Policy options for the banking sector in the Western Balkans May 14, 2009

Overview of pre-crisis conditions Dramatic growth in credit fueled consumption Privatization and deregulation of banking sector led to dominance of foreign banks in most countries Macroeconomic imbalances in some countries (i.e., BiH) Improving supervisory and regulatory capacity in most countries, but still significant gaps existed Most countries highly dependent on Trade and FDI Pre-crisis state made the Balkans vulnerable to a global financial crisis and a slowdown in trade, but less so than other ECA countries (e.g., Hungary, Ukraine, Latvia)

Deceleration in Credit Growth Change in Annual Private Credit Growth Rate from 3Q07 to 3Q08 20% 0% -60% -40% -20% -120% -140% -9% -2% -128% 4%1% AlbaniaBiHMacedoniaMontenegroKosovoSerbia 3Q 2007 Annual Growth = 54%29%41%185%33%29% Significant growth in consumption and asset prices was driven by the rapid growth in credit. However, decelerating private credit growth is likely to reverse this growth in consumption and asset prices.

Foreign Currency Lending Could Increase Pressure on Households and Enterprises Significant lending in foreign currency creates significant exchange rate risk in almost all countries except for Montenegro that utilizes the Euro. Exchange rate movements could increase carrying costs for borrowers. Need to get FY09 Growth Estimates Percentage Private Credit in Foreign Currency (or Indexed), 2007* * Data for Bosnia is from 2006

Foreign Ownership of Bank Assets Total Foreign Ownership of Bank Assets, Percentage 2007 Declines in credit growth occurring as foreign banks pull back support from their subsidiaries in the Balkans.

Likely Further Declines in Liquidity and Access to Finance Parent Banks with subsidiaries active in the Balkans likely to continue to decrease support due to: –Sharp increase in NPLs in their CEE subsidiaries, with insufficient loan-loss provisions, demanding additional capital and liquidity support. –Increasing FX mismatches; –Rollover risks and deposit runs; –Risks of seeing their ratings downgraded, their funding costs increase and eventually their market access curtailed; –Shrinking market capitalization and inability to help subsidiaries; –Reputational risks from letting subsidiaries fail.

Declining Liquidity in System Decreasing liquidity in almost all countries due to deposit withdrawals and decreased support from parent banks (as measured by increased loan to deposit ratio). However, ratios remain healthy (except for Montenegro) and are much better than in other ECA countries (e.g., Ukraine = 207%, Hungary = 180%) Loan to Deposit Ratio, FY07 to FY08

However, Banking problems have been minimized except for Montenegro Limited major government interventions in the Banking sector (except for Prva Bank in Montenegro) Prudent reserve requirements and other supervisory measures enacted prior to the crisis in most countries has helped to mitigate the impact of the crisis on the banking sector. Actions taken by a number of countries since crisis has also helped to mitigate the impact, such –Increased deposit guarantees (Montenegro, BiH, Serbia) –Updating of liquidity requirements (Serbia, Macedonia) –Improved monitoring and reporting (Albania, Serbia –Bank closures and support for critical financial institutions (Montenegro, Serbia) Foreign ownership has also helped as the Balkans constitute a small percentage of the parent bank assets

However, declining growth prospects could create banking sector problems going forward Need to get FY09 Growth Estimates Although banking systems are unlikely to be a major source of problems in the upcoming year, the transmission channels are likely to occur via decreased access to finance (and increased cost of finance), significant currency risks, and increased NPLs if the prospects of enterprises and household throughout the region continue to decline. Enterprise risk is due to a number of factors including: –Declining growth, export and trade –Decreased access to finance (including working capital) –Declining prospects in key industries (e.g., commodities, tourism, construction)

Potential Instruments to Respond Lending and Technical Assistance Bank Group Coordination (IFC and MIGA) & with Other MDBs Credit Lines to Increase Access to Finance (Armenia, Turkey, Bosnia, Croatia, Poland & Moldova under preparation) DPLs with Focus on Financial Sector Restructuring (Ukraine, Hungary, Latvia, Montenegro?) Discussion of new instruments, e.g., regional horizontal facility Technical assistance under the Balkan Facility TA component of investment lending focused on support for export related enterprises (Moldova) IFC strengthening key institutions (e.g., Raiffeisen) in the ECA region MIGA guarantee facility Partnerships with EIB and EBRD

Annex: Country Background

Serbia Main risks: o Rapid credit growth in recent years o Significant lending in foreign currency or indexed to foreign currency o Much of the banking system is foreign owned, and support from parent banks may decline Risks to Banking System Tempered due to: o Government instituted tight prudential policies in previous years (e.g., increased reserve requirements for foreign currency loans) o Although access to funding from parent banks may decline, failure of subsidiaries is unlikely to occur unless significant losses occur o Large current liquidity (liquidity rate of 31% as of October 2008) and capital buffers (CAR of 26% as of October 2008) Actions since the crisis to safeguard the Banking System: The GoS and NBS responded promptly to boost confidence and stability of the system following the loss of 15 percent of foreign currency deposits during October, The response included: o Increase of deposit insurance coverage to Eur 50,000 per deposit (from Eur 3,000) o Enhanced supervision with development of liquidity and early warning indicators monitored on a daily basis o Increased share of foreign currency mandatory reserves (from 20 to 40%) kept in domestic currency to increase banks’ foreign currency liquidity and withdraw excess dinars from circulation Risks to the banking system are low, but problems could occur if NPLs rise due to a slowdown in the economy and trade or currency fluctuations

Montenegro Main risks: o Majority of banking system is foreign owned, leading to risks related to decreased parent bank support o Private sector growth has declined rapidly, from over 170 percent in 2007 to less than 25 percent in 2008 (initial estimates) reflecting decline in deposits and lower risk appetite from foreign and domestic banks o Rising NPL ratios, which are likely to continue to increase as banks are heavily exposed to sectors that are experiencing slowdowns (e..g, construction, tourism) o Key Financial Sector Indicators are deteriorating, including bank profitability and provisioning o Average banking system solvency is 16 percent, but IMF estimates that a 10 percent loan loss will reduce it to 10 ½ percent, barely above the prudential minimum o Government provided 44million Euro loan to second largest bank (Prva Bank) in December and problems appear to have spread from liquidity to solvency concerns. Risks to Banking System Tempered due to: o Euroization shields Montenegro from currency crises o Although access to funding from parent banks may decline, failure of subsidiaries is unlikely to occur unless significant losses occur Actions since the crisis to safeguard the Banking System: The Central Bank responded following a crisis in confidence that started in September and led to significant deposit withdrawals, including: o Guaranteed all bank deposits, and on a case-by-case basis, interbank lending until end-2009 o Provided collateralized loan of 44million Euro to Prva Bank o Created short-term liquidity support facility enabling solvent banks to borrow against prime collateral for up to 30 days. Risks to the banking system are substantial as credit growth is declining rapidly, NPLs are rising, and financial sector indicators are declining.

Albania Main risks: o Rapid credit growth in recent years, which has slowed in recent month o Majority of banking system is foreign owned, which creates risks related to decreased support from parent banks o Non-performing loans have increased, but remain low relative to other countries in the region Risks to Banking System Tempered due to: o Larger percentage of credit growth funded via deposits than in neighboring countries o Credit growth is declining, but still remains substantial o Credit as a percentage of GDP remains relatively low (<40%) o Core indicators of financial soundness indicate that the system is solvent, liquid and profitable o Although access to funding from parent banks may decline, failure of subsidiaries is unlikely to occur unless significant losses occur Actions since the crisis to safeguard the Banking System: o BoA has stepped up cross-border coordination efforts with regional supervisors o Improved supervision and liquidity management tools o Increased maturity and volumes of liquidity it provides banks through the repurchase market Risks to the banking system are low, and mainly revolve around loss of support from parent banks or an increase in NPLs that could occur if the economy worsens

Macedonia Main risks: o Majority of banking system is foreign owned, leading to risks related to decreased parent bank support o Private credit growth has been substantial in recent years Risks to Banking System Tempered due to: o Financial intermediation remains low, with credit approximately 40 percent of GDP o Banking system appears to be sufficiently capitalized and other financial soundness indicators are not problematic o NPLs remain relatively low o Given the growth in deposits, banks have not had to overly rely on external financing Actions since the crisis to safeguard the Banking System: o Altered liquidity risk requirements to improve maturity matching of assets and liabilities in both domestic and foreign currencies o Instituted exposure limits for domestic banks related to individual foreign banks Financial system appears to be sound, with main risks related to foreign ownership and the potential for increased risks if the economy continues to slow

BiH Main risks: o Majority of banking system is foreign owned, leading to risks related to decreased parent bank support o Substantial (~40%) lending has been fueled by foreign borrowing from parent banks rather than deposit growth o Private credit growth has been substantial in recent years o Credit growth rate has declined in recent months, and is expected to continue to slow as banks become more risk averse Risks to Banking System Tempered due to: o Banking system appears to be sufficiently capitalized and other financial soundness indicators are not problematic o NPLs remain relatively low o Parent banks are unlikely to allow subsidiaries to fail Actions since the crisis to safeguard the Banking System: o Crisis of confidence led to significant withdrawals in late 2008, but government increase in deposit guarantee helped to stabilize the system Banking system appears to be sound, but access to finance is declining due to a pull-back from parent banks