## Executive Summary — _cr08160

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### Background and recent developments
- Financial sector progress since 2002 FSAP: rapid growth in banks and nonbank financial institutions (NBFIs); strengthened regulatory and supervisory frameworks; improved financial sector infrastructure aligned with EU directives in a predominantly foreign-owned banking system.
- 2002 FSAP findings largely addressed; remaining supervisory weaknesses concentrated in nonbank financial sector and group supervision.

### Macro-financial setting and sources of risk
- Rapid (though slowing) growth of bank credit to the private sector accompanied by rising asset prices, widening current account deficit, and external debt.
- Key indicators:
  - Real estate price data: average annual increases of about 9 percent over 2002–07.
  - Stock price increases: rising by 60 percent annually in 2006-07.
  - Current account deficit: 8.6 percent of GDP at end-2007.
  - External debt: 87.8 percent of GDP at end-2007.
  - Inflation: picked up to above 6 percent year-on-year in early 2008.
- Vulnerabilities:
  - Majority of loans at variable interest rates and linked to foreign currency.
  - Banks dependent on foreign funding — exposed to interest- and exchange-rate induced credit risks and cross-border contagion risk.
  - No direct exposures to the subprime market developments, but EMBI spread rose from historical lows in mid-2007 and remained high compared with other emerging European countries; widening CDS spreads.
  - Recent stock market falls (March 2008) partly due to liquidity disturbances from renewed global market tensions.

### Overall stability assessment
- Financial sector broadly healthy: banks’ profitability satisfactory; capital adequacy and asset quality at comfortable levels.
- Emerging vulnerabilities related to rapid credit growth, external imbalances, and rising asset prices.
- Supervisory strengths: CNB effective bank supervision framework; progress toward international best practices; risk-focused supervision evolving; Basel II preparations on track.
- Supervisory gaps: clarity on supervision of banking groups with nonbank operations; need systematic identification and supervision of group risks.

---

### Household, Corporate, and Banking Sector Vulnerabilities

### Household indebtedness and exposures
- Household debt: over 40 percent of GDP as of end-September 2007.
- Share of bank lending to households: rose from around 33 percent of total loans in 1998 to 55 percent in 2005, subsequently stabilized around this level.
- About 40 percent of household loans are for housing.
- Close to 70 percent of bank loans are denominated or indexed to foreign currencies, mainly the euro.
- Share of all unhedged loans in total bank loans: 90 percent at end-2007.
- Household sector unhedged items exposed to currency-induced credit risk: 95 percent; housing loans hedged: 2 percent (CNB Banks Bulletin 15, 2007).
- Less than 20 percent of all outstanding loans are at fixed rates; majority are floating rate and re-calculated quarterly.
- Average maturity of mortgage loans: around 20 years.
- Resulting risks:
  - Indirect FX risk to banks from FX-linked loans to mostly unhedged customers.
  - Credit risk via customers’ interest rate exposure due to floating-rate, frequently re-priced loans.

### Corporate debt and performance
- Non-financial corporations’ debt: 59 percent of GDP at end-2006.
- Debt owed to banks: around 57 percent of total corporate debt in 2006.
- 54 percent of corporate loans are FX-linked.
- Corporate return on equity: rose from 1.8 percent in 2003 to 5.1 percent in 2006.
- NPLs: ratio falling but absolute amount remained relatively stable.

### Key banking sector financial-soundness figures (selected)
- Household debt to GDP: 24.7 (2002), 28.9 (2003), 31.8 (2004), 35.5 (2005), 40.3 (2006), 40.3 (2007 1/ September 2007).
- Return on equity (commercial banks): 13.7 (2002), 14.1 (2003), 16.1 (2004), 15.1 (2005), 13.0 (2006), 11.8 (2007 1/).
- Regulatory capital to risk-weighted assets (commercial banks): 17.4 (2002), 16.5 (2003), 16.0 (2004), 15.2 (2005), 13.6 (2006), 16.1 (2007 1/).
- Nonperforming loans to total gross loans: 10.2 (2002), 8.9 (2003), 7.5 (2004), 6.2 (2005), 5.2 (2006), 4.9 (2007 1/).
- Foreign currency-denominated loans to total loans: 75.8 (2002), 70.9 (2003), 76.6 (2004), 77.8 (2005), 69.6 (2006), 60.8 (2007 1/).
- Foreign currency-denominated liabilities to total liabilities: 76.0 (2002), 76.1 (2003), 78.1 (2004), 78.8 (2005), 77.9 (2006), 73.8 (2007 1/).
- Liquid assets to total assets: 17.6 (2002), 18.7 (2003), 16.1 (2004), 11.5 (2005), 12.6 (2006), 11.1 (2007 1/).
- Capital adequacy ratio (CAR): recovered to 16 percent after dropping to 13.6 percent in 2006.

### Stress-test scenarios and principal findings
- Scenarios simulated: slow-down or reversal in capital inflows; euro-area slowdown with spillover; higher global interest rates with sharp kuna depreciation; rise in NPLs.
- Capital inflow reversal scenario (significant kuna depreciation and higher interest rates):
  - CAR would fall below the 10 percent regulatory minimum for 21 of 33 banks with a total of 55 percent of system assets.
  - Five banks would become insolvent.
- Euro-area slowdown and higher global interest rates:
  - Would significantly reduce banks’ capital but leave aggregate CAR above 10 percent; no insolvencies.
- Liquidity shock:
  - An outflow of 20 percent of bank liabilities with maturity up to three months would push system liquid asset ratios from 16 percent to 11 percent.
- Sensitivity to direct interest rate and exchange rate risks: negligible given limited FX mismatch and majority floating-rate loans.
- Heterogeneity:
  - Smaller banks and state-owned banks: greater vulnerability to direct and indirect credit risks.
  - Foreign-owned banks: greater vulnerability to liquidity and contagion risks due to parent funding dependence.
  - State-owned banks particularly vulnerable to liquidity shocks due to large maturity mismatches in at least one bank.

---

### Capital Markets, Nonbank Financial Sector, and Leasing

### Capital market developments and concerns
- Market capitalization: 133 percent of GDP at end-September 2007 (more than tripled since 2001).
- Overall turnover ratio: averaged 8.1 percent of capitalization.
- Low free float of many stocks contributes to low market liquidity and price volatility.
- Equities was the key driver of rapid capital market growth; significant price correction since early 2008.
- Favorable tax regime likely contributed to market popularity.
- Need for investor education to temper over-enthusiasm and herd behavior.

### Pension funds and insurance
- Mandatory pension funds (second pillar) introduced in 2002: total assets reached 7.7 percent of GDP by August 2007.
- Contribution rate: 5 percent (of gross salary).
- Investment restrictions: funds required to invest at least 50 percent of assets in government bonds and cannot place more than 20 percent in foreign assets; restrictions to be lifted on EU accession.
- Recommendation: contribution rate needs to be raised significantly, taking into account fiscal implications.
- Voluntary pension funds: small with modest participation; foreign securities limit restrictive; recommendation to remove small government co-contribution subsidy and liberalize foreign investment limits.
- Insurance sector: non-life reasonably well developed; life insurance lagging but share of life premiums grew between 2000 and 2006; market concentration high; observed risk retention ratios are high and need monitoring.
- Mortgage loan practice: frequent requirement for borrower to purchase life insurance as collateral; recommendation: obligatory collateral requirement should be based on fair pricing and customers must be informed and protected.

### Leasing sector
- Risks diminished with the new Leasing Act and supervision by HANFA.
- New Act: prohibits direct credit extension by leasing companies; requires more stringent capital thresholds, fit and proper requirements, management and supervisory board structures, and risk management rules.
- Historically, leasing companies claimed 11 percent of financial sector assets.
- Remaining needs: better regulatory reporting and risk analysis, assessment of capital adequacy, monitoring ownership and funding changes, include leasing clients in credit registry (subject to legislative change).

---

### Liquidity Management, LOLR, and Market Functioning

### CNB instruments and market structure
- CNB has broad range of liquidity instruments; FX auctions main instrument; stability of the kuna main operational target; other instruments include weekly auctions, reserve requirements, and administrative measures.
- Interbank money market weaknesses:
  - Daily turnover low; transactions concentrated in unsecured overnight maturities; no yield curve beyond one month.
  - Market unable to recycle liquidity across banks; government treasury-bills outstanding stock HRK12 billion and unevenly held.
  - Limited eligible collateral and frequent regulatory changes reduce banks' willingness to recycle excess liquidity.

### LOLR and contingency features
- LOLR facility: emergency liquidity to solvent banks at penal interest rates, for a period of no more than six months (used once since 2002); backed by eligible collateral; supervisory monitoring and conditionality apply.
- Exceptionally, collateral requirements can extend to long-term government securities, sovereign bonds of euro member countries, or other accepted collateral if system stability threatened.
- CNB provides emergency liquidity only in kuna; banks can exchange kuna funds borrowed for foreign currency.
- 32 percent FX LAR provides cushion in case of run on FX deposits.
- Substantial amounts of liquidity frozen at CNB for other regulatory requirements can be released in event of liquidity squeeze.
- Exceptional extension of LOLR maturity up to twelve months requires government guarantee and parliamentary approval; CNB plans to modify facility to extend use to 12 months with no requirement for state guarantee.

### Recommendations to improve liquidity and market functioning
- Expand set of eligible collateral to raise volume of securitized interbank lending (include government bonds with appropriate hair-cuts for longer maturities and FX denomination).
- Incorporate interbank market volatility information in daily liquidity forecasting and management.
- Allow greater flexibility in repo rate and continue dialog with banks on regulatory changes.
- Encourage development of hedging markets/instruments to facilitate management of interest and FX risks.

---

### Bank Resolution, Deposit Insurance, and Crisis Preparedness

### Bank resolution and legal framework gaps
- Legal powers: CNB has broad powers to license, supervise, take remedial action, and revoke licenses; three modalities for resolution: Bankruptcy, Liquidation, Use of special administrators.
- Legal gap: absence of an explicit pre-bankruptcy mechanism (partial balance sheet transfers) in law could expose CNB to legal challenge and delay depositor reimbursement.
- Recommendation: explicitly list partial asset/liability carve-out mechanism among legally permissible instruments under special administration; provide CNB adequate legal protection for supervisory action taken in good faith.

### Deposit insurance
- Current coverage: HRK 100,000 (approximately €14,000) per person per bank.
- New draft deposit insurance law would raise coverage to HRK 160,000 and cover SMEs as well as individuals; possibility of coinsurance to be carefully assessed.

### Crisis preparedness and cross-border coordination
- Need for documented contingency planning: manuals specifying crisis-management principles, analytical frameworks, steps, procedures, information needs, coordination and communication protocols.
- At time of update: no formal burden-sharing arrangements with foreign authorities; prevailing assumptions: parent bank responsibility first line; reserves at CNB secondary.
- Recommendations:
  - Establish formal communications and MoUs with monetary and supervisory authorities of parent banks.
  - Clarify modalities for action and coordination (who is in charge, guidelines for liquidity facilities use).
  - Participate in domestic and cross-border crisis simulations.
- Progress: CNB initiated formal communications with foreign supervisors; MoUs with Austria, Bosnia, Hungary, and Italy to be upgraded; MoUs to be established with France and Germany; no responses had been received at time of update.

---

### Regulatory and Supervisory Framework, Basel II, and BCP Findings

### Basel II preparations
- Basel II preparations on track to become effective in January 2009.
- Approaches (as of June 2007):
  - Credit Risk: SA 11 (Bank Assets, in percent); 61 (Number of banks, in percent). IRB 88 (Bank Assets, in percent); 27 (Number of banks, in percent). Not decided 1 (Bank Assets, in percent); 12 (Number of banks, in percent).
  - Market Risk: SA 82 (Bank Assets, in percent); 97 (Number of banks, in percent). Internal model 18 (Bank Assets, in percent); 3 (Number of banks, in percent).
  - Operational Risk: BIA 19 (Bank Assets, in percent); 52 (Number of banks, in percent). STA 24 (Bank Assets, in percent); 18 (Number of banks, in percent). AMA 54 (Bank Assets, in percent); 12 (Number of banks, in percent). Not decided 3 (Bank Assets, in percent); 18 (Number of banks, in percent).
- Most foreign-parent banks plan IRB and AMA; Croatian subsidiaries developing or adapting parent models; smaller domestic banks plan SA.

### Nonbank financial system supervision (HANFA)
- HANFA established in 2006 by unifying securities, pensions, and insurance supervision; assumed oversight of previously unregulated leasing companies.
- Benefits: narrowed supervisory gap; stepped-up coordination and information sharing with CNB.
- Weaknesses:
  - HANFA cannot directly impose fines without court involvement.
  - Enforcement of financial statement disclosure and auditing standards for nonfinancial companies shared across institutions.
  - Need for system of risk-oriented supervision across securities, pension, and insurance sectors.

### BCP assessment findings and supervisory enhancements (selected)
- CNB responsibilities established in law; powers to license, supervise, remediate, and revoke licenses.
- Governance: Governor and senior staff appointed by Parliament for six-year terms; individual supervisors protected from lawsuits; CNB itself lacks equivalent legal protection.
- Areas for enhancement:
  - Increase transparency of operational independence of the Supervision Department (CP 1.2).
  - Extend legal protection to the CNB for supervisory actions taken in good faith (CP 1.5).
  - Further advance forward-looking and risk-based supervision; improve integration of offsite and onsite work into supervisory cycle.
  - Clarify supervision of banking groups with nonbank operations; enhance CNB–HANFA coordination for consolidated supervision (CPs 19, 24).
  - Develop guidance on pre-emptive supervisory action and pre-planning for crises (CP 23).
  - Strengthen assessment of exposures to related parties and decision-making procedures (CP 11).
  - Improve accounting, auditing, and disclosure enforcement initiatives (CP 22).

---

### Measures to Address Rapid Credit Growth, Adverse Effects, and Transition Strategy

### Prudential and administrative measures adopted
- Prudential measures:
  - Requirement to set up reserves for general banking risks for banks with asset growth above specific threshold (2004, modified in 2006 to link reserves to credit growth only).
  - Introduction of capital charges for market risks (2004).
  - Increased risk weights on unhedged foreign-currency loans (2006, raised further in late 2007).
  - Guidelines for FX and household loan risk management (2006).
  - December 2007 amendment linking minimum required capital adequacy to credit growth and funding sources.
- Administrative/direct monetary measures:
  - Foreign-currency liquid asset requirement (FX LAR or the “32 percent rule”) (2003) (base broadened in late 2006 to include indexed instruments).
  - Marginal reserve requirement (MRR): introduced mid-2004 at 24 percent, subsequently increased in steps to 55 percent; loopholes closed.
  - Credit controls: “16 percent rule” in 2003; effective 2007 “12 percent rule” with subsequent tightening and retention in 2008; in 2008, 1 percent monthly sublimits apply; purchase requirement for excess credit growth increased to 75 percent; CNB bill yield cut to 0.25 percent.
  - Special reserve requirement, SRR (2006): set at 55 percent on banks’ liabilities arising from issued securities to close MRR loophole.
  - High general reserve requirement on bank deposits: 17 percent.
  - Credit registry started operations in May 2007.

### Effects and adverse side effects
- Achievements:
  - Share of FX-linked loans reduced.
  - Banks lowered external borrowing, intensified efforts to attract domestic deposits and capital, and tightened lending standards.
- Adverse side effects (selected):
  - Foreign banks arranging direct cross-border borrowing for clients, leaving domestic banks with less creditworthy customers.
  - Banks raising capital from parents rather than foreign borrowing, complicating capital-risk linkage.
  - Banks seeking higher returns to offset limits, increasing risk appetite.
  - Encouragement of financial disintermediation; undermining access to credit for SMEs; shifting bank lending to retail.
  - SRR on bond issuance can hinder development of long-term instruments and banks' liquidity and maturity management.

### Transition strategy and safeguards
- Administrative measures need careful, phased elimination due to incompatibility with EU accession/euro adoption and adverse implications.
- Transition design should:
  - Identify which measures to eliminate and when.
  - Specify timing and pace considering macroeconomic implications.
  - Include safeguards: supportive macroeconomic policies, resilient banking system, strong supervision.
- Tighter fiscal policies recommended to reduce excess demand as liquidity is reinjected.
- CNB to intensify monitoring of bank lending, risk management, and loan granting standards; consider further prudential measures as needed.

---

### Main Policy Recommendations and Priority Actions (selected)

- Financial system stability
  - Carefully plan a transition away from existing administrative measures — Timing: ST; Priority: High.
  - Continue to monitor closely bank risk management practices and lending standards — Timing: ST; Priority: High.
  - Strengthen stress testing analyses and regularly use stress tests in monitoring risks and assessing financial stability — Timing: ST; Priority: High/Med.
  - Reduce fiscal or other incentives that stimulate particular types of bank loans — Timing: MT; Priority: High/Med.
  - Continue efforts to raise risk awareness of banks, borrowers, and stock market investors — Timing: MT; Priority: High.
- Contingency planning
  - Establish formal arrangements with monetary and supervisory authorities of parent banks on crisis management — Timing: ST; Priority: High.
  - Strengthen bank resolution mechanism; clarify legal framework and roles of parties in bank resolution and restructuring — Timing: MT; Priority: High.
- Liquidity and risk management
  - Broaden range of eligible collateral for interbank securitized lending to reduce segmentation and support hedging markets — Timing: MT; Priority: High.
- Nonbank financial sector and cross-sector risks
  - Strengthen CNB–HANFA coordination to monitor and analyze group risks; map ownership structures and clarify supervisory lead roles — Timing: ST; Priority: High.
  - Build comprehensive data and monitoring processes for stock exchange transactions (investor composition, trading trends, automated early warning for suspicious trades) — Timing: ST; Priority: High/Med.

*Source: IMF Financial Sector Assessment Program — Executive Summary and FSAP Update (cr08160).*

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

### Executive Summary

### Background
- The Croatian financial sector has developed significantly since the 2002 FSAP assessment, with rapid growth in banks and nonbank financial institutions (NBFIs), strengthened regulatory and supervisory frameworks, and improved financial sector infrastructure aligned with EU directives in a predominantly foreign-owned banking system.
- The 2002 FSAP found large banks well-capitalized and banking supervision strong, while identifying supervisory weaknesses in the nonbank financial sector. Many issues from the 2002 FSAP have been addressed.

### Sources of Potential Risk to Financial Stability — Macro-Financial Setting
- Rapid (though slowing) growth of bank credit to the private sector has accompanied rising asset prices, a widening current account deficit, and external debt to levels that may not be sustainable.
- Key statistics and indicators:
  - Real estate price data: average annual increases of about 9 percent over 2002–07.
  - Stock price increases: rising by 60 percent annually in 2006-07.
  - Current account deficit: 8.6 percent of GDP at end-2007.
  - External debt: 87.8 percent of GDP at end-2007.
  - Inflation: picked up to above 6 percent year-on-year in early 2008.
- Vulnerabilities and exposures:
  - Majority of loans at variable interest rates and linked to foreign currency.
  - Banks dependent on foreign funding — exposed to interest- and exchange-rate induced credit risks and cross-border contagion risk.
  - Croatia has no direct exposures to the subprime market developments, but the EMBI spread rose from historical lows in mid-2007 and remained high compared with other emerging European countries; widening CDS spreads suggest concerns with external vulnerabilities.
  - Recent falls in the stock market (March 2008) partly due to liquidity disturbances from renewed global market tensions.

### Stability Assessment of the Financial System
- Overall assessment:
  - Financial sector remains broadly healthy: banks’ profitability remains satisfactory; capital adequacy and asset quality are currently at comfortable levels.
  - New areas of vulnerability have emerged related to rapid credit growth, external imbalances, and rising asset prices.
- Banking sector:
  - Higher capital buffers would seem warranted, especially for the most vulnerable banks.
  - The CNB has an effective bank supervision framework with progress toward international best practices; risk-focused supervision is evolving and Basel II preparations seem on track.
  - Lack of clarity remains on supervision of banking groups that conduct nonbank operations — group risks need systematic identification and supervision.
- Nonbank financial sector and cross-sectoral developments and risks:
  - Growth of the NBFI sector has been partly spurred by measures to contain bank credit.
  - Inclusion of previously unregulated leasing companies under HANFA oversight has closed a potential circumvention channel.
  - Weaknesses remain: need for strengthened CNB–HANFA coordination, HANFA’s inability to directly impose fines without court involvement, weak enforcement of financial statement disclosure and auditing standards, and development of a risk-oriented supervision system.
  - Market concerns: high and rising equity market valuations combined with low market liquidity; need to strengthen market analysis and surveillance, investor education, discourage market manipulation, and introduce an investor compensation scheme covering fraud and theft.

### Mitigation of Risks: Regulatory and Supervisory Issues
- Authorities’ actions:
  - CNB relied on administrative measures to curb credit growth and external debt within a tightly managed exchange rate regime; supervisory and prudential measures were also taken to enhance bank resilience and limit macro-financial vulnerabilities.
  - Established a credit registry; placed leasing sector under HANFA oversight; improved communications with banks.
- Effects and limits of measures:
  - Measures achieved some success: share of FX-linked loans reduced; banks lowered external borrowing, intensified efforts to attract domestic deposits and capital, and tightened lending standards.
  - Deceleration in total borrowing from local banks and other sources (including direct foreign borrowing) has been more modest.
  - Administrative measures will need to be eliminated in a carefully phased manner because some measures may become incompatible or difficult to sustain under EU accession or eventual euro adoption and may have adverse implications for financial stability, intermediation, and market development.
- Supervisory priorities:
  - Continue close monitoring of bank risk management practices and lending standards.
  - Strengthen supervision of banking groups with nonbank operations to ensure group risks are identified and supervised systematically.

### Systemic Liquidity Management and Contingency Planning
- Liquidity management instruments and market features:
  - CNB has a broad range of instruments to manage systemic liquidity and a LOLR facility that provides emergency liquidity to solvent banks at penal rates.
  - Day-to-day liquidity management by banks is complicated by a shallow money market.
  - Substantial amounts of kuna held at the CNB due to reserve requirements could be released in a liquidity squeeze.
- Recommendations to improve liquidity and market functioning:
  - Expand the set of eligible collateral to raise the volume of securitized interbank lending.
  - Incorporate information implied by interbank market volatility in daily liquidity forecasting and management operations.
  - Continue to allow greater flexibility in the repo rate and engage in greater dialog with banks on regulatory changes.
- Contingency planning and crisis management:
  - Authorities have initiated formal communications on contingency planning with supervisory authorities of foreign banks; continuation of these efforts and timely foreign responses are important.
  - Participating in domestic and cross-border crisis simulations recommended.
  - Legal framework governing pre-bankruptcy bank resolution procedures needs clarification to avoid delays in payments to depositors and preserve asset values; recent efforts to clarify institutional roles in bank resolution are welcome.

### Key Policy Recommendations and Priority Actions (from Table 1)
- Financial system stability
  - Carefully plan a transition away from the existing administrative measures, with the objective of eliminating negative side effects while maintaining financial stability — Timing: ST; Priority: High.
  - Continue to monitor closely bank risk management practices and lending standards to address any emerging prudential risks — Timing: ST; Priority: High.
  - Strengthen stress testing analyses and regularly use stress tests in monitoring risks and assessing financial stability — Timing: ST; Priority: High/Med.
  - Reduce fiscal or other incentives to the extent they stimulate particular types of bank loans and continue efforts to raise risk awareness of banks, borrowers, and stock market investors — Timing: MT; Priority: High/Med.
- Contingency planning
  - Establish formal arrangements with monetary and supervisory authorities of parent banks on crisis management — Timing: ST; Priority: High.
  - Strengthen bank resolution mechanism, clarifying the legal framework and roles of parties involved in bank resolution and restructuring process — Timing: MT; Priority: High.
- Liquidity and risk management
  - Broaden the range of eligible collateral for interbank securitized lending to help reduce segmentation in the interbank money market, which could support development of hedging markets/instruments to facilitate management of interest and FX risks — Timing: MT; Priority: High.
- Nonbank financial sector and cross-sector risks
  - Further strengthen coordination between the CNB and HANFA to systematically monitor and analyze group risks; map ownership structures of conglomerates to assess cross-sector risk exposures and ownership linkages; and clarify supervisory lead roles — Timing: ST; Priority: High.
  - Build comprehensive data and monitoring processes of transactions on the stock exchange (investor composition, trading trends and composition, automated early warning system for suspicious trades) — Timing: ST; Priority: High/Med.

*Source: IMF Financial Sector Assessment Program — Executive Summary.*

### 5.      The already high ratio of Croatian household debt to GDP continues to grow,

### 5.      The already high ratio of Croatian household debt to GDP continues to grow,

### Household indebtedness and vulnerabilities
- Household debt stood at over 40 percent of GDP as of end-September 2007.
- The share of bank lending to households rose from around 33 percent of total loans in 1998 to 55 percent in 2005, and subsequently stabilized around this level.
- About 40 percent of household loans are for housing.
- Close to 70 percent of bank loans are denominated or indexed to foreign currencies, mainly the euro.
- The share of all unhedged loans in total bank loans was 90 percent at end-2007.
- The household sector had a significant share of unhedged items exposed to currency-induced credit risk (95 percent), and only 2 percent of housing loans were hedged (CNB Banks Bulletin 15, 2007).
- Less than 20 percent of all outstanding loans are at fixed rates; the majority are floating rate and re-calculated quarterly.
- Average maturity of mortgage loans is around 20 years.
- Resulting risks:
  - Indirect FX risk to banks from FX-linked loans to mostly unhedged customers.
  - Credit risk via customers’ interest rate exposure due to floating-rate, frequently re-priced loans.

### Corporate debt and performance
- Non-financial corporations’ debt totaled 59 percent of GDP in end-2006.
- Debt owed to banks was around 57 percent of total corporate debt in 2006.
- 54 percent of corporate loans are FX-linked.
- Corporate return on equity rose from 1.8 percent in 2003 to 5.1 percent in 2006.
- The ratio of nonperforming loans (NPLs) to total corporate loans has been falling, but the absolute amount of NPLs remained relatively stable—decline in ratio largely reflects overall growth in corporate loans.
- Bank lending to corporates is sufficiently diversified, but the loan share to manufacturing and other productive, export-enhancing sectors is relatively small.

### Banking sector vulnerabilities and stress tests
- Financial soundness indicators as of end-2007:
  - Capital adequacy ratio (CAR) recovered to 16 percent after dropping to 13.6 percent in 2006.
  - NPL ratio on a declining trend.
  - Profitability has been falling; effect of narrowing interest margins and higher reserve requirements noted.
- Funding and contagion exposures:
  - Significant share of foreign banks in system; banks reliant on foreign funding (including parent banks) until mid-2006.
  - Exposure highly concentrated mainly to Austria, Italy, and France.
  - Since mid-2006, the share of deposit base in funding private sector credit has stabilized, with a fall in foreign liabilities in recent months.
- Stress-test scenarios and findings:
  - Tests simulated large but plausible shocks: slow-down or reversal in capital inflows, euro-area slowdown with spillover, higher global interest rates leading to higher domestic interest rates and sharp kuna depreciation, and rise in NPLs.
  - Under a capital inflow reversal scenario (significant kuna depreciation and higher interest rates) the CAR would fall below the 10 percent regulatory minimum for 21 of 33 banks with a total of 55 percent of system assets, and five banks would become insolvent.
  - A slowdown in the euro area and higher global interest rates would significantly reduce banks’ capital but leave aggregate CAR above 10 percent, with no insolvencies.
  - An outflow of 20 percent of bank liabilities with maturity up to three months would push system liquid asset ratios from 16 percent to 11 percent.
  - Sensitivity to direct interest rate and exchange rate risks was found negligible given limited foreign currency mismatch in bank balance sheets; majority of loans are floating rate. Sensitivity to equity risk was small.
- Heterogeneity of impact:
  - Smaller banks and state-owned banks exhibit greater vulnerability to direct and indirect credit risks.
  - Foreign-owned banks exhibit greater vulnerability to liquidity and contagion risks due to dependence on parent funding and wholesale foreign deposits.
  - State-owned banks particularly vulnerable to liquidity shocks due to large maturity mismatches in at least one bank.

### Key financial soundness figures (selected, as reported)
- Household debt to GDP: 24.7 (2002), 28.9 (2003), 31.8 (2004), 35.5 (2005), 40.3 (2006), 40.3 (2007 1/ September 2007).
- Return on equity (commercial banks): 13.7 (2002), 14.1 (2003), 16.1 (2004), 15.1 (2005), 13.0 (2006), 11.8 (2007 1/).
- Regulatory capital to risk-weighted assets (commercial banks): 17.4 (2002), 16.5 (2003), 16.0 (2004), 15.2 (2005), 13.6 (2006), 16.1 (2007 1/).
- Nonperforming loans to total gross loans: 10.2 (2002), 8.9 (2003), 7.5 (2004), 6.2 (2005), 5.2 (2006), 4.9 (2007 1/).
- Foreign currency-denominated loans to total loans: 75.8 (2002), 70.9 (2003), 76.6 (2004), 77.8 (2005), 69.6 (2006), 60.8 (2007 1/).
- Foreign currency-denominated liabilities to total liabilities: 76.0 (2002), 76.1 (2003), 78.1 (2004), 78.8 (2005), 77.9 (2006), 73.8 (2007 1/).
- Liquid assets to total assets: 17.6 (2002), 18.7 (2003), 16.1 (2004), 11.5 (2005), 12.6 (2006), 11.1 (2007 1/).

### Policy recommendations and supervisory actions
- Strengthen stress-testing analyses at the CNB by:
  - Integrating scenario analyses into tests.
  - Establishing data sources to facilitate quantitative assessment of various exposures.
- Encourage stress testing among banks as part of risk management for credit, liquidity, and market risks.
- Monitor closely small banks that show vulnerabilities and bank practices that could heighten risks.
- Include benchmarks to assess liquidity risks as part of supervisory oversight.
- Since the FSAP update mission, the CNB has intensified work on forward-looking stress tests and plans to produce a forward-looking financial stability report.
- Lending practices need to remain under close watch despite recent signs of tighter lending standards by some banks in response to CNB measures.

### Nonbank financial sector and cross-sectoral risks
- The systemic importance of NBFIs has increased since the 2002 FSAP, warranting closer examination.
- Some NBFIs are subsidiaries of foreign parent banks or owned by local banks, with important intragroup linkages in ownership and activity (e.g., mortgage borrowers required to provide life and hazard insurance; banks insure their credit risks).
- The full scope of cross-ownership and cross-sector exposures is not known.
- Recommendation: a consolidated mapping of ownership and exposure links to identify extent of risk exposures and inform necessary actions.

*Source: _cr08160 - 5.      The already high ratio of Croatian household debt to GDP continues to grow,*

### 16.      Croatia’s capital markets have experienced very rapid growth, but the market

### 16.      Croatia’s capital markets have experienced very rapid growth, but the market

### Capital market overview and concerns
- Market capitalization has more than tripled since 2001 to 133 percent of GDP at end-September 2007.
- Overall turnover ratio averaged 8.1 percent of capitalization.
- Existence of a number of company stocks that trade with a very low free float contributes to low market liquidity and the possibility that large orders generate significant price volatility.
- Equities have been the key driver of the rapid capital market growth.
- The limited supply of securities coupled with increasing demand exerted substantial pressure on prices; significant price correction has taken place since early 2008.
- The favorable tax regime applied to equities likely contributes to the popularity of the market.
- Investor education of the risks in the system is needed to temper over-enthusiasm and herd behavior (authorities have started addressing this after the FSAP update).

### Recommendations to deepen markets
- Stronger enforcement of disclosure requirements.
- Strengthening shareholder rights by revising provisions in the Companies Act regulating conflicts of interest.
- Enhanced market surveillance and analysis.
- An adequate legal framework and de-mutualization of the stock exchange to enhance market integrity.
- Addressing the legal framework for the finality of settlement (to be introduced with the Capital Market Act).
- Increased sale and privatization of public enterprise shares could add to market liquidity.

### The pension sector
- Mandatory pension funds (second pillar) introduced in 2002: total assets reached 7.7 percent of GDP by August 2007.
- Contribution rate: 5 percent (of gross salary) — characterized as quite low for a privately funded pillar still functioning mainly as a supplement to the public system.
- Investment restrictions: funds required to invest at least 50 percent of assets in government bonds and cannot place more than 20 percent in foreign assets. These restrictions will be lifted on EU accession.
- Policy recommendation: contribution rate needs to be raised significantly, taking into account fiscal implications.
- Footnote comparison: the rate is 6 percent in Hungary, 9 percent in Poland and Slovakia, and ranges from 7–12 percent in other selected emerging countries. Doubling the rate would allow a stronger development of the private pillar but imply additional public debt financing of about 28 percent of GDP over 20 years unless the parameters of the public pillar are modified.

### Voluntary pensions
- The voluntary pension system is small and participation is modest.
- Voluntary funds are subject to fewer investment restrictions, although the limit on foreign securities remains restrictive.
- Policy recommendations:
  - Remove the small government co-contribution subsidy to individuals participating in voluntary funds.
  - Liberalize foreign investment limits to provide broader client choice.

### Insurance sector
- Non-life insurance sector is reasonably well developed; life insurance is lagging behind.
- Share of life premiums in total premiums grew between 2000 and 2006, stimulated by the growth of the unit-linked business.
- Market concentration is high, with foreign-controlled companies having grown in relative importance.
- Observed risk retention ratios are high and need to be monitored to ensure risk transfer mechanisms are used appropriately.
- Mortgage loan practice: mortgage loan providers frequently require the borrower to purchase a life insurance policy as collateral to ensure coverage of mortgage payments through the payable benefit.
  - Policy guidance: obligatory collateral requirement needs to be based on fair pricing, not to promote insurance business within financial groups, and customers must be sufficiently informed and protected.

### Leasing sector
- Risks have diminished with the new Leasing Act and regulation and supervision of leasing companies by HANFA.
- The new Act:
  - Prohibits direct credit extension by leasing companies.
  - Requires more stringent capital thresholds, fit and proper requirements, management and supervisory board structures, and risk management rules.
- Historical context: leasing companies had claimed 11 percent of the financial sector assets—second to the banking sector.
- Remaining needs:
  - Greater efforts to fully assess sector developments including profit/loss dynamics, ownership structures, interest rate and funding risks through effective regulatory reporting and risk analysis.
  - Better assessment of capital adequacy to ensure commensurateness with size and risk of operations.
  - Monitor changes in ownership and funding structures in collaboration with home supervisors.
  - Include leasing clients in the credit registry—subject to the change in legislation—to improve information on debtors.

### IV. MITIGATION OF RISKS: Regulatory and Supervisory Issues — Measures to Address Rapid Credit Growth and Risks
- Authorities adopted prudential and supervisory measures to limit macro-financial vulnerabilities, including:
  - Higher capital requirements for market risk.
  - Higher risk weights for unhedged FX-loans.
  - Guidelines for managing risks related to household and FX loans.
  - A link between capital adequacy and credit growth.
- Administrative measures adopted by the CNB to curb credit and external debt include:
  - Prohibiting leasing companies from extending loans.
  - Setting up a credit registry (started operations in May 2007).
- Effects reported:
  - Administrative credit measures contributed to a slowdown in bank credit.
  - Total credit growth to the private sector from domestic and external sources slowed more modestly (a fall of 3 percentage points in total credit vs. 7 percentage points in bank credit at end-2007 vis-à-vis end-2006).
  - Prudential measures and euro area rate increases contributed to a fall in the share of FX-linked loans in total loans.
  - Banks reduced foreign borrowing and intensified efforts to attract deposits and capital.

### Adverse side effects of administrative measures (Box 1 highlights)
- Administrative measures have negative side effects with potential implications for financial stability, intermediation, and market development.
- Specific consequences:
  - Foreign banks arranging direct cross-border borrowing for clients, leaving domestic banks with less creditworthy customers.
  - Banks raising capital from parents rather than foreign borrowing, complicating the link between capital and the risks it should cover.
  - Banks seeking higher returns to offset limits, increasing risk appetite.
  - Administrative costs and successive adjustments as attempts to circumvent regulations prompt scope changes.
  - Encouragement of financial disintermediation and preservation of current market shares.
  - Undermining access to credit, particularly for small- and medium-sized enterprises, with banks directing loans to the retail sector.
  - Tightening credit limits can disproportionately hit banks and advantage stand-alone financial companies.
  - SRR on bond issuance can hinder development of long-term instruments and banks' liquidity and maturity management.

### Table 4: Measures to Address Credit Growth (summary of measures listed)
- Prudential and Supervisory Measures (selected):
  - Requirement to set up reserves for general banking risks for banks with asset growth above specific threshold (2004, modified in 2006 to link reserves set aside to credit growth only).
  - Introduction of capital charges for market risks (2004).
  - More emphasis on risks in CNB’s banking supervision (2004).
  - Increased risk weights on unhedged foreign-currency loans (2006, raised further in late 2007).
  - Issuance of guidelines for banks for managing risks related to FX and household loans (2006).
  - New law on leasing (effective 2007) limiting operations and bringing companies under HANFA supervision.
  - Credit registry started operations in May 2007.
  - December 2007 amendment linking minimum required capital adequacy to credit growth and funding sources.
  - Intensified cross-border supervisory coordination.
- Administrative or Direct Monetary Measures (selected):
  - Foreign-currency liquid asset requirement (FX LAR or the “32 percent rule”) (2003) (base broadened in late 2006 to include indexed instruments).
  - Marginal reserve requirement (MRR): introduced mid-2004 at 24 percent, subsequently increased in steps to 55 percent; loopholes closed.
  - Credit controls (2003, and since start of 2007): banks required to hold CNB bills tied to excess quarterly credit growth rules (“16 percent rule” in 2003; effective 2007 “12 percent rule” with subsequent tightening and retention in 2008). In 2008, 1 percent monthly sublimits apply; purchase requirement for excess credit growth increased to 75 percent; CNB bill yield cut to 0.25 percent.
  - Special reserve requirement, SRR (2006): set at 55 percent on banks’ liabilities arising from issued securities to close MRR loophole.
  - High general reserve requirement on bank deposits: 17 percent.

### Transition strategy and next steps
- Transition must be carefully designed to avoid undermining financial stability; it should identify:
  - Which measures should be eliminated, considering negative effects and compatibility with EU and euro frameworks.
  - Circumstances under which they could be eliminated.
  - Timing and pace of removal in light of macroeconomic implications.
  - Safeguards to limit potential consequences, including:
    - Supportive macroeconomic policies.
    - A resilient banking system.
    - Strong bank supervision.
- Tighter fiscal policies are crucial to reduce excess demand pressures as liquidity is reinjected.
- Banks must make prudent lending and borrowing decisions; CNB should intensify monitoring of bank lending, risk management, and loan granting standards.
- Consideration of further prudential measures to contain emerging prudential risks.
- Importance of increased risk awareness, effective home-host supervisory coordination, and deeper financial markets and instruments to facilitate risk management.

### Bank regulation and supervision
- The authorities have built necessary expertise and an effective framework for bank supervision.
- The BCP assessment by the FSAP update was positive; most significant weaknesses identified by the 2002 FSAP assessment have been addressed.
- CNB has remedial powers to deal with noncompliance, weaknesses in risk management, and banks’ financial condition; guidelines could be developed on when preemptive supervisory action might be undertaken and pre-planning for crisis actions.
- Significant progress in home-host supervisory coordination.
- Remaining areas needing attention include:
  - Improving transparency of the operational independence of bank supervision within the CNB.
  - Refining integration of offsite and onsite work into the supervisory cycle.
  - Further advancing forward-looking elements of supervision and moving toward risk-based supervision.
  - Clarifying supervision of banking groups that include nonbanking operations:
    - Need to enhance consideration of group risks as nonbanking activity grows.
    - Clarify the lead supervisor role and ensure group risks are systematically monitored.
    - Stronger coordination between the CNB and HANFA to understand cross-sector risk exposures and ownership links.

*Italic: Source — _cr08160 - 16.      Croatia’s capital markets have experienced very rapid growth, but the market*

### 31.      Basel II preparations are on track to become effective in January 2009. Most

### 31.      Basel II preparations are on track to become effective in January 2009. Most

### Basel II implementation: readiness and approaches
- Most foreign banks—shareholders of Croatian banks—plan implementing internal ratings based (IRB) and advanced measurement approach (AMA). Their Croatian subsidiaries are either developing their own models or adjusting models developed by their parents.
- Smaller domestic banks plan to implement standardized approach (SA) given the lack of data and experience for developing sophisticated models.
- The CNB and major Croatian banks seem well-placed to cope with the implementation.
- Impact studies are being prepared, including to assess the effect on capital.
- The framework for risk-focused supervision is still evolving, but current supervisory techniques and risk management processes do not appear to pose risks for successful implementation.
- Further dialog on a number of areas (e.g., consultative papers on Pillars 2 and 3 and the secondary legislation) would be helpful.
- Table 5. Croatia: Approaches for Basel II Implementation (Based on the data as of June 2007)
  - Credit Risk
    - SA 11 (Bank Assets, in percent); 61 (Number of banks, in percent)
    - IRB 88 (Bank Assets, in percent); 27 (Number of banks, in percent)
    - Not decided 1 (Bank Assets, in percent); 12 (Number of banks, in percent)
  - Market Risk
    - SA 82 (Bank Assets, in percent); 97 (Number of banks, in percent)
    - Internal model 18 (Bank Assets, in percent); 3 (Number of banks, in percent)
    - Not decided 0 (Bank Assets, in percent); 0 (Number of banks, in percent)
  - Operational Risk
    - BIA 19 (Bank Assets, in percent); 52 (Number of banks, in percent)
    - STA 24 (Bank Assets, in percent); 18 (Number of banks, in percent)
    - AMA 54 (Bank Assets, in percent); 12 (Number of banks, in percent)
    - Not decided 3 (Bank Assets, in percent); 18 (Number of banks, in percent)

### Nonbank financial system regulation and supervision
- HANFA, the unified regulator for the nonbank financial sector, was established in 2006 by integrating the former Croatian Securities Commission, Agency for Supervision of Pensions and Insurance, and Directorate for the Supervision of Insurance companies, and also assumed responsibility for supervision of the previously unregulated leasing companies.
- Inclusion of leasing companies under HANFA's oversight has helped narrow a supervisory gap and room for circumvention of credit measures on banks.
- Coordination efforts on information sharing have been stepped up with the CNB.
- Work is under way for joint inspections of banking groups under the CNB’s lead supervision, and to map cross-sector risk exposures and ownership linkages between banks and nonbanks.
- Remaining weaknesses:
  - HANFA’s inability to directly impose fines without the court system.
  - Enforcement of financial statement disclosure and accounting and auditing standards for nonfinancial companies is shared between HANFA and other state and private institutions.
  - A system of risk-oriented supervision needs to be developed across securities, pension, and insurance sectors to include monitoring of risks and identification of supervisory measures to mitigate them.
- Supervision should focus on management of market risks, credit risks, and corporate/financial governance risks in the nonbank sector.

### Systemic liquidity management: market structure and CNB instruments
- The CNB has a broad range of instruments to manage systemic liquidity, with FX auctions as the main instrument and stability of the kuna the main operational target; other instruments include weekly auctions, reserve requirements, and administrative measures.
- Interbank money market weaknesses:
  - Daily turnover in the interbank market is low, with transactions concentrated in the unsecured overnight maturities; no yield curve exists beyond one month.
  - The market is unable to recycle liquidity across banks: large banks rely on funds from the CNB, parents, or other large banks through bilateral arrangements, while small banks are constrained to trade with large banks due to exposure and internal limits.
  - Limited amount of eligible collateral (kept for dealings with the CNB) and frequent changes in regulations limit banks' willingness to recycle excess liquidity.
  - Government treasury-bills are the only collateral permitted in various monetary operations; the outstanding stock of treasury-bills (HRK12 billion) is small and unevenly held among the banks, with many banks not having sufficient collateral to borrow in times of liquidity shortage.
- Suggested measures to address impediments while maintaining kuna stability:
  - Greater flexibility in the repo rate to reflect liquidity conditions.
  - Expanding the set of appropriate eligible collateral to raise the volume of securitized lending (to include government bonds with appropriate hair-cuts for longer maturities and FX denomination).
  - Continued dialog with banks on frequent regulatory changes to reduce reluctance to recycle liquidity.
  - Incorporating information implied by interbank market volatility in daily liquidity forecasting and management operations.
- Post-FSAP update actions:
  - Since late 2007, the CNB allowed greater flexibility in the repo rate and emphasized repo auctions will mainly be used for managing liquidity.
  - Increased communication with banks has contributed to a better understanding of CNB measures.

### Contingency planning and lender-of-last-resort (LOLR)
- A broadly adequate framework for emergency liquidity provision exists.
- LOLR facility features:
  - Provides emergency liquidity to solvent banks at penal interest rates, for a period of no more than six months (used only once since 2002), accompanied by supervisory monitoring and conditionality (e.g., banks provide a detailed list of actions and cash flow projections for the period of loan use).
  - Liquidity support must be fully backed by eligible collateral.
  - Exceptionally, collateral requirements can be extended to long-term government securities, sovereign bonds of euro member countries, or other normally accepted collateral, if the CNB assesses that the bank’s liquidity problems threaten financial system stability.
  - The CNB provides emergency liquidity only in kuna, but banks can exchange with the CNB the kuna funds borrowed for foreign currency.
  - The 32 percent FX LAR provides a cushion in case of a run on FX deposits.
  - Substantial amounts of liquidity frozen at the CNB for various other regulatory requirements can be released in the event of a liquidity squeeze.
- Exceptional extension of LOLR maturity:
  - In exceptional circumstances, the maturity of the LOLR facility can be extended up to twelve months, but in that case, the loan must be requested and guaranteed by the government of Croatia with parliamentary approval.
  - The CNB plans to modify this facility to extend its use to 12 months with no requirement for state guarantee.

### Bank resolution, insolvency, and deposit insurance
- The legal framework provides the CNB with a broad range of powers to deal with solvency problems and to limit potential adverse effects on depositors’ confidence; powers include supervisory actions for bank improvement, restructuring/liquidation/bankruptcy actions.
- Three modalities of bank resolution covered by law:
  - Bankruptcy: used for fully insolvent institutions; depositors are paid off immediately; State recovers funds by sale of recoverable assets according to an established hierarchy of creditors.
  - Liquidation: depositors are not paid off but receive reimbursement once viable assets are sold and proceeds received.
  - Use of special administrators: reportedly have the option to sell off partial balance sheets (e.g., viable loans with matching deposits) to other acquiring banks as a first step in resolution, but the legal framework does not explicitly list this mechanism.
- Legal and procedural gaps:
  - The absence of an explicit pre-bankruptcy mechanism (partial balance sheet transfers) in law could expose the CNB to legal challenge by creditors and depositors if such mechanisms are used, potentially slowing resolution and delaying depositor reimbursement.
  - Recommendation: explicitly list the partial asset/liability carve-out mechanism among legally permissible instruments under special administration arrangements; provide CNB adequate legal protection for supervisory action taken in good faith.
- Deposit insurance:
  - Current scheme covers HRK 100,000 (approximately €14,000) for the sum of deposits of a person’s accounts held in a given bank.
  - The new draft deposit insurance law, drafted to meet the EU standards as part of the EU acquis, would raise the coverage to HRK 160,000, and would also cover small-medium enterprises (SMEs) as well as individuals, with the possibility of coinsurance; details on coinsurance remain pending and pros and cons need careful assessment.
- Clarity of roles in resolution:
  - At the time of the FSAP update, lack of clarity existed among CNB, DAB, Ministry of Finance (MoF), and courts regarding roles in bank resolution.
  - Mission recommendations:
    - Overall responsibility for rehabilitation programs for ailing institutions should be with CNB supervisors, with no competing agencies for this task.
    - Responsibility for providing capital to a troubled bank should be within the MoF.
    - Provision of liquidity support and other safety net funds should be the responsibility of the CNB and the DAB, respectively.
  - FSAP update recommended:
    - (i) establish clarity as to roles and responsibilities of parties involved in bank resolution and formalize the existing “common understanding” to limit delays and uncoordinated actions;
    - (ii) set out clearly who takes the first losses, with clear guidelines to limit CNB support to systemic risk cases;
    - (iii) establish provisions for quickly paying/servicing guaranteed depositors upon a bank’s failure—not only upon formal bankruptcy.
  - Authorities have recently stepped up efforts to clarify roles of agencies involved in bank resolution.

### Crisis preparedness and cross-border coordination
- Continued global financial market pressures underscore the need for contingency planning despite limited direct impact so far.
- Contingency planning should include:
  - Policy options and practical implementation steps, especially given a banking system largely foreign-owned.
  - Documentation in a manual specifying principles for crisis management; analytical frameworks for assessing a crisis; preparation of steps and procedures; key information needed for analyses; and specific forms of coordination, information sharing, and communication between authorities.
- At the time of the update, no formal arrangements existed for crisis management and burden sharing between the CNB and foreign authorities; prevailing assumptions:
  - Parent bank responsibility for its Croatian subsidiary as first line of defense.
  - Release of significant bank reserves held at the CNB as a secondary line.
  - A liquidity crisis could still cause difficulties if parent bank support failed to materialize or regional contagion occurred.
- Mission suggestions:
  - CNB to establish formal communications with monetary and supervisory authorities of parent banks and to specify modalities for action and coordination (e.g., in MoUs).
  - Home-host authorities should discuss “who is in charge,” and options/guidelines for use of liquidity facilities by foreign and domestic-owned banks in crisis.
  - Strengthening banks’ liquidity management capacity to reduce CNB burden in stress situations.
- Progress reported:
  - CNB initiated formal communications with foreign bank supervisory authorities to clarify parent bank reactions in case of problems in Croatia.
  - Existing MoUs with supervisory authorities of Austria, Bosnia, Hungary, and Italy are planned to be upgraded regarding crisis management arrangements; MoUs to be established with France and Germany.
  - No responses to formal communications had been received at the time of the update.
  - CNB has been monitoring banks’ liquidity and risk management through onsite-offsite inspections.
  - Recommendation: participation in crisis simulation exercises or “war games,” domestically and cross-border, to test coordination, procedures, responsibilities, and information needs.

### Institutional and legal framework for bank intermediation
- Institutional framework has been strengthened significantly since the last FSAP, with much legislative work ongoing to harmonize financial system legislation with the EU acquis communautaire, including the Credit Institutions Act.
- Legal system impediments:
  - Slow resolution of claims underlies slow recovery of collateral; average recovery takes about three years, constraining expansion of long-term corporate lending.
  - Banks often require multiple collateral forms (including guarantors), and insurance (life and hazard) or buy credit risk insurance through insurance companies.
  - Croatia compares unfavorably with other eastern European countries on investor protection and enforcement of contracts (World Bank “Doing Business Report for 2008”).
- Land registry and cadastral reform:
  - Progress since 2002 but further work needed.
  - Land registry had long delays and practical difficulties in registration and enforcement of pledges over movable property, encouraging banks to take additional collateral and undermining financial intermediation.
  - Land records can now be accessed through the Internet, but data in the cadastre book and land registry continue to diverge in some cases.
  - Completion of the project would help banks verify cadastre or land register data and facilitate loan granting procedures.

*Source: _cr08160 - 31.      Basel II preparations are on track to become effective in January 2009. Most*

### Appendix I. Main Recommendations of the FSAP Update

### Appendix I. Main Recommendations of the FSAP Update

### Financial sector stability
- Carefully plan the transition from administrative measures, with the objective of eliminating negative side effects while maintaining financial stability
  - Timing: ST
  - Priority: High
  - Status: Discussions ongoing
- Continue to monitor closely and frequently banks’ risk management practices and lending standards and take appropriate measures to address emerging risks
  - Timing: ST
  - Priority: High
  - Status: Ongoing
- Strengthen stress testing analyses and regularly use in monitoring risks and assessing financial stability
  - Timing: ST
  - Priority: High/Med
  - Status: Ongoing
- Reduce fiscal and other incentives to the extent they stimulate particular types of bank loans
  - Timing: MT
  - Priority: High
  - Status: Pending
- Continue efforts to raise risk awareness of banks, borrowers, and stock market investors
  - Timing: MT
  - Priority: High
  - Status: Ongoing
- Expand the coverage of the credit registry to include non-banking institutions
  - Timing: MT
  - Priority: High/Med
  - Status: Pending

### Contingency planning
- Establish formal communications with monetary and supervisory authorities of the parent banks on issues of crisis management
  - Timing: ST
  - Priority: High
  - Status: Initiated; waiting for response
- Adopt the law on deposit insurance consistent with the EU framework and design of an effective bank resolution mechanism, with clarity as to the legal framework and roles and responsibilities of all the parties involved in bank resolution and restructuring process
  - Timing: MT
  - Priority: High
  - Status: Ongoing; discussions took place to clarify the roles

### Liquidity and risk management
- Broaden the range of eligible collateral for interbank securitized lending to help reduce segmentation in the interbank money market
  - Timing: MT
  - Priority: High
  - Status: Pending
- Develop hedging markets/instruments to facilitate management of interest and FX risks
  - Timing: MT
  - Priority: High
  - Status: Pending

### Nonbank financial sector and cross-sector risks
- Build comprehensive data and monitoring processes (investor composition, trading trends and composition, automated early warning system for suspicious trades), and map ownership structures of conglomerates, and clarify the roles for their supervision
  - Timing: ST
  - Priority: High/Med
  - Status: Initiated, efforts ongoing
- Improve regulatory capacity to monitor and enforce financial accounting standards and market disclosure
  - Timing: ST
  - Priority: Medium
  - Status: Pending
- Increase pension funds’ permissible investments in foreign securities
  - Timing: MT
  - Priority: Medium
  - Status: Pending
- Pursue plans to increase the level of contribution and further privatize the pension fund system
  - Timing: MT
  - Priority: Medium
  - Status: Pending
- Enhance supervisory capacity to migrate to Solvency II risk based standards for insurance companies
  - Timing: MT
  - Priority: Medium
  - Status: Pending

*Source: Appendix I. Main Recommendations of the FSAP Update*

### 55.      Financial markets are relatively undeveloped. The interbank money market is

### _cr08160 - 55.      Financial markets are relatively undeveloped. The interbank money market is

### Financial markets: structure and activity
- Interbank money market: shallow and segmented; market unable to recycle liquidity efficiently across banks.
- Only 20 percent of all transactions take place in the interbank market with the remaining bilaterally.
- FX market: more active and less volatile.
  - Daily turnover increased more than four-fold since 2003 to an average of €500 million in 2007.
  - Spot transactions have traditionally been the bulk of FX activity; FX swaps rose to 60 percent of total transactions in 2007.
- Money market weaknesses and exchange rate stability hinder development of longer-term hedging markets for managing interest and exchange rate risks.
- Capital markets recently boomed:
  - Market capitalization: 133 percent of GDP (one of the highest in the region).
  - Bond market size: 15 percent of GDP.
  - Market continues to lack depth and liquidity and is dominated by equities.

### Stress testing: scope, design, and scenarios
- Tests were conducted jointly by the FSAP team and the CNB at aggregate, peer group, and individual bank levels.
- Tests included single factor sensitivity tests and macro-scenarios; simulated exceptional but plausible shocks using historical experience.
- Single factor shocks considered:
  - Direct and indirect credit risk induced by FX and interest rate exposure.
  - Exchange rate, liquidity, and interest rate risks.
- Three macro scenarios considered:
  - Slowdown or reversal in capital inflows resulting in a fall in net inflows.
  - Economic slowdown in the euro area with spillovers to Croatia.
  - Higher global interest rates.
- Calibration: combination of econometric analysis and coefficients from similar studies; in absence of a macro-model, stress tests assumed immediate impact.

### Key stress test results — solvency and credit risk
- Aggregate assessment: Croatia’s banking system is sufficiently capitalized to withstand a wide range of shocks, but there are pockets of vulnerability.
- Most significant risk: combined shock of a decline in capital inflows leading to significant currency depreciation and high interest rates.
  - Under this scenario:
    - Aggregate CAR would fall below the 10 percent minimum.
    - Shortfalls in capital would occur at 21 banks with 55 percent market share for assets.
    - Five banks would become insolvent.
- Other macro shocks:
  - Euro area slowdown and global interest rate increase would substantially reduce capital, but aggregated CAR remains above the 10 percent minimum, with no insolvencies.
- Sensitivity notes:
  - Sensitivity to direct interest rate and exchange rate risks is negligible given limited foreign currency mismatch in bank balance sheets and high ratio of floating rate loans.
  - Direct exposure to equity risk is very small (less than one percent for most banks; only one bank reporting 4 percent).
  - Indirect equity exposure could be more significant if borrowers took loans to buy stocks, but data were not available to test such exposure.

### Key stress test results — liquidity and contagion
- Liquidity risk substantial:
  - An outflow of 20 percent of liabilities with maturity up to 3 months would push the liquid asset ratios of the system from about 16 to 11 percent.
- Contagion risk within domestic banking system: negligible due to very limited interbank exposures.
- Contagion from parent-bank problems:
  - Withdrawal of 100 percent of deposits by parent banks would result in negative liquid-assets-to-liquid-liability ratios for four foreign-owned banks with a 25 percent share in total assets.
  - When more long-term funding (including loans and hybrid instruments) are withdrawn, most large foreign-owned banks with over 50 percent market share would show negative liquid-assets-to-liquid-liability ratios.

### Heterogeneity in impact and vulnerable subgroups
- Aggregate figures mask high heterogeneity across banks and sub-groups.
- Smaller banks and state-owned banks: greater vulnerability to direct and indirect credit risk.
- Foreign-owned banks, including some systemically important ones: greater vulnerability to liquidity and contagion risk from parent institutions.

### Recommendations and policy actions
- Strengthen stress testing analyses at the CNB:
  - Integrate scenario analyses in CNB stress testing exercises.
  - Integrate cross-sector and cross-border analyses.
  - Compile data series to facilitate quantitative assessment of exposures, including bankruptcy rates and leverage ratios for households and corporates.
  - Obtain more detailed information on distribution of assets by repricing and remaining maturities to facilitate interest rate and liquidity risk analysis.
- Make scenario analyses more macro-consistent:
  - Use the core macroeconomic structural model the CNB is developing to test sensitivity of financial and macroeconomic variables to alternative shocks (exchange rate, interest rates, output, capital inflows in the form of bank borrowing, policy instruments, etc.).
  - Use results as input for macro scenarios in stress testing.
- Encourage stress testing among commercial banks:
  - CNB should encourage banks to integrate stress testing into risk management.
  - CNB should request banks to undertake stress tests for CNB-determined risks and report results to the CNB for comparison with CNB analyses.
- Monitor developments in smaller banks that exhibit vulnerabilities:
  - Smaller banks, while less material in size, exhibit vulnerabilities that could undermine confidence and therefore need close attention.
- Monitor specific risks and bank practices:
  - Degree to which banks may undertake riskier investments in face of limits on credit growth and competition-induced margin compression.
  - Extent to which all-purpose loans are invested in the stock market.
  - Extent to which insurance collateral actually transfers risks out of banking groups.
  - Incorporate outcomes of such monitoring into stress testing and risk analyses and follow up with close onsite inspections.

### Basel Core Principles (BCP) assessment — summary context
- BCP assessment performed in accordance with October 2006 Core Principles Methodology during October/November 2007 in context of IMF-World Bank FSAP update.
- Assessment reflected legal and regulatory framework and supervisory practices as of early November 2007 and covered both essential and additional criteria.
- Croatian financial sector context as of end June 2007:
  - 33 banks and 5 housing savings banks, accounting for around 120 percent of GDP or 74 percent of the total financial sector assets.
  - Bank ownership composition: 15 foreign owned, 16 domestic private, 2 state-owned.
  - Five largest banks account for 72 percent of total banking system assets.
  - Foreign-owned banks make up over 90 percent of the banking system assets; largely Austrian and Italian owned.
- CNB supervision:
  - Prudential Regulation and Bank Supervision Area divided into five departments: Licensing and Market Competition; Prudential Regulation and Banking System Analysis; Off-site Supervision; On-Site Risk Management Supervision; Specialized On-site Supervision.
  - Banking Law (BL) introduced in 2002 strengthened CNB’s supervisory powers and resources.
  - Consolidated supervision and MoUs signed with almost all home supervisors of Croatia’s banks; HANFA’s establishment and inclusion of leasing companies under its purview help reduce regulatory arbitrage.
- Preconditions broadly in place for effective supervision, but gaps remain in information infrastructure (accounting, auditing, credit registry), legal infrastructure, and corporate governance.

*Source: _cr08160 - 55.      Financial markets are relatively undeveloped. The interbank money market is*

### 68.      The responsibilities of the CNB as the only banking supervisor are established in

### _cr08160 - 68.      The responsibilities of the CNB as the only banking supervisor are established in

### Objectives, independence, powers, transparency, and cooperation
- The responsibilities of the CNB as the only banking supervisor are established in law.
- Laws establish CNB powers to license, supervise, take remedial action against and revoke licenses of banks, and there is a clear and transparent decision-making process for such matters.
- The Central Bank is responsible to Parliament for its actions, and some details of supervisory activity are published in its Annual Report.
- The CNB’s resources are sufficient for its responsibilities.
- The Governor and other senior staff are appointed by Parliament for terms of six years, and can only be dismissed for cause.
- Arrangements are in place for exchanges of information with other supervisors, both at home and abroad, subject to the protection of confidentiality.
- Individual supervisors are protected from law suit when carrying out their work in good faith, but this legal protection does not extend to the CNB itself.
- Operational independence of the supervision department needs greater transparency (see CP 1.2, Table 10).

### Licensing and structure, CPs 2–5
- Use of the term ‘bank’ and its derivatives is limited to licensed institutions.
- A comprehensive set of criteria are established in law for the licensing of banks, together with any significant changes of ownership and major investments.
- Licensing criteria include ‘fit and proper’ tests for shareholders and senior managers, as well as the strategy, business plans and internal controls of the organization.

### Prudential regulations and requirements, CPs 6–17
- There is a generally satisfactory regime for supervision of risks in banks, covering credit, market, liquidity, operational and interest rate risk.
- The CAR regime is fully compliant with Basel I.
- The CNB needs to check that the side effects of non-prudential measures do not reduce the sensitivity of CAR to risk.
- Determining the effectiveness of risk management and management oversight, and assessing the amount of risk an institution is exposed to, is integral to CNB’s off- and on-site supervision.
- There is a need to further advance the forward-looking elements of the supervisory approach and qualitative risk assessment.

### Abuse of financial services, CP 18
- Croatia’s legal framework for dealing with the abuse of financial services covers all basic elements needed.
- Rules for ‘know-your-customer’ exist.
- A Financial Intelligence Unit has been established within the MoF to which transactions over a certain amount and all suspicious transactions are reported.
- The CNB monitors the effectiveness of these arrangements as part of its on-site work.

### Methods of ongoing supervision, CPs 19–25
- The CNB performs both off-site analysis and on-site inspections and receives a comprehensive set of regulatory reports.
- Enhanced supervision quality has enabled the CNB to shift from full-scope to more targeted examinations.
- The CNB has a process for rating the overall condition of banks that informally drives the supervisory cycle.
- Banks are required to produce financial statements audited to international standards, both on a solo and a consolidated basis.
- A full range of remedial actions is available, including fines, business restrictions, forced changes in management, liquidation/bankruptcy, and revocation of license.
- Exchanges of information and cross-border cooperation with home supervisors have been established and are likely to intensify.
- Supervisory approach could be further strengthened by:
  - Enhanced consideration of group risks within banking groups.
  - Improved coordination with HANFA.

### Table 10 — Key comments and recommended enhancements (selected)
- Independence, accountability and transparency (CP 1.2):
  - The previous practice of appointing Deputy Governor and Vice-Governors on the Governor’s recommendation could give disproportionate influence, although no evidence of misuse was observed.
  - Recent amendment to the LCNB changes appointments so Deputy Governor and Vice Governors will be appointed on recommendation of the special Parliamentary Committee.
  - Transparency of operational independence of the Supervision Department is affected by monitoring of credit measures within that Department.
  - Recommend a section in the Annual Report on supervision activities (avoiding confidential matters) and a more pro-active press attitude; set within explicit supervisory objectives enshrined in law.
- Legal framework (CP 1.3):
  - Recommend explicit cross-reference to the BL in Article 25 of the LCNB.
  - Article 5 of the BL states no one unauthorized by the CNB shall engage in banking activities “unless authorized by another law,” which could cause confusion; the law should clarify what other laws could be involved and make explicit that no other laws relevant to banking activities can exist.
- Legal protection (CP 1.5):
  - Adequate legal protection should be extended to the CNB.
- Licensing experience (CP 3):
  - The CNB has not licensed a new bank for many years and thus staff lack practical experience.
  - Recommend an explicitly more intensive supervisory regime in early days of a new bank, including merged banks.
- Transfer of significant ownership (CP 4):
  - BL provides a regime broadly in line with international standards, enabling suspension of voting rights of shareholders likely to exercise undue influence.
  - Significant ownership as defined by BL does not explicitly comprise exertion of control and BL does not stipulate a suitability test.
- Capital adequacy (CP 6):
  - Prudential CAR regime is fully acceptable in structure and monitoring by CNB.
  - Banks should adopt a forward-looking approach to management of capital adequacy.
  - While not explicitly in law, banks are required to maintain required CAR at all times (to be required explicitly in the future according to the draft Credit Institutions Act).
- Risk management process (CP 7):
  - CNB is dedicated to and moving toward being risk-focused; expected to further advance forward-looking supervisory elements assessing whether policies and procedures lead to greater or lesser risk.
- Credit risk (CP 8):
  - Assessment and management of credit risk is a major concern; recommend stronger emphasis on identifying weaknesses in banks’ risk management and addressing them on a case-by-case basis.
- Large exposures (CP 10):
  - BL stipulates limits for large exposures in line with international best practices; determination of compliance via off-site and on-site work.
  - Recommend participation of all (executive) Board members or unanimous decision for such exposures.
- Exposure to related parties (CP 11):
  - BL framework not entirely sufficient to prevent abuses/conflicts from exposures to related parties.
  - Recommend including exertion of control in definition of ‘persons in a special relationship with a bank’.
  - Recommend unanimous board decisions and explicit requirement to exclude conflicted executive board members from decision-making.
- Market risk, liquidity risk, operational risk, interest rate risk in banking book (CPs 13–16):
  - CNB has adequate powers to assess market risk; overall significance currently limited.
  - Legal framework provides necessary power to assess liquidity risk; CNB should monitor liquidity management policies as funding structure changes.
  - Lack of currency-by-currency reports is of minor relevance given fungibility of predominant currencies.
  - BL and secondary legislation permit assessment of operational risk mainly through on-site inspections.
  - Despite lack of specific legal framework for interest rate risk in the banking book, off-site and on-site work provide sufficient monitoring; recommend regular assessment of effects on economic value and profits following implementation of the new Credit Institutions Act.
- Internal control and audit (CP 17):
  - In some smaller banks internal audit lacks skills to audit information systems adequately and is more compliance than risk oriented.
- Supervisory approach and techniques (CPs 19–20):
  - Recommend ensuring full risk assessment is carried out regularly; current reliance on CAEL quarterly off-site and CAMELS mainly on-site can leave gaps (example: a two-year inspection cycle could delay full assessment of key elements for up to six years).
  - Recommend full integration of risk assessment into supervisory arrangements so CAMELS (or equivalent) guides frequency of on-site work and consistency of supervision across similar-risk banks.
  - Clarify duration of supervisory cycle varying with risk.
  - Hold prudential meetings with bank boards on a regular basis based on institution risks and changes.
- Supervisory reporting (CP 21):
  - Supplement analysis of past risks with forward-looking assessment (e.g., extrapolating trends, regular stress testing).
  - Consider placing banks into comparable risk-based peer groups.
- Accounting and disclosure (CP 22):
  - Consider trilateral meetings with bank and external auditor to discuss audit issues and internal controls.
  - CNB should deal appropriately with banks that missed the deadline for publishing 2006 Accounts if they have not already done so.
- Corrective/remedial powers (CP 23):
  - CNB has full range of powers; no formal ‘prompt corrective action’ regime exists and none is deemed necessary, though guidelines on pre-emptive action would be helpful.
  - Recommend some pre-planning for crises, particularly those affecting only Croatia.
- Consolidated supervision (CP 24):
  - Legal framework empowers CNB to undertake consolidated supervision; domestic and foreign subsidiaries are covered.
  - Recommended to increase frequency of consolidated prudential reports on a case-by-case basis if needed.
  - Recommend fine-tuning exchange of information and cooperation with HANFA on individual banking group basis to assess non-bank subsidiaries’ impact on group risk.

*Source: _cr08160 - 68.*

### 25. Home-host relationships The legal framework established by the BL enables the CNB to exchange

### 25. Home-host relationships The legal framework established by the BL enables the CNB to exchange information and cooperate with foreign supervisors

### Summary of context and assessment
- The legal framework established by the BL enables the CNB to exchange information and cooperate with foreign supervisors.
- Memoranda of Understanding (MoUs) have been signed with all relevant supervisors and supervisory cooperation is an integral part of the CNB's ongoing off-site and on-site supervision.
- Despite Croatia not yet being an EU member state, the CNB has profited from the intensified cooperation between European supervisory authorities.
- Enhancing supervisory cooperation is of particular importance for the CNB as the host supervisor of a banking market that is dominated by foreign banks.
- Basel II implementation is likely to intensify the trend towards more cooperation.

### Recommended action plan and authorities’ response
- Paragraph 73: "Table 11 lists the suggested steps for improving compliance and provides recommendations where deficiencies are assessed."
- Paragraph 74: "The Croatian authorities were in broad agreement with the BCP assessment. They provided a number of technical suggestions and factual corrections to the draft version of the assessment, most of which have been taken into account. In addition, the authorities noted that work is in hand to resolve some of the existing lacunae in the supervisory regime (e.g., draft guidance notes on various banking risks have been produced and are expected to be issued shortly)."

### Key recommendations from Table 11 (by Basel Core Principle reference)
- 1 (2). Independence, Accountability and Transparency
  - "The independence of supervision within the CNB, particularly the responsibility for the monitoring of non-prudential matters, should be made more transparent. Consideration should be given to pursuing enhanced disclosure; producing a section in the Annual Report on supervision, linked to explicit supervisory objectives enshrined in law; and adopting a more pro-active attitude to the Press."

- 1 (3). Legal Framework
  - "An explicit cross-reference should be provided to the BL in Article 25 of the LCNB. Article 5 of the BL says that no one unauthorized by the CNB shall engage in banking activities ‘unless authorized by another law’  (work under way)."

- 1 (5). Legal Protection
  - "The CNB should be protected in law against lawsuits for supervisory actions undertaken in good faith."

- 4. Transfer of Significant Ownership
  - "The significant ownership regime should be extended to cover persons exercising, or being able to exercise, control. A suitability test should be introduced."

- 6. Capital Adequacy
  - "The CNB should continue implementing a forward-looking approach to the management of capital adequacy. Potential side-effects that could reduce the risk sensitivity of the CAR regime should be closely monitored."

- 7, 8, 14. Risk Management Process, Credit, and Liquidity Risk
  - "The CNB should continue shifting focus from emphasis on capital adequacy, compliance with rules, and classification of risks, to the forward-looking elements of the supervisory approach, especially the assessment of the extent to which a bank’s current policies and risk management procedures are leading to greater or lesser risk."
  - "It should introduce explicit qualitative assessments of the risk a bank is exposed to and the quality of the risk management in the quarterly reports prepared by off-site on individual banks."
  - "These should be made the key element of the CNB’s risk review and assessment, with more emphasis put on identifying weaknesses of individual bank's risk management to assess the potential impact such weaknesses have on an individual bank's risk profile."
  - "The CNB should also closely monitor whether banks adopt their liquidity management policies and procedures to reflect changes to the structure of their funding."

- 11. Exposures to Related Parties
  - "An explicit requirement should be established for Board members with a potential conflict of interest to be excluded from the decision-making process."

- 19, 24. Supervisory Approach and Consolidated Supervision
  - "As consolidated supervisor and de facto ‘lead supervisor’ of financial conglomerates, the CNB should ensure that group risks are explicitly identified and supervised effectively; and that the CNB and HANFA have effective and efficient cooperation and coordination arrangements in place to enhance the understanding of the risks bank and nonbank operations pose to the institutions subject to their respective supervision."
  - "The frequency of consolidated prudential reports should be increased when needed, and cooperation with HANFA be fine tuned on an individual banking group basis as to the risks in the group that could affect the banking group."

- 20. Supervisory Techniques
  - "The CNB should ensure that a full risk assessment is carried out on a regular basis, and that it is fully integrated into the supervisory approach."
  - "It should clarify the duration of the supervisory cycle for each bank, which should vary with the degree of assessed risk, and hold prudential meetings with the senior management/ Board of all banks on a regular basis."

- 23. Corrective and Remedial Powers of Supervisors
  - "Guidelines should be developed on when pre-emptive supervisory action might usefully be undertaken, as well as some pre-planning on what to do in the event of a crisis."

*IMF staff report section: 25. Home-host relationships (excerpt) — Table 11 recommendations and authorities’ response.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08160.pdf_