© 2006 International Monetary Fund March 2006 IMF Country Report No. 06/96 Serbia and Montenegro: Serbia—Financial System Stability Assessment, including Reports on the Observance of Standards and Codes on the following topics: Monetary and Financial Policy Transparency, Banking Supervision, and Payment Systems This Financial System Stability Assessment on Serbia was prepared by a staff team of the International Monetary Fund and the World Bank as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on January 17, 2006. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Serbia or the Executive Board of the IMF. The policy of publication of staff reports and other documents by the IMF allows for the deletion of market-sensitive information. To assist the IMF in evaluating the publication policy, reader comments are invited and may be sent by e-mail to [email protected]. Copies of this report are available to the public from International Monetary Fund Ɣ Publication Services 700 19th Street, N.W. Ɣ Washington, D.C. 20431 Telephone: (202) 623 7430 Ɣ Telefax: (202) 623 7201 E-mail: [email protected] Ɣ Internet: http://www.imf.org Price: $15.00 a copy International Monetary Fund Washington, D.C. ©International Monetary Fund. Not for Redistribution This page intentionally left blank ©International Monetary Fund. Not for Redistribution INTERNATIONAL MONETARY FUND SERBIA AND MONTENEGRO Serbia—Financial System Stability Assessment Prepared by the Monetary and Financial Systems and European Departments Approved by Michael Deppler and Ulrich Baumgartner January 17, 2006 This Financial System Stability Assessment (FSSA) is based on work of the Financial Sector Assessment Program (FSAP) team, whose two main missions to Belgrade were in March and April 2005. The FSAP findings were further discussed with the authorities during the mission for the sixth review of the Extended Arrangement in October 2005. The FSAP team comprised Mark Stone (Mission Chief, IMF), Michael Edwards (Deputy Mission Chief, World Bank), Marie Thérèse Camilleri, Vania Etropolska, In Won Song, Neil Saker, Andreas Westphal, and Charmane Ahmed, mission assistant (all IMF); Peter Kyle, Rodney Lester, Susan Marcus, Angela Prigozhina, Branko Radulovic, Susan Rutledge, and Martin Slough (all World Bank); and Tom Kokkola, Ronald MacDonald, and Walter Zunic (all experts). The FSAP team received excellent cooperation from the authorities. The main findings of the FSAP are: x The transformation of Serbia’s financial system is bringing important benefits, but there are emerging signs that the rapid pace of credit growth is beginning to erode financial stability. x The main potential threat to financial stability is indirect credit risk arising from the large share of bank lending effectively denominated in foreign exchange. x A decline in the profitability of foreign banks seeking to gain market share, coupled with an adverse shock—especially an unexpected depreciation, could ultimately result in a credit crunch. x Although the authorities have implemented an array of measures in support of financial stability, further reforms are warranted in the areas of bank supervision and the financial infrastructure. x An improved monetary policy and liquidity framework would also enhance stability, as well as make monetary policy more effective. This report was prepared by Mark Stone and Neil Saker, based on the work of the FSAP team. FSAPs are designed to assess the stability of the financial system as a whole and not that of individual institutions. They have been developed to help countries identify and remedy weaknesses in their financial sector structure, thereby enhancing their resilience to macroeconomic shocks and cross-border contagion. FSAPs do not cover risks that are specific to individual institutions such as asset quality, operational or legal risks, or fraud. ©International Monetary Fund. Not for Redistribution - 2 - Contents Page Glossary .....................................................................................................................................4 Executive Summary...................................................................................................................5 I. The Macroeconomic Setting and the Structure of the Financial Sector.................................6 II. Assessment of Systemic Financial Vulnerabilities .............................................................11 A. Bank Credit Risk.....................................................................................................11 B. State-Controlled Banks ...........................................................................................13 C. Other Potential Vulnerabilities................................................................................15 III. Policies to Mitigate Financial Vulnerabilities....................................................................16 A. Enhancing the Supervisory Framework..................................................................16 B. Modernization of the Financial Infrastructure ........................................................18 C. State-Controlled Bank Governance and Privatization ............................................19 D. Measures to Slow Credit Growth............................................................................19 IV. Monetary and Systemic Liquidity Framework..................................................................21 V. Financial Development .......................................................................................................24 VI. Anti–Money Laundering and Combating the Financing of Terrorism..............................25 Tables 1. Financial System Structure, 2001–04 ....................................................................................8 2. Sources and Uses of Bank Funds, 2004–05...........................................................................9 3. Nonperforming Loans and Loan Provisioning ....................................................................12 4. Return on Assets and Return on Equity...............................................................................15 Figures 1. Bank Assets to GDP by Ownership.......................................................................................8 2. Credit Growth: Nominal and Real Year-on-Year Change.....................................................9 3. Credit in Selected CEE Countries........................................................................................10 4. Policy Interest Rates ............................................................................................................22 Boxes 1. Summary of Key Policy Recommendation............................................................................6 2. Credit in Serbia Compared with Other CEE Countries .......................................................10 3. The Benefits and Risks of Foreign Banks in Serbia ............................................................14 4. Euroization in Serbia............................................................................................................23 Annex Observance of Financial Sector Standards and Codes––Summary Assessments....................27 ©International Monetary Fund. Not for Redistribution - 3 - Appendices I. Banking Sector Financial Soundness Indicators ..................................................................40 II. Summary Table of Recommendations of April FSAP Mission..........................................41 ©International Monetary Fund. Not for Redistribution - 4 - GLOSSARY AML Anti-money laundering APML Administration for the Prevention of Money Laundering BCP Basel Core Principle CP Core Principle CAMEL Capital Assets Management Earnings and Liquidity CAR Capital adequacy ratio CEE Central and Eastern European CFT Combating the Financing of Terrorism CPSIPS Core Principles for Systemically Important Payment Systems CSDCHS Central Securities Depository and Clearing House of Serbia DIA Deposit Insurance Agency (formerly the Bank Rehabilitation Agency) DIS Deposit insurance scheme EBRD European Bank for Reconstruction and Development EU European Union FSAP Financial Sector Assessment Program GDDS General Data Dissemination System GDP Gross Domestic Product IAS International Accounting Standards IFRS International Financial Reporting Standards IPO Initial Public Offering ISD Insurance Supervision Department IT Information technology LOB Law on Banks LOLR Lender of last resort MEFP Memorandum on Economic and Financial Policies 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 MTPL Motor third-party liability NOS National Office of Statistics NPL Nonperforming loan OTC Over-the-counter PLC Paris and London Clubs ROA Return on Assets ROE Return on Equity RTGS Real-time gross settlement SC Securities Commission SDDS Special Data Dissemination Standard SME Small and medium-size enterprise SRD Serbian dinar SRR Statutory reserve requirements T-bill Treasury bill ©International Monetary Fund. Not for Redistribution - 5 - EXECUTIVE SUMMARY 1. The ongoing transformation of Serbia’s financial system is bringing important economic benefits. The entry of foreign banks in recent years has led to a sharp increase