## _cr12177 ## Source details **Canonical URL:** [_cr12177](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12177.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12177.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12177.pdf.json) --- ### Context and mission - Prepared by the Monetary and Capital Markets and European Departments; Approved by José Viñals and Reza Moghadam; April 4, 2012. - FSAP Update mission visited the Czech Republic in November/December 2011; FSAP findings were discussed with the Czech authorities during the Article IV consultation mission in February 2012. - FSAP team: Maher Hasan (head), Su Hoong Chang, Piyabha Kongsamut, Vassili Prokopenko, Christian Schmieder, Constant Verkoren (all MCM), Engin Dalgic (EUR), Dinah Knight (LEG), and Goran Lind (external expert). - Scope: assess stability of the financial system as a whole; not intended to evaluate risks specific to individual institutions. ### Executive summary — key findings and risks - Pre-crisis fundamentals and banking sector resilience: - Banks have ample capital and liquidity, and solid profitability. - Capitalization has improved since 2008 (reflecting slowed credit growth and strong profits). - Liquidity is ample as evidenced by relatively low loan-to-deposit ratios. - Stress-test conclusions: - Stress tests show Czech banks are resilient against substantial shocks. - Only a severe double dip (DD) scenario combined with simultaneous contagion from parent banks produces substantial vulnerability. - The likelihood of such combined risk is considered low at present. - Main systemic risk and transmission: - High reliance on exports to EU countries and ownership of large Czech financial institutions by EU parents. - Transmission channels: direct contagion from parent banks and indirect effects via weakened external demand; both may occur simultaneously. - Real estate market can amplify these risks. - Legal and institutional issues: - The CNB’s financial stability mandate should be elevated beyond a supporting element to strengthen accountability for microprudential, macroprudential, and crisis management roles. - Regulatory and supervisory framework generally sound but suffers from inadequate resources. - Crisis management and resolution framework broadly appropriate but has weaknesses, including related to the deposit guarantee scheme (DIF). ### Macroeconomic setting (selected indicators and dynamics) - Recent macro performance and outlook: - Post-crisis recovery stalled second half of 2011; activity expected to remain flat in 2012 due to Euro Area weakness and weak domestic demand. - Risks tilted to the downside, including potential intensification of the sovereign debt crisis in Europe. - Sectoral balance-sheet indicators: - Nonfinancial corporate financial liabilities: 46 percent of GDP. - Gross household debt to GDP: about 35 percent. - Real and external figures (selected from Table 2): - Nominal GDP (USD billions): 2007: 180.5; 2008: 225.4; 2009: 196.2; 2010: 197.7; 2011: 215.3; 2012: 206.0; 2013: 213.6. - Population (millions): 2007–2013: 10.3; 10.4; 10.5; 10.5; 10.5; 10.6; 10.6. - Real GDP (change in percent): 2007: 5.7; 2008: 3.1; 2009: -4.7; 2010: 2.7; 2011: 1.7; 2012: 0.1; 2013: 2.1 (staff proj.). - Output gap (percent of potential output): 2007: 3.1; 2008: 2.8; 2009: -3.6; 2010: -2.5; 2011: -1.9; 2012: -3.5; 2013: -3.2. - CPI (average): 2007: 2.9; 2008: 6.3; 2009: 1.0; 2010: 1.5; 2011: 1.9; 2012: 3.5; 2013: 1.9. - Current account balance (percent of GDP): 2007: -4.4; 2008: -2.1; 2009: -2.5; 2010: -3.0; 2011: -2.9; 2012: -2.1; 2013: -1.9. - Gross international reserves (US$ billion): 2007: 34.9; 2008: 37.0; 2009: 41.6; 2010: 42.5; 2011: 40.3; 2012: 42.9; 2013: 44.9. - Real estate: - Property prices rose as much as 70 percent between 2004 and 2008, followed by a fall of about 25 percent; recent annual decline about 1–3 percent. - Mortgage NPLs peaked at about 3 percent; loans to real estate sector pose significant risk due to elevated weight and unsold properties. ### Structure of the financial system - Size and composition: - Financial system assets ~133 percent of GDP (end-2010); credit to GDP ~57 percent. - Banking sector assets represent 84 percent of financial institutions’ assets. - Banking sector concentrated: 5 largest banks control 70 percent of total bank assets; 3 largest control 60 percent. - Largest banks are wholly or majority-owned subsidiaries of big European financial conglomerates. ### NBFIs and financial system structure (selected statistics) - NBFIs share: - Assets of insurance companies, pension funds, investment funds, credit unions (CUs), and other NBFIs account for only 16 percent of the total financial system assets. - Financial institutions (selected years and values): - Total Financial Institutions (2009): Number 302; Total assets 4,865,191 (millions CZK); % of total assets 100.0; % of GDP 134.2. - Total Financial Institutions (2010): Number 310; Total assets 5,019,608 (millions CZK); % of total assets 100.0; % of GDP 136.9. - Total Financial Institutions (Jun-11): Number 334; Total assets 5,106,175 (millions CZK); % of total assets 100.0; % of GDP 138.0. - Banks (2009): Number 39; Total assets 4,094,626 (millions CZK); % of total assets 84.2; % of GDP 112.9. - Banks (2010): Number 41; Total assets 4,188,929 (millions CZK); % of total assets 83.5; % of GDP 114.2. - Banks (Jun-11): Number 44; Total assets 4,266,749 (millions CZK); % of total assets 83.6; % of GDP 115.3. - Non Bank Financial Institutions (2009): Number 263; Total assets 770,565 (millions CZK); % of total assets 15.8; % of GDP 21.3. - Non Bank Financial Institutions (2010): Number 269; Total assets 827,327 (millions CZK); % of total assets 16.5; % of GDP 22.6. - Non Bank Financial Institutions (Jun-11): Number 290; Total assets 840,824 (millions CZK); % of total assets 16.5; % of GDP 22.7. - Pension funds (2009): Number 10; Total assets 215,873 (millions CZK); % of total assets 4.4; % of GDP 6.0. - Investment funds (2009): Number 110; Total assets 118,025 (millions CZK); % of total assets 2.4; % of GDP 3.3. - Credit unions (2009): Number 17; Total assets 17,649 (millions CZK); % of total assets 0.4; % of GDP 0.5. - Memo: GDP (millions CZK) 2009: 3,625,865; 2010: 3,667,429; Jun-11: 3,700,700. ### Banking sector performance and resilience - Funding and liquidity: - High share of resident deposits and loans denominated in the koruna; only around one-fifth of loans are denominated in foreign currencies. - Loan-to-deposit ratio around 70 percent. - Czech banking sector is a net external creditor and does not depend on wholesale or external funding. - Key ratios and trends: - NPL ratio: 6.4 percent as of end-March 2011 (from 3.2 percent as of end-2008). - Capital adequacy ratio: 12.3 percent in 2008; 15.9 percent in June 2011. - Regulatory Tier 1 capital to risk-weighted assets: 11.10 (2008); 13.86 (Dec-10). - Capital to assets: 5.46 (2008); 6.49 (Dec-10). - Return on assets: 1.10 (2008); 1.25 (Dec-10). - Return on equity: 20.68 (2008); 19.70 (Dec-10). - Liquid assets to total assets: 25.80 (2008); 29.43 (Dec-10). - Customer deposits to total (noninterbank) loans: 125.59 (2008); 129.61 (Dec-10). - NBFIs and other sectors: - Insurance companies report profitable results and adequate capitalization. - Building societies face challenges from planned reduction in government subsidies. - Credit unions: fast-growing but weak performance, with a high share of NPLs and a very low loan-loss provisioning ratio. ### Financial stability assessment — performance and risks - Performance summary: - Banks: ample capital, ample liquidity, solid profitability. - Household and corporate sectors: relatively sound though household debt rose during the credit boom. - Main risks: - External: contagion from EU sovereign/banking stresses given trade links and ownership by EU parents. - Domestic: real estate sector exposures; loans to construction, manufacturing, and transport record highest NPL ratios. - Combined scenario: severe double dip plus partial loss on exposures to foreign parent banks could push system-wide capital adequacy ratio below prudential minimum of 8 percent. ### Stress testing — methodology, scenarios, and results - Scope and approaches: - Tests covered solvency, liquidity, and contagion risks. - Approaches: (a) top-down (TD) CNB framework using quarterly data; (b) TD IMF framework using annual data; (c) bottom-up (BU) tests by largest banks (around 80 percent of system assets) using quarterly data. - Solvency tests: - Scenarios include: Double Dip (moderate and severe) and Slow Growth. - TD IMF framework used a five-year horizon to capture full impact and simulate introduction of Basel III. - Scenario likelihoods (historical cross-country evidence): moderate DD about 15 percent; severe DD 1-2 percent; slow growth scenario 5 percent. - Liquidity tests: - Moderate and severe bank-run scenarios; severe scenario more adverse than post-Lehman conditions. - Fire sales: only cash and sovereign bonds assumed liquid; government bonds assumed sold at a discount of 20 percent. - Contagion tests: - Assumed 40 percent of gross exposure of banks to their parent would be lost (average exposure of large Czech banks to their parents around 50 percent of their capital). - Key findings: - Majority of banks remain above prudential capital minimum of 8 percent under base and severe DD scenarios. - Only the severe DD scenario brings the system close to the regulatory minimum; small banks and building societies are hit hardest. - Severe DD combined with loss on parent exposures would render the system slightly undercapitalized. - A recapitalization of banks of up to 2 percent of GDP would be needed under the combined severe DD plus parent-loss scenario. - Liquidity: vast majority of banks can withstand large liquidity shocks; Czech banks hold about 20 percent of their assets in domestic government bonds. ### Financial policy framework — institutional and supervisory issues - CNB mandate and macroprudential role: - Current law: CNB objective is price stability; financial stability is a supporting element in achieving price stability. - Recommendation: elevate financial stability to a policy objective in the CNB law to strengthen accountability for microprudential, macroprudential, crisis management and bank resolution functions. - Need to improve decision-making mechanisms within CNB to take timely action to address systemic risk. - Upgrade stress testing framework for banks with emphasis on group-wide risk monitoring. - Regulation and supervision weaknesses and recommendations: - Inadequate supervisory resources — leads to infrequent on-site inspections (including AML/CFT), insufficient contacts with banks, delays in administrative action. - Introduce a structured framework for early intervention (quantitative and judgmental criteria). - Strengthen supervision of financial conglomerates with explicit legal authority to supervise directly all entities (including nonregulated entities) within a conglomerate. - Overhaul credit union sector: restructure some CUs into banks; restrict activities of remaining CUs to typical CU functions. - Set large exposure limits in line with globally agreed levels (Basel): reduce intra-group exposure exemptions (post-FSAP intention to reduce intra-group exposure limit from 100 percent to 50 percent of bank capital from July 2012). - Continue closely monitoring significant transactions between subsidiaries and parents, and take action if necessary. - Crisis management and resolution improvements: - Operationalize framework for using public funds to provide exceptional support to the banking sector; prepare expedited procedures to establish and capitalize a bridge bank. - Adjust conservatorship threshold to allow appointment under qualitative and quantitative criteria. - Strengthen DIF governance and capacity: - Improve governance by limiting participation of active industry representatives on the Board. - Increase target size of the fund (now 1.5 percent of insured deposits). - Clarify trigger for payout to reduce depositor uncertainty (current expectation: 20 working day payout). - Allow DIF to fund transfer of deposits via purchase & assumption agreements and advance funds to facilitate such transactions. - Consider introducing risk-based contributions and amend insolvency act to allow preferential treatment for claims of insured depositors. - Strengthen institutional coordination between CNB and MOF; reactivate and update existing MOU; include DIF in crisis coordination; conduct periodic crisis simulation analysis. - Cross-border crisis management: participate in and deepen CMG engagement; CNB participated in inaugural CMG meetings but refrained from signing written crisis agreements pending EU framework finalization. ### Key recommendations — priorities and timeframes (selected from Table 1) - CNB’s Mandate: - Elevate financial stability to a policy objective in the CNB law (¶ 17) — Priority: Medium; Timeframe: Medium term. - Macroprudential framework: - Improve decision-making mechanisms within the CNB to take timely action to address systemic risk (¶ 18) — Priority: High; Timeframe: Near term. - Upgrade the stress testing framework for banks, focusing on group-wide risk monitoring (¶ 19) — Priority: Medium; Timeframe: Near term. - Regulation and supervision: - Increase the number of supervisory staff to strengthen intrusiveness of supervision (¶ 21) — Priority: High; Timeframe: Immediate. - Introduce a “prompt corrective action” framework (¶ 22) — Priority: Medium; Timeframe: Near term. - Set large exposure limits in line with globally agreed levels (¶ 23) — Priority: High; Timeframe: Near term. - Continue closely monitoring significant transactions between subsidiaries and parents, and take action if necessary (¶ 24) — Priority: High; Timeframe: Ongoing. - Strengthen the framework for supervising financial conglomerates (¶ 25) — Priority: High; Timeframe: Near term. - Strengthen the CU sector by restructuring existing institutions (¶ 26) — Priority: Medium; Timeframe: Near term. - Crisis management and resolution: - Operationalize the framework for providing public support to banks (¶ 28) — Priority: High; Timeframe: Near term. - Adjust the threshold for imposing conservatorship (¶ 29) — Priority: High; Timeframe: Near term. - Enhance governance of the DIF, increase the target of the DIF and strengthen provisions for budgetary financing of possible shortfalls, clarify trigger for payout of insured deposits, and allow DIF to fund transfer of deposits via purchase & assumption agreements (¶ 30) — Priority: Medium; Timeframe: Medium term. - Timeframe definitions: - Near term: to be completed within one year. - Medium term: to be completed within three years. - Immediate: action to be taken without delay. ### Risk Assessment Matrix — major identified risks and impacts (selected) - A double dip recession - Likelihood of severe realization in the next 1–3 years: Medium (alternate entry: Medium/High). - Expected impact: slowed growth, more unfavorable export markets, drop in asset prices, reversal of capital flows, weaker bank asset quality and pre-impairment income, potential substantial drop of capitalization; concentration in commercial real estate and mortgages increases sensitivity. - Prolonged slow growth scenario - Likelihood of severe realization in the next 1–3 years: High. - Expected impact: Medium — transmission via trade partners (especially Germany), higher volatility in exchange rates and financial markets, moderate to medium stress on banks’ asset quality and pre-impairment income. - Failure of a foreign parent bank - Likelihood of severe realization in the next 1–3 years: Medium (alternate entry: High). - Expected impact: systemic repercussions if a parent of a relatively large Czech bank fails; possible upstreaming of capital and liquidity, deleveraging pressures on subsidiaries, higher funding costs, reputational risk, and constrained subsidiary action space. - Observed amplification channels: - Reversal of capital flows, flight-to-quality, declines in asset prices, weakened pre-impairment income, and funding vulnerabilities linked to parent-bank solvency and Basel III transitional effects. ### Basel Core Principles assessment — material issues and recommended action plan (selected) - Main supervisory and institutional observations: - Regulatory framework generally comprehensive and aligned with EU/BCBS standards; execution of supervision could be more intrusive. - Supervisory staffing shortfalls reduce frequency of on-site inspections and timeliness of enforcement. - The trigger for mandatory supervisory remedial action (capital below two-thirds of regulated minimum) considered too late. - Large exposure limits contain significant exemptions (exposures to EU parent/sister banks limited to 100 percent of bank capital) that exceed globally agreed Basel limits (25 percent). - Gaps in AML/CFT inspection frequency and sanctions; need to broaden KYC, beneficial ownership, and PEP definitions per FATF. - Need formal powers to inspect nonregulated entities within conglomerates and stronger consolidated supervision tools. - Recommended actions (selected from Table 6): - Increase CNB staffing levels to enable more frequent on-site inspections and greater engagement with audit committees and supervisory boards (CP 20; CP 1.2). - Introduce a structured framework for early intervention and remedial actions, and raise the capital trigger for mandatory supervisory intervention (CP 23; CP 6). - Require banks to have detailed policies on related-party transactions and limit aggregated related-party exposures to 25 percent of capital (CP 11). - Include trading book exposures in large exposure limits and cap intra-group exposures to 25 percent of capital (CP 10). - Enhance AML/CFT regime: increase inspection frequency; raise maximum fines under the money laundering act; broaden PEP definition; require senior compliance officers (CP 18). - Grant CNB powers to inspect entities outside the consolidated banking group and to require divestment of unsuitable qualifying holdings (CP 24; CP 4). - Authorities’ response (selected): - CNB reactivated existing MOU on cooperation and information sharing relating to financial stability and crisis management in March 2012. - CNB accepts recommendations to grant power to require divestment of a qualifying holding (Principle 4), widen remedial actions (Principle 23), set intra-group exposure limits (Principle 10), and will consider raising capital bar for intervention (Principle 23). - CNB disagrees with assessors on need to increase supervisory staff and on imposing monetary fines on bank managers; CNB cites risk-based supervision, sector size, and existing national provisions. - CNB has reservations about enlarging inspection powers over nonregulated group entities but asserts existing powers and EU-aligned framework. *International Monetary Fund — Financial System Stability Assessment Update (FSAP), Czech Republic; April 4, 2012.* ### 2012. The views expressed in this document are those of the staff team and do not necessarily reflect ### CZECH REPUBLIC — Financial System Stability Assessment Update ### Context and mission - Prepared by the Monetary and Capital Markets and European Departments; Approved by José Viñals and Reza Moghadam; April 4, 2012. - FSAP Update mission visited the Czech Republic in November/December 2011; FSAP findings were discussed with the Czech authorities during the Article IV consultation mission in February 2012. - FSAP team: Maher Hasan (head), Su Hoong Chang, Piyabha Kongsamut, Vassili Prokopenko, Christian Schmieder, Constant Verkoren (all MCM), Engin Dalgic (EUR), Dinah Knight (LEG), and Goran Lind (external expert). - Scope: assess stability of the financial system as a whole; not intended to evaluate risks specific to individual institutions. ### Executive summary — key findings and risks - Strong pre-crisis fundamentals contributed to resilience: - Banks have ample capital and liquidity, and solid profitability. - Capitalization has improved since 2008 (reflecting slowed credit growth and strong profits). - Liquidity is ample as evidenced by relatively low loan-to-deposit ratios. - Stress tests: - Show Czech banks are resilient against substantial shocks. - Only a severe double dip (DD) scenario combined with simultaneous contagion from parent banks produces substantial vulnerability. - The likelihood of such combined risk is considered low at present. - Main systemic risk: - High reliance on exports to EU countries and ownership of large Czech financial institutions by EU parents—risk stems from negative developments in EU countries. - Transmission channels: direct contagion from parent banks and indirect effects via weakened external demand; both channels may occur simultaneously. - Real estate market can amplify these risks. - Legal and institutional issues: - The CNB’s financial stability mandate should be elevated beyond a supporting element to strengthen accountability for microprudential, macroprudential, and crisis management roles. - Regulatory and supervisory framework generally sound but suffers from inadequate resources. - Crisis management and resolution framework broadly appropriate but has weaknesses, including related to the deposit guarantee scheme (DIF). ### Macroeconomic setting (selected indicators and dynamics) - Recent macro performance and outlook: - Post-crisis recovery stalled second half of 2011; activity expected to remain flat in 2012 due to Euro Area weakness and weak domestic demand. - Risks tilted to the downside, including potential intensification of the sovereign debt crisis in Europe. - Sectoral balance-sheet indicators: - Nonfinancial corporate financial liabilities: 46 percent of GDP. - Gross household debt to GDP: about 35 percent. - Real and external figures (selected from Table 2): - Nominal GDP (USD billions): 2007: 180.5; 2008: 225.4; 2009: 196.2; 2010: 197.7; 2011: 215.3; 2012: 206.0; 2013: 213.6. - Population (millions): 2007–2013: 10.3; 10.4; 10.5; 10.5; 10.5; 10.6; 10.6. - Real GDP (change in percent): 2007: 5.7; 2008: 3.1; 2009: -4.7; 2010: 2.7; 2011: 1.7; 2012: 0.1; 2013: 2.1 (staff proj.). - Output gap (percent of potential output): 2007: 3.1; 2008: 2.8; 2009: -3.6; 2010: -2.5; 2011: -1.9; 2012: -3.5; 2013: -3.2. - CPI (average): 2007: 2.9; 2008: 6.3; 2009: 1.0; 2010: 1.5; 2011: 1.9; 2012: 3.5; 2013: 1.9. - Current account balance (percent of GDP): 2007: -4.4; 2008: -2.1; 2009: -2.5; 2010: -3.0; 2011: -2.9; 2012: -2.1; 2013: -1.9. - Gross international reserves (US$ billion): 2007: 34.9; 2008: 37.0; 2009: 41.6; 2010: 42.5; 2011: 40.3; 2012: 42.9; 2013: 44.9. - Real estate: - Property prices rose as much as 70 percent between 2004 and 2008, followed by a fall of about 25 percent; recent annual decline about 1–3 percent. - Mortgage NPLs peaked at about 3 percent; loans to real estate sector pose significant risk due to elevated weight and unsold properties. ### Structure of the financial system - Size and composition: - Financial system assets ~133 percent of GDP (end-2010); credit to GDP ~57 percent. - Banking sector assets represent 84 percent of financial institutions’ assets. - Banking sector concentrated: 5 largest banks control 70 percent of total bank assets; 3 largest control 60 percent. - Largest banks are wholly or majority-owned subsidiaries of big European financial conglomerates. ### Financial stability assessment — performance and risks - Performance: - Banks: ample capital, ample liquidity, solid profitability. - Household and corporate sectors: relatively sound though household debt rose during the credit boom. - Risks to financial stability: - External: contagion from EU sovereign/banking stresses given trade links and ownership by EU parents. - Domestic: real estate sector exposures; loans to construction, manufacturing, and transport record highest NPL ratios. - Combined scenario: severe double dip plus partial loss on exposures to foreign parent banks could push system-wide capital adequacy ratio below prudential minimum of 8 percent. - Stress-test outcomes (summary): - Majority of banks remain adequately capitalized under large deterioration in asset quality under a severe DD scenario. - Vast majority of Czech banks can cope with large liquidity shocks. - Vulnerability substantial only with severe DD plus contagion from parent banks. ### Financial policy framework — institutional and supervisory issues - CNB mandate: - Current law: CNB objective is price stability; financial stability is a supporting element in achieving price stability. - Recommendation: elevate financial stability to a policy objective in the CNB law to strengthen accountability for microprudential, macroprudential, crisis management and bank resolution functions. - Macroprudential framework: - Need to improve decision-making mechanisms within CNB to take timely action to address systemic risk. - Upgrade stress testing framework for banks with emphasis on group-wide risk monitoring. - Regulation and supervision weaknesses: - Inadequate supervisory resources — leads to infrequent on-site inspections (including AML/CFT), insufficient contacts with banks, delays in administrative action. - Recommendation to introduce a structured framework for early intervention (quantitative and judgmental criteria). - Strengthen supervision of financial conglomerates for effective and timely problem identification. - Credit union (CU) sector: small but rapidly growing and requires major overhaul. - Crisis management and resolution: - Framework broadly appropriate but gaps exist: - Threshold for appointment of a conservator should be more flexible. - Governance of the Deposit Insurance Fund (DIF) should be improved: limit participation of active industry representatives on the board; increase its size to limit public risk; clarify trigger for payout to reduce depositor uncertainty. - Framework for using public funds to provide exceptional support to privately-owned banks should be further operationalized. - Allow DIF to fund transfer of deposits via purchase & assumption agreements (recommended). ### Key recommendations (from Table 1) — priorities and timeframes - CNB’s Mandate: - Elevate financial stability to a policy objective in the CNB law (¶ 17) — Priority: Medium; Timeframe: Medium term. - Macroprudential framework: - Improve decision-making mechanisms within the CNB to take timely action to address systemic risk (¶ 18) — Priority: High; Timeframe: Near term. - Upgrade the stress testing framework for banks, focusing on group-wide risk monitoring (¶ 19) — Priority: Medium; Timeframe: Near term. - Regulation and supervision: - Increase the number of supervisory staff to strengthen intrusiveness of supervision (¶ 21) — Priority: High; Timeframe: Immediate. - Introduce a “prompt corrective action” framework (¶ 22) — Priority: Medium; Timeframe: Near term. - Set large exposure limits in line with globally agreed levels (¶ 23) — Priority: High; Timeframe: Near term. - Continue closely monitoring significant transactions between subsidiaries and parents, and take action if necessary (¶ 24) — Priority: High; Timeframe: Ongoing. - Strengthen the framework for supervising financial conglomerates (¶ 25) — Priority: High; Timeframe: Near term. - Strengthen the CU sector by restructuring existing institutions (¶ 26) — Priority: Medium; Timeframe: Near term. - Crisis management and resolution: - Operationalize the framework for providing public support to banks (¶ 28) — Priority: High; Timeframe: Near term. - Adjust the threshold for imposing conservatorship (¶ 29) — Priority: High; Timeframe: Near term. - Enhance governance of the DIF, increase the target of the DIF and strengthen provisions for budgetary financing of possible shortfalls, clarify trigger for payout of insured deposits, and allow DIF to fund transfer of deposits via purchase & assumption agreements (¶ 30) — Priority: Medium; Timeframe: Medium term. - Timeframe definitions: - Near term: to be completed within one year. - Medium term: to be completed within three years. - Immediate: action to be taken without delay. ### Stress testing (high-level) - Solvency: - Majority of banks remain above prudential capital minimum of 8 percent under base and severe DD scenarios. - Combined severe DD plus partial loss on exposures to foreign parent banks can push system-wide capital adequacy ratio below 8 percent. - Liquidity: - Vast majority of banks can withstand large liquidity shocks per stress-test results. *International Monetary Fund — Financial System Stability Assessment Update (FSAP), Czech Republic; April 4, 2012.* ### 6. The nonbank financial institutions (NBFIs) are small, with limited linkages to ### _cr12177 - 6. The nonbank financial institutions (NBFIs) are small, with limited linkages to ### NBFIs and financial system structure - Assets of insurance companies, pension funds, investment funds, credit unions (CUs), and other NBFIs account for only 16 percent of the total financial system assets. - Households hold savings mainly in banks; the capital market in the Czech Republic is shallow; investors have easy access to EU markets. - The insurance industry has a high level of foreign participation and concentration. - The credit union sector is small but rapidly growing, with a tripling of the balance sheets within the last three years. - Selected table-level statistics (2009; 2010; Jun-11): - Total Financial Institutions (2009): Numbe r 302; Total assets 4,865,191 (millions CZK); % of total assets 100.0; % of GDP 134.2. - Total Financial Institutions (2010): Numbe r 310; Total assets 5,019,608 (millions CZK); % of total assets 100.0; % of GDP 136.9. - Total Financial Institutions (Jun-11): Numbe r 334; Total assets 5,106,175 (millions CZK); % of total assets 100.0; % of GDP 138.0. - Banks (2009): Numbe r 39; Total assets 4,094,626 (millions CZK); % of total assets 84.2; % of GDP 112.9. - Banks (2010): Numbe r 41; Total assets 4,188,929 (millions CZK); % of total assets 83.5; % of GDP 114.2. - Banks (Jun-11): Numbe r 44; Total assets 4,266,749 (millions CZK); % of total assets 83.6; % of GDP 115.3. - Non Bank Financial Institutions (2009): Numbe r 263; Total assets 770,565 (millions CZK); % of total assets 15.8; % of GDP 21.3. - Non Bank Financial Institutions (2010): Numbe r 269; Total assets 827,327 (millions CZK); % of total assets 16.5; % of GDP 22.6. - Non Bank Financial Institutions (Jun-11): Numbe r 290; Total assets 840,824 (millions CZK); % of total assets 16.5; % of GDP 22.7. - Pension funds (2009): Numbe r 10; Total assets 215,873 (millions CZK); % of total assets 4.4; % of GDP 6.0. - Investment funds (2009): Numbe r 110; Total assets 118,025 (millions CZK); % of total assets 2.4; % of GDP 3.3. - Credit unions (2009): Numbe r 17; Total assets 17,649 (millions CZK); % of total assets 0.4; % of GDP 0.5. - Memo: GDP (millions CZK) 2009: 3,625,865; 2010: 3,667,429; Jun-11: 3,700,700. ### Banking sector performance and resilience - Balance-sheet characteristics and funding: - High share of resident deposits and loans denominated in the koruna; only around one-fifth of loans are denominated in foreign currencies. - Loan-to-deposit ratio around 70 percent. - Czech banking sector is a net external creditor and does not depend on wholesale or external funding. - Capital, asset quality, liquidity, profitability: - NPL ratio climbed to 6.4 percent as of end-March 2011 (from 3.2 percent as of end-2008). - Capital adequacy ratio increased from 12.3 percent in 2008 to 15.9 percent in June 2011. - Regulatory Tier 1 capital to risk-weighted assets: 11.10 (2008); 13.86 (Dec-10). - Capital to assets: 5.46 (2008); 6.49 (Dec-10). - Return on assets: 1.10 (2008); 1.25 (Dec-10). - Return on equity: 20.68 (2008); 19.70 (Dec-10). - Liquid assets to total assets: 25.80 (2008); 29.43 (Dec-10). - Customer deposits to total (noninterbank) loans: 125.59 (2008); 129.61 (Dec-10). - Performance of NBFIs: - Insurance companies report profitable results and adequate capitalization. - Building societies face challenges from planned reduction in government subsidies. - Credit unions: fast-growing but weak performance, with a high share of NPLs and a very low loan-loss provisioning ratio. ### Risks to financial stability - External and macro risks: - Macroeconomic recovery that started in 2010 is losing momentum due to Euro Area developments; net exports and fixed investments likely to be negatively impacted. - Public and private consumption declining due to fiscal consolidation and weak labor market trends. - Main risk channels and concerns: - A recession in the Euro Area would derail domestic recovery and negatively affect financial institutions. - Global “DD” scenario could significantly slow economic activity in the Czech Republic, with reduced policy space compared to the onset of the global financial crisis. - Deterioration in financial condition of foreign parent banks may lead to parent-led deleveraging, upstreaming of earnings and liquidity, subsidiary sales under poor conditions, increased funding costs, or runs on deposits. - Exposure to domestic real estate through mortgage loans and loans to construction companies could amplify shocks, though risks are contained under current macro conditions due to dominance of owner-occupiers and prudent loan-to-value ratios. ### Stress tests: methodology and key scenarios - Scope and approaches: - Tests covered solvency, liquidity, and contagion risks. - Approaches: (a) top-down (TD) CNB framework using quarterly data; (b) TD IMF framework using annual data; (c) bottom-up (BU) tests by largest banks (around 80 percent of system assets) using quarterly data. - Solvency tests: - Focus on credit risk, market risk, funding risk, concentration risk, and sovereign risk. - Adverse macro scenarios: (a) a DD recession (moderate and severe); and (b) a prolonged period of low economic growth. - TD IMF framework used a five-year horizon to capture full impact and simulate introduction of Basel III. - Dynamic effects included increase in funding costs conditional on capitalization and stress of parent exposure under severe DD. - Scenario likelihoods (historical cross-country evidence): moderate DD about 15 percent; severe DD 1-2 percent; slow growth scenario 5 percent. - Liquidity tests: - Focused on funding shocks and bank counterbalancing capabilities. - Moderate and severe scenarios considered; severe scenario more adverse than post-Lehman conditions. - Fire sales of liquid assets simulated; only cash and sovereign bonds assumed liquid; government bonds assumed sold at a discount of 20 percent. - Contagion tests: - Simulated partial loss on exposures to parent banks under a severe double dip scenario. - Assumed 40 percent of gross exposure of banks to their parent would be lost (average exposure of large Czech banks to their parents around 50 percent of their capital). - Interbank contagion tests were not considered because interbank exposures across Czech banks are limited. ### Stress test results and implications - Standalone resilience: - Excluding parent contagion, the Czech banking system is resilient against substantial shocks. - Measured against current and future supervisory standards (Basel III), Czech banks are, with few exceptions among smaller banks, sufficiently capitalized to withstand stress scenarios. - Favorable income position and high current capital buffers enhance resilience. - Direct exposure to the riskiest sovereign debt in the Euro Area is limited, though indirect exposure exists via parent banks. - Scenario-specific outcomes: - Only the severe DD scenario brings the system close to the regulatory minimum capitalization; small banks and building societies are hit hardest, and some largest banks experience substantial drops in capitalization. - Moderate DD and prolonged low growth scenarios cause substantial stress but do not lead to a significant system-wide drop in capitalization; many banks remain profitable. - Banks can absorb reductions in lending margins, including under severe stress. - Contagion and recapitalization needs: - Severe DD combined with loss on parent exposures would render the system slightly undercapitalized due to simultaneous credit losses and reduced pre-impairment income. - A recapitalization of banks of up to 2 percent of GDP would be needed under this combined scenario. - The likelihood of materialization of such a combined scenario is considered low. - Liquidity outcomes: - Ample liquidity places the vast majority of banks in a position to withstand substantial stress. - Czech banks hold about 20 percent of their assets in domestic government bonds, which can generate liquidity if needed. - TD and BU tests are consistent, leaving most banks with considerable buffers even after stress (including additional upstreaming of liquidity to parents up to regulatory limits), except for some medium-sized banks. ### Financial policy framework and recommendations - CNB mandate: - The Czech authorities should consider strengthening the CNB’s financial stability mandate. - Current law: CNB’s objective is to ensure price stability, with financial stability as a supporting element of achieving price stability. - Recommendation: elevate financial stability to an explicit objective—without prejudice to the primary objective of price stability—to strengthen CNB’s mandate on microprudential and macroprudential supervision, crisis management, and bank resolution, and to establish stronger accountability. - Macroprudential framework and operationalization: - CNB has a solid macroprudential policy framework as integrated financial supervisor since 2006, with internal tools and processes for detecting and monitoring systemic financial risks. - No macroprudential policy instruments have been used to date, though they may have been useful during the boom period. - Suggested mechanism to take timely action: - (a) A pre-set schedule for CNB Board meetings on macroprudential policies to discuss systemic risks and decide on regulatory or other action. - (b) A recommendation by the Financial Stability Department on whether and what policy action is needed. - (c) A press statement released soon after the Board meeting explaining the nature of the risk and the consequent policy action (or inaction). - Such formalization would enhance CNB accountability for achieving financial stability. *Source: Czech National Bank / IMF staff (content as provided in the supplied unit).* ### 19. There is also room to strengthen analysis of risks to financial stability identified ### _cr12177 - 19. There is also room to strengthen analysis of risks to financial stability identified ### Risks to financial stability and macroprudential tools - Stress tests can help assess whether existing capital and liquidity buffers are adequate for risks arising from contagion from parent banks, and whether supervisory action is needed. - The CNB should strengthen its toolkit to mitigate the risk of real estate price bubbles and credit booms should they reemerge. - Some of these tools have been prescribed under Basel III and CRD-IV, such as counter-cyclical capital buffers, capital charges for systemically important financial institutions, and liquidity requirements. - An enhanced dialogue between the CNB and the ministry of finance (MOF) would help take macroprudential policy actions in a timely and coordinated fashion. - There is scope to improve coordination of policies affecting the housing market, where tax and other policies can significantly affect incentives for borrowing; adjustments in such policies could be considered for financial stability purposes. ### Regulation and supervision: assessment and recommendations - Overall legislative, regulatory, and guideline framework for banks in the Czech Republic is comprehensive and in line with sound international practices, but supervision could be more intrusive. - Supervision focuses on the largest banks and entities with higher risk profile or corporate governance deficiencies, relying on close and frequent monitoring and verification by the CNB. - Off-site monitoring of major banks is relatively intense, including through supervisory colleges, but three years or more may pass between full inspections even of large banks. - The frequency of on-site inspections (both targeted and full) is inadequate to ensure full understanding of developments in banks. - No structured process exists for preemptive supervisory action; there are no formally stipulated early triggers for supervisory action. - The only explicit trigger that mandates the CNB to take specified action is when a bank’s capital declines below two-thirds of regulated minimum capital. - Recommendation: The CNB should introduce a structured framework for early intervention (or decision not to intervene), based on quantitative as well as judgmental criteria. - Large exposure limits and exemptions are high and constitute additional risks. - The CNB applies a 100 percent of bank capital limit for exposures from the Czech subsidiary to its EU-based parent bank, sister bank, or investment bank. - The globally agreed Basel rules limit large exposures to a single or to connected counterparties to 25 percent of a bank’s capital funds. - Post-FSAP, authorities indicated intention to reduce the limit on intra-group exposures from 100 percent to 50 percent of bank capital from July 2012. - In the current uncertain external environment, the CNB introduced extraordinary monitoring in August 2011 through weekly reporting of subsidiaries’ liquidity position and the exposures towards their parent companies. - Enhanced monitoring should be supported by more frequent on-site visits of subsidiaries, commensurate with developments at the level of their parent banks. - In case of material deterioration of parent banks, the CNB may consider firm-specific prudential measures such as increasing capital and liquidity requirements, requiring pre-approval of material intra-group transactions, or reducing intra-group limits. - The CNB should continue a proactive role in cross-border cooperation with relevant home country supervisors. - Supervision of financial conglomerates should be strengthened to allow effective and timely identification of potential contagion risks. - The CNB should have explicit legal authority to supervise directly all entities (including nonregulated entities) within a conglomerate. - The CNB should formulate policy guidelines to determine the basis and necessity for conducting on-site inspection of nonregulated entities and an implementation plan, including adequacy of supervisory resources. - Need to overhaul regulatory framework for Credit Unions (CUs). - Recent strong growth was boosted by higher deposit rates and the level of deposit insurance on par with bank deposits. - Concerns that further defaults in the CU sector may deplete the DIF’s resources and pose reputational risks to the CNB. - Recommendation: Restructure the CU sector by converting some existing CUs into banks with appropriate fit and proper criteria, while restricting activities of remaining CUs to those of typical CUs (clearly defined membership criteria, not-for-profit objective, etc.). ### Crisis management and resolution: framework gaps and enhancements - Institutional framework broadly appropriate, but improvements needed. - Strengthen institutional coordination between the CNB and the MOF by activating and updating the existing Memorandum of Understanding (MOU) to provide for more frequent, formal coordination on crisis management-related issues. - The DIF should be included in crisis management coordination mechanisms to ensure early information sharing. - Authorities should periodically conduct crisis simulation analysis to assess ex ante the appropriateness of various policy responses under different circumstances. - Framework for using public funds to provide exceptional support to the banking sector should be operationalized. - Authorities should ensure appropriate policy guidelines and plans of action exist to enable swift provision of budget support when systemic financial stability is at stake. - Examples: preparing expedited procedures to establish and capitalize a bridge bank (including obtaining standing budgetary authorization) and developing clear policy criteria for extension of emergency liquidity assistance by the CNB. - Conservatorship threshold should be more flexible. - Current Act on Banks authorizes the CNB to appoint a conservator only where “shortcomings in a bank’s activities endanger the stability of the banking or financial system.” - Recommendation: Allow for appointment of a conservator under qualitative (e.g., activities or condition of the bank poses serious risks to the bank’s depositors) and quantitative (e.g., based on capital or liquidity requirements) criteria that are sufficiently flexible. - Strengthen the Deposit Insurance Fund (DIF) capacity and governance. - Improve governance by limiting participation of active industry representatives on the Board. - Increase financial means by raising the target size of the fund (now 1.5 percent of insured deposits) and streamlining backstop funding arrangements with the MOF. - At the time of the mission, the MOF and the DIF were negotiating an arrangement on potential bond issuances and other modalities to provide the DIF with backstop funding, if and when necessary. - Consider introducing risk-based contributions. - Clarify trigger for payout to ensure consistent determination of when payouts should be made (e.g., based on the revocation of an institution’s license) and timely compensation of depositors in line with their expectations of a 20 working day payout. - Currently, a payout is made after the CNB provides written notification to the DIF that the depositors’ funds are unavailable; there is no framework for determining when notification is made or when depositors’ funds are unavailable, which could result in significant delays. - DIF should be able to advance funds to facilitate purchase and assumption transactions involving the transfer of insured deposits to a healthy institution, on a least-cost basis. - Amend the insolvency act to allow for preferential treatment for claims of insured depositors to promote more effective recoveries by the DIF. - Cross-border crisis management participation is essential given dominance of foreign banks. - CMGs assess and discuss issues and barriers to coordinated action in severe stress, and share information on groups pertinent in crisis situations. - CNB participated in inaugural CMG meetings for various banks active in the Czech Republic but has refrained from signing written agreements on crisis management while awaiting finalization of the EU framework for bank recovery and resolution. ### Appendix I — 2002 FSAP main recommendations: status of implementation (selected outcomes) - Completing the transformation of banks and enterprises: Implemented. - Finalization of the carve-out of NPLs arising from the recent resale of IBP and the completion of the sale of KB: Implemented. - Acceleration of the pool sales of bad loans initiated by the KOB group in early 2001: Not Implemented. - Enhancing efforts to improve the collateral and insolvency regimes to expedite enterprise restructuring and bank workouts, and improve the auction price of NPLs: Implemented. - Introduction of full tax deductibility of mandatory provisions: Implemented. - Banking supervision: move to risk-based approach, target resources on key risks: Implemented. - Application of capital charges on a consolidated basis for other risks and introduction of consolidated supervision for financial holding companies and mixed holding companies: Implemented. - Anti-money laundering procedures need to be more explicit in CNB regulations: Implemented. - Safety net: public restatement of role of DIF and strengthen public credibility: Implemented. - DIF funding arrangements given expected removal of authorities’ obligation to cover shortfalls: Pending. - Credit union membership limited to a “common bond”: Not implemented. - CUSA rule-making powers, independence, and prudential responsibilities: Implemented. - Pension funds: adopting the mutual fund model — Ongoing; abolish guaranteed returns — Partially implemented. - Various securities, insurance, corporate governance, and market development recommendations: mostly Implemented or Ongoing as detailed in the Appendix. *Content derived from the provided IMF chapter text.* ### APPENDIX II. CZECH REPUBLIC: RISK ASSESSMENT MATRIX ### APPENDIX II. CZECH REPUBLIC: RISK ASSESSMENT MATRIX ### Major Identified Risks, Likelihood, and Expected Financial Stability Impact - A double dip recession - Likelihood of severe realization in the next 1–3 years: Medium - Description / source of risk: - Despite the global recovery after the height of the financial crisis in 2008/09, the sovereign debt crisis has increased uncertainties substantially. The vulnerabilities of the Western European sovereigns (but also the U.S. and Japan), together with a cooling down of major emerging economies could develop into a global DD recession with adverse macrofinancial feedback loops for the Czech Republic. - The macroeconomic and financial conditions are particularly weak in many European economies. This could result in a full blown global recession (severe DD) or a lighter dip based on regional stress, which could still be felt (moderate DD), the former one with noteworthy impact for the Czech Republic and the latter one with some impact. - Likelihood of severe realization in the next 1–3 years (alternate entry): Medium/High - Expected impact on financial stability if risk is realized: - Depending on the severity of the shock, the Czech economy could be hit harder and for a longer time than in 2008 or at least moderately, with slowed growth, more unfavorable export markets, and a drop in asset prices. The impact of shocks could be amplified by countercyclical fiscal policies. - The shocks could be further amplified by a reversal of capital flows. The pertinent impact depends on the severity of the macroeconomic shock and whether there is flight-to-quality. - Macroeconomic shocks would have negative effects on banks’ asset quality (i.e., result in credit losses), first through spillovers and then domestically if stress persisted, and reduce banks’ pre-impairment income. Both effects could lead to a substantial drop of capitalization or a gradual reduction, respectively. The concentration of banks’ lending activities in commercial real estate and mortgages is particularly sensitive to a severe macroeconomic shock, as is corporate exposure. - Specific banks could face challenges in terms of funding, resulting from concerns over solvency of their parent banks, in addition to being somewhat challenged by Basel III effects. Lending margins could shrink as a consequence of fiercer competition for deposits, and reduce banks’ first line of defense against losses. - Prolonged slow growth scenario - Likelihood of severe realization in the next 1–3 years: High - Description / source of risk: - Ongoing uncertainty in global financial markets could increase global risk aversion and reduce capital flows (to banks and corporates) away from countries like the Czech Republic, which have been perceived, to some degree, as safe haven. - Unless the potential shock translates into a full blown recession (see above), a (global) tendency towards flight-to-quality fuelled by persistent uncertainties in Europe resulting from the sovereign debt crisis could lead to a period of stagnation, i.e., a period of Japan-like conditions with persistent low growth. - Expected impact on financial stability if risk is realized: Medium - Although the Czech Republic might initially not be hit directly, it would feel the slowdown in growth through its main trade partners, especially Germany. - Exchange rates against major currencies and financial markets could face higher volatility, and amplify the stress conditions. - In addition to the moderate to medium level stress impact on banks’ asset quality and pre-impairment income, some of the banks (especially those without strong parent banks) could face higher funding costs, resulting from competition for deposits, and Basel III effects could amplify the situation to some degree. - Failure of a foreign parent bank - Likelihood of severe realization in the next 1–3 years: Medium - Description / source of risk: - In case of a materialization of stress in the euro area as a result of the sovereign debt crisis, parent banks could be negatively affected, which would have at least some repercussions on the Czech subsidiaries. - Recent stress test results by the EBA (to reach core tier 1 ratios of 9 percent) could amplify this stress conditions at the parent level. - Likelihood of severe realization in the next 1–3 years (alternate entry): High - Expected impact on financial stability if risk is realized: - The failure of a parent of a relatively large Czech bank would have systemic repercussions. - Some strains at parent banks could be felt in the Czech Republic, with parents’ upstreaming capital and/or liquidity and thus limiting the action space of the subsidiaries. Reputational risk could put pressure on liquidity and funding costs. In principle, subsidiaries could also be pressured to deleverage, which could have some feedback effects on the economy unless other banks increase their market share at the same time. ### Observations on Impacts Across Risks - Common channels of amplification include reversal of capital flows, flight-to-quality, declines in asset prices, and weakened pre-impairment income for banks. - Concentration in commercial real estate and mortgages, and corporate exposures are highlighted as particularly sensitive to severe macroeconomic shocks. - Funding vulnerabilities are linked to parent-bank solvency concerns and to transitional effects from Basel III on funding costs and liquidity margins. --- ### APPENDIX III. STRESS TEST MATRIX: SOLVENCY AND LIQUIDITY RISKS ### Solvency Assumptions — Coverage and Methodology - Institutions included: - Bottom-Up by Banks: 8 - Top-Down by Authorities: All banks - Top-down by FSAP Team: All Banks - Market share covered: - Bottom-Up: Percentage of total sector assets: 80 - Top-Down (Authorities): Percentage of total sector assets: 100 - Top-down (FSAP Team): Percentage of total sector assets: 100 - Data and baseline date: - Bottom-Up: Banks’ own data - Top-Down (Authorities): Supervisory - Top-down (FSAP Team): Supervisory - Methodology: - Bottom-Up: Combination of banks’ own models and pre-defined benchmarks (oriented on CNB framework, agreed with mission) - Top-Down (Authorities): CNB stress testing framework - Top-down (FSAP Team): IMF framework (Schmieder, Puhr and Hasan, 2011) - Stress test horizon: - Bottom-Up: 2.5 years (BU) - Top-Down (CNB): 3 years - Top-down (IMF): 5 years - Shocks: - Shocks based on GDP trajectories, other variables evolve conditional on GDP (according to output of CNB’s macro model) - Scenarios include: Double Dip (1 StD and 2.5 StD in historical terms), Slow Growth (cumulative 5-year deviation equal to 2 StD, only based on TD IMF framework) - Risks/factors assessed: - Comprehensive coverage of solvency risks (Credit, Market, income risks, fixed income holdings of banks in peripheral Europe, funding risk). Top-Down entries also include concentration risk. - Calibration of risk parameters: - Credit losses, pre-impairment income and credit growth based on satellite models, haircut on GIIPS exposure and funding risks based on expert judgment - Point in time risk parameters for credit risk parameters based on banks’ internal ratings-based (IRB) models, and proxies for the other banks - Asset correlations were assumed to be fixed (i.e., not to decrease with increasing PDs, LGDs), based on Schmieder, Puhr and Hasan (2011) - Behavioral adjustments: - Credit growth projected by satellite model, pre-defined payout depending on income after stress/capital buffer on banks’ IRB models (Bottom-Up) - For FSAP Team Top-down: assumption that capital constraint banks (i.e., those with capital conservation buffers less than 2.5 ppts would fully retain profit), otherwise in line with evidence for the Czech Republic - Regulatory standards: - Hurdle rates based on Basel II/III minimum for Total Capital and Tier 1 (Core Tier 1 is basically in line with Tier 1) - Basel II/III IRB rules applied (Top-down FSAP Team: Basel II/III (quasi-) IRB rules, & StA) - Results metrics: - CAR/shortfall, system wide. - Pass or fail; percentage of assets that fail. ### Liquidity Assumptions — Coverage and Methodology - Institutions included: - Bottom-Up by Banks: 8 - Top-Down by Authorities: All - Top-down by FSAP Team: NA (Robustness checks based on publicly available data) - Market share: - Bottom-Up: 80 - Top-Down: 100 - Data and baseline date: - Bottom-Up: Banks’ own data - Top-Down: Supervisory data - Methodology: - Bank-run type test based on two scenarios (moderate and severe bank-run, with scenarios similar to previous stress tests in CNB, see technical note for details) - Top-Down also considers Basel III ratio proxies (LCR, NSFR) - Risks: - Funding liquidity & market liquidity (Bottom-Up) - Funding liquidity & market liquidity, maturity mismatch (NSFR) (Top-Down) - Regulatory standards: - Bottom-Up: NA - Top-Down: Proxy for Basel III ratios (LCR, NSFR) - Results metrics: - Pass rate (Liquidity Position relative to Assets) Source: IMF staff. --- ### ANNEX I. SUMMARY OBSERVANCE OF THE BASEL CORE PRINCIPLES — Key Findings and Institutional Context - Information and methodology used: - The assessment reflects the regulatory and supervisory framework in place as of the date of completion of the assessment and was conducted in accordance with the revised Core Principles Methodology issued by the Basel Committee on Banking Supervision in October 2006. - Compliance with each core principle (CP) is made on a qualitative basis. - Institutional and macroeconomic setting and market structure—overview: - The Czech economy weathered the crisis relatively well so far. Limited external financing needs, a flexible exchange rate regime, credible monetary policy framework, healthy public and private balance sheets, and the absence of major pre-crisis asset bubbles helped contain the external shock and limit the output decline. - A recovery in 2010 was largely underpinned by external demand; this recovery stalled in 2011 and is at risk in 2012 because of external risks and planned fiscal consolidation. - Commercial bank assets around 114 percent of GDP. - Ratio of credit to GDP around 57 percent. - The 5 largest banks control 70 percent of total bank assets. - NBFIs are small. Czech banks are overall net external creditors. - The Czech financial system proved generally resilient to the effects of the global financial crisis; it is one of the few in the region where no exceptional state measures were needed. - Relaxation of monetary policy via interest rate cuts and market-driven exchange rate depreciation cushioned the downturn; banking sector has a traditional liquidity surplus. - Emergency liquidity provided by the ECB and support by home governments benefited some troubled parent banks and helped shield Czech subsidiaries from induced financial distress. - Preconditions for effective banking supervision: - As an EU member, much domestic legislation derives from EU regulations and is frequently updated. - The CNB can set legally binding regulations (secondary legislation) without government or parliamentary consent. Independence of the judiciary is established by the Constitution. - Czech Accounting Standards are in substance harmonized with IFRS; auditing standards are in line with relevant EU directives. - The CNB owns and operates the real-time gross interbank clearing and settlement system CERTIS, the only interbank payment system in CZK. - The CNB may provide liquidity against collateral to a bank, a CU or a branch of a foreign bank, or a state-owned bank (e.g., a bridge bank). If a bank is under conservatorship, the CNB may render financial assistance to overcome any temporary shortage of liquidity. - Main findings — supervisory framework and execution: - While the regulatory framework and supervisory processes are generally of high quality, a more intrusive and challenging execution of supervision would be welcome. - Supervisory authority independence, objectives, powers and resources (CP 1): - The CNB is the central bank and integrated supervisory authority regulating all financial sectors. - Independence of the CNB is enshrined in the Constitution; assessors did not find interference from external parties. - A shortage of staff resources for regulation and supervision was found, making supervision less effective in several areas, such as identifying and addressing bank problems at an early stage. - The CNB has entered into several MOUs with the MOF and with host-country supervisory authorities. Assessors recommend that domestic MOUs with the MOF be activated and used as a transparent channel of communication. - Licensing and structure (CPs 2-5): - CNB is the sole authority for issuing and revoking licenses for banks (including CUs and building societies). License applications are tested against comprehensive requirements. - CNB checks organization, management, business strategy, financial plan, and fit-and-proper status of owners and managers. - If a person holding a qualifying interest is found unsuitable, CNB may prohibit voting of his shares at a general shareholders’ meeting but does not have power to require divestment of the shares. - For certain investments in other financial institutions, prior consent from CNB is required. Banks may not invest in nonfinancial assets generally, except transitory holdings such as foreclosed assets. There is no requirement for prior notice to the CNB of intended investments in nonfinancial entities; CNB checks appropriateness at next onsite visit. - Prudential regulations and requirements (CPs 6-18): - The Czech Republic has implemented the Basel II standard for bank capital, per relevant EU directives. CNB cooperates with home country authorities on advanced model approaches. - CNB generally applies a limit of 25 percent of a bank’s capital for large exposures to single or connected parties in the banking book, but with important exemptions: - Exemptions include exposures to parent companies and affiliates within the Czech Republic that are subject to consolidated supervision by the CNB. - Exposures to parent companies, sister institutions, or investment firms within the EU have a limit of 100 percent of bank capital. - Exposures on a bank’s trading book are not included in the limit for large exposures (regarded as short term) and are subject to a 600 percent limit of bank capital. - Assessors acknowledge these exemptions align with EU regulations but recommend applying the globally agreed BCP, which sets a more stringent standard based on negative experiences of concentration risks. *Source: Excerpt from the IMF document "APPENDIX II. CZECH REPUBLIC: RISK ASSESSMENT MATRIX" and related appendices.* ### 46. Expectations for bank risk management systems are clear and comprehensive; ### 46. Expectations for bank risk management systems are clear and comprehensive; ### Risk management and corporate governance - The CNB provides clear expectations and guidelines regarding risk management systems. - More emphasis and focus should be placed on the role and power of supervisory boards. - The CNB should: - More formally evaluate the capability and participation of supervisory board members through regular meetings with them and evaluation of minutes and board packages. - Encourage supervisory boards to formally approve and monitor bank strategies and policies to a greater extent than at present. ### Credit risk, problem assets, and provisioning - Trends in credit risk and problem assets, as well as market, liquidity, interest rate, and operational risks, are monitored on an ongoing basis. - With the weakening Czech economy, the CNB is evaluating bank compliance with rules on restructurings and setting higher loss ratios in stress tests than warranted by experience. - The ratio of provisions to NPLs is somewhat below the average of countries in the region. - Recommendations: - Conduct targeted on-site visits to ensure banks’ provisioning and loan classification practices follow CNB guidelines. - Consider strengthening the CNB guidelines on provisioning and loan classification. - The past due schedule of 360 days should be shortened as it applies to unsecured as well as secured loans and appears excessive to the assessors. ### Related-party transactions and conflicts of interest - Czech legislation defines a broad range of individuals and legal persons as “related parties” and requires that transactions with related parties be on market terms and arm’s length. - There are no specific CNB regulations requiring banks to apply specific processes and policies on related party lending. - Recommendations: - The CNB should introduce rules and guidelines for banks’ policies and processes specifically regarding related party lending. - Define in CNB guidelines in more detail how “conflict of interest-rules” should be applied for related party transactions. - Banks should have rules for immediate reporting to their Boards of payment delays in significant related party exposures. - Reporting (also to the CNB) of related party exposures should be separate from reporting on large exposures and should be on an individual basis, except for insignificant transactions. - Aggregated exposures to all related parties, excluding exposures to group credit institutions and investment firms under consolidated supervision, should have a limit which should not exceed 25 percent of the bank’s capital. ### Internal controls, internal audit, and reliance by supervisors - The reliability of internal controls and internal audit are evaluated by CNB inspectors. - If considered reliable, CNB inspectors can leverage internal audit and adjust the scope of inspection. - All credit institution activities, including outsourced activities, are subject to internal audit. ### AML/CFT and financial crime prevention - There are gaps in requirements for preventing banks being used for criminal activity, including AML/CFT. - Bank compliance programs and reporting requirements should broadly address financial crime as well as AML/CFT, with officers who are senior bank officials responsible for the institution’s compliance program. - Recommendations: - Increase frequency of AML/CFT inspections. - Strengthen know-your-customer requirements related to low risk customers, beneficial ownership, and bearer shares. - Broaden the definition for PEPs (Politically Exposed Persons). - CNB should have the ability to apply sanctions for noncompliance with AML/CFT obligations and sanctions should be reviewed to be more dissuasive. - Credit institutions should regularly report to the CNB or financial intelligence unit suspected criminal activity, in addition to suspected AML/CFT activity. - The Czech Republic should increase the maximum level of fines for inadequate AML/CFT programs under the money laundering act. - Escalation procedures above the supervisor level are needed for high risk accounts. ### Supervisory techniques, staffing, and on-site inspections - Supervisory techniques include off-site and on-site programs; staffing shortfalls have created deficiencies in both programs. - Full scope and targeted on-site inspections are infrequent; CNB does not meet with audit committees and supervisory boards unless exigent circumstances arise. - Recommendations: - Increase staffing levels to allow for more frequent on-site inspections, including for AML and for new and problem banks, and to allow rotation of off-site inspectors. - Increase CNB interaction with audit committees and supervisory boards, particularly in large banks. - More CNB staff is needed for regulation, licensing, and enforcement given expanded mandate and international cooperation. ### Reporting, signatory requirements, and accounting - Banks submit monthly and quarterly reports on a wide scope of activity; large banks submit weekly liquidity reports. - There are no signatory requirements on regulatory reports. - Recommendations: - Establish guidelines or rules for signatories on regulatory reports and the possibility of imposing penalties for late or inaccurate submissions. - Establish monthly or quarterly peer reports to facilitate more frequent comparative and trend analyses. - The large majority of Czech banks report in accordance with IFRS; the local accounting standard does not differ significantly from IFRS. - Although the CNB cannot influence the scope of the statutory annual audit, it may and does ask for targeted or special audits and sets the content for these. ### Corrective and remedial powers and enforcement - The CNB identifies problems requiring remedial action but could better match follow up to the seriousness of issues; supervisory approach should move from reactive to proactive. - Recommendation: - Introduce a structured (staged) early intervention framework based on quantitative and judgmental criteria. - Introduce procedures implying narrowly targeted on-site visits in relevant cases to ensure timely implementation of remedial requirements. - The CNB has tools for corrective and remedial actions and has used them in practice, including voluntary recommendations and formal enforcement actions. - Weaknesses noted in timeliness of enforcement actions, often due to an internally-imposed requirement to precede enforcement with a new on-site review. - The CNB lacks explicit power to dismiss unsuitable bank managers once employed. Under the Act on Banks, the CNB can require remedial implementation within a deadline, which may include replacing managers or supervisory board members; assessors find explicit dismissal powers would be more appropriate, transparent, and effective. - There is scant legal support to issue monetary penalties to individuals. Assessors find CNB could benefit from broader powers to set monetary penalties on individuals. ### Consolidated and cross-border supervision; information sharing - The CNB applies consolidated supervision and is an integrated supervisory authority. - Consolidated supervision would be more effective if the CNB had the general power to directly require information (rather than request it through the bank part of the entity) and to verify this information through visits to nonregulated entities. - Given dominance of large foreign groups in the Czech banking sector, this has cross-border implications. - The CNB works via bilateral contacts, supervisory colleges, and EBA; intensity and depth of cooperation have increased recently with some cases of weekly information sharing. - The CNB has an extensive network of MOUs and informal arrangements with home and host supervisors and appropriate legal powers to share and keep information confidential as necessary. - Recommendation: - Provide CNB power to physically inspect entities outside the consolidated banking group. ### Key Basel Core Principles (selected CPs) — summary of material issues and recommendations - CP 1: No overarching CNB mandate for prudential supervision despite CNB’s integrated role. - CP 2: Number of supervisory staff is inadequate; heads of supervisory departments are civil servants with no fixed term of office and may be dismissed on short notice. - CP 3: No requirement for supervisory board to include independent members, except one in the Audit Committee. - CP 4: CNB can block voting rights of owners of qualified holdings but cannot require divestment. - CP 5: No requirement for prior CNB consent for significant nonfinancial acquisitions or investments; foreign supervisor quality not explicitly assessed. - CP 6: Trigger for mandatory remedial action is when capital declines below two-thirds of the capital requirement — considered too late; recommend remedial actions be prescribed when capital ratio declines below 8 percent; CNB must have formal power to require banks to abrogate or amend flawed internal models for risk-weighted capital. - CP 7: CNB provides clear expectations on risk management but should strengthen supervisory board oversight (see earlier recommendations). - CP 8: Credit institutions required to have appropriate credit risk management programs; these are verified. - CP 9: Past due schedule of 360 days considered excessive and should be shortened. - CP 10: Definition of large exposures excludes trading book; trading exposures limited at 600 percent of bank capital; temporary excesses over 25 percent limit should be offset by additional capital; exposures to parent/sister banks or investment firms exempted from 25 percent limit and subject to 100 percent limit — considered too high. - CP 11: No rule requiring separate policies for related party transactions; recommended detailed CNB guidelines and reporting/separation limits (see Related-party transactions). - CP 12–17: Requirements present for country/transfer risk, market risk, liquidity risk, operational risk, and interest rate risk, with expectations for limits, monitoring, independent valuation, stress testing, contingency plans, and contingency procedures. - CP 18: Compliance programs should address AML/CFT and financial crime; frequency of inspections should increase; strengthen KYC, beneficial ownership, bearer share guidance, define PEPs per FATF definitions. - CP 19–21: CNB’s supervisory approaches identified; full-scope and targeted on-site inspections infrequent; increase staffing and interaction with boards; establish peer reports and signatory rules. - CP 22: CNB largely aligned with IFRS reporting practices; may request targeted audits. - CP 23: Introduce structured early intervention and broaden CNB power to impose monetary penalties on individuals. - CP 24: Provide CNB power to physically inspect entities outside the consolidated banking group. - CP 25: Compensatory measures needed where cooperative agreements with some home supervisors (e.g., Russia) are not in place to secure adequate consolidated supervision. *Source: _cr12177 - 46. Expectations for bank risk management systems are clear and comprehensive;* ### 61. Table 6 lists the suggested steps for improving compliance. The recommendations ### Table 6. Recommended Action Plan to Improve Compliance with the Basel Core Principles ### Recommended actions (selected by principle) - CP 20 - Increase CNB staffing levels to allow for more frequent on-site inspections, including for AML and for new and problem banks, and to allow for the rotation of off-site inspectors. - Increase CNB interaction with audit committees and supervisory boards, particularly in large banks. - CP 23 (refers also partly to CP 6 and CP 20) - Introduce a structured framework for intervention in banks. - Introduce procedures, which in relevant cases would imply narrowly targeted on-site visits to banks, to ensure timely implementation of remedial requirements. - Broaden the powers of the CNB to apply monetary penalties also on individual persons. - Set a higher capital bar (than two-thirds of capital) for mandatory supervisory intervention. - CP 11 - Introduce rules that all banks must have a set of policies for related party transactions. - Define in more detail how “conflict of interest-rules” should be applied for related party transactions. - Banks should have rules for immediate reporting to their Boards of payment delays in significant related party exposures. - Reporting of related party exposures should be separate from reporting on large exposures in general and should be on an individual basis, except for insignificant transactions. - Aggregated exposures to related parties, if economically or otherwise connected (e.g., family), should have a limit which should not exceed 25 percent of the bank’s capital. - CP 5 - Introduce explicit requirements for banks to request prior consent from the CNB for significant acquisitions or investments. - The CNB must assess the quality of the foreign supervisor, and not only the fact that it practices consolidated supervision, in the case of a Czech bank acquiring (a part of) a financial institution abroad prior to giving its consent. - CP 18 - Require credit institutions to regularly report information on significant criminal activity, trends, and possible threats to reputation. - Increase the maximum level of fines for inadequate AML/CFT programs under the money laundering act. - Require escalation procedures above the supervisor level for high risk accounts. - Improve know-your-customer requirements or guidelines for low-risk customers and beneficial owners, and especially for bearer share companies. - Define PEPs to include all relevant politicians (according to FATF definitions). - Require compliance officers to be senior officers with responsibility for the credit institution’s financial crimes compliance program. - Increase the frequency of inspections. - CP 7 - Require inspectors to evaluate the capability and participation of supervisory board members, and require supervisory boards approve strategies and policies. - CP 10 - Exposures in the trading book should be included in “large exposures” and should be subject to the overall limit of 25 percent of capital. - Temporary excesses over the 25 percent limit for large exposures must be fully offset by adequate collateral or bank capital. - Exposures to parent banks abroad and to sister banks or investment firms should be capped at 25 percent of the bank’s capital. (The globally agreed BCPs set stricter standards in these areas than the present EU legislation.) - CP 1.2 - Increase the number of supervisory staff in order to make possible more intensified supervision, e.g., more frequent on-site visits, more intensive offsite monitoring, and participation in international and domestic negotiations, e.g., on new regulations. - CP 24 - The CNB should be given the powers to inspect entities outside the consolidated banking group. - CP 25 - Conclude an arrangement with Russia to ensure information sharing and supervisory cooperation, and also protecting confidential information. - CP 6 - Laws or regulations should set out a range of remedial actions to be considered, including revocation of the license, when a bank’s capital ratio declines below 8 percent. - CP 4 - Give the CNB the powers to require the divestment of a qualified holding in specified circumstances, e.g., if the owner proves unsuitable. - CP 1.6 - The existing MOUs between the MOF and the CNB on cooperation and information sharing relating to financial stability and crisis management should be activated as a preparatory matter. ### Authorities’ response — CNB position and actions - General - The CNB welcomes the assessment and acknowledges the extensive work done by the assessment team. - The CNB appreciates recognition of the resilience and stability of the Czech financial system. - The CNB expresses concerns about country-specific approach and procedural aspects of the mission. - Acceptances and intended actions (explicit) - Reactivated the existing MOU on cooperation and information sharing relating to financial stability and crisis management in March 2012. - Accepts recommendation to grant the CNB the power to require divestment of a qualifying holding (Principle 4), while noting existing measures are considered adequate. - Accepts widening the framework of remedial actions (Principle 23) and notes possible adjustments following adoption of the EU Crisis Management Framework (including potential new powers such as bail-ins). - Accepts recommendation to set limits relating to exposures and further restrictions concerning intra-group exposures (Principle 10); is preparing an amendment of the Prudential Rules Decree to tighten exposures to foreign parent and affiliate institutions from the current 100 percent to 50 percent of the capital. - Will consider broadening the definition of PEPs (Principle 18) while noting current Czech definition is fully in line with applicable EU law and that the issue will be discussed in the review of EU rules in the AML area. - Considering incorporation of the recommendation to set a higher capital bar for mandatory supervisory intervention (Principle 23). - Objections and refusals (explicit) - Increase of the number of supervisory staff (Principle 1(2), 20): CNB disagrees with assessors’ view of a substantive deficiency in supervisory resources, citing: - Use of a risk-based supervision approach focusing on systemically relevant entities and high-risk profiles. - The Czech banking sector is smaller in relation to GDP than some Western European peers. - Czech banks follow a traditional banking model with limited structured products and are primarily funded from local deposits rather than wholesale markets. - Monetary fines on bank managers (Principle 23): CNB considers national provisions to be equivalent and argues monetary penalties by the CNB would add administrative burden without corresponding benefit. - Additional supervision of nonregulated entities within a group (Principle 24): CNB has reservations about enlarging inspection powers; asserts that it currently has the power to inspect nonregulated entities and that the Czech regulatory framework follows the relevant EU directive focused on supplementary supervision. - Conclusion - The CNB considers itself to possess sufficient operational independence, transparent processes, sound governance, and adequate resources to discharge its duties accountably. *Source: IMF staff assessment text (Table 6 and Authorities’ response) from the provided content unit.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12177.pdf_