance sector had total assets o f430 million at end-2004, largely reflecting non-life activities, with apenetration (premiundGDP ratio) of 2.1 percent. 22. Since2000 the bankingsystem has undergoneconsolidationand re- nationalization.In2001 19relatively small and undercapitalized bankswere closed. The BRA was given authority to administer banksinbankruptcy andinJanuary 2002 four large state-owned banks (accounting for 57 percent of banking sector assets) were resolved. A debt- for-equity swap by the government in2002 to resolve the debt owed by Serbianbanks to Paris and London Club governments and banks caused a partial re-nationalization o f the banking system. 23. Bankownershipis undergoinga fundamentalchange from state-controlledto privateand foreign-owned.Six state-owned banks (17 percent oftotal bank assets) are now passing through the BRA-managed bank privatization program, of which the first was completed inJanuary 2005. Domestic private banksinclude one large, relatively dynamic bank and a number o f small banks. Twelve foreign banks have entered the market since 2001, through greenfield investmentsor acquisition, raisingthe foreign share o f total banking assets from around 38 percent (end-2004) to around 50 percent (mid-2005). 24. The insuranceindustry is smalland underdeveloped.Halfthe insurers have been closed since mid2004, largely owing to insolvency, failure to pay claims, or inability to meet the higher minimumcapital requirements.More rationalizationcanbe expected, as market conduct improves and prudential supervision becomes more institutionalized. The two largest insurersare slated for privatization. Currently, the industry is characterized by poor governance and inadequate risk management practices. Consumer confidence is lacking, primarilyowingto nonpayment ofmotor third-partyliability claims. 25. Leasingactivity is growingsharply. The eight-fold growth o fleasing assets in2004 to 350 million was attributable to the foreign-owned leasing companies registeredin2003- 2004. One-third o f new financial leasing investmentwas spent on cars and office equipment for SMEs and households. 26. The equity marketis very small, the moneymarketis segmentedand underdeveloped,and there are no domesticcorporate bondand paper markets,The government auctions 91-day and 182-day T-bills regularly, but primary and secondary T-bill markets are small, with outstanding stock at end-March 2005 o f only SRD 7 billion (88.1 million). The largest issues are the euro-denominated Frozen Foreign Currency Bonds (FFCBs) inthe amount o f2.8 billion. - 6 - MACRO-FINANCIAL VULNERABILITIES AND STABILITY ANALYSIS Systemicrisks 27. Financialvulnerabilityanalysisidentifiedtwo main systemic risks. First, the high proportiono f foreign currency-indexed loans exposes banks to credit risk shocks. Second, the large state-controlled banks pose potential systemic risks becausethey are less competitive thantheir peers. 28. Supportivemacroeconomicand structuralpolicieswould minimizesystemic risks.An acceleration ofthe reformprogramwould strengthenfinancial stability by enhancing the dynamismo f the economy, especially the export sector. A credible anti- inflationary framework, including tight monetary and fiscal policies, would dampen domestic demand, containthe current deficit and inflation, and encourage capital inflows. Conversely, a slowdown inreform would go hand-in-hand with a failure to contain domestic demand. Investors could reassess their exposure towards Serbia and assets denominated in SRD, creating pressure on the dinar and causing a slowdown inbank lending. 29. The team usedstress tests based on September2004 data to assess vulnerabilities, but the resultslikely understatethe consequences of shocks owingto data issues.To the extent that banks under-report NPL levels and/or make insufficient loan loss provisions for problems identified, owing to asset classification deficiencies or partial noncompliance, their capital or overall financial positionwould be overstated. Inthis case, re-capitalizationneeds may well be underestimated. 30. The riskinessof banks' loanportfoliosis increasing,owingto the 47 percent nominalgrowthin bankloansduring2004. Foreignbanks are responsible for most o fthis credit growth which is predominantly foreign exchange indexed. This lending i s being financed by new foreign exchange deposits, mainly by households, and by foreign exchange borrowing from banks' headquarters. 31. Duringthe first half of 2005 NBS implementedmeasuresto contain macroeconomicrisksarisingfrom rapidcredit growth, but although consumerlending has now slowed, growthin credit to enterpriseshas remainedrobust. The NBS:(i) tightenedconditions for consumer loans; (ii) broadenedthe reservable base to include commercial banks'foreign borrowing; (iii) increased the minimumcapital adequacy ratio from 8 percent to 10 percent; (iv) eliminatedremuneration on requiredreserves on enterprises' foreign currency deposits; (v) raised the Statutory Reserve Requirement(SRR) on enterprises' foreign currency deposits and on banks' foreign borrowing by 5 percentage points to 26 percent; (vi) loweredthe SRR on dinar deposits by 1 percentage point to 20 percent; and (vii) requiredbanks to monitor and assess borrower's exposure to exchange rate risk and to reflect their assessment inthe loan classification. 32. Credit risk is high, as evidencedby the stock of NPLswhichwas 22.8 percentof total loansat end-2004, Direct credit risk is most acute for state-owned banks, as their 33.5 percent NPL ratio was higher than the 27 percent ratio for private banks or the 7 percent ratio for foreign banks.NPLs are likely to increase further in2005 and 2006 across all banks, and - 7 - loan loss provisions will rise, as problems are recognized. This trend includes foreign banks whose lending has beengrowing the fastest. 33. Regional comparisons suggest that additional provisions are likely to be necessary infuture, as NPLsthat are not repaid or otherwise resolved migrate downwards over time to worse classification categories. The existing level of loan-loss provisions, especially at private banks (where only 38 percent of NPLs are provisioned), suggests bank capital may be overstated, although most banks appear to make loan loss provisions inaccordancewith present asset classification regulations. 34. Stress tests indicate that credit risk i s the most significant risk for the system. A shock of 25 percent of NPLs downgraded to the next classification category suggests that the capital adequacy ratio (CAR) of five banks would fall to below 8 percent (including four state banks). The systemwould have a CAR loss o f 6 percent after adjusting for additional provisions against Paris and London Club loans. State banks would lose 21percent o f their capital, requiring SRD 3.6 billion recapitalization. 35. The banking system is also exposed to indirectforeign exchange risk because most lending is in euros, or in dinars with a euro-index clause, which transfers the risks of dinar depreciation from the bank to the borrower. This has an indirect consequence for banks, as a sharp increase indebt-servicing requirementsarising from a sudden depreciation will lead to higher NPLs. NBS data inApril 2005 suggestedthat foreign currency- denominated and foreign currency-indexed loans represent 68 percent of the total, but this is likely an under-estimate, since anecdotal evidence basedon annual reports and discussions with banks suggeststhat indexedloans have beenunderreported. 36. T o mitigate direct and indirect credit risks the FSAP team has recommended technical measures related to risk management, portfolio classification, loan loss provisioning and reserve requirements. The risks identified would also be mitigated by measuresto strengthen bank supervision. Risksposed by state-controlled banks 37. The state banks are losing their competitive position against new foreign entrants and pose potential systemic risks ahead of their privatization. State banks' earnings are well below those of other banks owing to highNPLs, substantial loanloss provisioningand high administrative costs. Several state-controlled banks are significantly overstaffed compared with their private sector rivals. The banks remainvulnerable to further deterioration andunwarranted influence while instate hands. Once the current roundofprivatizationshas beencompleted, 10majority and minority state-owned banks will remain, most ofwhich are slated to be sold. The state-owned banks will continue to require close surveillance not only by the NBS but also by the BRA, which has taken over the state's ownership responsibilities inthose banks. - 8 - Other risks 38. The team analyzedother risks,which appear to warrant less attentionfrom policymakers: Management o f liquidity has not recently beena significant problem for banks, but stress tests suggest that although the system i s relatively liquid, risks may arise from high concentrations of short-term deposits and the withdrawal of public deposits held with state banks. 0 Stress tests indicated that the interest rate shock alone, arising from short-term maturity mismatches o f assets and liabilities, does not pose a significant risk to the banking system. 0 Leasing activity is equivalent to only 5 percent o f banking assets. The rapid growth o f leasing companies' assets in2004/2005 i s being financed primarily by borrowing from their respective affiliated and parentbanks, but this increased exposure is insufficient to pose a systemic risk. 0 Risksmay arise from a sudden cutback in lending byforeign banks which could slow GDPgrowth andleadindirectly to higherNPLs. However foreign bank entry is so recent that the risk of a rapid scaling-back o f their activities seems low, at least inthe short run. 0 Corporate external borrowing, mostly by Serbian subsidiaries o f multinationals, i s around 4 percent o f GDP, reflecting its low relative cost. An acceleration o f corporate external borrowing could eventually pose risks to stability iflarge-scale corporate distress threatens domestic banks. PrudentialSupervisionIssues 39. TheNBSBank SupervisionDepartment(BSD) hasmadeprogressin enhancing its effectiveness,guidedby a SupervisoryDevelopmentPlandesignedwith external assistance.Importantsteps includenew BSDmanagement; formation of a Supervisory ReviewCommittee to improve decision making; adoption of a supervisory operating policy anda standardized examination report format; improvedcommunications withinBSD; and the introduction o f a CAMEL rating process. 40. However, the Base1Core Principlesassessment of banksupervisionwas unfavorable.Out of 30 CPs, 19were assessed as materiallynoncompliant, and one as noncompliant, Some BCPs were assessed as materially noncompliant because supervision was not being undertaken on a consolidated basis. However, inthe new banking law consolidated supervision i s fully defined, so compliance with several BCPs should improve once consolidated supervision i s fully implemented. Poor corporate governance remains a major weakness, especially indomestic banks, as many boards o f directors and supervisory boards do not instituteproper systems for managing prudently the business risks incurred by the banksunder their control. Many problems inbanks have also beencaused by the self-serving behavior of major shareholders. The NBS needs legal authority to vet the suitability o f banks' governing board membersunder strengthened "fit-and-proper" criteria, and to remove persons who lack the necessary skills and integrity. The NBS should be empowered to freeze the - 9 - exercise o f voting rights by shareholders inserious cases, and the threshold at which a person or entity i s deemedto have significant ownership ina bank should be reduced from 15 percent to 5 percent. Many o f the measuresto improve bank supervision will needto be incorporated inthe newbankinglaw presentlybeingprepared. 41, Recentsuccessfulappeals againstNBS decisionsby commercialbanksand their ownersin the courtsindicatethere are weaknesses in the legalsystem. Inaddition, neither the NBSnor its officers have statutory protectionagainst actions for damages whencarrying out their duties ingood faith. The new banking law should clarify the grounds for appeals and introduce specific legal protection for supervisory staff. 42. Supervisionof banks' credit exposures to shareholders is weak. There are many recorded instances o f forbearance, including breaches o f the limit for individual exposures (5 percent o f capital), and no limit on a bank's aggregate exposure to connected parties. The new banking law should make provisionfor such a limit below the EUlevel o f 20 percent o f capital. The NBS should also obtain legal powers to supervise banks on a consolidated basis, inorder to capture risks incurredthroughbanks' financial subsidiariessuch as brokers and leasing companies. There should be a separate limit on the aggregate amount inrelation to capital of a bank's investments innon-financial entities. 43. Risk-basedapproachesto supervisionare still underdeveloped. Measures are neededto oblige governingboards of banks to establish integrated systems that identify, monitor, and control effectively all risks incurredintheir activities. There are weaknesses in theNBSrequirementsfor banks' credit systems. First, loan-loss provisions are mostly established inaccordance with regulatory prescriptions, rather than by an assessment of loan quality, including a borrower's cash flow, earnings and repayment capability. Second, the requirementsfor restructured loans needto be strengthenedto linkupgrades to a demonstrated track record o f repayments. The NBS also needs to ensure that banks' systems capture non- credit risks such as interest rate or market risks. 44. Off-siteanalysis, anti-money-laundering(AML) measuresand inter-agency cooperationshould be further strengthened.Accurate informationsystems are essential for continuous offsite analysis o f banks' risks, together with a databaseto provide meaningful comparisons over time and betweenbanks. The NBS should issue a "know your customer" regulationand ensure that AML issues are covered inits on-site inspections. NBS should also establish a formal system o f exchange o f information and cooperation with all other relevant domestic agencies, including the MOF. Frameworkfor Crisis Management 45. The designof emergency-lendingfacilities is generallysound, but couldbe improved.The authorities have acquired credibility inclosing weak banks, particularly the top four banks closed in2002. However, the new Lender o f Last Resort (LOLR) facility may worsen moral hazard by banks and increase political pressure on the NBS to intervene, as trigger procedures for intervention are not clearly defined. The LOLR interest rate structure also sends inappropriate signals, withthe longer-term facility, designedprimarily for insolvent banks, carrying a lower rate than the short-term facilities. - 10- 46. Euroization can constrain the LOLR functions. InApril 2005, gross foreign exchange reserves amounted to US$4.5 billion, while the deposit base was US$3 billion, o f which US$1.2 billion heldat the NBS as requiredreserves. Thus, gross foreign exchange reserves can cover a deposit runof the remaining free deposits inthe amount of US$1.8 billion. However, a suddendrawdown o f foreign exchange reserves inthe face o f a bank run could potentially erode confidence inthe exchange rate regime, contributing to a scenario in which banking sector and exchange rate crises interact. 47. The team proposedthree specific measuresto strengthenthe safety net. First, provide assistance to illiquidbanksbased on a single, fully collateralized facility with an interest rate that i s a multipleof the policy rate. Second, introduce a penalty for repeated use bymakingthe interest rate rise according to the frequency of access by a bank within a certain period. Third, any bank that repeatedly accesses the LOLR window, indicating a solvency problem, should be subject to resolutionby BRA. 48. In reviewingthe depositinsurancescheme (DIS),the institutional capacity of the BRA and the size of the deposit insurancefund are key issues. The newDIS Law approved on July 15, 2005 allows 3,000 coverage for household deposits only, targeting 98 percent o f household depositors and 23 percent o f household deposits. Moral hazard concerns are limited, since the scheme is to protect small depositors, andwould prohibit liquidity support to distressed banks. The size o f the fund i s presently limited, although 22 millionwill be lent by donors as seed capital. However the BRA may be overstretched, and the collection o f premiums will be suspended when the fund reaches 5 percent of total deposits. The team recommended that the authorities be given the discretion to require the collection of premiums to continue, evenafter the level of the fund reachesthe 5 percent threshold, based on an assessment o fthe overall soundness o f the banking systemwhenthe threshold i s achieved. DEVELOPMENT ISSUES Banking Privatization and Governance 49. The rapid growth of the banking sector from a small base and the lack of non- bank financing alternativesmeans that credit growth can be expectedto continueat a high level, and banks- mainly foreign-will remain the main source for financing economic growth. The process o fbankprivatization is accelerating which will increase the share o f foreign banks still further. With the notable exception of the third largest bank inthe country (KB), most existingmajority-owned state banks and several minority stakes heldare to be divestedin2006. However, since some banks may not attract an acceptable buyer, consideration should be given to alternative resolution strategies. 50. Bank governanceis stillweak, althoughbanks are required to comply with the 2004 Company Law which introduced a corporate governanceframework broadly in linewith international practice.Internalandexternal audit provisions for banks should be expanded. Banks should be requiredto establish audit committees, with a majority o f independentdirectors, andto establish credit and other relevant board subcommittees. Banks should be requiredto inform the NBS about the statutory auditor they have selected, and the NBS should have the power to veto such appointments. The NBSshould berequiredto establish a list of acceptable auditors. Audited IFRS financial statements-including auditor's - 11 - report, balance sheet, income statement, cash flows, statement o f changes inequity, and notes -shouldbefiledwiththeSolvencyCenter,placedonabank'swebsite,andbeavailablefrom the bankuponrequest by interested users. Insuranceand Pensions 51. In the short term, growthinthe insuranceindustryis likely to be limitedby several impediments.Current restrictions state that all reinsurance must be placed with domestic firms, discouraging global insurers.Viable firms are preventedfrom gaining market share by the non-commercialoperation o f the two dominant insurers.Multi-level selling o f life insurance by several companies should be discouraged. Inaddition, some insurers avoid paying motor claims, reflectingthe hightransaction costs of resorting to the legal system. The recent closure o f 18 companies will crystallize many claims that may not otherwise have been acknowledged, because claimants will have recourse against guarantee arrangements once wind-upprocedures have beencompleted. This will requirespecial transitional funding arrangements to be designed, approved, and implemented. 52. Underthe 2004 InsuranceLaw, supervisionwas transferred to the NBS and an InsuranceSupervisionDepartmentcreated.Under an experienced bank supervisor, the department has begun an impressivework program. This includes the closure o f 15 insurers betweenNovember 2004 and February 2005 which has highlighteddeficiencies inthe regime for insurance bankruptcy and liquidation, for which responsibilityhas been passedto the BRA.Recruitingandtraining the new supervisory staffis underway, but actuarial and off-site inspection skills are inshort supply. 53. The two largestateinsurersare slatedfor privatizationfor which DDOR appears to be better suitedinthe near term. The NBShasrequestedthat both insurersprepare business plans prior to full on-site inspections. Assistance will be needed to develop restructuring plans. A tender for a privatizationadvisor can only be launched by the BRA after the approval oftherespective legislation. 54. Voluntary pensionsare written through licensedlife insurerssubject to an additionalminimumcapitalrequirementof 1million.However, prudential standards are inadequate becausematching assets are not segregatedfrom insurance assets. The applicable tax policy i s also ad hoc. A new law on voluntary pensions should be finalized and implemented. CapitalMarkets 55. The Serbianfinancialsystemfaces several developmentalchallenges relatingto limitedaccess to finance by the corporatesector in the absenceof capitalmarket depth. The absence of corporate bonds and commercialpaper combinedwith inadequate accessto equity markets exacerbatesdependenceon bank financing, preventsthe corporate sector from hedgingagainst exchange rate depreciation and results inexcessive vulnerability ofthe economy to corporate sector stress. The authorities have initiated several reforms to modernize the regulatory and institutional framework. - 12- Leasing 56. Leasinggrew fast in2004 and has becomean importantsource of long-term financing for SMEs.Bankstypically consider lendingto SMEs, farmers and start up businesses to be risky owing to the lack o f proper collateral, credit history and high transaction costs. A lease allows a lessor to address such risks through ownership o f the asset, lower costs and flexibility intailoring lease payments to the cash flow o f a lessee. However, recent changes inthe tax treatment of financial leasing (under the VAT Law and Corporate Income Tax) have removed its competitive advantage, since VAT must be paidup front on the entire interest and fee element of a leasing contract, whereas interest and fees on bank loans do not bear VAT. Futuredevelopment will also dependupon a level playing field for investmentpromotion. Lessees are presentlynot allowed any incometax credit for fixed assets acquired through financial leasing, unlike for assets purchasedwith own funds and from the proceeds o f bank loans. 57. On July 15,2005 the parliamentapprovedamendmentsto the Law on Financial Leasingwhich empower the NBS to licenseand supervisefinancialleasingcompanies. The objective, as explained by the NBS, is to restrain the spillover from bank lending into leasing transactions that might circumvent prudentialregulations on banks. This understandable concern arises becausemost Serbianleasing companies are associatedwith banks, for which leasing i s essentially a credit substitute. The team supports supervision o f financial leasing by the NBS, providing that control i s exercised lightly. MonetaryPolicy and Payments 58. The main monetary policy instrumentfor discretechangesin the policy stance hasbeenthrough changesin statutory reserve requirements(SRR), but rep0 operations were recentlyintroduced. The effective SRR are changed relatively often and, as o f mid- August 2005, stood at 45 percent for foreign currency deposits ofhouseholds, 29 percent for all other foreign currency deposits, and 21 percent for S R D deposits. To address foreign exchange pressures, SRRs were complemented inJune 2004 by the requirement that each and every day banks maintainwith theNBS at least 80 percent o fthe SRR. However this minimumdaily requirement is an impedimentto money market development as it reduces liquidity and trading opportunities. Recognizingthe inadequacies ofthe reliance on SRR, in January 2005 the NBS introducedweekly rep0 auctions, collateralizedby government bonds. 59. There is much scope to strengthenmonetary policy transmission by deepening money markets.The first recommendation is to lower the 80 percent daily minimum requirement for SRR. The NBS should also encourage two-way rep0operations by injecting liquidity through very short-term repos. The increase inthe SRR and the removal o f remuneration on foreign currency deposits should encourage greater use o f dinars and increase the responsiveness of lendingratesto changes inpolicy interest rates, butthe designofthe interest rate corridor should be reviewed.NBS deposit rates, Lombardrates, andthe discount rate should be modified to be more responsive to market conditions. Monetary instruments mightbe renderedmore effective ifthe NBSwere to engage infurther analytical work on monetary transmission andpass-through variables. - 13 - 60. The MFP TransparencyAssessment notesthat policy effectivenesswould gain from greater public disclosureof broadobjectivesand intermediatetargets. The public information services o f the NBS rely on publishedmaterial, electronic updates and verbal communication, but the availability of information is underminedby poor consistency with statistical standards. 61. While the institutionalframework establishesthe broadmodalitiesfor monetary- fiscal coordination, operationaldemarcationsare somewhatunclearwhich at times complicatesmonetary operations.Inpart this stems from the reluctance o fthe MOF to increase its reliance on T-bills for financing the budget deficit, and political resistance to raisingmonetary policy interest rates to the extent neededto mop up excess liquidity. Weak coordination betweenthe NBS and the Treasury inthe areas of liquidity forecasts and the issuance of T-bills also complicates monetary operations. 62. Paymentsystems have beensubjectto major reformin recentyears and since January2003 Serbia has enjoyed a moderninfrastructurefor the handlingof interbank paymenttransactions.While large-value andtime-sensitive payments are settled incentral bankmoney inthe NBSreal-time gross settlement (RTGS) system, which is systemically important, retail payments are processedinthe NBS Clearing system, with multilateral net positions settledthree times a day inthe RTGS system. Securities settlement and delivery o f collateral incentral bank operations takes place inthe Central Securities Depository and Clearing House of Serbia (CSDCHS). The RTGS system has provedto be a very reliable and well functioning system, compliant with the Core Principles for Systemically Important Payment Systems (CPSIPS) and highly regarded by its participants. Corporatesector 63. A new regimefor the establishmentand operationof companiesand related corporateentities enteredinto force inNovember2004 based largelyon EUand internationalpractice. The new Law on Business Companies represents a significant improvement over the previous law. The provisions governing limitedliability companies have beensimplifiedandjoint stock companies may now be either open or closed. The latter have no capital maintenance requirementsand may impose restrictions on the transfer o f their shares. Most importantly, the new law introduced improvements to the provisions dealing with corporate governance, mergers, conversion from one corporate form to another, disclosure requirementsand company liquidation outside bankruptcy. An amendment will still be requiredto remove some inconsistencies and conflicts with the securities and other legislation. 64. However the legaland regulatoryframeworkleaves open substantial opportunitiesfor corporategovernanceabuses. Weaknesses are low transparency o f ownership, financial reportingand board activities. Issues also remainregarding protection of shareholders inthe event o f capital dilution and corporate takeovers. The securities regulator suffers from insufficient legal authority and weak institutional capacity. Investment funds remain unregulated and pose a risk for future private pension funds. Compared to the corporate sector, governance of banking i s relatively strong, but the NBS requires additional statutory authority to provide adequate supervision. - 14- 65. Proceduresfor the registrationof new companiesand filing of company documentshavebeenmuchimprovedfollowingthe entry into force of the Law on BusinessRegistryinJanuary 2005. Registration of companies, formerly handled by the courts, can now be done within days rather than weeks. Operation of the Registry has been handicapped by IT and other problems, but the new systemi s already regarded as a success by its users. The Registry i s expected to be self-financing and its scope i s to be expanded to handlethe registrationofpledges over movableproperty and financial leases. Auditingandfinancialreporting 66. Financialinformationto improveriskassessment is becomingavailablethrough the NBS SolvencyCenter and the CreditBureauestablishedby the Bankers' Association. The Solvency Center runs aregistryto which all legal entities (113,000) are requiredto send financial statements and corporate information. The Credit Bureau, on the other hand, collects informationon the liabilities, credit and transaction accounts of individuals (three million) from all commercial banks inthe system. Both agencies would be strengthenedby access to credit information from leasing companies, insurance companies and savings and credit cooperatives. 67. A potentially seriousshortageof auditorsexists, because the MOF has not issued any professionalcertificatessince early 2003 for the approvalof auditors.The Accounting and Auditing Law o f 2002 required the Federal Government to establish an Auditing Commissionto assume supervision on behalfofthe MOF andenvisaged that registeredprofessionals would be requiredto complete certificationexaminations inIFRS withinthree years. However the Federal Government did not establish the Commission, so newcertification is not occurring. The SerbianMOF is preparing a new draft law on accounting and auditing, which will address the licensing o f statutory auditors. 68. Financialreportingstandards for companiesand banksare presentlyin transition from compliancewith nationalstandardsto compliancewith international standards, but importantdiscrepanciesremain.The Accounting and Auditing Law of 2002 required banks to comply with IFRS for the end-2003 financial statements. All other enterprises, including sole traders, were required to comply with IFRS as from end-2004, an unduly onerous requirementfor small companies and micro-enterprises. Within the banking community, it i s recognized that bank financia1 statements for 2003 didnot comply with IFRS, andthat those for 2004 will show discrepancies. Notesto the financial statements include full details o f where the Serbian accounting policies employed differ from IFRS. Bankruptcy 69. Serbia introduceda modernand comprehensiveLaw on BankruptcyProcedure inJuly 2004 whichprovidesgreatly streamlinedproceduresfor bankruptcyandwill permit improveddebtor-creditorsolutionsto develop. The law is consistent withthe practices o f other countries that have recentlymodernizedtheir bankruptcy frameworks and with the World Bank Principles on Creditor Rights Systems. Unfortunately, the new Law on Bankruptcy Procedures will only come into effect after the Law on Bankruptcy Trustees also becomes effective. Inthe interim, bankruptcies are continuingto be handled under the old, unsatisfactory law. - 1 5 - 70. A new regimegoverningthe bankruptcyand liquidationof banksand insurersis containedin a draft law recentlysubmittedto the Assembly, but the draft lacksthe precisionrequired.O fparticular concern are provisions dealing with the consequencesof an NBSdecisionto revoke a license. The draft andthe current law bothrequiretheNBSto initiate liquidationproceedings immediately inthe Commercial Court, but the licensee has the right underthe banking law to have the decision o f the NBS reviewedby the Supreme Court. As recent events have indicated, the decisions ofthese two courts may be incompatible. Preferably the actions o f the NBS inrevoking a banking license and the consequenceso f those decisions should be subject to review by a single judicial authority. Property and Land 71. A modernLaw on Pledges on MovablePropertywas introducedin2003. The new law incorporated EUnorms, but could not become effective because o f delays inestablishing the Pledge Registry. A recent amendmentto the Law on Business Registers Agency has enabled the Pledge Registry to become operational as from July 1,2005. Pledgors will be given 90 days to register and acquire priority rights to their existing pledges. 72. Available landfor investmentpurposesis scarce becausemost landis still in state ownership and cannoteasily be acquired. For such land only aright ofuse can be obtained from the state. A draft Land Law addresses many o f the problems related to land reform but it will be some time before mortgages over real estate become common. The situation is complicated by the existence of three parallel systems for evidencing property rights over land: (i) Land Register heldbythe Municipal Courts basedon the Austro-Hungarian the system; (ii) Tappi systemheldby the District Courts based on the Ottoman system; and the (iii) CadastreheldbytheGeodeticalInstituteofSerbia.Theseregistriesareunconnected the and not all land i s contained within them. A new country-wide land registry based on the Cadastre is being introduced but this will take considerable time to implement. The Court System 73. There is generalagreementthat the court system does not functionwell and that the administrationofjustice is slow, inefficientand in needof reform.Notablythe weak judiciary precludes the prompt recovery o f collateral, undermining the ability o f the banks to lower their NPLs. Lack o f respect for judges and the rule o f law have resultedinthe courts beingperceived as a last resort. The authorities are well aware o f the weaknesses inthe court system and have begunto take appropriate measures. External help has beenobtained to promote reform inthe Commercial Court includingtraining and IT support. The government i s developing a comprehensive Strategy for Judicial Reformto regain the trust o f citizens in theirjudicial institutions andto assistthe ministryofjustice and thejudiciary to carry out the much-needed reforms. A new Law on Enforcement Procedure hasjust been enacted which has improved the ability o f creditors to enforce judgments and recover collateral. - 16- ANNEX. SummaryTable of Recommendations RecommendedMeasures Entity Status of Implementation Banks and BankingSupervision Short term Adopt a time boundcorrective actionplanto address NBS Includedinthe BankingSupervisionActionPlan deficienciesincompliancewith Base1CorePrinciples. agreed with the WorldBank I/and in the Memorandumon Economic andFinancialPolicies (MEFP) submittedto the IMF 2/ Ensurebanksprovidethe NBSwith accurateasset NBS Includedinthe new bankinglaw detailedinthe classifications ontheir loans. MEFP31 ExpandNBS datagatheringcapabilities to capture all NBS Amendmentsto the regulationsgoverning foreign currencyand foreign currency indexedloans. reportingrequirementsmade in May2005. Requirebanksto monitor and assess borrowers' NBS Done inNBS Decision. exposureto exchangerate risk andto reflect their assessment inthe loanclassification. Revisecriteriafor loan loss provisionsto minimizethe NBS Includedinthe new bankinglaw detailedinthe number ofreductionsin the requiredprovisionsthat are MEFP. allowedonthe basisof guaranteesand/ortangible collateralheld. Undertakefill-scopeexaminationofthe largest state NBS NBSaims to implementthis measureand - for all banksandensure that recommendationsarising from banksexamined-to ensurethe timely adoption of examinationsare adopted. the resultingrecommendations(MEFP). Bringforwardthe privatizationagendafor the two large MOFBRA IncludedinMEFP. state-controlledbanks. Long term Strengthenall state-controlledbanks' reporting MOF/BRA IncludedinMEFP. requirements. ReviseNBSchart of accounts to conformto IFRS. NBS Requirebankboardsto have audit committees NBS Includedinthe new bankinglaw detailed inthe comprisinga majorityofindependentmembers. MEFP. Requirebanksto discloseto borrowersthe effects of NBS Includedinthe new bankinglaw detailed inthe foreign exchange fluctuations ontheir debt service MEFP. costs. Enforcethe limits for exposureto largeborrowers,and NBS Includedinthe new bankinglaw detailed inthe for exposureto individualconnectedparties, with MEFP. respectto all banks, especially state-controlledbanks. Requirethat all state banks' directors are subject to NBS Includedinthe new bankinglaw detailed inthe NBS"fit andproper" criteria. MEFP. -17- RecommendedMeasures Entity Status of Implementation Amend bankinglaw to authorize the NBSto supervise NBS Includedinthe new bankinglaw detailedinthe bankson a consolidatedbasis. MEFP. Reduce significant ownership levelcriterionfor prior NBS Includedinthe new bankinglaw detailedinthe approvalbythe NBS from 15 percentto 5 percent, or MEFP. lower ifsignificant influencewill be acquiredover a bank. Seek explicitstatutoryprotectionfor the NBS, its NBS Includedinthe new bankinglaw detailedinthe officers and staff whenperformingbankingsupervision MEFP. ingoodfaith in accordancewith the law. Establishlimits for a bank's aggregateexposuresto NBS Includedinthe new bankinglaw detailedinthe relatedparties, preferablybelow the EUmaximumof MEFP. 20 percentof capital ... Requirebankboardsofdirectorsto accept NBS Measureempoweringthe NBSto apply remedial responsibility for establishingandoverseeingintegrated actions inthe event of financial misreporting riskmanagementsystems. includedinthe new bankinglaw detailedinthe MEFP. IncludeIT specialistswithinthe NBSexaminations NBS Proceduralandstaffenhancements started staff. recently. Definethe powers ofthe courts inthe BankingLaw to MOJ/NBS To be consideredfor inclusioninthe new banking review the substantiveor technical decisions ofNBS. law. Increasefurther the statutoryreserverequirement(SRR) NBS OnJune 10, the SRR on enterprises' foreign ratioon enterprises' foreign-currency depositsand currency depositsandon commercialbanks' commercialbanks' foreign borrowing. foreign borrowingwas raisedby 5 percentage pointsto 26 percent andthe SRR on dinar deposits was reducedby 1percentagepointto 20 percent. Monetary Policy Introducea single, fully collateralizedlender of last NBS resort facility priced at a multipleofthe marketrate. Lowerthe dailyminimumrequirementof 80 percentof NBS the SRR. Linkthe ceilingandthe floor ofthe interestrate NBS corridor with market conditions. Initiatethe processofparticipationof Serbiainthe NBS, GDDS. National Office o f Statistics Financial sector development Increasetransparency ofownership andcontrol of sc tradedcompanies. Requirepublicationofthe full IFRSaudit report, NBS Includedinthe new bankinglaw detailedin the supportingschedulesandauditor's opinion. MEFP. - 1 8 - RecommendedMeasures Entity Status of Implementation Strengthenthe responsibility andaccountabilityof SC/MOF supervisoryboards. Increaseshareholderprotectionduringcapitalincrease MOF andtakeovers. Ensure IFRSandNBSaccountingrules are fully NBS Includedin MEFP, appliedto insurancecompany fixedassets and accounts receivable. CommenceNBSon-siteexaminationsat the two large NBS IncludedinMEFP. state insurers (DDOR andDunav). RequireDDORandDunaveachto submit their NBS Privatization ofDDOR included in MEFP. businessplans andappoint financial advisorsto develop andexecute a privatizationstrategy. Developa strategy for funding ThirdPartyLiability NBS Insuranceunderthe guaranteearrangement. Phaseout restrictive trade practicesregarding NBS mandatoryreinsurancecessions and long-termproperty insurancecontracts. Implementthe corrective actionplanfor AML/CFT APML recommendationsput forward inMONEYVAL report. Strengthenthe SC's legal authority and institutional sc capacity. Developregulatory framework for investment hnds in sc line with EUDirectives andinternationalpractice. Finalize and implementthe law on voluntary pensions. MOF Constitutethe MOFCommissionto adopt certified MOF auditors andaccountants. Modify accountingandauditinglegislationand MOF/NBS regulationsto enable the implementationofthe policy recommendationsset out inthe Accountingand AuditingROSC. I/SeveraloftheproposedmeasuresinthisSummaryofRecommendationswilllikelybeincorporatedintheconditionalityforthe ProgrammaticPrivateand Financial DevelopmentPolicyLoan 1 (PPFDPL-1)presently under preparationby the World Bank. The key measuresfor addressingshortcomingsin bankingsupervisionare containedin a BankingSupervisionPlanalready agreed in principle by the NBS with the World Bank 21The MEFP was prepared as part ofthe FifthReview under the ExtendedArrangement (EA) which was concludedby the Executive Board ofthe IMF on June 29,2005. 3/ Under the EA, the parliamentary approval o f the new bankinglaw in line with the recommendationsof the FSAP team is a structural performancecriterionfor mid-November2005.