## Structure of the Bank of Slovenia Balance Sheet

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### Summary and overall stability assessment
- The Slovenian financial system appears sound overall but faces increased competitive pressures with accession to the European Union (EU), which could lead to substantial further restructuring that needs to be managed to avoid contributing to systemic risk.
- The system has become more complex with the formation of financial conglomerates, creating new sources of risk and placing new demands on supervision.
- Slovenia prepares to enter ERM2 by early 2005 and EMU two years later, creating new policy challenges and risks.
- Since the 2001 FSAP, monetary policy successfully managed the transition to a low inflation environment using a crawling band exchange rate regime but must now adapt to ERM2.
- Slovenia is well positioned to meet the Maastricht criteria for EMU but will need to focus on ensuring inflation and interest rate convergence, and exchange rate stability in ERM2.

### Risks to financial stability
- Interest rate convergence in the transition to EMU could produce several macroeconomic risks:
  - Real interest rates could fall to low levels as nominal interest rates decline more rapidly than inflation, stimulating demand for credit.
  - Associated shift in bank portfolios, possibly with large capital inflows, could fuel rapid loan growth—loan growth has recently accelerated, especially loans denominated in euros.
  - This could contribute to inflationary pressures and deterioration in bank credit quality as banks make riskier loans; together with compression of interest margins, banking sector vulnerability could increase.
- Monetary policy framework effects and concerns:
  - The current framework has lessened incentives for the banking system to restructure, increasing the scale of restructuring needed to be competitive in the EU.
  - Relatively high yields on BoS bills have supported earnings of weaker banks; these yields have fallen and likely will decline further with interest rate convergence in ERM2.
  - The arrangement has reduced incentives to develop market risk management and operations capacity, disadvantaging smaller banks as capacity strengthens.
- Recommendation:
  - The Bank of Slovenia (BoS) should enhance the role of markets in the financial system, especially repo markets. This could include some limited market intervention by the BoS, provided it does not pose exchange rate instability risk. Developing repo capacity beforehand is appropriate as the BoS will use repos as a Eurosystem national central bank with EMU.

### Stress test findings and scenarios
- Stress test shocks used:
  - 1) An exchange rate depreciation of 10 percent to the bottom of, or below, the ERM band.
  - 2) A 50 percent narrowing of interest rate margins to the EU average of 1.6 percentage points.
  - 3) Combination of stress test 2 with an offsetting reduction in the total expenses to assets ratio to the EU average.
  - 4) Deterioration in credit quality: 25 percent of loans in each classification migrate down one category, raising the NPLs/loans ratio by 3.2 percentage points (or 45 percent).
- Main stress test outcomes (selected results):
  - Stress test 1 (10 percent currency depreciation excluding swaps):
    - Domestically owned banks: Change in CAR 0; New CAR 11.8; Change in profits -3.
    - Foreign bank subsidiaries: Change in CAR -0.2; New CAR 10.5; Change in profits -68.
    - Banks below 8 percent CAR: 0.
  - Stress test 2 (50 percent narrowing of interest margin):
    - Domestically owned banks: Change in CAR -0.6; New CAR 11.2; Change in profits -109.
    - Foreign bank subsidiaries: Change in CAR -1.1; New CAR 9.6; Change in profits -193.
    - Banks below 8 percent CAR: 3.
  - Stress test 3 (after reduction in operating cost to EU level):
    - Domestically owned banks: Change in CAR 0; New CAR 11.8; Change in profits -22.
    - Foreign bank subsidiaries: Change in CAR -0.1; New CAR 10.6; Change in profits -23.
    - Banks below 8 percent CAR: 1.
  - Stress test 4 (credit quality deterioration; NPLs/loans rise 45 percent):
    - Domestically owned banks: Change in CAR -4.2; New CAR 7.2; Change in profits -226.
    - Foreign bank subsidiaries: Change in CAR -3.9; New CAR 7.2; Change in profits -414.
    - Banks below 8 percent CAR: 8.
  - Combined scenario (stress tests 2 + 4):
    - Impact: reduces the capital ratio of domestic banks by 4.8 percentage points.
- Interpretation:
  - Narrowing of margins to the EU average pushes the banking system into loss, indicating a need to strengthen competitiveness.
  - Offsetting effect: if banks also reduce operating costs to the EU average, much of the adverse effect can be offset.
  - Deterioration in credit quality raises NPLs by roughly 50 percent and pushes the average capital adequacy ratio below 8 percent.

### Strengthening supervision of the financial system
- Supervisory priorities:
  - Limit adverse effects on banking system soundness from increased competitive pressures and interest rate spread compression by closely monitoring bank profitability, credit risk and loan pricing, and be prepared to take prompt action to resolve weak banks.
  - Limit risks from an acceleration of credit growth by evaluating banks’ credit risk management and loan pricing and, if inadequate, consider scope for using prudential tools to address this source of risk.
  - Monitor banks’ indirect credit risk arising from the foreign currency exposure of the corporate sector and ensure banks adequately account for it in lending and loan pricing decisions.
- Supervisory capacity and reform needs:
  - Banking supervision registered a high level of compliance with the Basel Core Principles, but rapid change and increasing complexity may necessitate a higher standard of supervision with a stronger risk focus.
  - Supervisors need to be more proactive ensuring banks upgrade risk assessment skills and that pricing of risk and provisioning are appropriate. Supervisory resources will have to expand to meet demands (e.g., AML/CFT).
  - Insurance sector lacks transparency and needs capacity to set pricing, provisioning and capital at appropriate levels.
  - Limited independence of the supervisory agency should be addressed by reforming laws to give the supervisor more administrative and budgetary autonomy and by providing supervisors indemnity against legal action.
  - There is a clear gap in supervision of the pensions sector, which is split between securities market and insurance supervisors.
- Institutional arrangements:
  - A single regulatory agency has been proposed to replace the lead supervisor approach. Preconditions for success include application of a risk-focused approach across all areas of supervision and avoiding implementation during periods of system stress or rapid change.
  - Authorities have deferred a decision on integrated supervision until conditions are more suitable. In the short term, strengthening cooperation between the three supervisory agencies is needed.
  - Slovenia’s corporate governance legal framework is well developed with transparency in disclosure of ownership and control; effectiveness of supervisory boards can be strengthened. International Financial Reporting Standards and relevant EU guidelines are being adopted, but institutional arrangements to enforce the standards are not yet in place.

### Macroeconomic context and fiscal/monetary indicators
- Real GDP growth slowed to 2.3 percent in 2003 from 2.9 percent in 2002 due to weak external demand despite strengthening domestic demand.
- Inflation declined from 7.2 percent in December 2002 to 3.6 percent in February 2004.
- Policy focus: with growth expected to rebound, policy may need to bring inflation below 3 percent by 2006 to meet the Maastricht inflation criteria.
- Fiscal metrics for 2003:
  - General government deficit: 1.4 percent of GDP.
  - Government debt: 27 percent of GDP.
  - Both are within Maastricht limits (deficit below 3 percent; debt below 60 percent).
- Monetary policy and liquidity management:
  - Official interest rates have declined in tandem with inflation and in mid March were around 5½ percent on 60-day Tolar Treasury bills.
  - Large capital inflows since the 2001 FSAP totaled roughly 7 percent of GDP in 2002.
  - BoS instruments used: 7-day foreign exchange swaps to absorb inflows and Tolar central bank bills to absorb excess liquidity.

### BoS operational framework and market development considerations
- Key features of BoS framework (operational mechanics relevant for ERM2 adaptation):
  - A foreign exchange swap based on a formal contract with banks for “cooperation between bank[s] and the BoS in foreign exchange interventions;”
  - Use of Tolar central bank bills to absorb liquidity created by the swap; and
  - Prudential rules that create a strong incentive for banks to participate in the swap.
- Mechanics and effects:
  - Banking system has a structural long position in euros; banks use swaps to transfer exchange rate risk to the BoS; volume of swaps is around 10 percent of banking sector assets.
  - BoS then sells central bank bills to banks to absorb Tolar liquidity created by swaps.
  - Since BoS is the sole counterparty in these transactions, incentives for banks to develop wholesale interbank markets are reduced.
  - Net cost to banks of the swap is roughly 50 basis points; relatively high interest rate paid on BoS bills sold to banks more than offsets this cost on average.
  - Arrangement tends to slow restructuring by supporting earnings of weaker banks; swaps are used primarily by larger banks while high-yielding BoS bills go disproportionately to smaller banks.
  - Recent change: BoS has tied sale of higher yielding 270-day bills directly to the volume of swap transactions.
- Market development and Eurosystem considerations:
  - Advantages to develop capacity before EMU entry include minimizing operational risks and helping banks prepare to operate in Eurosystem money markets.
  - Key constraint: limit risks to exchange rate stability—liquid wholesale markets could be used to take speculative positions against the currency. This risk can be minimized by strong convergence to Maastricht criteria and a mutual agreement with the Eurosystem to defend the narrow band.
  - Eurosystem policy: interventions at the margins of the ERM2 band are “in principle automatic and unlimited.” Provision of euros for intra-marginal intervention requires a “mutual agreement” with the Eurosystem; indications are Eurosystem will set a relatively low limit on size of intra-marginal intervention and will initiate it only after Slovenia’s foreign currency reserves have been largely exhausted.
- Operational recommendations for gradual market development:
  - Continue to use existing instruments to manage overall liquidity while using market intervention at the margin on a limited scale initially.
  - Use variable rate auctions to encourage market pricing of foreign exchange.
  - Foreign exchange swaps could continue to function as main instrument for absorbing foreign exchange but at a predetermined exchange rate that could differ slightly from the market rate.
  - For domestic currency liquidity and sterilization, BoS could start to use repo as well as transactions in BoS bills.
- Market infrastructure and bank capacity:
  - Banks need to develop risk management and trading capacity to participate in interbank repo and foreign exchange markets; supervisors must ensure adequate risk management systems.
  - BoS could support market development by helping to put in place market infrastructure including market making capacity; repo market prerequisites being implemented include a workable repo master agreement and market making arrangements for a market in Treasury bills.
  - BoS lacks sufficient holdings of government securities to use for repo but can (and plans to) conduct repos using other securities on its balance sheet.
  - BoS has government securities from Euro area countries on its balance sheet as reserve assets that it could use to conduct repo operations as a Eurosystem national central bank upon entry into EMU.

### Structure of the Bank of Slovenia Balance Sheet (Table 1 — percentage of total assets in 2002)
- Assets:
  - Foreign Currency: 98
    - Of which: Securities: 58
  - Domestic currency: 0.4
  - Fixed assets: 2
- Liabilities:
  - Foreign currency: 37
    - Of which:
      - BoS bills: 33
  - Domestic currency: 39
    - Of which:
      - BoS Tolar bills: 23
      - Gov. deposits: 8
  - Currency: 11
  - Capital: 13

### Banking sector structure, key indicators, and vulnerabilities
- Systemic importance and concentration:
  - The banking sector accounts for most of the financial system; total assets of the sector at end-2002 were about 80 percent of GDP.
  - The sector is highly concentrated: the largest bank accounts for around one-third of sector assets and the three largest banks account for around 55 percent of sector assets.
  - Six out of the 20 banks have majority foreign ownership; foreigners own one-third of banking system equity.
  - State ownership of bank equity fell from 37 percent at end-2001 to around 20 percent at end-2002.
- Selected financial soundness indicators (selected figures and trends):
  - Regulatory capital to risk-weighted assets: 13.5 (2000); 11.9 (2001); 11.9 (2002); 11.6 (2003H1); 11.4 (2003Q3).
  - Regulatory Tier 1 capital to risk-weighted assets: 12.6 (2000); 11.3 (2001); 9.9 (2002); 9.7 (2003H1); 9.6 (2003Q3).
  - Capital (net worth) to assets: 10.1 (2000); 8.8 (2001); 8.3 (2002); 7.8 (2003H1); 7.8 (2003Q3).
  - Total assets (in billions of Euro): 14.8 (2000); 17.5 (2001); 19.8 (2002); 20.7 (2003H1); 21.0 (2003Q3).
  - Nonperforming loans to total gross loans: 6.5 (2000); 6.9 (2001); 6.9 (2002); 6.8 (2003H1); 6.7 (2003Q3).
  - Nonperforming loans net provision to capital: 32.1 (2000); 35.5 (2001); 36.3 (2002); 34.8 (2003H1); 34.1 (2003Q3).
  - ROA: 1.1 (2000); 0.5 (2001); 1.1 (2002); 1.2 (2003H1); 1.2 (2003Q3).
  - ROE: 11.4 (2000); 4.8 (2001); 13.3 (2002); 14.8 (2003H1); 15.7 (2003Q3).
  - Net interest margin to (operating income) average interest bearing assets: 4.7 (2000); 3.6 (2001); 3.7 (2002); 3.4 (2003H1); 3.3 (2003Q3).
  - Spread between average lending and deposit rates (for all banking system): 6.4 (2000); 4.9 (2001); 5.1 (2002); 4.9 (2003H1); 4.9 (2003Q3).
  - Operating expenses to operating income: 59.0 (2000); 65.2 (2001); 59.7 (2002); 62.7 (2003H1); 60.7 (2003Q3).
  - Average short-term assets to average short-term liabilities: 85.4 (2000); 89.2 (2001); 90.4 (2002); 93.2 (2003H1); 93.4 (2003Q3).
  - Net open position in foreign exchange to capital: 21.5 (2000); 33.9 (2001); 51.6 (2002); 55.9 (2003H1); 53.5 (2003Q3).
- Lending and currency exposure:
  - In September 2003, lending was 10 percent above its level one year earlier.
  - Roughly one-third of lending to the corporate sector is in foreign exchange, contributing to large short foreign exchange exposure and indirect credit risk to banks.

### Supervisory assessment and policy recommendations (selected)
- Supervisory actions and capacity:
  - Supervisors should limit adverse effects on banking soundness as competitive pressures increase with EU accession and interest rate spreads narrow by closely monitoring profitability, credit risk and loan pricing, and being prepared to facilitate orderly exit of weak banks.
  - Evaluate banks’ credit risk management capabilities; if inadequate, consider prudential tools, including provisioning policies.
  - Intensify consolidated supervision of domestic conglomerates, including intra-group transactions and risk transfers; this requires increased supervisory resources.
  - Use of credit register and corporate database should be expanded to assess corporate credit risk.
  - BoS should consider adapting the Bank of Spain dynamic provisioning model to the Slovenian situation.
- Insurance and pensions supervision:
  - Address lack of transparency in life insurance sector financial positions.
  - Address risks from guarantees that transfer borrower credit risk from banks to insurers—insurers should adopt risk management, pricing, provisioning, and capital structures to match product guarantees.
  - Strengthen independence of the Insurance Supervision Agency (ISA); consider training programs and technical assistance; provide responsible officers with indemnity against legal actions.
  - Close supervision gap in the pensions sector split between securities market and insurance supervisory agencies.
- Institutional and legal framework:
  - Amendments to the Securities Law will allow fines to be levied from January 2005; supervisors still lack indemnity against legal actions.
  - Preconditions for a single regulatory agency include consistent risk-focused approach, ensured independence and adequate staffing, and timing that avoids periods of stress or rapid change.
  - Ensure effective mechanisms for timely provision of supervisory information to the central bank for macro-prudential surveillance and crisis management.

### Insurance sector: IAIS assessment and recommended actions
- Key sector statistics and structure:
  - Total written premiums in 2002: SIT 266 billion (US$1.4 billion).
  - Insurance penetration (premium as percentage of GDP, including health): 5.1 percent.
  - Sector financial investments as at June 30, 2003: SIT 422 billion; equates to 8 percent of GDP.
  - Supplementary pensions assets as at June 30, 2003: SIT 35.9 billion; growing by approximately SIT 10 billion p.a.
  - Market participants: 19 insurers based in Slovenia, including 2 reinsurers, 1 specialist trade credit insurer and 1 mutual.
- Main findings and vulnerabilities:
  - Industry generally profitable following strengthening of provisions in 2001, but some insurers remain financially vulnerable.
  - Catastrophe exposure (earthquake) noted; recommendation for a detailed loss potential study.
  - Credit risk concentration: Triglav appears to be assuming 100 percent of credit risk associated with most consumer loans issued by banks.
  - Supplementary DC voluntary pensions guarantee mechanics raise concerns given downward trending interest rates and nominal bond issuance.
- Recommended supervisory actions (condensed):
  - Accelerate actuarial profession development program and establish actuarial–accounting coordination capacity.
  - Reassess ISA governance and funding to ensure operational independence; provide legal protection for responsible officials acting in good faith.
  - Institute a risk-based formal early intervention regime and allocate resources for conglomerate supervision; nominate a lead supervisor where appropriate.
  - Strengthen prudential requirements: review liability valuation assumptions, introduce balance sheet resilience testing, amend law to address derivatives and structured instruments, and encourage separation of composites into life and non-life.
  - Strengthen consumer protection, intermediary licensing powers, and implementation of AML measures at supervisory level.

### Basel Core Principles assessment and supervisory capacity
- As at June 30, 2003:
  - Slovenian banking system comprised 20 banks with total assets of SIT 4,832.6 billion, 2 savings banks with total assets of SIT 17.2 billion, and 14 savings and loan institutions with total assets of SIT 42.9 billion.
  - Aggregate total assets of the system to GDP is almost 80 percent.
  - Banking supervision was carried out by a staff of 54 employees (on June 30, 2003) in the Banking Supervision Department of the Bank of Slovenia.
- Ownership and concentration:
  - Foreign ownership of banking system equity: 32.5 percent as at 31 December 2002; 33.1 percent by end of June 2003.
  - Market share statistics at end-2002: largest bank market share (unconsolidated total assets) 35.5 percent; market share of the three largest banks 55.4 percent; market share of the seven largest banks 80.6 percent.
- Performance pressures and supervisory resource gaps:
  - Banks ended 2002 with pre-tax profits of SIT 46.0 billion; results up by SIT 30.6 billion on 2001 before accounting for SIT 19.5 billion in losses by a major bank.
  - Growing pressure on earning capacity in 2003 due to ongoing erosion of interest margins likely to reduce bank profitability.
  - Supervisory staff salary scales insufficient to attract and retain qualified staff; high turnover, especially on-site examiners.
  - Recommended actions include structural change of remuneration, legal protection for supervisory staff, and installation of mechanisms for systematic evaluation of banking group risks from nonbanking elements.
- Principle-by-principle selected findings and recommended actions:
  - CP 1.2 Independence: address insufficiency of salary schemes and perform in-depth analysis of supervisory objectives and means.
  - CP 1.5 Legal protection: establish appropriate legal protection of supervisory staff.
  - CP 7 Credit Policies: revisit the role of the supervisory board in credit decisions.
  - CP 9 Large Exposure Limits: enhance off- and on-site supervision of large exposures.
  - CP 10 Connected Lending: enhance prudential reporting and introduce legal requirement for arm’s-length lending to related parties.

### Immediate supervisory actions (market risks checklist)
- accelerate training of recently hired staff
- issue additional guidelines on operational risk
- explore additional synergies with the external auditors in order to maximize efficiency
- fulfill the primary target of bi-annual meetings with bank management
- organize enhanced comprehensive analysis of consolidated financial information
- install mechanism for systematic evaluation of risks from nonbanking elements in banking group
- increase scope and enhance practice of global consolidated supervision

*Source: IMF staff report content (selected excerpts) — content unit _cr04137.*

### 1. Structure of the Bank of Slovenia Balance Sheet ..................................................................9

### 1. Structure of the Bank of Slovenia Balance Sheet

### Summary and overall stability assessment
- The Slovenian financial system appears sound overall but faces increased competitive pressures with accession to the European Union (EU), which could lead to substantial further restructuring that needs to be managed to avoid contributing to systemic risk.
- The system has become more complex with the formation of financial conglomerates, creating new sources of risk and placing new demands on supervision.

Key risks and observations:
- Slovenia prepares to enter ERM2 by early 2005 and EMU two years later, creating new policy challenges and risks.
- Since the 2001 FSAP, monetary policy successfully managed the transition to a low inflation environment using a crawling band exchange rate regime but must now adapt to ERM2.
- Slovenia is well positioned to meet the Maastricht criteria for EMU but will need to focus on ensuring inflation and interest rate convergence, and exchange rate stability in ERM2.

A. Risks to financial stability
- Interest rate convergence in the transition to EMU could produce several macroeconomic risks:
  - Real interest rates could fall to low levels as nominal interest rates decline more rapidly than inflation, stimulating demand for credit.
  - Associated shift in bank portfolios, possibly with large capital inflows, could fuel rapid loan growth—loan growth has recently accelerated, especially loans denominated in euros.
  - This could contribute to inflationary pressures and deterioration in bank credit quality as banks make riskier loans; together with compression of interest margins, banking sector vulnerability could increase.

- Current monetary policy framework should effectively limit risks to exchange rate stability in ERM2, but it has:
  - Lessened incentives for the banking system to restructure, increasing the scale of restructuring needed to be competitive in the EU.
  - Supported earnings of weaker banks via relatively high yields on BoS bills; these yields have fallen and likely will decline further with interest rate convergence in ERM2.
  - Reduced incentives to develop market risk management and operations capacity; as banks strengthen capacity, smaller banks will be at a disadvantage.

- Recommendation:
  - The Bank of Slovenia (BoS) should enhance the role of markets in the financial system, especially repo markets. This could include some limited market intervention by the BoS, provided it does not pose exchange rate instability risk. Developing repo capacity beforehand is appropriate as the BoS will use repos as a Eurosystem national central bank with EMU.

Stress test findings:
- Stress tests included an exchange rate depreciation, narrowing of banks’ interest rate margins, and worsening of loan portfolio credit quality.
- Narrowing of margins to the EU average pushes the banking system into loss, indicating a need to strengthen competitiveness.
- Offsetting effect: if banks also reduce operating costs to the EU average, much of the adverse effect can be offset.
- Deterioration in credit quality raises nonperforming loans (NPLs) by roughly 50 percent and pushes the average capital adequacy ratio below 8 percent, underscoring the importance of adequate credit assessment capabilities and provisioning policies.

### Strengthening supervision of the financial system
- Supervisory priorities to address vulnerabilities:
  - Limit adverse effects on banking system soundness from increased competitive pressures and interest rate spread compression by closely monitoring bank profitability, credit risk and loan pricing, and be prepared to take prompt action to resolve weak banks.
  - Limit risks from an acceleration of credit growth by evaluating banks’ credit risk management and loan pricing and, if inadequate, consider scope for using prudential tools to address this source of risk.
  - Monitor banks’ indirect credit risk arising from the foreign currency exposure of the corporate sector and ensure banks adequately account for it in lending and loan pricing decisions.

- Supervisory capacity and reform needs:
  - Banking supervision registered a high level of compliance with the Basel Core Principles, but rapid change and increasing complexity may necessitate a higher standard of supervision with a stronger risk focus.
  - Supervisors need to be more proactive ensuring banks upgrade risk assessment skills and that pricing of risk and provisioning are appropriate. Supervisory resources will have to expand to meet demands (e.g., AML/CFT).
  - Insurance sector lacks transparency and needs capacity to set pricing, provisioning and capital at appropriate levels. The limited independence of the supervisory agency should be addressed by reforming laws to give the supervisor more administrative and budgetary autonomy and by providing supervisors indemnity against legal action.
  - There is a clear gap in supervision of the pensions sector, which is split between securities market and insurance supervisors.

- Institutional arrangements:
  - A single regulatory agency has been proposed to replace the lead supervisor approach. Preconditions for success include application of a risk-focused approach across all areas of supervision and avoiding implementation during periods of system stress or rapid change. Authorities have deferred a decision on integrated supervision until conditions are more suitable. In the short term, strengthening cooperation between the three supervisory agencies is needed.
  - Slovenia’s corporate governance legal framework is well developed with a high degree of transparency in disclosure of ownership and control. However, effectiveness of supervisory boards can be strengthened. International Financial Reporting Standards and relevant EU guidelines are being adopted, but institutional arrangements to enforce the standards are not yet in place.

### Macroeconomic context
- Real GDP growth slowed to 2.3 percent in 2003 from 2.9 percent in 2002 due to weak external demand despite strengthening domestic demand.
- Inflation declined from 7.2 percent in December 2002 to 3.6 percent in February 2004.
- Policy focus: with growth expected to rebound, policy may need to bring inflation below 3 percent by 2006 to meet the Maastricht inflation criteria.
- Fiscal metrics for 2003:
  - General government deficit: 1.4 percent of GDP.
  - Government debt: 27 percent of GDP.
  - Both are within Maastricht limits (deficit below 3 percent; debt below 60 percent).

### Monetary policy and liquidity management
- Monetary policy focused on reducing inflation using a crawling band exchange rate regime.
- Official interest rates have declined in tandem with inflation and in mid March were around 5½ percent on 60-day Tolar Treasury bills.
- Large capital inflows since the 2001 FSAP totaled roughly 7 percent of GDP in 2002.
- BoS instruments used:
  - 7-day foreign exchange swaps to absorb inflows.
  - Tolar central bank bills to absorb excess liquidity.

Box: Operation of the Slovenian Exchange Rate Regime (key features)
- Main features of BoS framework (likely to be adapted to hold the exchange rate within a very narrow band inside ERM2):
  - A foreign exchange swap based on a formal contract with banks for “cooperation between bank[s] and the BoS in foreign exchange interventions;”
  - Use of Tolar central bank bills to absorb liquidity created by the swap; and
  - Prudential rules that create a strong incentive for banks to participate in the swap.

Mechanics and effects:
- The banking system has a structural long position in euros because depositors exchange euros for higher yielding local currency deposits while borrowers prefer euro loans with lower and less volatile interest rates.
- Banks need to close this long position to meet open position and liquidity ladder prudential restrictions. The swap transfers banks’ exchange rate risk to the BoS; the volume of swaps is around 10 percent of banking sector assets.
- BoS then sells central bank bills to banks to absorb Tolar liquidity created by swaps.
- Since BoS is the sole counterparty in these transactions, incentives for banks to develop wholesale interbank markets are reduced.
- Net cost to banks of the swap is roughly 50 basis points (interest rate paid to the BoS exceeds capital gain from exchange rate depreciation). However, relatively high interest rate paid on BoS bills sold to banks more than offsets this cost on average.
- Arrangement tends to slow restructuring by supporting earnings of weaker banks: swaps are used primarily by larger, more efficient, internationally oriented banks who receive a large share of capital inflows while high-yielding BoS bills go disproportionately to smaller banks.
- Recent change: BoS has tied sale of higher yielding 270-day bills directly to the volume of swap transactions.

Transition risks to ERM2
- Transition entails several risks stemming from likely decline in real interest rates as nominal rates converge to EU levels while inflation falls more slowly:
  - A sharp acceleration in economic growth preventing inflation from declining sufficiently to meet Maastricht criteria during the assessment period;
  - Rapid credit growth, perhaps supported by large capital inflows, substantially increasing bank credit risk exposures;
  - Further narrowing of bank interest margins, weakening bank earnings and possibly inducing banks to take additional credit risk.

- Monetary policy focus on maintaining exchange rate stability reduces scope to respond to other sources of risk, increasing the need to rely on other macroeconomic and prudential policy tools.

Market development considerations
- Monetary policy framework contributes to financial system vulnerability by:
  - Relatively high yields on BoS central bank bills contributing to an average interest rate spread well above that in the EU, supporting weaker banks’ earnings and reducing restructuring pressure;
  - Cost of foreign exchange swaps borne disproportionately by a few larger internationally oriented banks, distorting competition and slowing restructuring;
  - BoS operations transferring most exchange rate risk to the BoS, removing incentives for banks to develop market risk management and operations capacity and discouraging wholesale market development.

- Steps to develop markets in monetary operations are being undertaken by BoS. Advantages to develop capacity before EMU entry include minimizing operational risks and helping banks prepare to operate in Eurosystem money markets.

- Key constraint: limit risks to exchange rate stability—liquid wholesale markets could be used to take speculative positions against the currency. This risk can be minimized by strong convergence to Maastricht criteria and a mutual agreement with the Eurosystem to defend the narrow band. Eurosystem policy:
  - Interventions at the margins of the ERM2 band are “in principle automatic and unlimited.”
  - Provision of euros for intra-marginal intervention to defend a narrower band requires a “mutual agreement” with the Eurosystem.
  - Indications are Eurosystem will set a relatively low limit on size of intra-marginal intervention and will initiate it only after Slovenia’s foreign currency reserves have been largely exhausted.

Operational recommendations for gradual market development
- Continue to use existing instruments to manage overall liquidity while using market intervention at the margin on a limited scale initially.
- Use variable rate auctions to encourage market pricing of foreign exchange.
- Foreign exchange swaps could continue to function as main instrument for absorbing foreign exchange but at a predetermined exchange rate that could differ slightly from the market rate (functioning like a standing facility fixing the edge of the fluctuation band).
- For domestic currency liquidity and sterilization, BoS could start to use repo as well as transactions in BoS bills.

Market infrastructure and bank capacity
- Banks need to develop risk management and trading capacity to participate in interbank repo and foreign exchange markets; supervisors must ensure adequate risk management systems.
- BoS could support market development by helping to put in place market infrastructure including market making capacity, which should strengthen competitiveness and soundness and prepare banks for Eurosystem money markets; it could also encourage consolidation as smaller banks may be unable to achieve economies of scale in risk management.

- Repo market prerequisites being implemented include a workable repo master agreement and market making arrangements for a market in Treasury bills (T-bills).
- BoS lacks sufficient holdings of government securities to use for repo but can (and plans to) conduct repos using other securities on its balance sheet.
- BoS has government securities from Euro area countries on its balance sheet as reserve assets that it could use to conduct repo operations as a Eurosystem national central bank upon entry into EMU.

### Structure of the Bank of Slovenia Balance Sheet (Table 1)
(Percentage of total assets in 2002)

- Assets:
  - Foreign Currency: 98
    - Of which: Securities: 58
  - Domestic currency: 0.4
  - Fixed assets: 2

- Liabilities:
  - Foreign currency: 37
    - Of which:
      - BoS bills: 33
  - Domestic currency: 39
    - Of which:
      - BoS Tolar bills: 23
      - Gov. deposits: 8
  - Currency: 11
  - Capital: 13

### Macro-prudential analysis highlights
- Stress testing indicates vulnerability to narrowing margins and credit quality deterioration:
  - Narrowing of margins to EU average pushes system into loss.
  - Reducing operating costs to EU average can offset much of margin-compression impact.
  - Worsening credit quality raises NPLs by roughly 50 percent and pushes average CAR below 8 percent.

- Supervisory implications reiterate need for:
  - Enhanced monitoring of profitability, credit risk, loan pricing.
  - Evaluation of credit risk management and consideration of prudential tools if needed.
  - Attention to indirect credit risk from corporate foreign currency exposure.

*Source: IMF staff report content (selected excerpts).*

### 21.      The banking sector accounts for most of the financial system making it the

### 21.      The banking sector accounts for most of the financial system making it the

### Banking sector structure and systemic importance
- The banking sector is the primary source of systemic risk.
- Total assets of the sector at end-2002 were about 80 percent of GDP.
- The sector is highly concentrated:
  - The largest bank accounts for around one-third of sector assets.
  - The three largest banks account for around 55 percent of sector assets.
- Ownership:
  - Six out of the 20 banks have majority foreign ownership.
  - Foreigners own one-third of banking system equity.
  - State ownership of bank equity fell from 37 percent at end-2001 to around 20 percent at end-2002, though government influence can remain via minority holdings and through pension and compensation funds.
- Insurance sector:
  - Has grown rapidly but accounts for only 6 percent of financial system assets.
  - Interlinkages with banking (guarantees on household loans; guaranteed rates on bank-owned insurers’ products) create potential contagion channels.

### Key financial soundness indicators (selected figures and trends)
- Capital adequacy and capital ratios (Table 2 & Table 3):
  - Regulatory capital to risk-weighted assets: 13.5 (2000); 11.9 (2001); 11.9 (2002); 11.6 (2003H1); 11.4 (2003Q3).
  - Regulatory Tier 1 capital to risk-weighted assets: 12.6 (2000); 11.3 (2001); 9.9 (2002); 9.7 (2003H1); 9.6 (2003Q3).
  - Capital (net worth) to assets: 10.1 (2000); 8.8 (2001); 8.3 (2002); 7.8 (2003H1); 7.8 (2003Q3).
  - For Slovenian-owned banks (2003Q3): Regulatory capital to risk-weighted assets 11.5; Regulatory Tier 1 capital to risk-weighted assets 9.6; Capital (net worth) to assets 7.9.
- Assets and asset quality:
  - Total assets (in billions of Euro): 14.8 (2000); 17.5 (2001); 19.8 (2002); 20.7 (2003H1); 21.0 (2003Q3).
  - Nonperforming loans to total gross loans: 6.5 (2000); 6.9 (2001); 6.9 (2002); 6.8 (2003H1); 6.7 (2003Q3).
  - Nonperforming loans net provision to capital: 32.1 (2000); 35.5 (2001); 36.3 (2002); 34.8 (2003H1); 34.1 (2003Q3).
  - For Slovenian-owned banks (2003Q3): Nonperforming loans to total gross loans 6.5; Nonperforming loans net provision to capital 35.2.
- Profitability and margins:
  - ROA: 1.1 (2000); 0.5 (2001); 1.1 (2002); 1.2 (2003H1); 1.2 (2003Q3).
  - ROE: 11.4 (2000); 4.8 (2001); 13.3 (2002); 14.8 (2003H1); 15.7 (2003Q3).
  - Net interest margin to (operating income) average interest bearing assets: 4.7 (2000); 3.6 (2001); 3.7 (2002); 3.4 (2003H1); 3.3 (2003Q3).
  - Spread between average lending and deposit rates (for all banking system): 6.4 (2000); 4.9 (2001); 5.1 (2002); 4.9 (2003H1); 4.9 (2003Q3).
  - Operating expenses to operating income: 59.0 (2000); 65.2 (2001); 59.7 (2002); 62.7 (2003H1); 60.7 (2003Q3).
- Liquidity and market risk:
  - Average short-term assets to average short-term liabilities: 85.4 (2000); 89.2 (2001); 90.4 (2002); 93.2 (2003H1); 93.4 (2003Q3).
  - Net open position in foreign exchange to capital: 21.5 (2000); 33.9 (2001); 51.6 (2002); 55.9 (2003H1); 53.5 (2003Q3).
  - For Slovenian-owned banks (2003Q3): Net open position in foreign exchange to capital 35.3; Net open position in equities to capital 4.9.

### Lending, currency exposure, and sectoral performance
- Lending to the nonfinancial sector:
  - In September 2003, lending was 10 percent above its level one year earlier.
  - Roughly one-third of lending to the corporate sector is in foreign exchange, contributing to large short foreign exchange exposure and indirect credit risk to banks.
- Sectoral currency exposures and ROA (Table 4, selected figures):
  - Manufacturing: Open position/Assets 12 (2001) and 13 (2002); Export Share of Sales 58 (2001) and 61 (2002); ROA 4 (2001) and 3 (2002).
  - Electricity, gas and water: Open position/Assets -20 (2001) and -22 (2002); Export Share of Sales 0 (2001) and 0 (2002); ROA -2 (2001) and 4 (2002).
  - Business services: Open position/Assets -26 (2001) and -14 (2002); Export Share of Sales 0 (2001) and 0 (2002); ROA 11 (2001) and 9 (2002).

### Stress tests and scenario outcomes
- Stress test shocks used to assess macroeconomic risks (paragraph 26):
  - 1) An exchange rate depreciation of 10 percent to the bottom of, or below, the ERM band.
  - 2) A 50 percent narrowing of interest rate margins to the EU average of 1.6 percentage points.
  - 3) Combination of stress test 2 with an offsetting reduction in the total expenses to assets ratio to the EU average.
  - 4) Deterioration in credit quality: 25 percent of loans in each classification migrate down one category, raising the NPLs/loans ratio by 3.2 percentage points (or 45 percent).
- Main stress test findings (paragraphs 27–28 and Table 5):
  - Stress test 1 (10 percent currency depreciation excluding swaps):
    - Domestically owned banks: Change in CAR 0; New CAR 11.8; Change in profits -3.
    - Foreign bank subsidiaries: Change in CAR -0.2; New CAR 10.5; Change in profits -68.
    - Banks below 8 percent CAR: 0.
  - Stress test 2 (50 percent narrowing of interest margin):
    - Domestically owned banks: Change in CAR -0.6; New CAR 11.2; Change in profits -109.
    - Foreign bank subsidiaries: Change in CAR -1.1; New CAR 9.6; Change in profits -193.
    - Banks below 8 percent CAR: 3.
  - Stress test 3 (after reduction in operating cost to EU level):
    - Domestically owned banks: Change in CAR 0; New CAR 11.8; Change in profits -22.
    - Foreign bank subsidiaries: Change in CAR -0.1; New CAR 10.6; Change in profits -23.
    - Banks below 8 percent CAR: 1.
  - Stress test 4 (25 percent of loans migrate to lower rating category; NPLs/loans rise 45 percent):
    - Domestically owned banks: Change in CAR -4.2; New CAR 7.2; Change in profits -226.
    - Foreign bank subsidiaries: Change in CAR -3.9; New CAR 7.2; Change in profits -414.
    - Banks below 8 percent CAR: 8.
- Combined scenario (stress tests 2 + 4):
  - Impact: reduces the capital ratio of domestic banks by 4.8 percentage points (paragraph 28).

### Supervisory assessment and policy recommendations
- Supervisory capacity and prudential actions (paragraphs 29–31):
  - Supervisors should limit adverse effects on banking soundness as competitive pressures increase with EU accession and interest rate spreads narrow by:
    - Closely monitoring profitability, credit risk and loan pricing.
    - Being prepared to take prompt action to facilitate the orderly exit of weak banks.
  - To limit risks from rapid credit growth:
    - Evaluate banks’ credit risk management capabilities.
    - If inadequate, consider prudential tools, including provisioning policies.
  - Monitor banks’ indirect credit risk from corporate sector foreign currency exposure and ensure adequate consideration in lending decisions and loan pricing.
- Strengthening supervision and tools (paragraph 30):
  - Supervisors need capacity to assess how banks measure and quantify risks to foster appropriate pricing of risk and adequate provisioning.
  - More use could be made of the credit register and corporate database to assess corporate credit risk.
  - The Bank of Slovenia (BoS) should consider how different prudential tools could be used, including exploring adaptation of the Bank of Spain dynamic provisioning model to the Slovenian situation.
  - Intensify consolidated supervision of domestic conglomerates, including intra-group transactions and risk transfers; this requires increased supervisory resources.
  - BoS has an action plan to implement Basel Core Principles recommendations, including off-site monitoring of connected lending and guidelines for best practices.
- Insurance and pensions supervision (paragraph 31):
  - Address lack of transparency in life insurance sector financial positions.
  - Address risks from guarantees that transfer borrower credit risk from banks to insurers—insurers should adopt risk management, pricing, provisioning, and capital structures to match product guarantees.
  - Strengthen independence of supervisory agency (current laws leave administrative and budgetary authority with the government); consider training programs and technical assistance.
  - Provide responsible officers with indemnity against legal actions.
  - Close supervision gap in the pensions sector split between securities market and insurance supervisory agencies.
- Institutional and legal framework considerations (paragraphs 32–33):
  - Securities market supervision: most enforcement powers in place; amendments to the Securities Law will allow fines to be levied from January 2005; supervisors still lack indemnity against legal actions.
  - Proposal for a single regulatory agency to replace lead supervisor approach—preconditions for success include:
    - Consistent risk-focused approach across the three areas of supervision.
    - Ensured independence and adequate staffing (may require legislative transfer of powers).
    - Comprehensive strategy to harmonize regulatory powers and supervisory practices.
    - Implementation timing should avoid periods when the financial system is under stress or undergoing rapid change.
    - Effective mechanisms for timely provision of supervisory information to the central bank for macro-prudential surveillance and crisis management.

*Source: Bank of Slovenia; content unit _cr04137 (sections 21–33).*

### 34.      Both the integrated supervisor and lead supervisor models can be successful

### _cr04137 - 34.      Both the integrated supervisor and lead supervisor models can be successful

### Supervisory models for financial conglomerates
- Both the integrated supervisor and lead supervisor models can be successful models for supervision of financial conglomerates.
- Rationale for integrated supervisor model:
  - Potential to more effectively use scarce supervisory resources.
  - Scope for exploiting synergies.
- Limitations and considerations:
  - Benefits depend on the structure of the conglomerates; benefits might be limited or absent if one type of institution dominates the conglomerate (e.g., a large bank with a small insurance subsidiary).
  - Transition risks during implementation must be considered.

### Summary of key recommendations to address vulnerabilities
- The current BoS monetary policy framework can effectively limit risks to exchange rate stability in the transition to EMU, but the BoS should develop the market infrastructure and gradually rely more on market intervention to prepare for EMU and strengthen the banking sector.
- Banking supervision should strengthen its risk focus and ensure that pricing of risk and provisioning are appropriate and give consideration to how prudential tools, including provisioning policies, could be used to address risks.
  - The BoS could continue discussions with Bank of Spain exploring the scope for adapting the dynamic provisioning model used in Spain to the Slovenian situation.
  - These efforts may require an expansion of supervisory resources.
- Insurance supervision needs to:
  - Strengthen the independence of the ISA.
  - Develop the technical skills of its staff (possibly making use of technical assistance).
  - Provide senior staff with protection against legal actions for carrying out their duties.
  - Clarify responsibility for supervision of pensions.
- In considering creation of a unified supervisory agency, the authorities need to assess whether the preconditions are in place and determine the most appropriate time to proceed taking into account the stresses on the financial system.

### Implementation of recommendations from the 2001 FSAP — overview
A. Liquidity and Foreign Exchange Management Arrangements
- 2001 FSAP recommendations included:
  - the foreign currency liquidity requirement should be gradually reduced or, if retained, should be on an average basis;
  - the rule that this requirement should be met with BoS bills should be ended and replaced by stipulated classes of acceptable assets; and
  - reserve requirements should be made uniform across maturities to remove the implicit tax on deposits and remunerated at market-linked interest rate.
- Update on Implementation Progress:
  - Arrangements for liquidity management have not fundamentally changed although a number of specific recommendations have been implemented such as those related to reserve requirements.
  - The foreign currency liquidity requirement has been retained with an arrangement that favors use of BoS bills.

B. Interconnectedness of the Financial System
- 2001 FSAP recommendations included:
  - the BoS should supervise banks based on consolidated accounts and pay special attention to related-party lending, especially to shareholders;
  - cross-sector supervisory cooperation need to be strengthened; and
  - the regulatory gap from the absence of insurance company investment guidelines urgently needs to be addressed (this was scheduled to occur in January 2003).
- Update on Implementation Progress:
  - The system remains highly interconnected, with the formation of financial conglomerates increasing cross sector linkages since the 2001 FSAP.
  - Legal provisions on the review, approval, and disclosure of related party transactions could be strengthened further, but supervisory oversight has improved and is consistent with EU guidelines.
  - Banking supervision is on a consolidated basis but there is scope to strengthen cross-sector supervisory cooperation.
  - The gap in insurance regulation was closed.

C. Strengthening of Financial Sector Infrastructure
- 2001 FSAP recommendations included:
  - the replacement ratio of the pension system needs to be addressed, as the system is actuarially unsound and requires budgetary support of around 4 percent of GDP;
  - obstacles to the development of the stock market must be removed by: (i) leveling the playing field in terms of taxation of capital gains and income; (ii) recapitalizing the privatization investment funds to reduce the risk of instability when they are transformed into open-ended mutual funds; and (iii) improving disclosure, especially regarding acquisitions; and
  - reduce the period that is often required to resolve disputes in courts to lessen the disincentive to enforce contracts.
- Update on Implementation Progress:
  - The fiscal challenges implicit in the current pension system have not been addressed, although there is a growing recognition of the need to take action over and above the incremental steps implemented to date.

### Summary assessments of standards and codes (ROSC overview)
- Assessed standards: Basel Core Principles for Effective Banking Supervision, and the IAIS Insurance Core Principle.
- Assessment process:
  - Detailed assessments undertaken based on a collegial peer review process as part of the FSAP update.
  - Marcel Maes responsible for the Basel Core Principles and Rodney Lester responsible for the Insurance Core Principles.
  - Slovenian authorities completed self-assessment questionnaires; responses were clarified and checked through discussion with authorities and market participants.
- Key findings:
  - Banking supervision was fully or largely compliant with a large number of core principles and had improved in some areas relative to the 2001 assessment.
  - Insurance Core Principles were evaluated under the new methodology, contributing to downgrades in a number of areas; the ROSC details areas of low compliance that need to be addressed.
  - Securities market supervision had a high degree of compliance in the 2001 assessment and authorities have undertaken reforms to address remaining weaknesses.
  - An important area needing strengthening across banking, insurance and securities market supervision is the lack indemnity for supervisors against legal action.

### Basel Core Principles — institutional and macro-prudential overview (selected findings and statistics)
- As at June 30, 2003:
  - Slovenian banking system comprised 20 banks with total assets of SIT 4,832.6 billion, 2 savings banks with total assets of SIT 17.2 billion, and 14 savings and loan institutions with total assets of SIT 42.9 billion.
  - The ratio of the aggregate total assets of the system to gross domestic product (GDP) is almost 80 percent.
  - Supervision of these institutions was carried out by a staff of 54 employees (on June 30, 2003) in the Banking Supervision Department of the Bank of Slovenia.
- Ownership and market concentration:
  - In 2002, sale of 39 percent of the government share in the biggest bank turned the government into a minority shareholder, decreasing state ownership in the overall banking system to around 20 percent.
  - Foreign ownership of banking system equity more than doubled in 2002 to stand at 32.5 percent as at 31 December, and rose slightly further to 33.1 percent by the end of June 2003.
  - At the end of 2002, of the 20 banks: six were in majority foreign ownership (including one branch of a foreign bank), six were wholly domestically owned, and eight were in majority domestic ownership. Of the last group, half had less than 1 percent foreign equity ownership.
  - Market share statistics at end-2002:
    - largest bank market share (unconsolidated total assets): 35.5 percent, or 39.3 percent including its three subsidiaries.
    - market share of the three largest banks: 55.4 percent.
    - market share of the seven largest banks: 80.6 percent.
- Performance and pressures:
  - Banks ended 2002 with pre-tax profits of SIT 46.0 billion; only three banks posted a loss.
  - Results were up by SIT 30.6 billion on 2001 before taking into account SIT 19.5 billion in losses by a major bank.
  - Slovenian Accounting Standards changes: general capital revaluation is undertaken only if appreciation of the Euro against the Tolar in the preceding financial year exceeds 5.5 percent (in 2001 this appreciation was 4.7 percent).
  - Growing pressure on earning capacity in 2003 due to ongoing erosion of interest margins likely to reduce bank profitability.
  - Anticipated responses by banks: introduction of new fee generating financial products and higher risk taking in both balance and off-balance operations.
  - Supervisor should enhance attention toward risk management issues.

### Main findings on supervision capacity and gaps
- BoS supervision responsibilities have increased rapidly driven by prospective EU-membership and alignment to EU regulation, triggering extensive secondary legislation and recommendations.
- Capacity concerns:
  - Salary scales are not adequate to attract and retain qualified staff, leading to high turnover, especially regarding on-site examination staff.
  - A structural change of remuneration conditions should be envisaged and given highest priority to maintain an efficient and adequately staffed supervisory organization.
- Major issues highlighted:
  - Insufficient level of salaries compared to other financial institutions undermines ability to attract and maintain necessary professional skills.
  - Need to introduce in the Banking Act (BA) the requirement that banks lend to persons in a special relationship with the bank on an arm’s-length basis.
  - Consolidated supervision shortfall: BoS has not installed a mechanism for systematic evaluation of risks from nonbanking elements in a banking group; efforts strongly recommended.

### Principle-by-principle findings (selected)
- Objectives, autonomy, powers, and resources (CP 1):
  - Prudential regulations are sound; BoS commended for enhancements, but salary scheme insufficiency and need for legal protection of supervisory staff must be addressed.
- Licensing and structure (CPs 2–5):
  - Effective licensing authority in place with fair and equitable criteria.
- Prudential regulations and requirements (CPs 6–15):
  - BoS requires licensed banks to maintain capital commensurate with risk; in practice all Slovenian banks operate at capital adequacy levels in excess of required limits.
  - BoS supervision addresses general credit policy, loan approval procedures, loan utilization and repayment procedures, and delimitation of competencies for loan approval.
  - Recommendation to revisit role of supervisory board in credit decisions; enhance prudential reporting of connected lending and corporate governance in this area.
  - BoS reviewed banks’ adherence to anti-money laundering requirements.
  - A BoS decree requires an annex to auditors’ reports covering compliance with risk control rules and internal audit activities.
- Methods of ongoing supervision (CPs 16–20):
  - Off-site supervision relies on accounting statements, prudential reporting and risk-based analysis; on-site examinations follow a predetermined schedule adjusted by off-site results.
  - Depth and frequency of supervision hampered by resource constraints and high staff turnover; additional synergies with external auditors should be explored.
  - BoS required banks to manage risks on a group basis but lacks a mechanism for systematic evaluation of risks from nonbanking elements in banking groups.
- Information requirements (CP 21):
  - BoS established requirements for adequate accounting, records and internal control systems; annual and consolidated annual reports must be adequately audited by a certified public accountant.
- Formal powers of supervisors (CP 22):
  - BoS has legal authority to restrict bank activity, revoke licenses, and object to potential controllers or shareholders; in practice the BoS often seeks remedial action through moral suasion.
- Cross-border banking (CPs 23–25):
  - BoS has legal means to supervise activities of EU and foreign branches of Slovenian banks.
  - Global consolidated supervision is exercised in practice but only on a limited scale; future supervisors will need additional training.

### Recommended Action Plan to Improve Compliance of the Basel Core Principles (selected items)
- CP 1.2 Independence:
  - the insufficiency of the salary schemes of supervisory staff will have to be addressed in order to be able to attract and maintain the appropriate mix of skills.
  - perform an in-depth analysis of the supervisory objectives and the means needed to fulfill those objectives.
- CP 1.5 Legal protection:
  - appropriate legal protection of the supervisory staff must be established.
- CP 7 Credit Policies:
  - revisit the role of the supervisory board in credit decisions.
- CP 9 Large Exposure Limits:
  - enhance off- and on-site supervision of large exposures.
- CP 10 Connected Lending:
  - enhance prudential reporting.
  - introduce legal requirement that loans to persons in special relationship with the bank are extended at arm’s-length.

*Source: _cr04137 - 34.      Both the integrated supervisor and lead supervisor models can be successful*

### 12. Market Risks

### 12. Market Risks

### Immediate supervisory actions (extracted checklist)
- accelerate training of recently hired staff
- issue additional guidelines on operational risk
- explore additional synergies with the external auditors in order to maximize efficiency
- fulfill the primary target of bi-annual meetings with bank management
- organize enhanced comprehensive analysis of consolidated financial information
- install mechanism for systematic evaluation of risks from nonbanking elements in banking group
- increase scope and enhance practice of global consolidated supervision

### IAIS Insurance Core Principles — General overview
- Assessment of the insurance regulatory and supervisory system in Slovenia carried out as part of a joint World Bank/ IMF FSAP; follow-up to the Slovenian 2001 FSAP.
- Primary focus: effectiveness of the Insurance Supervision Agency (ISA), a statutory body set up on June 1, 2000.
- Amendments to the law remain the responsibility of the Ministry of Finance.
- EU Directives generally supersede local law; Insurance Law due to be extensively amended in anticipation of Slovenia’s entry into the EU on May 1st, 2004.
- Assessment period: carried out between November 12 and November 21, 2003.

### Institutional and macroprudential setting — key statistics and market structure
- Total written premiums in 2002: SIT 266 billion (US$1.4 billion).
- Insurance penetration (premium as percentage of GDP, including health): 5.1 percent.
- Property and casualty share of premium income: 54.9 percent (down from 65 percent in 1997).
- Life insurance share: 19.5 percent (17.5 percent in 1999).
- Sector financial investments as at June 30, 2003: SIT 422 billion; equates to 8 percent of GDP (up from 6 percent in 1999).
- Sector investments (before pensions assets) represent 20 percent of household savings in banks.
- Supplementary pensions assets (specialist pensions companies and pension mutual funds) as at June 30, 2003: SIT 35.9 billion; growing by approximately SIT 10 billion p.a.
- As of August 31, 2003, members in the new voluntary system: more than 212,000; 84 percent written through life insurance or pensions companies.
- Market participants: 19 insurers based in Slovenia, including 2 reinsurers, 1 specialist trade credit insurer and 1 mutual.
- Of 12 active “classic” insurers, 10 write both life and nonlife classes; four surviving pension companies.

### Market vulnerabilities and exposures
- Industry generally profitable following strengthening of provisions in 2001, but some insurers remain financially vulnerable.
- Industry efficiency: premiums per employee relatively low by northern/western European standards.
- Catastrophe exposure: major earthquake risk (19 earthquakes of intensity VII or greater in the last millennium); recommendation for a detailed loss potential study using modern modeling techniques.
- Credit risk concentration: concentrated with Triglav; Triglav appears to be assuming 100 percent of credit risk associated with most consumer loans (including overdrafts) issued by banks.
- Supplementary DC voluntary pensions: required guaranteed monthly return based on 40 percent of the long term (greater than 1 year) real government bond rate over the previous two years, adjusted upwards by an inflation index (TOM).
  - Pension institutions have hedged by investing in indexed bonds and bank deposits.
  - With bonds being issued in nominal terms and interest rates trending downwards, likelihood that no secure assets will be available to match the guarantee — indicating need to modify the guarantee and possibly introduce new product structures with higher long term returns and increased short term asset value volatility.

### Main findings
- Two significant differences from the 2001 assessment:
  - Employment of a new, substantially more demanding and searching methodology.
  - ISA assessed as a “going concern.”
- Since 2000: basic supervisory infrastructure built; 28 staff now in place (most committed and able but relatively inexperienced).
- ISA has established an impressive body of regulations, operating procedures, and systems.
- ISA actions since last assessment: on- and off-site analyses for all insurers; inspections of major insurers and those deemed at risk; administrative decisions including requests for capital injection into some insurers.
- Concerns identified: Agency’s organization and lack of independence; interaction issues between insurer accounting and prudential management principles; supervision of derivative and structured instrument exposures.

### Conditions for effective insurance supervision
- Macro management in Slovenia is effective; institutional settings well developed.
- No reason private insurance and pensions sectors could not be further developed.

### The supervisory system — governance and independence issues
- ISA is notionally independent but practical shortcomings exist:
  - Responsible officer is the President of the Chamber of experts (rather than the Director); no requirement that this person be a full time employee of the Agency.
  - At assessment time presidency changed to a civil servant working in a government department.
  - Budget control rests with the government rather than the ISA Council.
- Lack of legal protection for ISA responsible officers when carrying out normal activities in good faith.

### The supervised entity — governance and market conduct
- Criteria largely observed or will be after proposed amendments.
- Main concern: governance—supervisory boards not always as strong as required.
- Recommendation: Slovenia may take the lead in introducing a cooperation and information exchange protocol in the FRY countries.
- Market conduct regime relatively strong.
- Need for greater specificity and powers for ISA regarding withdrawal of an intermediary’s license when the intermediary is a legal person.
- Further regulation required to ensure insurers have procedures to ensure fair treatment of consumers.
- Industry has introduced claims resolution procedures and a related concordat.

### Ongoing supervision
- ISA has made a good start with relatively active on- and off-site inspection regime, though some activity has resembled audit rather than risk-based supervision.
- Current legal structure limits ISA’s ability to intervene early; recommendation to institute a regulatory ladder consistent with fully risk-based regimes (e.g., Canada and Mexico).
- Slovenia advanced in preparation for group and conglomerate supervision but should allocate more resources given deadlines (late 2004 for conglomerates).
- Need for coordinated supervisory approach given emergence of three potential financial conglomerates and fragmentation of pensions supervision.
- ISA has enforced difficult decisions including management changes and requiring increases in subscribed capital and reinsurance capital support.

### Prudential requirements
- Slovenia basically follows the EU prudential approach, which is recognized as inadequate if not supplemented.
- Appointed actuary is main line of defense; must allow for full balance sheet position when setting provisions.
- Actuarial profession is young but showing professional maturity; recommendation for an accelerated development program supported by a senior advisor from a risk-based jurisdiction.
- Concern: disconnect between actuarial and accounting professions; recommendation for a formal liaison committee if accounting standards change.
- Recently introduced standard on valuation of listed assets may have perverse impacts given liability valuation unchanged.
- Current Insurance Act deficient regarding derivatives and structured instruments and should be substantially strengthened.
- Recommendation: introduce balance sheet resilience testing (as a precursor to Solvency II) and review liability valuation assumptions given move to market valuation of assets.
- Recommendation: encourage composites to separate into life and non-life insurers.
- Recommendation: high risk classes such as credit insurance should ideally be written through appropriately capitalized, and separately licensed, specialist insurers.

### Anti-money laundering and combating financing of terrorism
- Legal underpinnings in place to deal with fraud and money laundering.
- Need to strengthen administrative and supervisory procedures at the ISA level.

### Table 5 — Recommended Actions (condensed by theme)
- Conditions for effective insurance supervision (CP 1):
  - Accelerate actuarial profession development program.
  - Establish actuarial–accounting standard coordination capacity (ideally a formal liaison committee).
- The supervisory system (CPs 2–5):
  - Reassess distribution of powers within ISA: Director to have day-to-day supervisory responsibilities; policy matters and important approvals remain with the Council of Experts.
  - Funding arrangements to ensure greater independence at the Council level.
  - Provide legal protection for responsible officials performing duties in good faith.
- The supervised entity (CPs 6–10):
  - Clarify role of Supervisory boards; require audit and risk committees (particularly if above 5 members).
  - Use recent precedent in Germany and Austria to address legal barrier concerns.
- Ongoing supervision (CPs 11–17):
  - Institute a risk-based formal early intervention regime supported by relevant law and regulation.
  - Allocate increased resources to preparations for the financial conglomerate supervision directive; nominate a lead supervisor.
  - Intensify coordination between the three financial supervisors.
- Prudential requirements (CPs 18–23):
  - Strengthen professional standing of the actuarial profession and coordinate actuarial and accounting standards and methodologies.
  - Review liability valuation assumptions given move to market valuation of assets; introduce balance sheet resilience testing.
  - Amend law to incorporate derivatives and structured instrument requirements of IAIS core principle.
  - Encourage separation of composites into life and non-life; high risk classes such as credit insurance to be written through properly capitalized and separately licensed specialist insurers.
- Markets and consumers (CPs 24–27):
  - Strengthen ISA’s powers regarding withdrawal of legal person intermediary licenses.
  - Impose insurer responsibility for information exchange at the consumer interface.
- Anti-money laundering (CP 28):
  - Law generally adequate; require more implementation activity at the supervisory level.

*Source: _cr04137 - 12. Market Risks*

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