## _cr06403 - Executive Summary

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### Executive summary: main findings
- Economic growth: GDP has tripled since 1995.
- Currency and inflation: Growth has been underpinned by the currency board arrangement (CBA), which has contributed to low inflation and confidence in the currency (the KM).
- Banking sector size and drivers:
  - Banking assets are now around 75 percent of GDP.
  - Expansion driven largely by the entry of subsidiaries of reputable European banks.
  - The six large foreign-owned bank subsidiaries accounted for 65 percent of total assets and deposits at end-2005 and hold more than 60 percent of total loans.
- Nonbank financial sector:
  - Insurance sector assets are 3.4 percent of GDP.
  - Equity markets show low turnover reflecting corporate governance weaknesses.
- Key vulnerability:
  - The large current account deficit was -21.3 percent of GDP in 2005.
  - Foreign-owned banks’ reliance on foreign funding creates risks to the sustainability of FX reserves.
- Overall resilience:
  - Financial system appears resilient to traditional solvency risks given parental support to subsidiaries.
  - Maintaining confidence in the currency should help limit potential pressures on FX reserves.
- Institutional gap:
  - Development of institutions providing oversight has not kept pace with private sector expansion; supervision needs strengthening.

### Structure and development of the financial system
- Banking sector:
  - Assets roughly 75 percent of GDP.
  - Rapid consolidation following privatization; most state-owned banks reduced or under provisional administration.
  - Financial system dominated by majority foreign-owned banks; banks from four countries hold more than 70 percent of foreign-owned bank capital in BiH.
- Nonbank sector:
  - Insurance: assets equal to 3.4 percent of GDP; 90 percent of premium income in 2004 was nonlife business; foreign-owned companies earn close to one-half of insurance premiums.
  - Leasing: outstanding leasing contracts grew by 74 percent between 2004 and 2005, reaching 190 million euros by end-2005; three of six leasing companies account for over 95 percent of leasing activity and rely largely on foreign parent funding.
  - Equity markets: relatively undeveloped with low turnover.

### Risks and vulnerabilities
- Transformation risk:
  - Dominance of foreign-owned subsidiaries shifts primary risk from solvency crises to sustainability of FX reserves due to reliance on parent funding.
- Credit growth and data weaknesses:
  - Rapid credit growth around 27 percent in 2005.
  - Foreign-owned banks account for 84 percent of loans; six largest foreign-owned banks account for 65 percent of total loans.
  - Indicative pretax ROE targets for subsidiaries roughly 20 to 25 percent before tax; example: Austrian bank groups earned 43 percent of their profits in the CEE region although only 23 percent of their assets were invested there.
  - Institutional weaknesses (credit monitoring, accounting, auditing, opaque ownership) may lead to underestimation of credit risk.
- Foreign funding, capital flows, and FX reserves:
  - Parent banks’ funding accounted for over 70 percent of all bank-related capital inflows in 2005.
  - Reported foreign funding costs in 2005 around 4-5 percent (EURIBOR plus 150-250 basis points).
  - Lending rates on long-term euro-indexed loans between 7 to 11 percent.
  - Domestically-owned private banks represent only 9 percent of banking system assets.
  - High euroization, the CBA, foreign-owned bank reliance on external funding, and large external imbalances increase reserve vulnerability.
- Contagion potential:
  - Reassessment of CEE risks could lead parent banks to cut exposures in BiH.
  - Austrian banks’ exposure to BiH is only 2 percent of their total CEE regional exposure but represents 68 percent of BiH borrowing from foreign banks.
- Supervisory and insurance weaknesses:
  - Weaknesses in loan classification and provisioning impede timely detection of credit risk build-up.
  - Insurance sector problems (discounted motor third-party liability premiums below floors) could weaken confidence and signal intent not to pay.

### Stress testing: scenarios and key quantitative results
- Focus: liquidity risk from (i) slowdown in credit growth reducing capital inflows and (ii) a potential shift from KM into euros as a second-round effect.
- Illustrative combined medium-sized scenario components:
  - Asset quality worsens by 10 percent.
  - Credit growth slows to zero.
  - A 10 percentage point shift of KM currency and deposits into euros.
- Combined scenario quantitative impact (Table 9 and text):
  - Reduces FX reserves by 29 percent (reported as -29.3 percent in table).
  - Reduces FX reserves by 7.6 percentage points of GDP.
  - Change in capital inflows: -1,051.7 (in mill. of KM).
  - Pre shock: FX Reserves 4.57 (In months of imports); FX Reserves/GDP 25.8 (In percent).
  - Stress Test 1 (Slowdown in credit growth): FX Reserves 3.8 (In months of imports); FX Reserves/GDP 21.5 (In percent); Change in FX Reserves -16.8 (In percent); Change in Capital Inflows -603.5 (In mill. of KM).
  - Stress Test 2 (Deposit shift from KM to euros): FX Reserves 4.2 (In months of imports); FX Reserves/GDP 23.8 (In percent); Change in FX Reserves -7.8 (In percent); Change in Capital Inflows -279.2 (In mill. of KM).
  - Stress Test 3 (Exchange of KM for euro cash): FX Reserves 4.4 (In months of imports); FX Reserves/GDP 24.6 (In percent); Change in FX Reserves -4.7 (In percent); Change in Capital Inflows -169.1 (In mill. of KM).
  - Pre shock growth rates cited: M0 = 9.1 percent; m2 = 18.5 percent; GDP growth = 6.5 percent.
- Interpretation:
  - System appears resilient to each shock individually; combined shocks produce substantial reserve losses warranting close surveillance.
  - Stress tests ignore macroeconomic feedbacks that could reduce the impact (for example, recession narrowing the trade balance).

### Policy recommendations (FSSA Priority Recommendations; verbatim priorities condensed)
- Enhance banking supervision and regulatory framework:
  - Upgrade supervision of bank provisioning and loan evaluation per BCP assessment.
  - Foster shift from foreign to local financing by: (i) relaxing tight limits on maturity and currency mismatches; (ii) introducing a regulatory capital charge for market and other risks from such mismatches; and (iii) possibly treating very stable “core” deposits as long term deposits for maturity matching purposes.
- Strengthen cooperation with home supervisors of foreign-owned banks:
  - Enhance consolidated supervision in line with BCP assessment recommendations.
  - Develop information sharing with home supervisors to assess parent bank condition and contagion risk.
- Develop a financial sector surveillance unit within the CBBH:
  - Ensure high-level meetings between the Governor and Banking Agency Directors use the unit’s outputs.
  - Report and disseminate financial surveillance analysis, possibly in a Financial Stability Report.
- Unify the two entity-level supervisors at the State level:
  - Draft a State-level Banking Law to ensure legal protection from political pressure.
  - Place the new agency within the CBBH as the most reliable way to ensure independence.
- Strengthen insurance supervision:
  - Issue necessary technical regulations and upgrade supervisory enforcement capacity urgently.
- Enhance corporate governance:
  - Strengthen disclosure of beneficial owners, transparency and quality of financial reporting, and accountability of corporate boards and managers in line with the Corporate Governance ROSC.

### Supervision, legal framework, and corporate governance priorities
- Supervision and legal protection:
  - Supervisory independence is compromised by inadequate legal protection; lifetime immunity for supervisors conducting duties in good faith and authority to levy higher fines recommended.
  - Supervisory unification at state level (preferably within CBBH) recommended with dedicated boards, administrative separation, and salary structures.
- Basel Core Principles (selected supervisory gaps and actions):
  - Account for market, country, and transfer risks in capital requirements.
  - Revise loan category definitions and provisioning percentages; establish reserves for foreign currency indexed loans.
  - Implement consolidated supervision and conclude MOUs with important foreign supervisors.
  - Improve IT and market-risk expertise within supervisory agencies.
  - Implement IAS/I IFRS by 2007 for companies above thresholds.
- Corporate governance and capital markets:
  - Fragmented laws across entities; new ISC to place accounting and auditing under a single state-level commission.
  - At end-2005, 1579 companies available for trading on the two exchanges (SASE and BLSE combined); typical daily trading low (45–55 on SASE; 35–45 on BLSE).
  - State ownership remains substantial (as high as 90 percent in some FBiH publicly traded companies; 65 percent in RS).
  - Recommendations include institutional capacity building for Securities Commissions, harmonization toward state-level regulation, introduction of a single BiH Code of Corporate Governance, improved transparency (including disclosure of indirect ownership), and strengthened investor protection.

### Selected economic and financial indicators (as presented)
- Real GDP: 2001 3.6  2002 5.0  2003 4.1  2004 5.8  2005 5.0
- CPI: 2001 3.2  2002 0.3  2003 0.6  2004 0.2  2005 2.8
- Credit to the private sector (in percent of GDP): 2001 13.7  2002 36.2  2003 24.8  2004 27.5  2005 27.5
- General government balance: 2001 -4.5  2002 -3.3  2003 -2.0  2004 -0.4  2005 0.9
- Current account balance: 2001 -13.3  2002 -19.1  2003 -20.9  2004 -19.3  2005 -21.3
- FDI (net, bank and nonbank): 2001 2.1  2002 4.3  2003 4.9  2004 6.6  2005 3.0
- Foreign loans: 2001 15.9  2002 4.6  2003 6.0  2004 2.5  2005 8.5
- Gross international reserves: 2001 22.5  2002 19.4  2003 20.8  2004 24.0  2005 27.1
- Monetary liabilities of the CBBH: 2001 21.4  2002 18.3  2003 19.5  2004 22.6  2005 25.7

*Source: Executive Summary, IMF Financial System Stability Assessment, Bosnia and Herzegovina.*

### Executive Summary ......................................................................................................

### _cr06403 - Executive Summary

### Executive summary: main findings
- Economic growth: GDP has tripled since 1995.
- Currency and inflation: Growth has been underpinned by the currency board arrangement (CBA), which has contributed to low inflation and confidence in the currency (the KM).
- Banking sector size and drivers:
  - Banking assets are now around 75 percent of GDP.
  - Expansion driven largely by the entry of subsidiaries of reputable European banks.
  - The six large foreign-owned bank subsidiaries accounted for 65 percent of total assets and deposits at end-2005 and hold more than 60 percent of total loans.
- Nonbank financial sector: Small but growing rapidly; insurance sector assets are 3.4 percent of GDP; equity markets show low turnover reflecting corporate governance weaknesses.
- Key vulnerability: The large current account deficit, equal to 21 percent of GDP in 2005, combined with foreign-owned banks’ reliance on foreign funding, creates risks to the sustainability of FX reserves.
- Risk channel highlighted: Recognition of a build-up of credit risk or contagion via international linkages could trigger a sudden slowing of credit growth, reduce capital inflows, and put pressure on FX reserves—an indirect effect in addition to the direct macroeconomic effect of slower credit growth.
- Overall resilience: The report concludes the financial system appears resilient to these risks and that maintaining confidence in the currency should help limit potential pressures on FX reserves.
- Institutional gap: Development of institutions providing oversight has not kept pace with the private sector; supervision needs strengthening to contain risks to financial stability.

### Box 1 — FSSA Priority Recommendations (verbatim)
1. Enhancing the banking supervision and regulatory framework
- Upgrade supervision of bank provisioning and loan evaluation, as recommended in the BCP assessment, to better identify build ups in credit risk and strengthen bank risk management.
- Foster a shift from foreign to local financing of credit by: (i) relaxing tight limits on maturity and currency mismatches; (ii) introducing a regulatory capital charge for market and other risks that can arise from such mismatches; and (iii) possibly treating very stable “core” deposits as long term deposits for maturity matching purposes.

2. Strengthen cooperation with the home supervisors of foreign-owned banks
- Enhance consolidated supervision in line with the BCP assessment recommendations.
- Develop information sharing with home supervisors of foreign-owned subsidiaries to assess the condition of parent banks and the risk of contagion from these banks’ activities abroad.

3. Develop a financial sector surveillance unit within the CBBH
- Ensure that the high-level meetings between the Governor and Banking Agency Directors on financial sector policies make effective use of the unit’s surveillance outputs.
- Report and disseminate financial surveillance analysis, possibly in a Financial Stability Report.

4. Unify the two entity-level supervisors at the State level
- Draft a State-level Banking Law that ensures adequate legal protection from political pressure.
- Place the new agency within the CBBH as the most reliable way to ensure independence.

5. Strengthen insurance supervision to avoid weakening confidence in the financial sector
- Issue the necessary technical regulations and upgrade supervisory enforcement capacity.

6. Enhance corporate governance to improve transparency of corporate sector risk
- Strengthen disclosure of beneficial owners, transparency and quality of financial reporting, and accountability of corporate boards and manages in line with the Corporate Governance ROSC.

### I. Macroeconomic and political environment — key points
- Postwar recovery: GDP has tripled since 1995; the consolidated fiscal deficit has fallen by 5 percentage points of GDP since 2001 so that the budget is now roughly in balance.
- CBA: Established in 1997; has contributed to low inflation and exchange rate stability.
- Governance and reform: Reform process partly driven by international community; stronger domestic ownership of reforms will be required given the complex, decentralized government structure (two largely autonomous regional entities and an autonomous district with a relatively weak state-level government).
- EU process: Negotiation of a Stabilization and Association Agreement with the EU was initiated in December 2005.
- Current account vulnerability: The large current account deficit was -21.3 percent of GDP in 2005 and remains well above sustainable levels.
- Counterpart to external deficit: Low private sector savings relative to investment appears to be the principal counterpart of the external deficit; the general government budget is roughly in balance.
- FX reserves and CBA mechanics: FX reserves rose in parallel with monetary liabilities of the central bank; under the rules of the CBA, monetary liabilities composed of currency and deposits by banks at the central bank must be fully backed by the FX reserves, so a decline in FX reserves will lead to a fall in monetary liabilities and a monetary contraction through the operation of the CBA.

### Table 1 — Selected economic indicators (as presented)
- Real GDP: 2001 3.6  2002 5.0  2003 4.1  2004 5.8  2005 5.0
- CPI: 2001 3.2  2002 0.3  2003 0.6  2004 0.2  2005 2.8
- Credit to the private sector (in percent of GDP): 2001 13.7  2002 36.2  2003 24.8  2004 27.5  2005 27.5
- General government balance: 2001 -4.5  2002 -3.3  2003 -2.0  2004 -0.4  2005 0.9
- Current account balance: 2001 -13.3  2002 -19.1  2003 -20.9  2004 -19.3  2005 -21.3
- FDI (net, bank and nonbank): 2001 2.1  2002 4.3  2003 4.9  2004 6.6  2005 3.0
- Foreign loans: 2001 15.9  2002 4.6  2003 6.0  2004 2.5  2005 8.5
- Gross international reserves: 2001 22.5  2002 19.4  2003 20.8  2004 24.0  2005 27.1
- Monetary liabilities of the CBBH: 2001 21.4  2002 18.3  2003 19.5  2004 22.6  2005 25.7
- Source: Central Bank of Bosnia and Herzegovina.

### II. Structure and development of the financial system — key findings
- Banking sector:
  - Assets relatively high at 75 percent of GDP.
  - Rapid consolidation following privatization of state-owned banks; number of state-owned banks has fallen sharply and most remaining are under provisional administration.
  - Financial system dominated by majority foreign-owned banks.
  - Banks from four countries hold more than 70 percent of foreign-owned bank capital in BiH (Figure 1 referenced).
- Nonbank sector:
  - Insurance: assets equal to 3.4 percent of GDP; 90 percent of premium income in 2004 was nonlife business; foreign-owned companies earn close to one-half of insurance premiums.
  - Leasing: outstanding leasing contracts grew by 74 percent between 2004 and 2005, reaching 190 million euros by end-2005; three of the six leasing companies (all subsidiaries of foreign banks or leasing companies) account for over 95 percent of leasing activity and rely largely on their foreign parent institutions for funding.
  - Equity markets: relatively undeveloped with low turnover, reflecting corporate governance weaknesses.

### III. Risks and vulnerabilities highlighted
- Transformation risk: Dominance of foreign-owned bank subsidiaries has transformed the financial sector and altered risks to financial stability—system more robust to traditional solvency crises because subsidiaries can typically draw capital and liquidity from parents, shifting primary risks to the sustainability of FX reserves.
- Foreign funding and current account mismatch:
  - Reliance of foreign-owned bank subsidiaries on foreign funding combined with a large current account deficit (21 percent of GDP in 2005) is a critical vulnerability.
  - Recognition of credit risk build-up or contagion via international linkages could trigger sudden credit slowdown, reduce capital inflows, and pressure FX reserves.
- Supervisory gaps: Weaknesses in oversight of loan classification and provisioning may impede effective bank management of credit risk and supervisory identification of build-ups in risk from rapid credit growth.
- Insurance sector risk: Unsettled conditions in insurance, including companies offering motor third-party liability premiums below prescribed floor prices, could weaken confidence in the financial system and may reflect intent not to pay.
- Corporate governance: Opacity of ownership structures, lack of accountability of boards and managers, and poor transparency and financial reporting weaken banks’ capacity to manage corporate sector credit risk.

### IV. Policy recommendations (high level)
- Strengthen banking supervision and align with Basel Core Principles (BCP); prioritize oversight of loan classification and provisioning to identify credit risk buildup.
- Increase banks’ flexibility to rely on local funding:
  - Relax tight prudential limits on maturity mismatches.
  - Introduce a capital charge for market and other risks arising from mismatches.
  - Consider treating very stable “core” deposits as longer-term deposits for maturity matching.
- Enhance cooperation with home supervisors of foreign-owned banks:
  - Sign memoranda of understanding (MOUs).
  - Strengthen consolidated supervision per BCP recommendations.
- Build financial surveillance capacity:
  - Create a financial surveillance unit in the CBBH to monitor risks to financial stability.
  - Ensure the unit’s analysis is integrated into high-level deliberations involving the Governor and heads of supervision.
- Unify entity-level supervisors:
  - Draft a State-level Banking Law ensuring legal protection from political pressure.
  - Place the unified supervisor within the CBBH to ensure independence, or set up as an independent agency with appropriate protections.
- Strengthen insurance supervision:
  - Upgrade supervisory enforcement capacity and issue necessary technical regulations urgently to avoid a crisis in the sector.
- Improve corporate governance:
  - Enhance disclosure of beneficial owners, transparency and quality of financial reporting, and accountability of corporate boards and managers in line with the Corporate Governance ROSC.

*Source: Executive Summary, IMF Financial System Stability Assessment, Bosnia and Herzegovina.*

### 6.      Micro credit institutions (MCIs) have a significant presence in BiH. At end

### 6.      Micro credit institutions (MCIs) have a significant presence in BiH. At end

### Micro-credit institutions (MCIs): size and funding
- At end 2004, there were 46 registered MCIs, although the number of active institutions is significantly less.
- Their credit portfolio totaled over 130 million euros with a client base of about 100,000.
- MCIs do not take deposits and were mostly established with donor funds but over the last two years have shifted their funding source toward bank loans.

### III. FINANCIAL SYSTEM RISKS AND VULNERABILITIES — Overview
- The domination of the banking system by large foreign banks has improved soundness but altered risk composition: the main risk is to the sustainability of FX reserves arising from potential capital flow volatility rather than a traditional banking solvency crisis.
- Key sources of risk:
  - Possible underestimation of a build up in credit risk from rapid credit growth (Section III.A).
  - Potential for a sharp slowing or fall in bank-intermediated capital inflows if banks reduce credit growth (Section III.B).
  - Potential for regional contagion through foreign-owned banks (Section III.C).
- The significance of these risks can be assessed using Financial Soundness Indicators (FSIs) and stress tests (Section III.D and Appendix).

### A. Credit Growth and underestimation of build-up in credit risk
Findings:
- Rapid credit growth was around 27 percent in 2005.
- Rapid credit growth can overstretch banks’ credit assessment capacity and temporarily depress reported nonperforming loans (NPLs).
- Institutional weaknesses contributing to underestimation of credit risk include lack of adequate credit monitoring tools and corporate governance weaknesses (weak accounting, auditing, financial reporting and disclosure, and opaque ownership structures).
- Poor quality of credit risk data limits effectiveness of foreign-owned banks’ risk models; banks relied heavily on collateral and third-party guarantors.
- Improvements: establishment of a collateral registry and the CBBH credit registry covering firms; planned extension of the CBBH credit registry to cover individuals.
- Data limitations: banks sometimes cannot identify when the same person has guaranteed multiple loans.
- Indexation risk: most KM loans are indexed to the euro, creating indirect credit risk for unhedged borrowers and potential moral hazard in underpricing/under-provisioning.
- Foreign-owned banks account for 84 percent of loans; the six largest foreign-owned banks account for 65 percent of total loans.
- Indicative ROE targets set by parent banks for subsidiaries in BiH are generally between 20 to 25 percent before tax in BiH.
- Example: Austrian bank groups earned 43 percent of their profits in the CEE region in June 2005, although only 23 percent of their assets were invested there.

Exact figures and citations preserved from source (selected):
- Credit growth around 27 percent in 2005.
- Foreign-owned banks account for 84 percent of loans.
- Six largest foreign-owned banks account for 65 percent of total loans.
- Indicative pretax ROE targets for subsidiaries in the CEE regions indicated by large Austrian, German, and Italian banks active in BiH is roughly 20 percent.
- Austrian bank groups earned 43 percent of their profits in the CEE region, although only 23 percent of their assets were invested there.

### B. Foreign funding of credit, capital flows, and FX reserves
Findings:
- Foreign-owned bank subsidiaries rely on long-term foreign funding, mostly from their parent banks.
- Domestically-owned private banks represent only 9 percent of banking system assets and generally use local deposits.
- Parent banks’ funding to BiH subsidiaries accounted for over 70 percent of all bank-related capital inflows in 2005.
- Reported foreign funding costs in 2005 were around 4-5 percent (EURIBOR plus 150-250 basis points), below interest rates on local long-term euro denominated deposits in BiH.
- Lending rates on long-term euro-indexed loans reported at between 7 to 11 percent.
- Strict maturity and currency matching requirements contributed to reliance on foreign funding; short maturity of local deposits limits their role.
- Balance sheet segmentation described:
  - euro-indexed loans mostly funded through long-term euro deposits and loans from abroad;
  - local short term KM deposits fund banks’ excess reserves (the only short term KM asset);
  - resident short term euro denominated deposits fund banks’ correspondent banks euro deposits abroad.
- Table 3 (six largest banks, June 2005) highlights currency and maturity composition (percent of total):
  - By currency: KM 29.2 32.6 ; FX 70.8 67.4
  - By maturity: ST 19.0 56.8 ; LT 81.0 43.2
  - By currency and maturity (Loans / Deposits in percent of total):
    - KM-ST 5.9 28.3
    - KM-LT 23.3 4.4
    - FX-ST 13.1 28.5
    - FX-LT 57.6 38.8
  - Resident (Loans / Deposits in percent of total):
    - KM - ST 5.9 27.7
    - KM - LT 23.3 4.0
    - FX - ST 13.1 25.9
    - FX -LT 57.6 18.0
  - Nonresident (Deposits in percent of total):
    - KM - ST n.a. 0.6
    - KM - LT n.a. 0.4
    - FX - ST n.a. 2.7
    - FX -LT n.a. 20.8
- Bank-intermediated capital inflows to finance credit contribute to increases in FX reserves because euro-denominated funding is converted into KM-indexed loans, directly increasing FX reserves.
- Figures 6 and 7 estimate contribution of foreign funding to FX reserves; international community support also increased FX reserves but is expected to diminish as it scales back involvement.
- Risk: a reduction in bank-intermediated capital inflows would lead to drawdown in FX reserves to finance the large current account deficit; shifts by residents from KM into euro cash or euro deposits would exacerbate reserve declines.
- Underlying features increasing risk to FX reserves: (i) high euroization; (ii) a fixed exchange rate regime (i.e., the CBA); (iii) a largely foreign-owned banking system reliant on external funding; and (iv) large external imbalances.

Exact figures preserved:
- Parent banks’ funding accounted for over 70 percent of all bank-related capital inflows in 2005.
- Foreign funding cost: EURIBOR plus 150-250 basis points → around 4-5 percent in 2005.
- Lending rates on long-term euro-indexed loans: between 7 to 11 percent.
- Domestically-owned private banks represent only 9 percent of banking system assets.

### C. Potential for contagion through foreign-owned banks
Findings:
- Rapid expansion of foreign-owned banks in BiH has contributed to stability but also to potential contagion from shocks elsewhere in the CEE region.
- Contagion channels:
  - Reassessment of risk in other CEE countries could lead parent banks to reassess exposures in BiH and slow or reverse credit growth.
  - Developments in banks’ home countries could trigger cuts to exposures in BiH.
- Large asymmetry in bilateral credit exposures: changes modest from parent-bank perspective can have large impacts on BiH.
  - Example: Austrian banks’ exposure to BiH is only 2 percent of their total CEE regional exposure but represents 68 percent of BiH borrowing from foreign banks.

Exact figures preserved:
- Austrian banks’ exposure to BiH is only 2 percent of their total CEE regional exposure but represents 68 percent of BiH borrowing from foreign banks.

### D. Assessing risks to financial stability
Findings:
- Robust FSIs and the capacity of foreign-owned banks to draw support from strong foreign parents suggest the banking system is highly resilient to a traditional solvency crisis.
- Reported capital adequacy ratios (CARs) are above the 12 percent minimum required by supervisors in all three key peer groups (Table 4).
- The CAR for the peer group of reputable foreign-owned banks is significantly lower, reflecting strategy of maintaining relatively low capital ratios in BiH subsidiaries to raise reported ROE; parents can be expected to provide additional funding or capital when needed.
- Stress-test results (Appendix): a 15 percent reclassification of performing and watch category loans into NPL categories would push CARs below the regulatory minimum only for large foreign-owned subsidiaries, which can typically draw capital from their parents.

Exact figures preserved:
- Regulatory minimum CAR: 12 percent.
- Stress test scenario: 15 percent reclassification would push CARs below the regulatory minimum only for large foreign-owned subsidiaries.

_Final source: IMF staff report text (section and figures as provided)._

### 21.      In view of the apparent soundness of the banking system, stress testing focused

### _cr06403 - 21.      In view of the apparent soundness of the banking system, stress testing focused

### Stress-testing findings and risks to financial stability
- Stress testing focused on risks arising from heavy reliance on potentially volatile bank-intermediated capital inflows to finance rapid credit growth, emphasizing liquidity risk from:
  - (i) a slowdown in credit growth that reduces capital inflows; and
  - (ii) a potential second-round effect if this triggers a shift from KM into euros, although the latter would be limited by continued confidence in the currency.
- These two shocks could result from recognition of a build up in credit risk or by contagion from abroad; they have a direct macroeconomic impact through a credit crunch and an indirect effect through reduced capital flows.
- The stress tests focus on the indirect effect through capital flows as it relates to risks to financial stability.
- System resilience:
  - The financial and monetary system appears resilient to a relatively modest loss in foreign exchange reserves associated with a fall in credit growth and the capital inflows financing it.
  - When combined with a shift from KM into euros the overall impact may be large enough to warrant concern.
- Hypothetical scenario (illustrative; not a prediction):
  - Credit growth slowing to zero and a 10 percentage point shift of KM currency and deposits into euros could reduce FX reserves by as much as 29 percent, or 7.6 percentage points of GDP.
  - These stress tests ignore macroeconomic feedback effects that could reduce the impact (for example, a recession narrowing the trade balance and slowing reserve loss).

### Policy priorities: focus and rationale
- Main policy focus:
  - Target risks related to potential volatility in bank-intermediated capital inflows rather than attempting to directly slow credit growth.
- Rationale:
  - The risk of a traditional banking system solvency crisis is very low.
  - Rapid credit growth financed largely by foreign funding may lead to underestimation of credit risk.
  - Foreign-owned banks have been adept at circumventing measures to control credit growth (see Box 2).
- Institutional response:
  - Strengthen surveillance capacity of the CBBH through creation of a new financial surveillance unit.
  - Integrate analysis of this unit into discussions by the CBBH Governor and Directors of the Banking Agencies, reflecting the greater importance of prudential policy to financial stability in a CBA.

### Prudential measures to improve credit-risk oversight
- Strengthen supervisors’ monitoring and enforcement of provisioning and loan evaluation in line with BCP assessment recommendations to ensure banks hold sufficient regulatory capital consistent with underlying risks, including indirect credit risk from euro-indexed lending to unhedged borrowers.
- Strengthen cooperation between BiH supervisors and home supervisors of foreign-owned banks; sign and implement MOUs with all home supervisors to ensure effective consolidated supervision.
- Improve quality of creditor information:
  - Require companies to provide accurate financial reports.
  - Extend the new CBBH credit registry to cover households as well as corporations.
- Encourage banks to tighten limits on debt-to-income and/or debt service-to-income ratios; supervisors could require use of more reliable household debt and income data on prudential grounds if signs of unsustainable credit-risk buildup appear.

### Policies to reduce risks from volatile bank-intermediated capital inflows
- Objective: encourage banks to diversify funding sources by fostering a shift from foreign to local financing of credit growth, thereby weakening the link between credit growth and capital inflows.
- Justification:
  - Foreign bank groups may not fully internalize risks from reliance on foreign funding due to (i) moral hazard from perceived guarantees of the CBA by the international community, and (ii) BiH exposures being a small share of parent banks’ overall exposure.
- Specific policy adjustments:
  - Relax very tight limits on maturity and currency mismatches and adopt a capital charge for market and other risks arising from such mismatches to:
    - Provide flexibility for banks to rely on shorter maturity local funding.
    - Provide a buffer and incentive to limit mismatches.
  - Allow banks to treat a proportion of sight and savings deposits that are statistically very stable as “core deposits” (banking industry practice known as “mapping”) to fund medium- and long-term loans.

### Expected effects and implementation cautions
- These policies should not have much impact on FX reserves but must be implemented gradually as they alter banks’ balance sheet structures and tend to make banks less liquid.
- As balance sheet segmentation is relaxed, banks are likely to rely more on shorter maturity local euro deposits to fund loans, which they can obtain by liquidating deposits in correspondent banks abroad; repatriation of these deposits will contribute to FX reserves but may be largely offset by smaller capital inflows from parent banks.
- Primary benefit: weaken the link between credit growth and capital inflows, reducing potential negative impacts on capital inflows and FX reserves and helping to maintain confidence in the currency.

### Strengthening banking supervision (institutional reforms)
- Progress made but key institutional weaknesses remain (identified in the BCP assessment): lack of independence and legal protection from political interference, and lack of unified supervision.
- Legal and governance measures:
  - Strengthen supervisors’ discretionary powers by eliminating uncertainty about legal immunity; lifetime immunity should apply to banking supervisors who conduct duties in good faith.
  - Grant supervisors authority to levy higher fines (current fines are too low to deter imprudent activities).
- Unification of supervision:
  - Supervision should be unified at the state level to ensure adequate independence and adapt to a single national banking market dominated by foreign-owned banks.
  - Unification within the CBBH is recommended to best assure operational independence and protection from political interference; CBBH has a high degree of operational independence.
  - Unification in the CBBH would facilitate closer cooperation between supervisors and CBBH staff, strengthening surveillance and oversight of foreign-owned banks.
- Required framework for unification within the CBBH:
  - Banking supervision directed by its own banking supervision board and management committee.
  - Administrative separation from rest of CBBH with a separate salary structure.
  - Regulatory decision making by an executive committee rather than solely by agency directors.
  - Adequate protection to the CBBH from potential legal actions against supervisors.

### Insurance supervision
- The insurance sector is too small to be systemically important, but rapid change and weak supervisory capacity pose a threat to confidence.
- Problems identified:
  - Fierce competition, particularly in motor third-party liability, and lack of supervisory enforcement have enabled discounted premiums below prescribed floor prices that would ensure solvency—possible intent not to pay future claims.
- Legal and institutional needs:
  - State and entity insurance laws provide a framework, but many technical regulations and enforcement capacity urgently need to be put in place.
  - State-level and two entity-level insurance supervision agencies have been given more autonomy under new legislation, but appointments to these agencies have been slow and they are not yet fully functional.

### Anti-Money Laundering / Countering Terrorist Financing (AML/CFT)
- A detailed MoneyVal assessment of compliance with FATF 40+8 recommendations was reviewed in July 2005.
- Authorities have made significant progress, including development of an effective state-level Financial Intelligence Unit.
- Additional progress is needed; technical assistance could help develop AML/CFT capacity building on MoneyVal recommendations.

### Corporate governance
- Lack of transparency and opaque ownership structures hinder banks’ ability to assess corporate-sector risk exposures.
- Opaque ownership limits banks’ capacity to monitor maximum group exposures and intra-group transaction risks.
- Recommendations to address corporate governance weaknesses are provided in the attached ROSC.

### Circumvention risk of using reserve requirements to slow credit growth (Box 2)
- Experiences with higher reserve requirements targeted at credit growth have been mixed due to circumvention by banks. Potential channels for circumvention include:
  1. Parent bank lending directly to borrowers rather than through local subsidiary.
  2. Parent bank channeling funds through nonbank corporations it controls, which then deposit in or lend to the subsidiary.
  3. Parent bank funding local nonbank institutions it controls or has arrangements with that lend directly to borrowers.
  4. Subsidiaries borrowing from or selling securities to unaffiliated nonbank institutions with access to low-cost funds from abroad.
  5. Foreign-owned nonbank financial institutions without links to large foreign-owned banks providing credit directly (e.g., leasing firms).
- BiH constraints:
  - Limited capacity to control circumvention even if the 20 percent cap on required reserves in the central bank law is removed, due to limits on coverage of the reserve base and lack of data on foreign parent banks’ financing activities.
  - Circumvention through unaffiliated foreign-owned nonbank institutions would likely be difficult to detect and control.

*Source: _cr06403 - 21.      In view of the apparent soundness of the banking system, stress testing focused*

### 37.      The banking sector dominates the financial system in BiH. Bank assets are

### _cr06403 - 37.      The banking sector dominates the financial system in BiH. Bank assets are

### Overview
- Bank assets are roughly 75 percent of GDP.
- The nonbank financial sector is very small; capital markets are in early stages of development.
- The banking sector is largely foreign-owned, which has contributed to the soundness of the financial system.
- Credit to the private sector increased by around 27 percent in 2005.

### Structure of supervision and general preconditions
- Banking supervision is conducted by two supervisory agencies: the Federation Banking Agency (FBA) in the Federation of Bosnia and Herzegovina (FBiH) and the Republika Srpska Banking Agency (RSBA) in the Republika Srpska (RS), each governed by separate entity-level legislation.
- There is cooperation and a Cooperation Agreement between RSBA and FBA; the CBBH is empowered to coordinate activities of the two entity agencies.
- Close collaboration exists between the two agencies and the Deposit Insurance Agency (DIA) on training, prudential reporting, and coordination of supervisory action.

### Main findings
- Supervisors in the FBiH and the RS have made substantial progress but significant weaknesses remain that undermine effectiveness (assessment against the Basel Core Principles (BCP) identified these weaknesses and provided recommendations).
- Supervision should be unified at the state level to ensure adequate independence, legal protection, and resources, and to adapt to a single national banking market dominated by foreign-owned banks.
- Of possible unification options, unification within the CBBH is identified as the option that can probably guarantee adequate independence and protection from political interference in current circumstances; a draft banking law was prepared but not approved by both entity parliaments.

### Federation Banking Agency — Summary Assessment (selected points)
- Objectives, autonomy, powers, and resources (CP 1)
  - Prudential regulations are generally sound.
  - Key weakness: inadequate legal protection for supervisors compromises independence.
  - Arrangements for information sharing with foreign supervisory authorities are lacking; an MOU with the supervisor of the Austrian banks is needed.
- Licensing and structure (CPs 2–5)
  - An effective licensing authority is in place with fair and equitable criteria.
- Prudential regulations and requirements (CPs 6–15)
  - Market, country, and transfer risks are not accounted for in capital analysis or requirements; adequate reporting for country and transfer risk is lacking.
  - Supervisors lack familiarity with market risk; regulations for monitoring and management of such risks should be issued.
  - Current definition of special mentioned loans should not include any loans past due more than 30 days.
  - Credit bureau and registry of movables information is inaccurate; difficulties exist in accurate valuation of collateral.
- AML/CFT (CP15)
  - FBA effectively carries out AML/CFT obligations; main responsibility lies with the State Agency for Investigation and Security (SIPA) and the FIU; assessment does not represent full AML/CFT evaluation (MoneyVal assessment endorsed July 2005 provides comprehensive evaluation).
- Supervisory methods (CP16)
  - Combination of full scope and targeted on-site examinations, off-site surveillance, and regular meetings provide thorough understanding of banks.
  - Weakness: lack of electronic systems specialists to assess reliability and accuracy of financial institutions' information.
  - FBA and RSBA do not conduct consolidated supervision; should be authorized to impose prudential standards on a consolidated basis and have direct unlimited access to subsidiaries.
- Information requirements (CP21)
  - FBA should clarify guidance on accounting methods for supervisory reports.
  - LOB requires accounts in accordance with International Accounting Standards; full implementation of IAS (notably IAS 32 and IAS 39) and International Standards for Audit is needed, particularly for asset quality evaluation.
- Formal powers of supervisors (CP22)
  - FBA has legal provisions to take regulatory action; monetary fines payable by managers and staff are relatively low and may not deter improper behavior.
- Cross-border banking (CPs 23–25)
  - Absence of formal MOUs with supervisors of important foreign-owned banks impedes best practice compliance; perceived lack of independence and presence of two supervisory authorities discourage foreign supervisors from signing MOUs with FBA.

### Federation of Bosnia and Herzegovina: Recommended Action Plan (selected entries preserved verbatim)
- Independence (CP1.2): -Strengthen corporate governance
- Legal protection (CP 1.5): -Provide comprehensive legal protection and coverage of legal defense costs
- Information sharing (CP1.6): -Conclude MOU with the Security Agency
- Capital Adequacy (CP6): -Account for market risk, country risk, and transfer risks  in capital analysis and requirements. While very low at present, such risks could grow and should be incorporated in the capital requirements. -Consult Rating Agencies regarding ratings for Government and the Central Bank obligations.
- Credit policies  (CP7): -IT specialists to assess the reliability and accuracy of the information supplied by the banks related to lending are required.
- Loan Loss Provisioning (CP8): -Revise definitions of loan categories and revise percentage of loan loss reserves. - Establish reserves for foreign currency indexed loans.
- Large Exposure Limits (CP9): -Analyze large exposures on a consolidated basis. -Improve the quality of the information required to evaluate collateral.
- Connected Lending (CP10): - Analyze connected lending on a consolidated basis.
- Country Risk (CP11): -Issue a decision specifically addressing country risk.
- Market Risk (CP12): -Introduce capital charges for foreign exchange and other market risks.
- Other Risks (CP13): -Issue specific standards for risk management that cover and better enforce  interest rate, operational and systems risks. -Establish capital requirements for other risks. -Training  should  be  increased  and  the  guidelines  for  examination procedures  for  other  risks  should be incorporated in the Onsite Supervision Manual.
- On site and offsite supervision (CP16): -Supervisors should enhance their expertise in verifying the accuracy of financial statements and management information. -Supervisors require targeted training in the areas of market risks.
- Off site Supervision based on bank reports (CP18): -Supervisors should collect, review and analyze reports from banks on a solo and a consolidated basis.
- Validation of Supervisory Information (CP19): -IT specialists who can assess the reliability and accuracy of the information supplied by the banks in the loan area are required.
- Consolidated Supervision (CP 20): -Implement a supervisory framework for evaluating risks arising from the non-financial activities of a banking group.
- Accounting Standards (CP21): -Implementation of IAS is required and should become effective in 2007. -Formally define qualifications of external auditor, and grant FAB the power to revoke an auditor’s license.
- Remedial Measures (CP 22): -Increase maximum amount of fines.
- Supervision Over Foreign Banks’ Establishments (CP 25): -Establish formal relations with foreign supervisors, including through MOUs.

### Authorities’ response
- Authorities indicated verbally they were satisfied with the assessment and raised no particular issues with the ratings; they were informed about opportunity to provide written comments but chose not to do so.

### Republika Srpska Banking Agency — Summary Assessment (selected points)
- Objectives, autonomy, powers, and resources (CP 1)
  - Prudential regulations are generally sound.
  - Key weakness: inadequate legal protection for supervisors compromises independence.
  - Past failure to confirm acting appointments for long periods undermined effectiveness; revenues may fall short of needed resources; relatively low salary scale prevents recruitment and retention of qualified staff.
  - Recommended addressing vacancies, planned retirements, and need to attract high quality staff without delay.
- Other assessment areas (CPs 2–25)
  - Comments made with respect to the FBA generally apply to the RSBA across licensing and structure, prudential regulations, methods of ongoing supervision, information requirements, formal powers, and cross-border banking.

### Republika Srpska: Recommended Action Plan (selected entries preserved verbatim)
- Independence (CP1.2):  -Guarantee adequate financial resources for the RSBA, review salary scales and staffing needs. -Ensure acting appointments to the RSBA are converted into regular appointments without excessive delay.
- Legal framework (CP1.3): -Amend secondary legal framework and ongoing supervisory practice.
- Legal protection (CP1.5): -Amend law in order to ensure legal protection to supervisors.
- Information Sharing (CP.6): -Conclude MOU with the Securities Agency.
- Capital Adequacy (CP6): - Account for market risk, country risk, and transfer risks  in capital analysis and requirements. While low at present, such risks could grow and should be incorporated in the capital requirements. -Consult Rating Agencies in order to establish  rating of obligation of the Government and of  the Central Bank.
- Credit policies  (CP7): -Hire IT specialists who can assess the reliability and accuracy of the information supplied by the banks in the loan area.
- Loan Loss Provisioning (CP8):  -Revise definitions of loan categories and revise percentage of loan loss reserves. - Establish reserves for foreign currency indexed loans.
- Large Exposure Limits (CP9): -Analyze large exposures on a consolidated basis. Improve quality of the information requested from banks to adequately  evaluate collateral.
- Connected Lending (CP10): -Analyze connected lending on a consolidated basis.
- Country Risk (CP11): -Issue a Decision to specifically address country risk.
- Market Risk (CP12): -Introduce capital charges for foreign exchange and market risks.
- Other Risks (CP13): -Issue specific standards for risk management and for better enforcement to include interest rate, operational and systems risks. -Establish capital requirement to cover other risks. -Increase training in this specialized area. -Issue  guidelines  for  the  examination  procedures  of  other  risks  and  incorporate  instructions  in  the  Onsite Supervision Manual.
- On site and offsite supervision (CP16):  -Hire IT experts to participate with the onsite and off site supervisors in the verification of the financial information submitted by the banks. -Supervisors require targeted training in the areas of market risks. -Enhance their expertise in procedures to verify the accuracy of the financial statements and of  management information systems.
- Off site Supervision based on bank reports (CP18): -Supervisors should collect, review and analyze reports from banks on a solo and a consolidated basis.
- Validation of Supervisory Information (CP19): -Ensure and verify implementation of all IAS and International Auditing Standards. -Establish limit on number of consecutive external audits carried out by the same firm and establish strict conditions for the reappointment of an External Auditor.
- Consolidated Supervision (CP20): -Implement consolidated supervision. -Provide for a supervisory framework evaluating risks of non-financial activities of a banking group.
- Accounting Standards (CP21): -Ensure Implementation of IAS by 2007. -Formally define qualifications of external auditor, and grant the Agency  the power to revoke an auditor’s license.
- Remedial Measures (CP22): -Increase maximum amount of regulatory fines.
- Supervision over Foreign Bank establishments (CP25): -Establish formal relations with foreign supervisors.

### Annex II: Corporate governance — selected facts
- Sarajevo Stock Exchange (SASE) and Banja Luka Stock Exchange (BLSE) began operating in 2002.
- At end-2005, 1579 companies were available for trading on the two exchanges, including 24 privatization investment funds (PIFs).
- On a typical day the shares of 45 to 55 companies are traded on the SASE and 35 to 45 on the BLSE.
- State ownership remains substantial: state shares as high as 90 percent in publicly traded companies in FBiH and 65 percent in RS.
- Hundreds of thousands of shareholders exist in each entity; PIFs can have tens of thousands of shareholders.
- There are no legal limits on foreign ownership in BiH.

*Source: _cr06403 - 37.      The banking sector dominates the financial system in BiH. Bank assets are*

### 64.      Each entity has a distinct Law on Enterprises (LE) and Law on Securities (LS).

### _cr06403 - 64.      Each entity has a distinct Law on Enterprises (LE) and Law on Securities (LS).

### Legal framework and harmonization
- Each entity has a distinct Law on Enterprises (LE) and Law on Securities (LS).  
- Some elements are “harmonized” across entities: Laws on Public Enterprises (LPE), Laws on Banking, and Laws on Insolvency.  
- New Laws on Accounting and Auditing will place accounting and auditing standards, testing, and oversight under the authority of a single state-level commission (ISC).  
- A state-level electronic platform for the local court registers is being introduced.  
- As an aspirant for membership in the EU, harmonization and moving functions to the state level are likely to continue to achieve compliance with the Acquis Communautaire.  
- Footnote data: This includes 774 companies (including 11 PIFs) on the SASE and 805 companies (including 13 PIFs) on the BLSE.

### Securities commissions, registries and investor protection framework
- Each entity has its own securities commission (SC) responsible for regulating capital markets and protecting investors.  
- Each entity uses a “triple registry” system: founding documents filed at a local court register; share ownership recorded in an entity-wide central registry of securities (CRS); issuers tracked in an entity-wide register of issuers maintained by the SCs.  
- Investor protection frameworks differ between entities; both shareholders and issuers have limited awareness of rights and obligations.  
- Shareholder powers described: place items on GMS agenda; approve changes to statutes; authorize dividends; approve increases to authorized capital and mergers; appoint auditor; call exceptional meetings; inspect certain company documents; call for a special audit; approve board remuneration. Preemptive rights during capital increases are limited and procedures differ between entities.  
- Shareholder participation: direct GMS attendance, proxies, or mail; some shareholder associations pool votes. Majority of shareholders hold ordinary, single vote shares. Pyramid structures not widely used.  
- Barriers to participation: no rules on timing of meetings in RS; FBiH timing rules unclear; agendas rigid; rules for cumulative voting in FBiH are mandatory but not always followed or well understood.  
- Related party transactions: disclosure in financial statements required but compliance poor; neither entity requires shareholder or explicit board approval; shareholder approval of large transactions required only in FBiH.  
- Mandatory bid rules: shareholders with at least 30 percent (FBiH) or 25 percent (RS) of a company’s shares must make an offer to other shareholders.  
- Conversion rules: each entity has different rules for conversion to a limited liability company; complaints that some conversions have not allowed small shareholders to exit.  
- PIFs: participate in shareholder meetings and board selection; represent hundreds of thousands of shareholders; RS PIFs may take controlling stakes, FBiH PIFs are not allowed to; PIFs are regulated by SCs but are not required and do not disclose or develop voting or corporate governance policies; legal provisions on conflicts of interest may be inadequate.

### Transparency and disclosure
- Companies produce basic financial statements, but annual reports often omit company objectives, foreseeable risk factors, stakeholder issues, and governance structures and policies.  
- Ownership reporting remains opaque: only direct ownership reported; “indirect ownership” referenced in law is not defined or used in practice. Recent CRS decisions to list the top ten owners of each company should significantly improve transparency.  
- Accounting and audit standards historically: each entity had its own standards based on outdated translations of IFRS and IAS with limited implementation and poor auditor oversight. Only companies with foreign owners or investment typically produced international-standard reports.  
- New ISC requirements: full IFRS and IAS compliance for all companies in BiH with revenue of one million KM or greater or 50 or more employees. Legislation not yet fully implemented at time of assessment; implementation will be challenging for companies and auditors not connected to the “big four”.  
- Access to information: basic company documents at local court register (not online); full financial statements available from specialized agencies; shareholders can request information from JSC at their own expense; many reports published in daily newspapers; exchange and SC websites contain growing company data.

### Company oversight and board structures
- Multiple board structures across entities:
  - FBiH: single “supervisory” board of nonexecutives.
  - RS: supervisory board and management board; RS companies with fewer then 100 shareholders can choose not to have boards; RS may have an optional executives committee distinct from management board.
  - SOEs under LPE: supervisory board and management board, with management board chosen by supervisory board (not directly elected by shareholders as in other RS companies).
  - Banks: single supervisory board in each entity.
- Result: multiple organs with same names performing different functions and limited market understanding of legal requirements and board powers. Few companies have specialized board committees.  
- Fiduciary duties: LE in FBiH requires supervisory board members to act in interest of shareholders and the company; in RS management board members are to act in the interest of the company. Practical implications are limited; suits against board members are rare.  
- No definition or requirements for “independent” board members in BiH. Management may not serve on supervisory boards in FBiH or RS; RS executive committee members limited to one third of management board. SOE board members may not be civil servants, members of government or parliament. No local training for board members to enhance independent judgment.

### SOE governance reforms and limits
- 2004 LPEs require open process for choosing SOE supervisory board members and give audit boards greater powers, including oversight of an independent internal auditor.  
- SOEs have been corporatized and separated from public administration; state-owned utilities now have independent regulators.  
- Governments and political parties still exercise significant direct influence through ministers or others who vote state capital in the GMS; SOEs retain non-commercial objectives that are often not explicit or consistent.

### Enforcement and redress
- Shareholders can call extraordinary GMS, request audits, and challenge GMS decisions. FBiH shareholders can demand company buyback of shares in certain cases; RS shareholders can bring suits against directors.  
- Restrictive/divergent legal provisions, limited court specialization, and costs of litigation reduce effectiveness of shareholder powers.  
- SCs actively police brokers and PIFs but cannot levy fines or bring cases directly against issuers (local prosecutors hold that responsibility). SCs have limited resources relative to the large number of companies.  
- Stock markets provide only basic surveillance; no other regulator has authority over capital markets or explicit mandate to protect shareholders. New codes of corporate governance in each entity have been issued but not fully implemented.

### Assessment recommendations (summary of Table 7)
- Institution Building (Immediate/Medium/Long term priorities):
  - Strengthen institutional capacity & competence of Securities Commissions; Securities Commissions prepare & adopt Institutional Development Plans. (Immediate)  
  - Prepare diagnostic and recommendations to improve SOE corporate governance based on OECD Guidelines. (Immediate)  
  - Raise awareness via seminars, discussions, training (ex. through IFC PEPSE). (Immediate)  
  - Give Securities Commissions authority to levy sanctions and take direct action against issuers (with appeals to courts). Revisions to Securities and related law. (Medium term)  
  - Prepare phased program to move securities and related supervision to state-level regulators; review costs and benefits; possible legal revisions. (Long term)  
- Legislative Framework (Immediate/Medium term):
  - Develop strategy for introduction of closed companies and other elements of new Law on Enterprises; establish state-level working group. (Immediate)  
  - Introduce a new state-level or tightly harmonized Law on Enterprises based on EU requirements. (Medium term)  
  - Upgrade and harmonize Laws on Securities and Investment Funds. (Medium term)  
- Boards and Oversight (Immediate/Medium term):
  - Introduce a single BiH Code of Corporate Governance covering traded companies, PIFs, SOEs & banks. (Immediate)  
  - Increase training for management and supervisory board members; establish domestic governance institute. (Immediate)  
  - Encourage independent board members; introduce common board structure for all traded companies. (Immediate/Medium term)  
  - Introduce board member duties in line with EU practice via new Laws on Enterprises. (Medium term)  
- Transparency and Disclosure (Immediate/Medium/Long term):
  - Fully implement new accounting and auditing regime; introduce standard annual report format. (Immediate)  
  - Improve direct disclosure through central registries; require disclosure of significant indirect ownership in line with EU Transparency Directive. (Immediate/Medium term)  
  - Improve access to company information including online court register & web portals; introduce “one window” for company information. (Medium/Long term)  
- Investor Protection (Medium/Long term):
  - Adopt common procedures for major and related party transactions, shareholder redress & changes in share capital. (Medium term)  
  - Adopt common provisions for tenders, control transactions, and company conversion; consider “mandatory tender offer” and “squeeze-out” rights. (Medium/Long term)  
  - Require investment funds to disclose and develop policies on ownership and conflicts of interest. (Long term)

### Macro-prudential analysis and stress testing (banking sector)
- Financial Soundness Indicators (FSIs) show reported capital adequacy ratios (CARs) are above the 12 percent minimum required by supervisors in all three key peer groups: foreign-owned bank subsidiaries, domestically owned private banks and state-owned banks.  
- Reported CAR for foreign-owned bank peer group is significantly lower (but still above 12 percent); this is attributed to parent banks’ strategy of maintaining relatively low capital ratios in BiH subsidiaries to raise reported ROE and providing additional capital as needed.  
- Relatively poor asset quality in state-owned and domestic private banks does not pose systemic risk because many state-owned banks are under provisional administration and domestic private banks constitute a small share of the system. NPLs for foreign-owned banks are low but may underestimate credit risk buildup.  
- Liquidity risk focus: foreign-owned banks’ ability to draw support from parents implies resilience to solvency crises; attention should be on liquidity risk related to foreign funding of credit. Recent trends in FX reserves, bank foreign funding contribution, and euroization ratios have been favorable but can worsen sharply in shocks.  
- Stress test scenarios combine shocks: (1) sharp deterioration in asset quality; (2) associated slowdown in credit growth reducing capital inflows; (3) potential loss of confidence in local currency with shift from KM into euros. A second “regional contagion” scenario starts from losses elsewhere triggering similar reassessment and second-round currency confidence effects.  
- Shock magnitudes and findings:
  - Loan reclassification shocks of 5, 10, and 15 percent moving performing/watch loans into NPL categories reduce average CAR for peer groups; only large foreign-owned banks see CAR fall below the regulatory minimum in these shocks.  
  - Credit growth slowdown shock scenarios to 10, 0, and -10 percent result in declines in FX reserves that are modest relative to overall stock and only partially reverse recent reserve buildup.  
  - FX reserves only exceed the monetary liabilities they back by around 5 percent (see Table 1).  
  - A variation where share of credit growth funding from abroad falls to 50 percent (versus 100 percent) under zero credit growth shock reduces the loss in FX reserves by half.  
- Conclusion: banking sector appears resilient to deterioration in loan quality given parental support and current reserve positions, but liquidity and foreign-funded credit vulnerabilities merit monitoring; stress tests used sensitivity analysis given limited regional experience.

*Source: Assessment chapter text from the provided IMF content unit.*

### 86.      The third shock is a shift from KM cash into euro cash and a shift from KM

### _cr06403 - 86.      The third shock is a shift from KM cash into euro cash and a shift from KM

### Description of the third shock
- The third shock comprises:
  - A shift from KM cash into euro cash.
  - A shift from KM bank deposits into euro bank deposits.
- Trigger: could be triggered by a large enough fall in FX reserves from the second shock.
- Mechanisms and effects:
  - The shift into euro cash reduces FX reserves directly.
  - The shift into euro deposits reduces FX reserves because the prudential currency matching requirement forces banks to exchange their KM excess reserves at the CBBH for FX reserves and place them abroad in correspondent banks (the only short term euro asset available).
- Magnitude illustrated in Figure 13 for a 5, 10, and 15 percentage point shift of KM currency and deposits into euros.

### Stress test findings (individual and combined shocks)
- Individual shock impact:
  - By itself, the third shock "has a moderate impact on FX reserves that could probably be absorbed."
- Combined shocks (medium-sized scenario):
  - Components of the medium-sized shocks:
    - Asset quality worsens by 10 percent.
    - Credit growth slows to zero.
    - A 10 percentage point shift of KM currency and deposits into euros.
  - Cumulative impact:
    - Reduces FX reserves by 29 percent.
    - Reduces FX reserves by 7.6 percentage points of GDP.
    - Table 9 reports a combined change in FX reserves of -29.3 percent and a change in capital inflows of -1,051.7 (in mill. of KM).

### Key quantitative results (from Table 9 and text)
- Pre shock:
  - FX Reserves: 4.57 (In months of imports)
  - FX Reserves/GDP: 25.8 (In percent)
- Stress Test 1. Slowdown in credit growth:
  - FX Reserves: 3.8 (In months of imports)
  - FX Reserves/GDP: 21.5 (In percent)
  - Change in FX Reserves: -16.8 (In percent)
  - Change in Capital Inflows: -603.5 (In mill. of KM)
- Stress Test 2. Deposit shift from KM to euros:
  - FX Reserves: 4.2 (In months of imports)
  - FX Reserves/GDP: 23.8 (In percent)
  - Change in FX Reserves: -7.8 (In percent)
  - Change in Capital Inflows: -279.2 (In mill. of KM)
- Stress Test 3. Exchange of KM for euro cash:
  - FX Reserves: 4.4 (In months of imports)
  - FX Reserves/GDP: 24.6 (In percent)
  - Change in FX Reserves: -4.7 (In percent)
  - Change in Capital Inflows: -169.1 (In mill. of KM)
- Combinations of 1, 2, and 3:
  - FX Reserves: 3.2 (In months of imports)
  - FX Reserves/GDP: 18.3 (In percent)
  - Change in FX Reserves: -29.3 (In percent)
  - Change in Capital Inflows: -1,051.7 (In mill. of KM)
- Pre shock growth rates cited:
  - M0 = 9.1 percent
  - m2 = 18.5 percent
  - GDP growth = 6.5 percent

### Interpretation and caveats
- The system appears resilient to each shock individually, but combined impacts on FX reserves are "substantial enough to justify careful surveillance of these sources of risk."
- The reported cumulative impact "is substantial (and the same) under both scenarios" but could be softened by offsetting effects:
  - Slower credit growth should reduce imports (with a lag), which would reduce the current account deficit and therefore the loss in FX reserves associated with the shocks.
- Uncertainty: "It is of course impossible to estimate the probability or size of these shocks with any degree of precision," motivating the need for "close surveillance of these risks."

*Source: _cr06403 (excerpt; IMF staff estimates and supporting agency data).*

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