## _cr0850

## Source details

**Canonical URL:** [_cr0850](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr0850.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr0850.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr0850.pdf.json)

---

### Executive Summary — Background
- Montenegro declared independence on June 3, 2006; referendum on May 21. Joined the IMF and World Bank on January 18, 2007.
- Monetary framework:
  - Montenegro uses the euro unilaterally.
  - CBM is not a member of the European System of Central Banks, is not authorized to issue currency, conducts no independent monetary policy, may affect local liquidity by changing reserve requirements, may not grant loans to the government, and does not have authority to participate in the primary market for government securities.
- Benefits and costs of unilateral euroization:
  - Benefits: dramatic reduction in inflation when the dinar was abolished; reduced transaction costs; elimination of currency risk premium.
  - Costs: (i) loss of monetary/exchange rate policy to cushion external shocks; (ii) strictly limited lender-of-last-resort functionality; (iii) loss of seigniorage revenue; (iv) higher liquidity management costs.
- Financial deepening and capital inflows:
  - Banking sector assets rose from around 30 percent of GDP in 2001 to 72 percent in 2006.
  - Over 2004–06, cumulative capital account inflows exceeded the current account deficit by 14 percent of GDP.
  - Total foreign bank borrowing at end-2006 amounted to EUR 156 million.
- Fiscal stance:
  - Fiscal balance before grants moved from an average deficit of 4.3 percent of GDP in 2002–04 to a surplus of 2.2 percent of GDP in 2006.
  - Public debt fell by well over 40 percentage points of GDP to 38 percent of GDP at end-2006.
  - Risks to public debt: restitution of state-seized property, future pension liabilities, contingent liabilities in state-owned enterprises.
- Selected indicators (2002–2007, annual percent changes and levels):
  - Real GDP: 1.7, 2.4, 4.2, 4.0, 6.5, 7.5
  - Retail prices (period average): 19.7, 7.5, 3.1, 3.4, 2.1, 3.5
  - Bank credit to private sector (2004–2007): 43.2, 33.2, 138.9, 191.3
  - Enterprises (2004–2007): 40.6, 30.2, 112.2, 198.4
  - Households (2004–2007): 49.4, 39.9, 193.0, 180.7
  - Bank deposits - private sector (2004–2007): 23.0, 84.2, 119.5, 129.4
  - Revenue and grants (percent of GDP): 37.2, 41.8, 37.8, 37.4, 44.9, 50.7
  - Overall balance (percent of GDP): -1.8, -4.8, -2.7, -1.8, 2.4, 5.4
  - Central government deposits (end-of-period): 1.6, 1.1, 4.1, 6.2, 8.9
  - General government gross debt (end of period, stock): 89.4, 51.8, 45.9, 41.6, 37.7, 40.5
  - External debt: 68.7, 33.2, 29.6, 28.9, 26.1, 22.3
  - Nominal GDP (millions of euro): 1,302; 1,392; 1,651; 1,785; 1,979; 2,204
  - Population (millions): 0.6
  - Current account balance, excl. grants: -11.1, -10.1, -8.9, -30.7, -37.0
  - Foreign direct investments: 2.8, 3.4, 21.4, 23.6, 24.4

### Key Financial Sector Risks and Vulnerabilities
- Main vulnerabilities:
  - Extremely rapid growth of the banking system; stress tests confirmed growing credit and liquidity risk.
  - Exacerbating factors: stock market buoyancy, weak disclosure regime, absence of traditional lender-of-last-resort function due to unilateral euroization.
- Rapid banking sector growth:
  - Growth in assets supported by increases in deposits from high capital inflows and greater formalization.
  - Large and growing foreign presence; largest bank purchased in 2006 by Hungarian banking group OTP.
  - Not all foreign owners are internationally-rated financial institutions able to provide risk management expertise, capital, and liquidity support.
  - Recent indicators: foreign banks increasing foreign borrowing as deposit growth slows; some domestic banks pursuing aggressive expansion.
- Credit growth specifics:
  - Credit outstanding more than doubled in 2006; year-on-year growth as of end-September 2007 was 177 percent.
  - Some banks exceeded this rate substantially.
  - Limited quality of borrower information and weak internal control systems.
  - Nonperforming loans are at low levels but are lagging indicators.
  - Indicators of bank liquidity are decreasing.
  - Signs that rapid credit growth is leading to macroeconomic overheating.
- Funding and ownership considerations:
  - Funding for credit growth primarily from asset sales to non-residents, including coastal real estate sales.
  - Share of bank assets owned by rated financial institutions is declining despite some improvement after OTP purchase.
  - Unilateral euroization increases liquidity risk relative to eurozone members; CBM has limited lender-of-last-resort ability.
  - Public sector bank deposits and lending remain significant and concentrated; public sector deposits important funding sources and create governance, transparency, and risk management concerns.
- Stock market and system scale:
  - Market indices rose by over 300 percent during the 12 months to end-April 2007, before declining about 40 percent.
  - Financial reporting requirements for traded firms are weak.
  - Banks’ direct exposure to the stock market is modest, but customers invested in the stock market, often using “cash” loans based on salary deposits.
  - Small country fixed-cost disadvantages affect supervisory organization and market structure.
- Supervisory challenges:
  - Rapid credit growth posing supervisory challenges despite relatively strong regulation and supervision.
  - Until mid-2006 credit growth concentrated in one large bank; recently multiple banks experienced triple-digit lending growth.
  - Stress tests confirm growing credit and liquidity risk.

### Main Recommendations and Policy Priorities
- Overall approach: mix of prudential strengthening to address risks from rapid credit growth and measures targeting specific vulnerabilities.
- Prudential measures to manage credit growth:
  - Encourage banks to strengthen internal processes and controls.
  - Supervisor actions: continuously re-evaluate bank risk management practices; prepare bank-by-bank responses; strengthen regulatory framework, including liquidity regulation.
  - Strengthen home-host supervisory coordination given foreign bank ownership and adoption of Basel II.
  - Broaden credit registry access to facilitate banks’ risk management.
- Legal and supervisory enforcement:
  - Adopt the Law on Banking.
  - Strengthen supervisory enforcement powers:
    - increase legal protection for supervisors;
    - empower supervisors to impose appropriate remedial measures in individual situations;
    - authorize supervisors to impose monetary penalties directly without first obtaining court approval;
    - enhance rights of appeal to administrative court decisions.
  - Securities and Exchange Commission should investigate suspicious trading vigorously and build a strong enforcement record.
- Public sector deposit management:
  - Gradually transfer most public sector deposits from commercial banks to the CBM to (i) establish more arms-length relations between banks and government-related agencies, and (ii) help sterilize large capital inflows funding the credit boom.
  - Set timeframe to allow banks to adjust smoothly; deposits should be remunerated appropriately by the CBM.
- Efficiency and financial architecture:
  - Use efficiency considerations in determining supervisory and financial architecture, including size of CBM and supervisory agencies.
  - Pool scarce human resources and training to improve supervision effectiveness and quality.
  - Establish a common platform for securities exchanges and interoperability in electronic payment infrastructure.
- Specific actions (time-frame categories: ST = short term, MT = medium term, LT = long term):
  - Manage Growing Credit Risk:
    - Adopt draft Law of Banks. (ST)
    - Tighten prudential supervision. (ST)
  - Reduce Public Role in Financial Sector:
    - Gradually transfer public sector deposits to CBM. (ST/MT)
    - Public sector to operate at an arms-length basis to improve governance and risk management. (ST)
  - Liquidity Management Framework:
    - Use a single required reserve ratio; use liquidity ratio regulations for prudential purposes, while reducing the reserve requirement gradually over time; remove option of holding required reserves in treasury bills; gradually remove the limit of 50 percent on maximum usable reserves. (MT)
    - Reference the interest rate on liquidity maintenance credits to the relevant ECB rate; abolish interest charges for intraday credit and use automatic collateral system. (LT)
  - Payment Systems:
    - Prepare and enact a Law on Payment and Settlement Systems. (MT)
    - Start oversight of settlement and clearing systems for electronic payment instruments. (ST)
    - Provide leadership to develop national infrastructure for electronic payment instruments that allows for inter-operability. (MT)
  - Credit Registry:
    - Broaden access to credit registry. (ST)
  - Capital Markets:
    - Strengthen disclosure requirements and enforcement in securities market. (ST)
    - Evaluate consequences in legislation, regulation and infrastructure of moving to an open market allowing cross-border membership and off-exchange/OTC trading. (ST)
    - Move both stock exchanges to one common trading platform. Reorganize market/listing structure. (MT)
  - Legal Framework:
    - Provide legal protection for the CBM, its officers, staff and agents against liability for damages caused by such persons in the good faith performance of their duties. (ST)
    - Empower supervisors to impose appropriate remedial measures in individual situations. (ST)
    - Authorize the supervisors to impose monetary penalties directly without having to first obtain court approval. (ST)
    - Create precedent in judicial handling of criminal cases including regarding insider trading and other market abuses. (ST)

### Financial Soundness Indicators — Overall assessment and recent trends
- Capitalization:
  - Overall capital adequacy ratio (CAR) at end-June 2007: 18.7 percent (down from over 30 percent at end-2004).
- Liquidity indicators:
  - Liquid assets fell to 25 percent of total assets at end-June 2007 (Table 3: Jun. 2007 liquid assets, percent of total assets = 25.4).
  - Loan-to-deposit ratio increased to 95 percent—up from 88 percent one year earlier.
- Earnings:
  - Earnings rebounded on the back of growing interest margins; net interest margin movements and falling overhead costs contributed to profit recovery.
- Nonbank financial sector:
  - Assets at end-2006 stood at about 16 percent of total financial sector assets; leasing activity expanded after the Law on Leasing (2005).

### Key Financial Soundness Figures (Dec. 2004 to Jun. 2007, exact sequences)
- Regulatory capital as percent of risk-weighted assets: 31.3; 28.3; 27.8; 20.3; 21.3; 18.7.
- Capital as percent of assets: 20.4; 17.8; 15.3; 14.3; 10.4; 9.5.
- Liquid assets, percent of total assets: 24.2; 28.7; 38.4; 28.4; 35.8; 25.4.
- Liquid assets, percent of short-term liabilities: 41.0; 47.3; 58.8; 43.0; 63.0; 43.0.
- Deposits, percent of assets: 61.5; 65.6; 70.1; 73.0; 75.2; 74.5.
- Loans, percent of deposits: 103.0; 95.8; 77.1; 88.1; 78.8; 95.0.
- Non-performing loans (NPL), percent of gross loans: 5.2; 7.0; 5.3; 7.0; 2.9; 2.0.
- Provisions, percent of NPL: 77.3; 54.5; 67.4; 67.4; 78.8; 104.1.
- Provisions, percent of total loans: 4.0; 3.8; 3.6; 2.7; 2.2; 2.0.
- NPL net of provisions, percent of capital: 3.6; 11.3; 6.1; 5.9; 3.5; -0.6.
- Gross profits, percent of average assets (ROAA): -0.3; 2.5; 0.8; 0.6; 1.1; 1.4.
- Gross profits, percent of average equity capital (ROAE): -1.4; 13.8; 5.3; 4.6; 8.6; 11.6.
- Net interest margin (net interest income, percent of interest bearing assets): 6.9; 3.4; 5.4; 2.6; 3.5; 1.8.

### Rapid Credit Growth — Findings and Implications
- Loan-loss provisions low: 2 percent of total loans at end-June 2007.
- CBM examinations found asset classification in most banks ridden with errors and too lax—NPLs reported at 2 percent at end-June 2007.
- Capital adequacy fell in all but one bank over the twelve months ending June 2007, but remained above regulatory minima.
- Risk management weaknesses per BCP assessment:
  - Significant weaknesses in internal controls.
  - Untested and under-resourced risk management processes.
  - Shortage of trained credit officers relative to rapid credit growth.
  - Questionable accuracy of bank clients’ financial statements used in credit analysis (notable improvement after VAT introduction).
- Measures to improve asset quality:
  - Banks: adopt proper risk management, internal policies, procedures, and governance aligned with modern practices.
  - Supervisors: validate and monitor banks’ systems; conduct additional reviews of critical areas; issue guidance notes; periodically review prudential framework.
  - Medium-term: broaden access to the credit registry (programmed for early 2008) and enhance disclosure of financial information by bank clients.
- Recent CBM macroprudential measures (mostly effective January 1, 2008):
  - Increased reserve requirements.
  - Ceilings on credit growth ranging from 30 to 60 percent per annum of the loan portfolio depending on the size of the bank.
  - Higher provisions on new loans.
  - Increases in capital adequacy ratios for banks with rapid credit growth.
- Caution on direct controls: credit ceilings can produce regulatory arbitrage toward nonbank channels (e.g., leasing). Consider less distortionary prudential measures, including reversing the reduction in risk weight of residential mortgages (risk weight was reduced in October 2006).

### Vulnerabilities Associated with Unilateral Euroization — Findings and Recommendations
- Unilateral euroization limits scope for CBM to act as lender-of-last-resort or to tighten monetary conditions.
- Liquidity management should be more conservative:
  - Foreign-owned subsidiaries can face withdrawal of support or cross-country contagion.
  - Vulnerability higher for domestically owned banks or banks owned by unrated foreign banks/investors.
- Supervisory actions suggested:
  - Consider further tightening liquid asset requirements.
  - Suspend lower liquidity requirement in periods of rapid credit growth until credit growth moderates.
  - Alternatively, establish liquidity requirements that account for banks’ available liquidity support (including contingent credit lines).
- Public deposits:
  - Public deposits doubled from end-2003 to mid-2006 and reached about 18 percent of total deposits and 15 percent of total loans.
  - Deposits exceed borrowings throughout the period; about half arise from the Development Fund.
  - Deposit concentration: one bank holds 65 percent of public sector deposits, accounting for 23 percent of its deposit base.
  - Risks: sudden withdrawal could be destabilizing; public deposits contribute to credit growth and inflation pressures; governance issues and corruption risk.
- Recommendation: transfer central government deposits above transaction needs to the CBM on a timeframe that accommodates smooth bank funding adjustment. These deposits should be remunerated by the CBM; state-enterprise deposit placements and transaction accounts should be transparently competed among qualified banks.

### Stress Testing — Approach and Main Results
- Tests updated using end-June 2007 data. Banks grouped into large and small (each group of five banks).
- Credit risk stress tests:
  - Test 1: migration of asset classifications—10 percent A→B; 15, 20, 40 percent migrations to Categories C–E; provisions increased in line with existing regulations.
  - Test 2: Test 1 worsened by an additional 50 percent increase in NPLs and a 30 percent increase in provisions (hard-landing scenario).
  - Test 3: default of a large borrower defined as the median of the largest 20 borrowers.
- Results:
  - For one large bank, under the first two stress tests its CAR falls below the required minimum 8 percent.
  - Other banks maintain capital above 10 percent under Test 1, but two additional large banks fall below that threshold under Test 2.
  - Default of a single (median-sized) large borrower did not put any bank below regulatory norms (contrast with Jun. 2006 tests where one large bank’s CAR fell below 8 percent).
- Liquidity risk stress tests:
  - Coverage of customer deposits by cash, bank deposits and other liquid assets decreased from nearly 40 percent at end-June 2006 to around 34 percent at end-June 2007.
  - Two scenarios: generalized loss of depositor confidence; withdrawals limited to larger depositors including public sector deposits.
  - Results:
    - Some banks experience tight liquidity conditions and high deposit concentration.
    - One bank had no free liquidity at the stress test start date.
    - Two large banks could not meet the first three hypothetical withdrawal shocks from free liquidity and had to tap required reserves (permitted).
    - If all public sector deposits were withdrawn, one bank would run out of free liquidity.
    - In four banks, public sector deposits account for more than 13 percent of total deposits; in two banks the share is greater than 20 percent.
- Market risk stress tests (interest rate and foreign exchange) showed modest impact due to low exposure.

### Stress-Test Key Figures (selected exact values)
- 1. Migration to lower asset categories: 14.3 5.7 16.1 11.9 199.0
- 2. Increase in NPLs: 13.0 3.5 15.7 10.1 201.8
- 3. Large exposures: 17.4 11.8 16.5 16.7 198.3
- Free liquidity (cash and free reserves, as percent of total deposits): 18.0 -5.7 36.6 22.2 445.5
- Liquidity stress test (free liquidity available after shock, percent of total deposits):
  - 15 percent of deposits withdrawn: 3.0 -20.7 21.6 7.2 430.5
  - loss of largest depositor: 10.5 -14.1 34.1 15.7 371.2
  - loss of 50 percent of top ten depositors: 5.4 -24.6 31.1 8.2 399.4
  - loss of public sector deposits: 5.5 -31.5 35.8 0.8 440.9

### Stock Market Volatility — Findings and Risks
- NEX and MOSTE indices rose by 338 percent and 373 percent during the 12 months to end-April 2007 and have since fallen about 40 percent from the April peak.
- Market turnover relatively low at less than EUR 2 million per day (both exchanges combined, 2006).
- Governance and stability concerns:
  - Weak disclosure requirements: reporting not timely; filing violations not enforced.
  - SEC has yet to investigate suspect trading and has no proven enforcement record.
  - High yields have tempted bank customers to invest in the stock market, including using payroll consumer lending (typically up to EUR 5,000 per loan).

### Structural Issues — Prudential Supervision and Supervisory Architecture
- Basel Core Principles assessment: overall compliance satisfactory; areas for improvement include internal controls of banks, insufficient legal protection of CBM supervisors, relatively weak enforcement powers.
- Banking supervision strengths:
  - Periodic offsite analysis and onsite inspections.
  - CBM operational and financial independence; direct levy of fees for regulatory and examination activities.
  - Senior staff progressing in international best practices.
- Recommendations to strengthen the draft Law on Banking:
  - Strengthening corrective action and problem bank resolution procedures.
  - Ensure CBM resolution execution not suspended where it addresses imminent threat to depositors’ interests.
  - Strengthen provisions for exchange of information with foreign supervisors.
  - Permit on-site inspections by foreign financial sector supervisors in Montenegro.
  - Expand fit and proper criteria to include senior management and directors/managers of financial holding companies.
  - Require banks to apply AML/CFT legislation as part of bank examinations.
  - Empower CBM to divest owners of qualified participation acquired without prior CBM approval.
  - Strengthen independence requirements for non-executive directors.
- Remaining legal/regulatory weaknesses:
  - Protection for the CBM, its officers, staff and agents against liability for damages caused in good faith performance of duties.
  - Empower CBM to impose remedial measures in individual situations.
  - Authorize CBM to impose monetary penalties directly on banks without first obtaining court approval.
  - Inadequate access to judicial review: administrative court decision cannot be appealed.
- Organizational response:
  - New Bank Supervision Department structure adopted to strengthen supervisory capacities, focus on risk-based and consolidated supervision.
- Rethinking supervisory architecture:
  - Need to reduce fixed costs; consider unified supervision as sector integrates.
  - Insurance supervision resources inadequate; alternatives include empowering CBM as insurance regulator.
  - Emergence of conglomerates suggests potential need for a single supervisory agency; recommend considering a study.
  - Broker/dealer activity: banks likely to act as securities brokers/dealers, requiring closer CBM–SEC cooperation.

### Liquidity Management and Financial Infrastructure
- Medium-term objective: converge financial system conditions to the Eurozone and integrate with the euro money market.
- Obstacles to access euro area money markets: high rating and transaction costs, legal security and reputational concerns.
- Balance-sheet stability measures:
  - Encourage limiting short-term liabilities and moving longer-term assets off banks’ books.
  - Include incentives in liquidity regulation favoring deposit contracts not subject to early withdrawal optionality.
  - Explore securitization of longer-term assets (e.g., mortgages) for sale to pension funds and insurance companies.
- Liquidity framework and reserve-requirement changes:
  - Recently adopted liquidity ratio should be principal framework; allow simplification of reserve requirement regime over time.
  - Liquidity ratio: "10–15 percent daily and 15–20 percent ten-day liquidity ratio, depending on asset quality indicators"; remuneration on required reserves must be adjusted to remain neutral.
  - Specific policy changes recommended:
    - Remove option of holding 10 percent of required reserves in domestic treasury bills.
    - Develop collateralized intraday credit to allow interest-free intraday fund use.
    - Remove 50 percent limit on use of reserve requirements and allow averaging over the entire maintenance period.
    - Reference CBM standing facility interest rates to relevant ECB rates: recommend setting rate as the ECB overnight interest rate plus an appropriate margin.
- CBM lending practices:
  - CBM grants intraday and overnight credit up to 80 percent of nominal value of collateral, which must be securities issued by the Republic of Montenegro or an EU member state.
- Payments and settlement:
  - Need for a Law on Payments and Settlement; draft: Law on the Transfer of Funds, Electronic Payment Instruments and Payment Systems.
  - Revisions needed for irrevocability and timing of settlement finality, legal recognition of netting, use of collateral pledges, admissibility of electronic payment instructions.
  - CBM does not monitor settlement systems involving credit and debit cards; settlement/clearing arranged by individual banks without national standard for interoperability.
  - CBM should take a more active coordinating role and establish technical parameters ensuring effective interfaces with low-value payment system and shared e-payments infrastructure.
- Accounting and auditing:
  - Larger companies required to abide by IFRS, but compliance varies.
  - Banks’ IFRS compliance generally good.
  - Large listed nonbank companies: financial reporting mediocre; SMEs: financial reporting poor.
  - Audit quality uneven; external quality control over the country’s 32 licensed auditors does not exist.
- Nonbank financial institutions:
  - Insurance sector: assets EUR 31 million at end-2005; premiums grew 22 percent in 2005; five insurance companies and one domestic re-insurance company.
  - Leasing: after Law on Leasing (late 2005), about 500 contracts total value EUR 42 million; two-thirds financial leases for autos and buses; leasing companies not subject to regulation beyond Business Organizations law.
  - Micro-finance institutions: four MFIs; total assets about EUR 34 million at end-2006 (up from EUR 9 million in June 2003); MFIs not permitted to accept deposits.
  - Capital markets: nearly 450 companies exchange-traded; six investment funds; bond market nearly non-existing.
- Registry and information systems:
  - Modern registry systems: register of legal persons; registry of pledges over movable property; cadastre/land registry including mortgage registry; central securities registry/depository (CDA).
  - Mandatory collection of credit information in a closed registry system maintained by the CBM.

### Central Bank of Montenegro (CBM): Independence, Accountability, Legal Framework
- New Constitution: CBM is an independent organization; accountable for monetary and financial stability and functioning of the banking system.
- Draft amended Central Bank Law and the Law on Banks should be revised to align with international standards.
- Areas of particular concern:
  - (i) prioritization of CBM's objectives;
  - (ii) ability of CBM to impose administrative sanctions without prior court approval;
  - (iii) limits on judicial review of CBM decisions related to its supervisory role;
  - (iv) protection for CBM, its decision-making members, staff, and agents against liability for actions/omissions made in good faith.
- Bank bankruptcy, liquidation, and judicial review:
  - Law on Bank Bankruptcy and Liquidation under technical review.
  - Appeals have shown CBM did not have the right to challenge Administrative Court decisions.
  - Concern that Administrative Court could reverse CBM decisions; principle asserted that judges should not substitute technical judgment for the CBM.
- AML/CFT:
  - MONEYVAL assessed Serbia and Montenegro in 2003; report issued January 2005.
  - Key changes: amended AML/CFT law; start of operations of financial intelligence unit.
  - MONEYVAL plans new AML/CFT assessment of Montenegro in September 2008; report may be adopted by MONEYVAL plenary possibly within first half of 2009, after which an AML/CFT ROSC will be prepared and circulated to the IMF Board for information.
- Basel Core Principles — main findings and recommended action plan (selected highlights):
  - CP 1(2) Remuneration: keep supervisors’ remuneration broadly competitive with commercial banks.
  - CP 1(5) Legal Protection: provide legal protection for CBM, Council, employees and agents for actions in good faith.
  - CP 1(6) Information sharing: new Law of Banks should specify confidential information disclosure gateways.
  - CP 3 Licensing: apply same standards of personal integrity to managers in banks as for board members.
  - CP 6 Capital Adequacy: define general reserves eligible for Tier 2 capital.
  - CP 8 Loan Evaluation: past due loans of 30 to 90 days should be classified as Substandard, not Special Mention.
  - CP 14 Internal Audit and Controls: recommend banks increase staff and quality of internal auditors.
  - CP 20 Consolidated Supervision: review formats for consolidated reports.
  - CP 21 Accounting Standards: new Law of Banks should place legal responsibility on managing board for comprehensive and reliable accounting records and accuracy of supervisory reports.
  - CP 22 Remedial Measures: simplify/clarify situations to place a bank in interim administration; empower CBM to levy fines directly.
  - CP 25 Supervision of Foreign Banks’ establishments: continue efforts to negotiate cooperation agreements with home country supervisors.
- Authorities’ response:
  - Authorities broadly agreed; emphasized progress in internal controls uncovered during on-site examinations.
  - CBM strengthened regulation and supervision of internal control systems and internal audit; Decision on Internal Controls Systems and Internal Audit in Banks (adopted December 2003) has been strengthened.
  - Plan: upon adoption of new Law on Banks, adopt new decision on capital adequacy moving classification of asset items to standardized approach of Basel II.

### Financial Sector Overview — Structure and Key Statistics
- Number of banks: ten.
- CKB (purchased by OTP at end-2006) rapid growth:
  - assets more than doubled in the 12-month period ending in June 2007;
  - holds 36 percent of assets;
  - 35 percent of loans (up 120 percent in the 12-month period to June 2007);
  - 40 percent of deposits as of end-June 2007;
  - accounts for 19 percent of total banking sector capital.
- Market concentration and ownership changes:
  - Largest three banks represent 63 percent of total assets.
  - New bank license issued December 2005; started operating March 2006.
  - Two operating banks are under a supervisory plan.
  - Recent takeovers: Podgorica Bank purchased by Société Générale (2005); Euromarket Bank purchased by Nova Ljubljanska Bank (NLB) (2005); Atlasmont Bank purchased stake in Pljevaljska Bank (renamed Invest Bank Montenegro) (2006); OTP purchased CKB (2006); state sold 30 percent in Niksicka Bank (renamed Prva/First Bank) to a former shareholder in CKB.
  - Several banks liquidated; one bank (Ekos Bank) in final stages of liquidation.
- Rapid growth indicators (12-month period ending in June 2007):
  - Deposits increased by 149 percent.
  - Loans increased by 169 percent.
  - System capital adequacy: 18.7 percent as of end-June 2007, dispersion across banks ranging from 14 percent to 169 percent.
  - Bank profitability: return on assets fell from 2.5 percent in June 2005 to 1.4 percent at end-June 2007.
- Banking sector performance (selected)
  - Nonperforming loans (NPLs) have fallen to 2 percent of total loans, with provisions of 104 percent of NPLs.
  - Provisions have fallen as percent of total loans.
  - Loan-to-deposit ratio: 95 percent at end-June 2007, up from 77 percent in December 2005.
  - Liquid assets fell to 25 percent of total assets at end-June 2007.
  - Some lengthening of maturities more pronounced on assets than liabilities.
- Privatization and ownership:
  - State holds minority shares in five banks, total 4 percent of banking system at end-2006.
  - State sold stake in Niksicka Bank (30 percent) but continues to own over 14 percent of the bank after that transaction.
  - Other state-held shares: Invest Bank Montenegro (13 percent), Podgoricka Bank (6 percent), Hipotekarna Bank (3 percent), NLB Montenegro Bank (2 percent).
- Foreign bank presence and parent linkages:
  - CKB, NLB Montenegro Bank, Podgoricka Bank, Hypo-Alpe-Adria Bank have rated parent institutions; other majority foreign-owned banks may have limited access to know-how, capital, liquidity.
  - Parent ratings mentioned: NLB rated A-/F2 by Fitch Ratings; Société Générale AA/F1+; OTP Bank rated BBBpi in December 2006 by Standard & Poor’s.
- Concentration risk:
  - Banks’ net exposure to the 30 largest debtors amounted to 16 percent of loans at end-June 2006.
  - Largest 20 depositors in each bank range from 21 percent to 91 percent of deposits.
  - The 20 largest depositors in all banks account for 36 percent of all deposits.
- Nonbank financial sector:
  - NBFIs total about 16 percent of GDP at end-2006.
  - Insurance sector assets EUR 31 million at end-2005; premiums grew 22 percent in 2005.
  - Leasing: about 500 contracts, total value EUR 42 million.
  - MFIs: total assets about EUR 34 million at end-2006.
  - Capital markets: exchange-traded nearly 450 companies; six investment funds; bond market nearly non-existing.
- Registry and information systems:
  - Modern registries in place: register of legal persons; registry of pledges over movable property; cadastre/land registry including mortgage registry; central securities registry/depository (CDA).
  - Mandatory credit information collection in a closed registry system maintained by the CBM.

*Source: _cr0850 - Executive Summary and IMF staff report excerpt*

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

### Executive Summary

### Background
- Montenegro declared independence on June 3, 2006, following a referendum on May 21. The country joined the IMF and World Bank on January 18, 2007.
- Monetary framework: Montenegro uses the euro unilaterally; the Central Bank of Montenegro (CBM) is not a member of the European System of Central Banks, is not authorized to issue currency, conducts no independent monetary policy, may affect local liquidity by changing reserve requirements, may not grant loans to the government, and does not have authority to participate in the primary market for government securities.
- Benefits and costs of unilateral euroization noted:
  - Benefits: dramatic reduction in inflation when the dinar was abolished; reduced transaction costs; elimination of currency risk premium.
  - Costs: (i) loss of monetary/exchange rate policy to cushion external shocks; (ii) strictly limited lender-of-last-resort functionality; (iii) loss of seigniorage revenue; (iv) higher liquidity management costs.
- Financial deepening and capital inflows:
  - Banking sector assets rose from around 30 percent of GDP in 2001 to 72 percent in 2006 (Table 2).
  - Over 2004–06, cumulative capital account inflows exceeded the current account deficit by 14 percent of GDP.
  - Total foreign bank borrowing at end-2006 amounted to EUR 156 million.
- Fiscal stance: fiscal balance before grants moved from an average deficit of 4.3 percent of GDP in 2002–04 to a surplus of 2.2 percent of GDP in 2006.
  - Public debt fell by well over 40 percentage points of GDP to 38 percent of GDP at end-2006.
  - Risks to public debt: restitution of state-seized property, future pension liabilities, contingent liabilities in state-owned enterprises.
- Selected indicators (2002–2007, annual percent changes and levels):
  - Real GDP: 1.7, 2.4, 4.2, 4.0, 6.5, 7.5
  - Retail prices (period average): 19.7, 7.5, 3.1, 3.4, 2.1, 3.5
  - Bank credit to private sector (2004–2007): 43.2, 33.2, 138.9, 191.3
  - Enterprises (2004–2007): 40.6, 30.2, 112.2, 198.4
  - Households (2004–2007): 49.4, 39.9, 193.0, 180.7
  - Bank deposits - private sector (2004–2007): 23.0, 84.2, 119.5, 129.4
  - Revenue and grants (percent of GDP): 37.2, 41.8, 37.8, 37.4, 44.9, 50.7
  - Overall balance (percent of GDP): -1.8, -4.8, -2.7, -1.8, 2.4, 5.4
  - Central government deposits (end-of-period): 1.6, 1.1, 4.1, 6.2, 8.9
  - General government gross debt (end of period, stock): 89.4, 51.8, 45.9, 41.6, 37.7, 40.5
  - External debt: 68.7, 33.2, 29.6, 28.9, 26.1, 22.3
  - Nominal GDP (millions of euro): 1,302; 1,392; 1,651; 1,785; 1,979; 2,204
  - Population (millions): 0.6
  - Current account balance, excl. grants: -11.1, -10.1, -8.9, -30.7, -37.0
  - Foreign direct investments: 2.8, 3.4, 21.4, 23.6, 24.4

### Key Financial Sector Risks and Vulnerabilities
- Main vulnerabilities: extremely rapid growth of the banking system; stress tests confirmed growing credit and liquidity risk. These are exacerbated by stock market buoyancy, weak disclosure regime, and absence of traditional lender-of-last-resort function due to unilateral euroization.
- Rapid banking sector growth, particularly since 2006:
  - Growth in assets supported by increases in deposits from high capital inflows and greater formalization of the economy.
  - Large and growing foreign presence: the largest bank was purchased in 2006 by Hungarian banking group OTP; a foreign bank commencing operations in 2006 ranks fourth in assets.
  - Not all foreign owners are internationally-rated financial institutions able to provide risk management expertise, capital, and liquidity support.
  - Recent indicators show foreign banks increasing foreign borrowing as deposit growth slows; some domestic banks pursuing aggressive expansion.
- Credit growth specifics:
  - Credit outstanding more than doubled in 2006; year-on-year growth as of end-September 2007 was 177 percent.
  - Some banks exceeded this rate substantially; vigorous competition pressured profitability.
  - Limited quality of borrower information and weak internal control systems.
  - Nonperforming loans are at low levels but are lagging indicators and may not reflect loan quality amid rapid growth.
  - Indicators of bank liquidity are decreasing.
  - Signs that rapid credit growth is leading to macroeconomic overheating.
- Funding and ownership considerations:
  - Funding for credit growth primarily from asset sales to non-residents, including coastal real estate sales; increased formalization has contributed to bank funding.
  - Share of bank assets owned by rated financial institutions is declining despite recent improvement after OTP purchase.
  - Unilateral euroization increases liquidity risk relative to eurozone members; CBM has limited lender-of-last-resort ability.
  - Public sector bank deposits and lending remain significant and concentrated despite sharp reduction in direct state ownership; these deposits have been important funding sources and create governance, transparency, and risk management concerns.
- Stock market and system scale:
  - Significant correction in stock market prices is underway; market indices rose by over 300 percent during the 12 months to end-April 2007, before declining about 40 percent.
  - Financial reporting requirements for traded firms are weak.
  - Banks’ direct exposure to the stock market is modest, but high yields incentivized bank customers to invest in the stock market, including using “cash” loans based on salary deposits.
  - Small country fixed-cost disadvantages affect the ability to establish a low-cost operating environment for the financial system, with implications for supervisory organization and market structure.
- Supervisory challenges:
  - Rapid credit growth is posing supervisory challenges despite relatively strong regulation and supervision.
  - Until mid-2006, credit growth concentrated in one large bank; recently multiple banks experienced triple-digit lending growth, stretching supervisory resources.
  - Stress tests confirm growing credit and liquidity risk.

### Main Recommendations and Policy Priorities
- Overall approach: a mix of prudential strengthening to address risks from rapid credit growth and measures targeting specific vulnerabilities.

- Prudential measures to manage credit growth:
  - Encourage banks to strengthen internal processes and controls.
  - Supervisor actions: continuously re-evaluate bank risk management practices; prepare bank-by-bank responses; strengthen regulatory framework, including liquidity regulation.
  - Strengthen home-host supervisory coordination given foreign bank ownership and adoption of Basel II.
  - Broaden credit registry access to facilitate banks’ risk management.

- Legal and supervisory enforcement:
  - Adopt the Law on Banking.
  - Strengthen supervisory enforcement powers: (i) increase legal protection for supervisors; (ii) empower supervisors to impose appropriate remedial measures in individual situations; (iii) authorize supervisors to impose monetary penalties directly without first obtaining court approval; (iv) enhance rights of appeal to administrative court decisions.
  - Securities and Exchange Commission should investigate suspicious trading vigorously and build a strong enforcement record.

- Public sector deposit management:
  - Gradually transfer most public sector deposits from commercial banks to the CBM to (i) establish more arms-length relations between banks and government-related agencies, and (ii) help sterilize large capital inflows funding the credit boom.
  - Set timeframe to allow banks to adjust smoothly; deposits should be remunerated appropriately by the CBM.

- Efficiency and financial architecture:
  - Use efficiency considerations in determining supervisory and financial architecture, including size of CBM and supervisory agencies.
  - Pool scarce human resources and training to improve supervision effectiveness and quality.
  - Establish a common platform for securities exchanges and interoperability in electronic payment infrastructure for operational efficiency.

- Specific recommended actions (time-frame categories: ST = short term, MT = medium term, LT = long term):
  - Manage Growing Credit Risk:
    - Adopt draft Law of Banks. (ST)
    - Tighten prudential supervision. (ST)
  - Reduce Public Role in Financial Sector:
    - Gradually transfer public sector deposits to CBM. (ST/MT)
    - Public sector to operate at an arms-length basis to improve governance and risk management. (ST)
  - Liquidity Management Framework:
    - Use a single required reserve ratio; use liquidity ratio regulations for prudential purposes, while reducing the reserve requirement gradually over time; remove option of holding required reserves in treasury bills; gradually remove the limit of 50 percent on maximum usable reserves. (MT)
    - Reference the interest rate on liquidity maintenance credits to the relevant ECB rate; abolish interest charges for intraday credit and use automatic collateral system. (LT)
  - Payment Systems:
    - Prepare and enact a Law on Payment and Settlement Systems. (MT)
    - Start oversight of settlement and clearing systems for electronic payment instruments. (ST)
    - Provide leadership to develop national infrastructure for electronic payment instruments that allows for inter-operability of different platforms. (MT)
  - Credit Registry:
    - Broaden access to credit registry. (ST)
  - Capital Markets:
    - Strengthen disclosure requirements and enforcement in securities market. (ST)
    - Evaluate consequences in legislation, regulation and infrastructure of moving to an open market allowing cross-border membership and off-exchange/OTC trading. (ST)
    - Move both stock exchanges to one common trading platform. Reorganize market/listing structure. (MT)
  - Legal Framework:
    - Provide legal protection for the CBM, its officers, staff and agents against liability for damages caused by such persons in the good faith performance of their duties. (ST)
    - Empower supervisors to impose appropriate remedial measures in individual situations. (ST)
    - Authorize the supervisors to impose monetary penalties directly without having to first obtain court approval. (ST)
    - Create precedent in judicial handling of criminal cases including regarding insider trading and other market abuses. (ST)

*Source: _cr0850 - Executive Summary*

### 8.      Financial soundness indicators, while not yet alarming, are rapidly deteriorating

### 8.      Financial soundness indicators, while not yet alarming, are rapidly deteriorating

### Overall assessment and recent trends
- Capitalization remains high but has declined: overall capital adequacy ratio for the banking system at end-June 2007 stood at 18.7 percent, but well below the over 30 percent rate at end-2004.
- Liquidity indicators are tightening:
  - Liquid assets fell to 25 percent of total assets at end-June 2007 (Table 3 shows liquid assets, in percent of total assets, at 25.4 for Jun. 2007).
  - Loan-to-deposit ratio increased to 95 percent—up from 88 percent one year earlier.
- Earnings have rebounded on the back of growing interest margins; net interest margin movements and falling overhead costs contributed to profit recovery even as bank employment lagged credit expansion.
- Nonbank financial sector: assets at end-2006 stood at about 16 percent of total financial sector assets; leasing activity expanded after the Law on Leasing (2005).

### Key financial soundness figures (selected, exact)
- Regulatory capital as percent of risk-weighted assets (Dec. 2004 to Jun. 2007): 31.3; 28.3; 27.8; 20.3; 21.3; 18.7.
- Capital as percent of assets (same sequence): 20.4; 17.8; 15.3; 14.3; 10.4; 9.5.
- Liquid assets, in percent of total assets (Dec. 2004 to Jun. 2007): 24.2; 28.7; 38.4; 28.4; 35.8; 25.4.
- Liquid assets, in percent of short-term liabilities (Dec. 2004 to Jun. 2007): 41.0; 47.3; 58.8; 43.0; 63.0; 43.0.
- Deposits, in percent of assets (Dec. 2004 to Jun. 2007): 61.5; 65.6; 70.1; 73.0; 75.2; 74.5.
- Loans, in percent of deposits (Dec. 2004 to Jun. 2007): 103.0; 95.8; 77.1; 88.1; 78.8; 95.0.
- Non-performing loans (NPL), in percent of gross loans (Dec. 2004 to Jun. 2007): 5.2; 7.0; 5.3; 7.0; 2.9; 2.0.
- Provisions, in percent of NPL (Dec. 2004 to Jun. 2007): 77.3; 54.5; 67.4; 67.4; 78.8; 104.1.
- Provisions, in percent of total loans (Dec. 2004 to Jun. 2007): 4.0; 3.8; 3.6; 2.7; 2.2; 2.0.
- NPL net of provisions, in percent of capital (Dec. 2004 to Jun. 2007): 3.6; 11.3; 6.1; 5.9; 3.5; -0.6.
- Gross profits, in percent of average assets (ROAA) (Dec. 2004 to Jun. 2007): -0.3; 2.5; 0.8; 0.6; 1.1; 1.4.
- Gross profits, in percent of average equity capital (ROAE) (Dec. 2004 to Jun. 2007): -1.4; 13.8; 5.3; 4.6; 8.6; 11.6.
- Net interest margin (net interest income in percent of interest bearing assets) (Dec. 2004 to Jun. 2007): 6.9; 3.4; 5.4; 2.6; 3.5; 1.8.

### A. Rapid Credit Growth — findings and implications
- Loan-loss provisions are low: 2 percent of total loans at end-June 2007.
- CBM examinations found asset classification in most banks ridden with errors and too lax—NPLs were reported at 2 percent at end-June 2007.
- Capital adequacy fell in all but one bank over the twelve months ending June 2007, but remained above regulatory minima.
- Risk management weaknesses identified by the BCP assessment:
  - Significant weaknesses in internal controls.
  - Untested and under-resourced risk management processes.
  - Shortage of trained credit officers relative to rapid credit growth.
  - Questionable accuracy of bank clients’ financial statements used in credit analysis (notable improvement after VAT introduction).
- Measures to improve asset quality should be multi-pronged, involving banks, the supervisor, disclosure, and institutional strengthening:
  - Banks: adopt proper risk management, internal policies, procedures, and governance aligned with modern practices.
  - Supervisors: validate and monitor banks’ systems; conduct additional reviews of critical areas (risk management); issue guidance notes; periodically review prudential framework (including bank-specific capital adequacy levels, provisioning requirements, risk weights).
  - Medium-term: strengthen financial infrastructure—broaden access to the credit registry (programmed for early 2008) and enhance disclosure of financial information by bank clients.
- Recent CBM macroprudential measures (mostly effective January 1, 2008) include:
  - Increased reserve requirements.
  - Ceilings on credit growth ranging from 30 to 60 percent per annum of the loan portfolio depending on the size of the bank.
  - Higher provisions on new loans.
  - Increases in capital adequacy ratios for banks with rapid credit growth.
- Caution on direct controls: regional experience shows credit ceilings can produce regulatory arbitrage toward nonbank channels (e.g., leasing). Consider less distortionary prudential measures, including reversing the reduction in risk weight of residential mortgages (risk weight was reduced in October 2006).

### B. Vulnerabilities Associated with Unilateral Euroization — findings and recommendations
- Unilateral euroization limits scope for CBM to act as lender-of-last-resort or to tighten monetary conditions.
- Liquidity management should be more conservative:
  - Foreign ownership does not eliminate liquidity vulnerabilities; foreign-owned subsidiaries can face withdrawal of support or cross-country contagion (bank runs abroad, wholesale funding problems, interbank market liquidity problems).
  - Vulnerability higher for domestically owned banks or banks owned by unrated foreign banks/investors.
- Supervisory actions suggested:
  - Consider further tightening liquid asset requirements.
  - Suspend lower liquidity requirement in periods of rapid credit growth until credit growth moderates.
  - Alternatively, establish liquidity requirements that account for banks’ available liquidity support (including contingent credit lines).
- Public deposits:
  - Public deposits doubled from end-2003 to mid-2006 and reached about 18 percent of total deposits and 15 percent of total loans.
  - Deposits exceed borrowings throughout the period; about half arise from the Development Fund.
  - Deposit concentration: one bank holds 65 percent of public sector deposits, accounting for 23 percent of its deposit base.
  - Risks: sudden withdrawal could be destabilizing; public deposits contribute to credit growth and inflation pressures; governance issues and corruption risk.
- Recommendation: transfer central government deposits above transaction needs to the CBM on a timeframe that accommodates smooth bank funding adjustment. These deposits should be remunerated by the CBM; state-enterprise deposit placements and transaction accounts should be transparently competed among qualified banks.

### C. Stress Testing — approach and main results
- Tests updated using end-June 2007 data. Banks grouped into large and small (each group of five banks).
- Credit risk stress tests:
  - Test 1: migration of asset classifications—10 percent A→B; 15, 20, 40 percent migrations to Categories C–E; provisions increased in line with existing regulations.
  - Test 2: Test 1 worsened by an additional 50 percent increase in NPLs and a 30 percent increase in provisions (hard-landing scenario).
  - Test 3: default of a large borrower defined as the median of the largest 20 borrowers.
- Results:
  - For one large bank, under the first two stress tests its CAR falls below the required minimum 8 percent.
  - Other banks maintain capital above 10 percent under Test 1, but two additional large banks fall below that threshold under the more severe Test 2.
  - Default of a single (median-sized) large borrower did not put any bank below regulatory norms (contrast with Jun. 2006 tests where one large bank’s CAR fell below 8 percent).
- Liquidity risk stress tests:
  - Coverage of customer deposits by cash, bank deposits and other liquid assets decreased from nearly 40 percent at end-June 2006 to around 34 percent at end-June 2007.
  - Two testing scenarios: generalized loss of depositor confidence; withdrawals limited to larger depositors including public sector deposits.
  - Results:
    - Some banks experience tight liquidity conditions and high deposit concentration.
    - One bank had no free liquidity at the stress test start date.
    - Two large banks could not meet the first three hypothetical withdrawal shocks from free liquidity and had to tap required reserves (permitted).
    - If all public sector deposits were withdrawn, one bank would run out of free liquidity.
    - In four banks, public sector deposits account for more than 13 percent of total deposits; in two banks the share is greater than 20 percent.
- Market risk stress tests (interest rate and foreign exchange) showed modest impact due to low exposure.

*Source: IMF staff report excerpt (Tables and text as provided).*

### 1. Migration to lower asset categories 14.3 5.7 16.1 11.9 199.0

### _cr0850 - 1. Migration to lower asset categories 14.3 5.7 16.1 11.9 199.0

### Key indicators and stress-test figures
- 1. Migration to lower asset categories: 14.3 5.7 16.1 11.9 199.0
- 2. Increase in NPLs: 13.0 3.5 15.7 10.1 201.8
- 3. Large exposures: 17.4 11.8 16.5 16.7 198.3
- Free liquidity (cash and free reserves, as a percentage of total deposits): 18.0 -5.7 36.6 22.2 445.5

Liquidity stress test (free liquidity available after shock, as a percent of total deposits):
- 1. 15 percent of deposits withdrawn: 3.0 -20.7 21.6 7.2 430.5
- 2. loss of largest depositor: 10.5 -14.1 34.1 15.7 371.2
- 3. loss of 50 percent of top ten depositors: 5.4 -24.6 31.1 8.2 399.4
- 4. loss of public sector deposits: 5.5 -31.5 35.8 0.8 440.9

### D. Stock Market Volatility — findings and risks
- A significant correction in stock market prices is underway; NEX and MOSTE indices rose by 338 percent and 373 percent during the 12 months to end-April 2007 and have since fallen about 40 percent from the April peak.
- Market turnover was relatively low at less than EUR 2 million per day (both exchanges combined, 2006), while capitalization has reached a high level compared with other countries.
- Governance and stability concerns:
  - Weak disclosure requirements: reporting is not timely, and filing violations are not enforced.
  - Trading does not appear to be based on new information; the Securities and Exchange Commission has yet to investigate suspect trading and has no proven enforcement record.
  - Weak links with the banking system now, but high market returns have tempted bank customers to migrate and take on more risk.
  - Fast-growing payroll consumer lending (typically up to EUR 5,000 per loan) can be used to purchase shares.
  - Indirect credit-risk effects via declining household net worth expected to be small because debt service is collateralized by wage payments; however, such effects would depress growth.

### III. STRUCTURAL ISSUES — A. Prudential Supervision
- Basel Core Principles assessment: overall compliance satisfactory; areas for improvement include:
  - internal controls of banks;
  - insufficient legal protection of CBM supervisors;
  - relatively weak enforcement powers.
- Banking supervision strengths:
  - Periodic offsite analysis and onsite inspections.
  - CBM operational and financial independence; direct levy of fees for regulatory and examination activities.
  - Senior staff progressing in international best practices, stronger risk management, and proactive AML compliance oversight.
- Recommendations to strengthen the draft Law on Banking (LOB):
  - Strengthening corrective action and problem bank resolution procedures.
  - Providing that execution of a CBM resolution should not be suspended where it addresses an imminent threat to depositors’ interests.
  - Strengthening provisions for exchange of information with foreign supervisors.
  - Permitting on-site inspections by foreign financial sector supervisors in Montenegro.
  - Expanding fit and proper criteria to include senior management and directors/managers of financial holding companies.
  - Providing that banks must apply AML/CFT legislation and that compliance will form part of bank examinations.
  - Empowering the CBM to divest owners of qualified participation acquired without prior CBM approval.
  - Strengthening independence requirements for non-executive directors.
- Remaining legal/regulatory weaknesses to address post-adoption:
  - Protection for the CBM, its officers, staff and agents against liability for damages caused in good faith performance of duties.
  - Empowering the CBM to impose appropriate remedial measures in individual situations.
  - Authorizing the CBM to impose monetary penalties directly on banks without first obtaining court approval.
  - Inadequate access to judicial review: administrative court decision cannot be appealed.
- Organizational response:
  - New Bank Supervision Department structure adopted to strengthen supervisory capacities, focus on risk-based and consolidated supervision.

### III. STRUCTURAL ISSUES — B. Rethinking the Supervisory Architecture
- Small country context: need to reduce fixed costs of the supervisory system; case for unified supervision grows as the financial sector integrates.
- Insurance supervision:
  - In June 2006 only three MoF staff dedicated to insurance supervision; resources inadequate.
  - Draft Law on Insurance proposes a separate regulator; alternatives include empowering the CBM to serve as insurance regulator if legal obstacles can be overcome.
- Emergence of conglomerates:
  - First financial/mixed conglomerate small but on high-growth path; consolidated reports filed since mid-2006; 2007 onsite exams addressed consolidation.
  - Potential need for a single supervisory agency; recommendation to consider commissioning a study.
- Broker/dealer activity:
  - Banks likely to act as securities brokers/dealers, requiring closer CBM–SEC cooperation and adaptation of EU Capital Adequacy Directive principles for broker/dealer activities using a simplified methodology.

### III. STRUCTURAL ISSUES — C. Efficient Liquidity Management
- Medium-term objective: converge financial system conditions to the Eurozone and integrate with the euro money market for economies of scale in liquidity management.
- Obstacles to access euro area money markets: high rating and transaction costs, concerns about legal security and reputational issues for some banks.
- Balance-sheet stability measures:
  - Encourage limiting short-term liabilities and moving longer-term assets off banks’ books.
  - Include incentives in liquidity regulation favoring deposit contracts not subject to early withdrawal optionality.
  - Explore securitization of longer-term assets (e.g., mortgages) for sale to pension funds and insurance companies, with awareness of originate-and-sell risks.
- Liquidity framework and reserve-requirement changes:
  - Recently adopted liquidity ratio should be principal framework; allow simplification of reserve requirement regime over time.
  - Guidance by existing Eurosystem framework, with one rate for liabilities up to two years.
  - Liquidity ratio currently: "10–15 percent daily and 15–20 percent ten-day liquidity ratio, depending on asset quality indicators"; remuneration on required reserves must be adjusted to remain neutral.
  - Urgent consideration should be given to tightening liquidity regulation during periods of rapid credit growth.
- Specific policy changes recommended:
  - Remove the option of holding 10 percent of required reserves in domestic treasury bills because it creates a captive market and distorted yields.
  - Develop collateralized intraday credit to allow interest-free intraday fund use as markets develop.
  - Remove the 50 percent limit on the use of reserve requirements and allow averaging over the entire maintenance period.
  - Reference CBM standing facility interest rates to relevant ECB rates: currently CBM charges the rate determined in the latest treasury bill auction; recommend setting the rate as the ECB overnight interest rate plus an appropriate margin.
- CBM lending practices:
  - CBM grants intraday and overnight credit up to 80 percent of nominal value of collateral, which must be securities issued by the Republic of Montenegro or an EU member state.

### III. STRUCTURAL ISSUES — D. Financial System Infrastructure
- Payments and settlement:
  - Need for a Law on Payments and Settlement (draft: Law on the Transfer of Funds, Electronic Payment Instruments and Payment Systems); LEG suggests breaking into several acts including a "Law on the National Payment System."
  - Revisions needed for international best practice, including:
    - irrevocability and timing of settlement finality for all payment instruments and systems;
    - legal recognition and protection of netting arrangements (insolvency context);
    - use of collateral pledges and clear admissibility of electronic payment instructions/messages in court;
    - e-based payment instruments.
- CBM oversight gaps:
  - CBM does not monitor settlement systems involving credit and debit cards; settlement/clearing arranged by individual banks without national standard for interoperability (ATMs, POS).
  - CBM should take a more active coordinating role and establish technical parameters ensuring effective interfaces with low-value payment system and shared e-payments infrastructure.
- Non-cash payment access:
  - Improving access to non-cash payment services and reducing costs/risks is particularly important; cash use is inefficient and euro cash use incurs significant opportunity and logistic costs.

### III. STRUCTURAL ISSUES — Accounting and auditing
- IFRS and audit practices:
  - Montenegro requires larger companies to abide by IFRS, but compliance varies.
  - Banks’ IFRS compliance generally good and equal to peers in other EU Member States.
  - Large listed nonbank companies: financial reporting mediocre due to incomplete disclosures, questionable asset valuations, and poor accounting for taxes.
  - SMEs: financial reporting remains poor.
  - Limited enforcement of financial reporting regulations; corporate management lacks incentives to align with IFRS.
  - Joint stock companies must have audits under International Standards of Auditing, but audit quality is uneven and external quality control over the country’s 32 licensed auditors does not exist.

### III. STRUCTURAL ISSUES — E. Nonbank Financial Institutions
- Insurance sector regulatory shortcomings:
  - Current framework dated; falls short on regulatory reporting and limits regulator’s on-site supervision rights.
  - New law would expand regulator rights and encourage competition.
  - Draft law issues to reconsider:
    - increasing minimum capital requirements;
    - strengthening licensing requirements;
    - developing an insurance contracts law chapter to address inadequacies in general contract law;
    - removing discriminatory limits on business types for licensed branches of foreign insurers.

### III. STRUCTURAL ISSUES — F. Capital Markets and Pensions
- Progress and structure:
  - Significant progress in establishing a capital market in last five years.
  - SEC regulates and supervises exchanges, Central Depository Agency (CDA), broker/dealer licensing and operation, investment funds, and new listings with a relatively small, cost-efficient staff.
- Enforcement weaknesses:
  - SEC lacks power to levy fines or impose monetary penalties; serious abuses can be pursued via criminal law but evidential difficulties and court inefficiencies impede cases.
  - Authorities should amend the law to allow imposition of monetary penalties.
- Market structure recommendations:
  - Move both stock exchanges to one common trading platform to reorganize listing structure and gain operating efficiency.
  - Concerns over free markets where companies traded are not subject to the same reporting requirements as listed companies—raises valuation and manipulation concerns.
  - At end-2006 there were six investment funds trading on the two exchanges.
- Institutional investor base:
  - Main weakness: lack of domestic institutional investors such as planned pension funds or life insurance companies.
  - A competent institutional investor base would improve corporate governance, financial statement quality, and audit standards.
- Future regulatory changes:
  - As capital market matures and EU conformity pressure increases, introduce European passports for intermediaries, risk-based capital adequacy measures for brokers (especially dealers), and abandon the "all securities must be traded on the exchange" principle.

### III. STRUCTURAL ISSUES — G. Legal Framework
- Legal progress:
  - Significant progress in last six years developing laws for banking, companies, bankruptcy, property security, competition, consumer protection, judicial sector, and nonbank financial sector-related issues.
  - These laws are well-drafted, comprehensive and generally in accordance with best international practice.
- Remaining concerns:
  - Some key legal issues remain to be addressed; concerns over implementation and enforcement persist.
  - Government introducing amended financial sector legislation following Parliament’s adoption of the new constitution.

*Source: _cr0850 - 1. Migration to lower asset categories 14.3 5.7 16.1 11.9 199.0*

### 54. The new Constitution provides that the CBM is an independent organization,

### _cr0850 - 54. The new Constitution provides that the CBM is an independent organization,

### Central Bank of Montenegro (CBM): independence, accountability, and legal framework
- The new Constitution provides that the CBM is an independent organization and identifies areas the CBM is accountable for, including monetary and financial stability and the functioning of the banking system.
- The draft amended Central Bank Law and the Law on Banks should be revised to bring these acts as much as possible in line with international standards and best practices for central banking legislation.
- Areas of particular concern to be addressed in law:
  - (i) prioritization of CBM's objectives;
  - (ii) the ability of the CBM to impose administrative sanctions to address prudential infractions without prior court approval, as the sole agency in this domain;
  - (iii) limits on the judicial review of decisions of the CBM, especially those related to its supervisory role;
  - (iv) protection for the CBM, the members of its decision-making bodies and staff, and its agents against liability for actions taken and/or omissions made while discharging their duties in good faith.

### Bank bankruptcy, liquidation, and judicial review
- The Law on Bank Bankruptcy and Liquidation is under technical review.
- Appeals have shown the CBM did not have the right to challenge decisions of the Administrative Court.
- Concern: some jurists view that the Administrative Court can review and reverse CBM decisions it believes to be procedurally defective and/or substantively wrong.
- Principle: judges should correct procedural irregularities but should not substitute their technical judgment for that of the CBM; otherwise courts could become the ultimate regulator of the banking system rather than the CBM.

### Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT)
- MONEYVAL assessed Serbia and Montenegro in 2003; the assessment report was issued in January 2005 based on an earlier methodology.
- Key changes since that assessment:
  - an amended AML/CFT law explicitly addressing issues related to the financing of terrorism;
  - start of operations of the financial intelligence unit.
- MONEYVAL plans a new AML/CFT assessment of Montenegro in September 2008; the assessment report may be adopted by the MONEYVAL plenary possibly within the first half of 2009, after which an AML/CFT ROSC will be prepared and circulated to the IMF Board for information.

### Basel Core Principles (BCP) assessment — general preconditions and supervisory effectiveness
- The CBM is the sole supervisory authority for banks in Montenegro and is empowered to issue regulations to implement relevant laws.
- The Law on Banks is being revised; proposed changes will enhance supervisory capacity.
- Banking supervision is effective, using periodic off-site analysis and a robust system of on-site supervision.
- CBM has operational independence for monetary policy and supervisory functions and financial independence (directly levies fees for regulatory and examination activities and may use income in the supervision budget).
- Senior supervisory staff are highly knowledgeable and have promoted stronger risk management and anti-money laundering compliance.
- In 2005, resource gaps for supervision became pronounced; the Banking Supervision Department (BSD) organizational structure is being redesigned to strengthen supervisory capacity.

### Main findings by core principle categories (selected highlights)
- Objectives, autonomy, powers, and resources (CP 1)
  - Legal provisions largely conform to international standards.
  - No specific legal protection exists for the CBM, its officers, employees and agents when performing supervision in good faith; protection is needed against claims for compensation for financial losses caused by supervisory measures taken in good faith.
  - Law does not explicitly provide for disclosure of confidential information to other financial supervisors; CBM has acted via by-laws but the new Law on Banks should address this.
  - Currently adequate resources, but attention needed to attract and retain human resources given rapid sector development.
- Licensing and structure (CPs 2–5)
  - Supervision complies with international standards.
  - Recommendation: apply same standards of personal integrity to senior managers (heads of functions) as to members of managing boards.
- Capital adequacy (CP 6)
  - Current requirements implement the Basel Capital Accord (Basel I) effectively.
  - Reservation: lack of clarity on the definition of general reserves eligible for Tier 2 capital.
  - CBM intends to apply relevant elements of Basel II; LOB allows differing minimum capital ratios for individual banks.
- Prudential regulations and requirements (CPs 7–15)
  - Asset classification system: 5 risk groups (Category A to E) with provision requirements:
    - Category A (Pass/Good loan): 1 percent
    - Category B (Special Mention credits): 2 to 10 percent
    - Category C (substandard category): 20–30 percent
    - Doubtful category: 50–75 percent
    - Category E (loss): 100 percent
  - Ranges for Category B and C are wide and should be decreased.
  - CBM Decision treats past due loans of 30 to 90 days as Special Mention; such credits should be classified as Substandard.
  - Credit Register developed; at time of report available only to bank supervisors but planned to be open to all banks by end of 2006.
- Methods of ongoing supervision (CPs 16–19)
  - Combination of full scope and targeted on-site examinations, off-site surveillance, and meetings gives BSD senior management a thorough understanding.
  - Full scope on-site examinations, including larger branches, are conducted on a two year basis.
  - Off-site monitoring uses information provided by banks daily, weekly, fortnightly, monthly and quarterly.
  - Need for focused training in specialized areas (e.g., market risks) for junior staff.
  - Lack of an IT examiner to assess reliability and accuracy of banks' financial information.
- Consolidated supervision (CP 20)
  - No banking or financial groups exist presently, but CBM has regulations to comply with consolidated supervision standards.
- Accounting standards (CP 21)
  - Accounting standards for banks are almost completely compliant.
  - Recommendation: new Law of Banks should place specific legal responsibility on a bank’s managing board for maintenance of comprehensive and reliable accounting records and accuracy of supervisory reports.
  - CBM should clarify guidance on accounting methods for supervisory reports.
- Remedial measures (CP 22)
  - CBM powers to require remedial measures and to close banks are largely compliant.
  - One successful challenge: bank placed in interim administration after remedial measures applied under one article only of two separate articles permitting such measures.
  - Recommendations: provide greater flexibility to impose appropriate remedial measures; empower CBM to levy fines directly on banks.
- Cross-border banking (CPs 23–25)
  - No Montenegrin bank has a foreign branch or subsidiary; three major banks are subsidiaries of foreign banks.
  - In one case CBM has a formal agreement with a home country supervisor for information exchanges and joint examinations; in another case CBM is seeking similar agreements to enable confidential information exchange and comply with CP 25.

### Recommended Action Plan (selected recommendations as stated)
- CP 1(2) Autonomy and Resources: The CBM should keep supervisors’ remuneration broadly competitive with that offered by commercial banks.
- CP 1(5) Legal Protection: The CBM, its Council, employees and agents should have legal protection for actions taken while discharging their supervisory duties in good faith.
- CP 1(6) Information sharing: The new Law of Banks should contain clear provisions regarding confidential information and the circumstances (“gateways”) in which it may be disclosed.
- CP 3 Licensing: The new Law of Banks should apply the same standards of personal integrity to managers in banks as those proposed for board members.
- CP 6 Capital Adequacy: The CBM should define more clearly those general reserves of banks which are eligible to be included in Tier 2 capital.
- CP 8 Loan Evaluation: Past due loans of 30 to 90 days should not be considered as Special Mention credits. Such credits should be classified as Substandard.
- CP 14 Internal Audit and Controls: CBM should recommend to banks to increase the staff and quality of internal auditors.
- CP 20 Consolidated Supervision: The CBM is recommended to review the formats for reports which will be submitted by the banks on a consolidated basis.
- CP 21 Accounting Standards:
  - The new Law of Banks should provide that the managing board of a bank is legally responsible to the CBM for the maintenance by the bank of comprehensive and reliable accounting records, and for the accuracy of the information submitted in its supervisory reports.
  - The CBM should give clear guidance to banks on the accounting methods to be used in the preparation of supervisory reports.
- CP 22 Remedial Measures:
  - The new Law of Banks should simplify/clarify the situations in which the CBM is entitled to place a bank in interim administration.
  - The new Law of Banks should empower the CBM to levy fines directly on the banks.
- CP 25 Supervision of Foreign Banks’ establishments: The CBM should continue efforts to negotiate cooperation agreements with home country supervisors.

### Authorities’ response to findings
- Authorities broadly agreed with findings and emphasized progress in internal controls uncovered during on-site examinations.
- CBM strengthened regulation and supervision of internal control systems and internal audit in banks; the Decision on Internal Controls Systems and Internal Audit in Banks (adopted December 2003) has been significantly strengthened.
- Inspections have focused on adequacy of internal audit; recommendations and statements on violations have fed into measures against banks.
- The proposed new Law on Banks focuses on strengthening corporate governance, risk management systems, and internal audit; CBM and the Bank of Slovenia are organizing a seminar for banks on these topics.
- On legal protection of supervisors, authorities noted that the Constitutional Court ruled that the protective provision was unconstitutional despite CBM counter-arguments.
- Regarding loan classification, authorities noted that in practice examiners require more severe classification than Category B for loans past due more than 30 days; banks apply Basel minimal standards through examination.
- Plan: upon adoption of the new Law on Banks, adopt a new decision on capital adequacy moving classification of asset items to the standardized approach of Basel II.

### Financial sector overview — structure and key statistics
- Number of banks: There are currently ten banks in the country.
- CKB (purchased by OTP at end-2006) rapid growth:
  - assets more than doubled in the 12-month period ending in June 2007;
  - holds 36 percent of assets;
  - 35 percent of loans (up 120 percent in the 12-month period to June 2007);
  - 40 percent of deposits as of end-June 2007;
  - accounts for 19 percent of total banking sector capital.
- Market concentration and recent ownership changes:
  - The largest three banks represent 63 percent of total assets.
  - A new bank license was issued in December 2005; that bank started operating in March 2006.
  - Two operating banks are under a supervisory plan.
  - Recent takeovers: Podgorica Bank purchased by Société Générale (2005); Euromarket Bank purchased by Nova Ljubljanska Bank (NLB) (2005); Atlasmont Bank purchased a stake in Pljevaljska Bank (renamed Invest Bank Montenegro) (2006); OTP purchased CKB (2006); state sold 30 percent in Niksicka Bank (renamed Prva/First Bank) to a former shareholder in CKB.
  - Several banks have been liquidated; one bank (Ekos Bank) in final stages of liquidation.
- Rapid growth and indicators (12-month period ending in June 2007):
  - Deposits increased by 149 percent.
  - Loans increased by 169 percent.
  - System capital adequacy: 18.7 percent as of end-June 2007, with dispersion across banks ranging from 14 percent to 169 percent.
  - Bank profitability: return on assets fell from 2.5 percent in June 2005 to 1.4 percent at end-June 2007.

*Source: IMF staff report content from _cr0850 - 54. The new Constitution provides that the CBM is an independent organization,*

### 1.8 percent at end-June 2007 as a result of increased competition in the context of high

### _cr0850 - 1.8 percent at end-June 2007 as a result of increased competition in the context of high

### Banking sector performance
- Nonperforming loans (NPLs) have fallen to 2 percent of total loans, with provisions of 104 percent of NPLs.
- Provisions have fallen as a percentage of total loans (see Table 3).
- The loan-to-deposit ratio is at 95 percent at end-June 2007, up from 77 percent in December 2005, due to the strong growth of loans.
- Liquidity—quite seasonal—has declined, with liquid assets falling to 25 percent of total assets at end-June 2007.
- There is some lengthening of maturities, more pronounced on the assets than on the liabilities side.

### Privatization and ownership structure
- Privatization of banks has substantially progressed, but the state continues to hold minority shares in five banks, for a total of 4 percent of the banking system at end-2006.
- The state (Ministry of Finance, the Employment Agency of Montenegro and the Development Fund) recently sold a stake in Niksicka Bank (30 percent), but the state continues to own over 14 percent of the bank after that transaction.
- Other shares are held in Invest Bank Montenegro (13 percent), Podgoricka Bank (6 percent), Hipotekarna Bank (3 percent), and NLB Montenegro Bank (2 percent).

### Foreign bank presence and parent linkages
- Foreign banks have a large presence in Montenegro, but not all foreign–owned banks have first-tier parent institutions.
- CKB, NLB Montenegro Bank, Podgoricka Bank, and Hypo-Alpe-Adria Bank have rated parent institutions—the other majority foreign-owned banks may have more limited access to know-how, capital, and liquidity.
- Notes on ownership (as described):
  - Second largest NLB Montenegro Banka is majority-owned by Nova Ljubljanska Bank (NLB) from Slovenia.
  - Podgoricka Bank is the third largest bank, purchased in March 2006 by Société Générale.
  - Among the medium-sized banks, Opportunity Bank is entirely foreign-owned, but not by a bank.
  - Komercijalna Bank Budva is a small bank owned by Komercijalna Bank (Serbia).
  - Hipotekarna Banka has close to 70 percent foreign capital, but those shareholders are not a bank.
  - Newly-licensed Hypo-Alpe-Adria Bank is wholly-owned by Austrian Hypo Group Alpe-Adria.
  - Ratings mentioned: NLB is rated A-/F2 by Fitch Ratings; Société Générale AA/F1+; OTP Bank is rated BBBpi in December 2006 by Standard & Poor’s.

### Concentration risk
- Banks’ net exposure to the 30 largest debtors amounted to 16 percent of loans at end-June 2006.
- The largest 20 depositors in each bank range from 21 percent of deposits in the least exposed bank to 91 percent in the most exposed bank.
- The 20 largest depositors in all banks account for 36 percent of all deposits.

### Nonbank financial sector (NBFIs)
- The non-bank financial institutions sector (NBFIs) represents in total about 16 percent of GDP at end-2006.
- Regulation: Insurance and leasing companies are regulated by the Ministry of Finance, micro-finance providers by the CBM and capital markets by the SEC.
- The NBFIs have experienced substantial growth in the past couple years, although at rates well below bank assets, and a number of (mostly foreign) market participants have entered the market.

### Insurance sector
- The insurance sector, with EUR 31 million of assets at end-2005 remains small, though premiums grew 22 percent in 2005.
- Five insurance companies and one domestic re-insurance company are currently in operation, providing property, casualty (or accident), life and motor third-party liability (MTPL) insurance.
- Risk exposures are concentrated amongst two insurers, Lovcen and Montenegro Insurance, which together received more than 90 percent of all premiums in 2005.
- Two newer small insurers are fully foreign owned and Lovcen, the dominant market player, is majority-owned by foreign interests.
- About one-half of all insurance premiums invoiced in 2005 were for MTPL, with life insurance representing the smallest amount, less than 3 percent of total invoiced premiums.
- Total reported assets are roughly equivalent to the total realized gross 2005 insurance premium of EUR 32 million, which suggests insurers have established small reserves to date.
- With only one registered re-insurance provider in the country, Lovcen-Re, all such risks remain with the domestic re-insurer or are transferred to one of several foreign re-insurers.

### Leasing market
- Following the introduction of the Law on Leasing in late 2005, five firms have entered the market, three of which are affiliated with foreign-owned banks.
- To date, about 500 contracts have been entered into with a total value of EUR 42 million.
- About two-thirds of the contracts issued are financial leases for the purchase of autos and buses.
- Leasing companies are required to be registered under the Business Organizations law but are not subject to any form of regulation and can thus operate with minimal capital or controls in place.
- Potential risks: while leasing does not give rise to systemic risk issues, potential operational and/or credit risks may arise in the event that credit extended to bank-owned leasing companies is transferred to the banks’ balance sheets. The CBM monitors such exposures.

### Micro-finance institutions (MFIs)
- The Law on Micro Credit Financial Institutions, which came into force in 2003, has resulted in the establishment of four micro-finance institutions (MFIs).
- As at end-2006 total assets were about EUR 34 million, up from EUR 9 million in June 2003.
- This sharp growth indicates a continuing strong demand for largely unsecured lending to new micro-entrepreneurs.
- The CBM licenses and regulates MFIs, providing annual on-site examinations and receiving regular off-site reports.
- MFIs are not permitted to accept deposits.
- The established MFIs have accumulated a substantial capital base and longer term source of funding through their successful lending practices.
- The micro finance industry appears to be operating well and does not give rise to any particular concerns at this stage.

### Capital markets
- The exchange traded part of the capital market consists of nearly 450 companies.
- Six investment funds (with assets consisting of both domestic and foreign securities and real estate) are traded on the exchange with a turnover of EUR 52 million during 2006, 14 percent of total.
- There hardly exist domestic institutional investors, pending the creation of pension funds.
- The bond market is nearly non-existing.
- Market turnover of all bond issues on the exchanges is EUR 19 million, 5 percent of total turnover.

### Registry and information systems
- Montenegro has developed a set of modern registry systems that facilitate the assessment and management of financial risks. The registry systems include:
  - register of legal persons maintained in the Commercial Court;
  - registry of pledges over movable property, also maintained in the Commercial Court;
  - cadastre or land registry, including mortgage registry, which is maintained and operated by the Agency for Real Estate; and
  - central securities registry/depository, which is maintained and operated by the Central Depository Agency (CDA).
- In addition, there is a mandatory collection of credit information in a closed registry system maintained and operated by the CBM.

*Source: _cr0850 - 1.8 percent at end-June 2007 as a result of increased competition in the context of high (PDF).*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr0850.pdf_