## _cr16201

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### Executive summary — introduction and background
- Technical Note reviews banking supervision and regulation in Montenegro against selected Basel Core Principles (BCP) as part of an FSAP update conducted jointly by the IMF and World Bank in September 2015.
- Assessment covered 15 select BCPs, including Consolidated Supervision, Home/Host Relationships, Risk Management, and Transactions with Related Parties.
- Review drew on: 29 CP self-assessments, the authorities’ completed questionnaire, inspection procedures and reports, prudential reports, and assessment of bank license application procedures (including review of one full application).
- Legislative updates since 2006 FSAP: Law on the Central Bank of Montenegro (LCBM) in 2010 and Banking Law amendments in 2010 and 2011; adoption of regulations on general risk management including a 2010 regulation on Capital Adequacy implementing Basel II.
- Prepared by Damodaran Krishnamurti (Lead Financial Sector Specialist, World Bank) and Michael Deasy (Consultant, IMF).

### Financial system and supervisory structures — key statistics
- Banking sector:
  - Accounts for about 90 percent of financial system assets, equivalent to about 93 percent of GDP as of June 2015.
  - Number of banks: 14 (up from 11 in 2013).
  - Six foreign bank subsidiaries hold 79 percent of banking sector assets.
  - Banks’ assets concentrated in lending products: 70 percent.
  - Lending concentrated in trade sector and households (mostly mortgages), each representing about 38 percent of total loans.
  - Loans to nonresidents represent 18 percent of the total.
  - Deposits represent three-quarters of liabilities: demand deposits 46 percent and time deposits 53 percent.
  - Foreign deposits represent about 6 percent of total deposits.
- Nonbank financial sector:
  - Insurance sector about 5 percent of financial system assets; average annual growth of 3 percent in the past five years; 11 insurance companies with total assets ~EUR 170 million as at end-2014.
  - Five microeconomic financial institutions with total assets of about EUR 40 million; not funded by deposits.
  - No credit unions or credit guarantee business operations; small and declining unregulated leasing market.
- Key banking indicators (as of June 2015 unless stated):
  - System-wide NPL ratio: trending down from 18.4 percent in 2013 to 16.4 percent at end-June 2015.
  - Aggregate tier I capital ratio about 14 percent; capital adequacy ratio (CAR) close to 16 percent (regulatory minimum 10 percent).
  - Profitability weak: aggregate ROA 0.5 percent and ROE 3.4 percent in June 2015.
  - RWAs for credit risk: 98.57 (percent to total RWA); market risk 0.03; operational risk 1.40.
  - Banks’ assets and supervisory emphasis: limited domestic interconnectedness; foreign exchange loan exposure modest; bank liquidity ample.

### Supervisory framework — governance, funding, staffing
- Authority and funding:
  - Central Bank of Montenegro (CBM) is sole banking supervisory authority; responsible for authorization, ongoing supervision, and revocation of bank licenses; also supervises micro-credit financial institutions, credit unions, and credit guarantee operations.
  - CBM funded from general central bank activities, issuing of licenses, and annual fees; adopts budget independently and submits final budget and annual financial report (with external auditor’s report) to government and parliament for information.
  - Supervision fees basis: assets (0.065 percent) and recalculated monthly based on prudential reports.
- Staffing:
  - Staff complement: 45; vacancies: seven.
  - Within CBM, salaries in banking supervision are 30 percent higher than in other CBM areas.
  - CBM salaries higher than public sector but generally lower, sometimes considerably lower, than industry; recruitment difficulties and retention issues noted.
- Legal protection:
  - Article 83 of the LCBM and article 106 of the Banking Law: directors, employees, and agents not liable for damages incurred while performing duties per laws/regulations unless action was deliberate or gross negligence; CBM shall cover expenses of bank staff in court proceedings concerning performance of duties.
  - Deficiencies: legislation silent on coverage for omissions made in good faith (BCP Principle 2, EC 9) and silent on protection coverage for the CBM itself.

### Main findings — supervisory framework observations
- Consolidated supervision:
  - Legislation provides for consolidated supervision but not implemented meaningfully; largely confined to reporting.
  - Company law does not define ‘holding company’; CBM devised own definition of financial holding company.
  - Consolidated supervision is defined narrowly (accounting consolidation) and insufficient on group-wide risk, contagion, reputational risk.
- New bank licensing:
  - Three new banks licensed in past year; more conservative approach to new licenses recommended given depressed market conditions.
  - CBM has rejected some applications (e.g., for failure to provide audited accounts in ownership chain); directors and chief executives must be approved in advance, but not other senior management posts.
- Cross-border resolution and home-host:
  - Most major banks are subsidiaries of international banks; essential these banks be party to home-country resolution plans.
  - CBM is member/observer of several supervisory colleges; MOUs in place with some jurisdictions; CBM has not developed bank or group resolution plans with resolution authorities in home-country jurisdictions.
- Capital framework:
  - Basel II implementation conservative: minimum CAR 10 percent; operational risk capital set at 18.75 percent of average net income (previous three years); country risk additional weights up to 300 percent possible.
  - Deviations from Basel II treatment: hybrid debt not discounted in last five years; fixed asset revaluation reserve not discounted; deferred tax assets and certain significant investments not deducted.
- Credit risk environment:
  - Weak operating environment: non-availability/reliability of audited financial statements; inability to verify connectedness among counterparties (especially non-residents); difficulty in collateral valuation and timely disposal; third-party modifications to bank-borrower contracts undermining credit discipline.
- Problem assets and provisioning:
  - Prudential framework conservative in some respects but gaps exist; loan classification and reclassification practices allow delays or inappropriate upgrades contrary to criteria, producing incorrect NPA presentation.
- Large exposures and related parties:
  - Prudential limits exist but implementation weak: aggregate limit for related-party exposures high at 200 percent of own funds; measurement norms diverge from Basel and shift focus from gross exposures.
  - Significant gaps in definitions of ‘related party’ and ‘related-party transactions’; in practice banks can assume related-party exposures without Board prior approval.
- Public disclosure:
  - Legislation requires quantitative and qualitative disclosure, but disclosure by some banks is poor; several banks’ financial statements were qualified by external auditors (mainly under-provisioning).

### Main recommendations — prioritized actions (selected items and priorities)
- Implement consolidated supervision meaningfully: prudential ratios on group basis; assess risks to banks from the wider group; include group structures in on-site and off-site supervision. (Para No. 46, 62, 137) — Priority: I
- Initiate a more intensive dialogue with individual audit firms to resolve qualified auditors’ opinions. (Para No. 144) — Priority: I
- Fill current vacancies in banking supervision urgently and provide career paths for specialist staff. (Para No. 21) — Priority: I
- Adopt a more rigorous approach to assessment of bank license applications, particularly business plans. (Para No. 27) — Priority: I
- Seek to be party to home-country resolution plans for systemically important subsidiaries. (Para No. 62) — Priority: I
- Engage formally with domestic insurance and securities regulators and conclude MOU with insurance regulator. (Para No. 62) — Priority: I
- Tighten prudential norms for identification, classification, and reclassification of nonperforming assets; review adequacy of provisioning rates. (Para No. 115) — Priority: I
- Tighten exposure measurement and commence monitoring name-risk concentrations both on gross and net exposure basis. (Para No. 123) — Priority: I
- Tighten legal and regulatory framework for related-party exposures and transactions. (Para No. 130) — Priority: I
- Tighten regulatory framework for liquidity risk with respect to significant currencies and maturity mismatches; assess feasibility of liquidity contingency plans during market-wide stress events. (Para No. 137) — Priority: I / MT
- Note: Priority coding — I = “Immediate” (within one year); NT = “Near-term” (1–3 years); MT = “Medium-term” (3–5 years).

### Legal and institutional issues — CHF-to-euro conversion law
- Law provides conversion of Swiss Franc-denominated loans into euros at exchange rate on date loan first granted.
- Law affects one bank only (only bank to offer CHF loans between 2005 and 2007).
- Number of loans: in the region of 450.
- Current value of loans: in the region of EUR 30 million.
- Potential exchange loss to the bank: could be as high as EUR 9 million.
- Higher interest charges on converted loans: 8.2 percent per annum (partly offsetting exchange loss).
- Bank initiated constitutional proceedings; CBM charged with implementation but did not initiate the law and disagrees with it; concern law retrospectively alters contractual terms and may compromise CBM operational independence if precedent used further.

### Supervisory approach, on-site/off-site, and stress testing
- On-site and off-site regimes: effective for solo-bank supervision; absence of effective consolidated supervision limits scope.
- Inspection resources: five portfolio managers cover banks; supported by risk experts; credit risk team lacks a real estate valuation expert.
- Inspection frequency: all banks subject to annual inspection; mix of full-scope and mostly targeted inspections.
- Reporting: prudential returns range daily (liquidity) to three-monthly (balance sheet, income statement); CAMELS reports updated quarterly with components rated 1 to 5.
- Stress testing:
  - CBM undertakes stress testing; latest in 2014 with baseline and adverse scenarios.
  - CBM requires banks to have forward-looking stress testing; banks submit quarterly credit stress testing results to CBM.
  - Recommendation: strengthen methodology and rigor of stress testing and explicitly require stress testing of risk concentrations (name, sector, geographic, collateral).

### Consolidated supervision — findings and corrective recommendations
- Finding: absence of effective consolidated supervision could give rise to systemic risk in the banking sector.
- Recommendations:
  - Implement consolidated supervision beyond accounting consolidation: assess group-wide risks including reputational and contagion risk; calculate prudential ratios on a consolidated basis.
  - Incorporate concept of a holding company into national business law.
  - Examine interconnectedness of Banks A, B and C to identify common risks, large exposures, and related-party lending; assess reputational and contagion risks.
  - Seek deletion of article 134 of the Banking Law (which permits exclusion from consolidated reporting where foreign legal impediments exist).

### Corrective and sanctioning powers
- CBM corrective measures: letters and on-site reports to Boards with eight days to respond.
- Since 2010, seven occasions where banks required to introduce fresh capital or increase solvency ratio.
- Historic powers used: appointment of interim administrator (2001, 2003), authorized representative to attend Board meetings (2009), ordered CEO replacement, capital increases, activity restrictions.
- Monetary fines:
  - CBM cannot impose monetary fines directly; fines imposed through Court of Misdemeanors.
  - Court fines range from EUR 3,000 to EUR 15,000; CEO fines range from EUR 500 to EUR 1,000.
  - CBM can require one-off payments to Deposit Protection Fund (DPF) ranging from 0.1 percent to 1.00 percent of bank’s own funds (upper limit recently increased to 1.5 percent of own funds).
- Recommendation: CBM should seek powers to impose monetary fines in its own right at significantly higher levels than current Court of Misdemeanors.

### Corporate governance — findings and recommendations
- Legislative basis detailed; Boards and CEOs generally understand roles; optional committees (e.g., risk) less certain.
- Directors appointed for four-year terms, renewable; no overall time limit on total service.
- Internal audit and compliance required and report to audit committee but usually confined to solo bank activities; internal audit weaknesses noted, including IT expertise gaps.
- Compensation standards: Montenegro has not implemented FSB standards; Banking Law revision expected by end-2016 to propose implementation.
- Recommendations:
  - Provide guidance to banks on expectations for sound corporate governance.
  - Consider imposing maximum tenure on directors (recommendation: maximum of two renewable periods, i.e., up to 12 years).
  - Extend internal audit function to cover group activities.
  - Introduce a specific corporate governance section in on-site inspection manual.
  - Require banks to notify CBM promptly of material information that may negatively affect fitness and propriety of Board members or senior management.

### Capital adequacy and Pillar 2 — framework and actions
- Minimum absolute capital: €5 million.
- Minimum CAR: 10 percent of RWAs for all but one bank (one bank minimum 12 percent).
- CBM implemented Basel II simple approaches since 2011: standardized credit risk, BIA for operational risk, simple maturity approach for interest rate/commodities risk, risk weight approach for forex.
- Composition of regulatory capital (percent to total capital): Tier 1 capital 86.1; Tier 2 capital 13.9; Total Reg. Capital 100.0.
- Percent to Total Risk-Weighted Assets: Tier 1 capital 14.2; Total Reg. Capital 16.5.
- CBM conservative add-ons: operational risk capital at 18.75 percent of average net income (before provisions, excluding extraordinary items) of previous three years; country risk weights up to 300 percent; deduction of investment in immovable property and fixed assets excess of 25 percent of own funds.
- ICAAP and Pillar 2 are established; banks maintain ICAAPs and Pillar 2 capital for multiple risks; CBM evaluates ICAAPs through SREP annually.
- Recommendations:
  - Review eligible capital items and risk weights to align with Basel II.
  - Further improve Pillar 2 implementation by developing supervisory guidance and benchmarks to enhance consistency, including for systemic or internationally active banks.

### Operational risk, governance, and contingency planning
- Operational risk RWAs: 1.40 percent of total RWAs (low relative to Basel Committee calibration averages of 5 percent to 7 percent for Group 2 banks).
- Observations:
  - Banks use BIA for operational risk; low RWAs may weaken incentives to manage operational risk.
  - Governance weaknesses: fit-and-proper norms may not ensure Boards’ collective knowledge; no Board risk committees; CRO removal can occur without CBM prior approval.
  - Outsourcing concentration: several banks outsource core systems to a limited number of providers — common points of exposure and systemic vulnerability.
- CBM and banks need improved information systems for operational risk event/loss data and an operational risk database.
- Recommendations:
  - Strengthen governance framework for risk management.
  - Require improvements to banks’ information systems to monitor/report operational risk events and losses; develop operational risk database.
  - Require banks to develop contingency plans for common points of operational risk exposure; CBM to formulate system-level contingency plans.

### Credit risk, collateral, and NPL treatment
- Credit risk scale:
  - Loans and receivables account for about 70 percent of total assets.
  - Investment in securities about 11 percent; cash/balances with CBM about 14 percent.
  - Loans to residents about 82 percent of total loans: 43 percent to legal entities; 39 percent to individuals.
  - RWAs for credit risk account for almost 99 percent of total Pillar 1 capital requirements.
- Collateral and recovery:
  - Loans invariably collateralized by charges on real estate (residential and commercial).
  - Recovery of dues by foreclosing collateral: about five years.
  - Cost of recovery: around 25 percent.
  - Recovery rate in bankruptcy proceedings: less than 50 percent.
- Asset classification and provisioning:
  - Five asset categories A to E with DPD and provisioning requirements (Art 48). Provisioning table (percent):
    - A: Provisioning requirement 0
    - B1: Provisioning requirement 2
    - B2: Provisioning requirement 7
    - C1: Provisioning requirement 20
    - C2: Provisioning requirement 40
    - D: Provisioning requirement 70
    - E: Provisioning requirement 100
  - Rules allow loans to be kept in performing categories up to 180 DPD if covered by “prime” collateral; banks may reclassify/up-grade exposures, creating potential understatement of NPAs.
  - Reclassification and RRL (restructured/rescheduled loans) rules ambiguous; CBM has not issued clear guidance for reclassifying NPLs as performing.
- System outcomes:
  - Transfer of assets to special purpose vehicles/parents reduced reported NPLs to 16.45 percent at end-June 2015 (from 21 percent at end-2010), but NPLs may remain in system-wide entities.
  - NPLs at individual banks ranged from 5.45 percent to 34.97 percent.
- Recommendations:
  - Clarify and tighten prudential norms for identification, classification, and reclassification of NPAs (delink classification from collateral).
  - Undertake study of adequacy of provisioning rates by sector, collateral type and location, and time to recover to inform provisioning calibration.
  - Require banks to develop comprehensive three-year NPL strategies and annual operating objectives; supervisors to monitor progress and require reclassification/additional provisions where needed.

### Concentration risk, large exposures, and related-party transactions
- Prudential limits:
  - Single large exposure: 10 percent or more (as percentage of own funds).
  - Maximum exposure to a single counterparty or group of connected counterparties: Not more than 25 percent (of own funds).
  - Sum of all large exposures: Not more than 800 percent (of own funds).
- Observed divergences and issues:
  - Methodology allows exemptions, deductions, discounts when measuring exposures — at variance with Basel approach that emphasizes gross exposures.
  - CBM does not treat exposures to central governments and public sector enterprises as large exposures (contrary to Basel norms).
  - Average gross large exposure per counterparty exceeded 25 percent of own funds in two banks (CBM expert review based on available secondary data, excluding certain public exposures).
- Related-party prudential limits (as percentage of capital funds):
  - Aggregate exposure on all related parties: 2 (i.e., 200 percent of capital funds).
  - Aggregate exposure to each member of top management and their respective relatives: 0.02.
  - Aggregate exposure to legal entities controlled by each member of top management: 0.1.
  - Exposure to ONE employee (excluding top management): 0.01.
  - Exposure to ONE shareholder without qualified participation and its controlled legal entities: 0.1.
  - Aggregate exposure to shareholder with qualified participation and related entities: 0.2.
- Distribution of aggregate exposures to related parties (gross/net):
  - Gross: Less than 25%: 2 banks; 25%–<50%: 4; 50%–<75%: 4; 75%–<100%: Nil; 100% & above: 1.
  - Net: Less than 25%: 2; 25%–<50%: 7; 50%–<75%: 2; 75%–<100%: Nil; 100% & above: nil.
- Governance weaknesses:
  - Transactions with related parties can occur without Board prior approval in nine banks despite regulatory requirement.
  - One newly established bank assumed exposure about 300 percent of own funds on a single bank-related party without apparent breach of prudential rules.
- Recommendations:
  - Comprehensive revision of legal and regulatory framework for related-party exposures and transactions to align with Basel; review and tighten prudential limits, reporting and disclosure.
  - Specify maximum limit up to which a bank can transact with a related party without Board prior approval.

### Liquidity risk, funding, and contingency planning
- International activity indicators (June 2015):
  - FA/TA: >20% in 7 of 13 banks.
  - FL/TL: >20% in 12 of 13 banks.
- Significant currency exposure:
  - USD is second major currency.
  - Six banks have more than 5 percent of assets and liabilities denominated in foreign currencies.
- Monitoring and maturity mismatches:
  - CBM’s liquidity indicators set at aggregate level for all currencies; limited monitoring by contractual maturities.
  - Supervisory guidance for plotting time-bands limited; inconsistencies observed between supervisory and publicly disclosed mismatch positions.
  - Basel expectation: supervisors to monitor both contractual and behavioral maturity mismatches.
- Liquidity contingency plans (LCPs):
  - Banks’ LCPs often rely on parent support or CBM reserves and lending, sale of government securities, Nostro balances, or foreign lines.
  - CBM should assess feasibility of LCPs under market-wide stress and develop its own contingency plans.
- Funding risk and nonresident deposits:
  - On average, 19.6 percent of deposits in banking system belong to nonresidents (stable over five years).
  - System longer-term liquidity less resilient; funding risk sizable amid deposit competition and low profitability.
- Recommendations:
  - Assess liquidity risks per significant currency; strengthen monitoring of maturity mismatches (contractual and expected).
  - Periodically assess feasibility of individual banks’ LCPs during market stress to inform CBM contingency planning.
  - Implement comprehensive assessment of funding risk including concentration limits and diversification requirements.

### Disclosure, auditors, and transparency
- Disclosure practice:
  - Banks with foreign parents generally have extensive disclosures and align with Pillar 3; some domestic banks’ disclosure does not meet legal requirements.
  - 2011 “Decision on Public Disclosure of Data and Information by Banks” omits explicit modern requirements (e.g., related-party lending).
- Auditor qualifications and cases:
  - Multiple banks’ 2014 accounts qualified by auditors for under-provisioning and other concerns (examples: Bank A understatement of provisions EUR 5.1 million; investment EUR 5.3 million; deposits EUR 10.4 million with foreign subsidiary; deposit EUR 3.3 million in a bank in liquidation).
  - Bank A own funds recorded EUR 29.3 million; CAR on solo basis 10.3 percent.
  - Bank D auditors qualified 2014 for under-provisioning EUR 1.2 million and accounting treatment issues; auditor did not notify CBM as required.
  - Bank B 2014 auditor qualified for under-provisioning and investment issues.
- CBM engagement with auditors:
  - CBM reviews banks’ annual accounts for regulatory capital; meets auditing profession periodically but not intensively on individual bank cases.
- Recommendations:
  - CBM to review banks’ annual accounts more closely to ensure compliance with disclosure requirements.
  - Initiate more intensive bilateral and tripartite dialogue with individual audit firms to address and resolve qualified opinions.
  - Update Decision on Public Disclosure to require broader disclosures including related-party lending.

*Italic source attribution: IMF/World Bank FSAP Technical Note (Executive Summary), September 2015.*

### EXECUTIVE SUMMARY ___________________________________________________________________________  4

### EXECUTIVE SUMMARY

### INTRODUCTION AND BACKGROUND
- This Technical Note reviews banking supervision and regulation in Montenegro against selected Basel Core Principles (BCP) as part of an FSAP update conducted jointly by the IMF and World Bank in September 2015.
- The assessment covered 15 select BCPs, including Consolidated Supervision, Home/Host Relationships, Risk Management, and Transactions with Related Parties.
- The review drew on: 29 CP self-assessments, the authorities’ completed questionnaire, inspection procedures and reports, prudential reports, and the assessment of bank license application procedures (including review of one full application).
- Legislative updates since the 2006 FSAP include the Law on the Central Bank of Montenegro (LCBM) in 2010 and Banking Law amendments in 2010 and 2011, and adoption of regulations on general risk management including a 2010 regulation on Capital Adequacy implementing Basel II.
- Prepared by Damodaran Krishnamurti (Lead Financial Sector Specialist, World Bank) and Michael Deasy (Consultant, IMF).

### FINANCIAL SYSTEM AND SUPERVISORY STRUCTURES
- Banking sector:
  - Accounts for about 90 percent of financial system assets, equivalent to about 93 percent of GDP as of June 2015.
  - 14 banks operating in Montenegro, up from 11 in 2013.
  - Six foreign bank subsidiaries hold 79 percent of the banking sector assets.
  - Banks’ assets concentrated in lending products (70 percent); lending concentrated in the trade sector and households (mostly mortgages), each representing about 38 percent of total loans.
  - Loans to nonresidents represent 18 percent of the total.
  - Deposits represent three-quarters of liabilities: demand deposits 46 percent and time deposits 53 percent.
  - Foreign deposits represent about 6 percent of total deposits.
- Nonbank financial sector:
  - Insurance sector about 5 percent of financial system assets; average annual growth of 3 percent in the past five years; 11 insurance companies with total assets ~EUR 170 million as at end-2014.
  - Five microeconomic financial institutions with total assets of about EUR 40 million; not funded by deposits.
  - No credit unions or credit guarantee business operations; small and declining unregulated leasing market.
- Key banking indicators (as of June 2015 unless stated):
  - System-wide NPL ratio trending down from 18.4 percent in 2013 to 16.4 percent at end-June 2015.
  - Aggregate tier I capital ratio about 14 percent; capital adequacy ratio (CAR) close to 16 percent (regulatory minimum 10 percent).
  - Bank liquidity is ample.
  - Profitability weak: aggregate ROA 0.5 percent and ROE 3.4 percent in June 2015.
  - Foreign exchange bank loan exposure modest.
  - Banking system has limited domestic interconnectedness.
- Supervision:
  - The Central Bank of Montenegro (CBM) is the sole banking supervisory authority; responsible for authorization, ongoing supervision, and revocation of bank licenses; also supervises micro-credit financial institutions, credit unions, and credit guarantee operations.
  - Two other financial regulators: Insurance Supervisory Agency and Security Commission.

### MAIN FINDINGS AND RECOMMENDATIONS

A. Supervisory Framework — Key findings
- Staffing:
  - Seven vacancies out of a staff complement of 45 remain unfilled despite a significant increase in supervisory work.
- Governance and funding:
  - LCBM contains articles on central bank governance (Board of Directors, appointment/removal of governor and deputies) meeting acceptable standards; governor and two vice-governors obliged by law to appear before parliamentary committees if requested.
  - CBM funded from general central bank activities, issuing of licenses, and annual fees; adopts budget independently and submits final budget and annual financial report (with external auditor’s report) to government and parliament for information.

A. Supervisory Framework — Observations (from Executive Summary text)
- Consolidated supervision:
  - Legislation provides for consolidated supervision but it is not implemented in a meaningful way and is largely confined to reporting.
- New bank licensing:
  - Three new banks were licensed in the past year while the banking market was depressed; a more conservative approach to new licenses is warranted.
- Staffing pressures:
  - Staff shortages in the Banking Supervision Department have arisen due to departures and increased workload.
- Cross-border resolution:
  - Most major banks are subsidiaries of international banks; it is essential these banks be party to home-country resolution plans.
- Capital framework:
  - Basel II implementation is conservative, requiring banks to maintain higher minimum capital ratios, and higher capital for operational risk and for country risk.
  - Pillar 2 and supervisory review are well established, but gaps exist in measurement of capital and RWAs.
- Credit risk environment:
  - Weaknesses in the operating environment dilute banks’ credit risk management and CBM’s supervision: unavailability and reliability of audited financial statements; inability to independently verify or establish connectedness among counterparties (especially non-residents); difficulty in quality evaluation and timely disposal of collateral; third-party-initiated modifications to bank-borrower contracts that harm credit discipline.
- Problem assets and provisioning:
  - Prudential framework for identification and measurement of problem assets is conservative in some respects but has gaps; loan classification can be delayed and reclassification to better categories can be hastened contrary to quantitative/qualitative criteria, leading to incorrect presentation of NPA levels and quality.
- Large exposures and related parties:
  - Prudential limits exist for related-party and large exposures but effective implementation needs improvement.
  - Aggregate limit for all related-party exposures is high at 200 percent of own funds.
  - Norms for measuring exposures differ from Basel norms and divert attention from gross exposures that reflect maximum exposure to loss.
  - Significant gaps in definitions of ‘related party’ and ‘related-party transactions’; banks can assume related-party exposures without Board prior approval.
- Public disclosure:
  - Legislation requires quantitative and qualitative public disclosure, but disclosure by some banks is poor.
  - Several banks’ financial statements were qualified by external auditors, mainly due to under-provisioning, raising confidence concerns.

B. Main Recommendations (from Montenegro: Table 1. Main Recommendations)
- Implement consolidated supervision in a meaningful way, including prudential ratios on a group basis, assessment of risks to banks from the wider group; include group structures in on-site and off-site supervision. Para No. 46, 62, 137 — Priority: I
- Initiate a more intensive dialogue with individual audit firms to seek a solution to the problem of qualified auditors’ opinions in banks. Para No. 144 — Priority: I
- Review bank-audited accounts more closely; ensure their disclosure regime meets requirements. Para No. 144 — Priority: NT
- Fill current vacancies in banking supervision as a matter of urgency and provide career paths for specialist staff. Para No. 21 — Priority: I
- Adopt a more rigorous approach to assessment of bank license applications, particularly their business plan. Para No. 27 — Priority: I
- Seek to be party to the resolution plans with the resolution authorities in home country. Para No. 62 — Priority: I
- Engage with domestic insurance and securities regulators on a more formal basis and conclude signing of the Memorandum of Understanding (MOU) with the insurance regulator. Para No. 62 — Priority: I
- Banks and CBM to review and revise public disclosures on large exposures, related-party transactions and risk concentrations; Update Decision on Public Disclosure of Data and Information by Banks. Para No. 104, 144 — Priority: NT
- Extend staff protection legislation to cover omissions made by staff while discharging their duties in good faith and also to cover the CBM itself. Para No. 21 — Priority: NT
- Provide guidance to banks on expectations for sound corporate governance. Para No. 72 — Priority: NT
- Seek to be able to impose Central Bank monetary fines for infringements by banks. Para No. 51 — Priority: NT
- Further improve effectiveness of Pillar 2 implementation in banks by developing additional supervisory guidance and benchmarks. Para No. 80 — Priority: MT
- Ensure an improved governance framework for risk management in banks. Para No. 95 — Priority: I
- Require improvements to banks’ information systems to monitor and report operational risk events and losses; develop operational risk database to promote better operational risk management in banks and in their supervision. Para No. 95 — Priority: NT
- Require banks to develop appropriate contingency plans to address common points of exposure to operational risk; formulate CBM contingency plans for addressing any potential stress events in this area. Para No. 95 — Priority: I
- Promote improvements in the operating environment to facilitate more meaningful assessment and management of credit risk by banks and its supervision by the CBM. Para No. 104 — Priority: NT
- Tighten prudential norms for identification, classification, and reclassification of nonperforming assets, including norms for uniform classification and restructured loans. Para No. 115 — Priority: I
- Review adequacy of prudential provisioning rates. Para No. 115 — Priority: I
- Tighten exposure measurement and commence monitoring name risk concentrations both on gross and net exposure basis. Para No. 123 — Priority: I
- Improve regulatory and supervisory frameworks for management and supervision of risk concentrations. Para No. 123 — Priority: NT
- Explicitly require banks to stress test their risk concentrations. Para No. 123 — Priority: I
- Tighten legal and regulatory framework for related-party exposures and transactions. Para No. 130 — Priority: I
- Tighten regulatory framework for liquidity risk with respect to significant currencies and for maturity mismatches. Para No. 137 — Priority: I
- Assess feasibility of banks’ liquidity contingency plans during market-wide stress events. Para No. 137 — Priority: MT

- Note on priority coding: I = “Immediate” (within one year); NT = “Near-term” (1–3 years); MT = “Medium-term” (3–5 years).

*Italic source attribution: IMF/World Bank FSAP Technical Note (Executive Summary), September 2015.*

### 12. Article 83 of the LCBM and article 106 of the Banking Law provide legal protection to

### _cr16201 - 12. Article 83 of the LCBM and article 106 of the Banking Law provide legal protection to

### Legal protection for CBM staff
- Article 83 of the LCBM and article 106 of the Banking Law:
  - Directors, employees, and agents will not be held liable for damages incurred during the performance of duties in accordance with the relevant laws and regulations, unless it can be proved that the particular action has been performed deliberately or as an act of gross negligence.
  - The CBM shall cover expenses of bank staff who are in court proceedings concerning the performance of their duties.
- Deficiencies:
  - Legislation is silent on coverage for omissions made by staff while discharging their duties in good faith as required by Essential Criteria 9 of Principle 2 of the BCPs.
  - Legislation is silent on protection coverage for the CBM itself.

### CBM reporting, accountability, and operational independence
- Annual reporting and parliamentary interaction:
  - The CBM publishes an annual report relating to its prior year’s activities, including review and assessment of policies followed and description/explanation of policies to be followed during the following year.
  - On average, the governor and his vice-governors appear four times a year before a parliamentary committee.
- Operational independence and legislative risk:
  - Legislation provides for clear operational independence for the CBM, but recent legislative actions may infringe upon the supervisor’s authority.
  - No evidence of interference in day-to-day running, but concern about the “Law on the Conversion of Swiss Franc (CHF)-denominated loans into Euro-denominated Loans” (see paragraph 16).

### CHF-to-euro loan conversion law: scope and implications
- Scope and impact:
  - Law provides for conversion of Swiss Franc-denominated loans into euros converted at the exchange rate obtained on the date the loan was first granted.
  - In effect, law applies to one bank only (it was the only bank to offer Swiss franc denominated loans between 2005 and 2007).
  - Number of loans: in the region of 450.
  - Current value of loans: in the region of EUR 30 million.
  - Potential exchange loss to the bank: could be as high as EUR 9 million.
  - Higher interest charges on the now euro-denominated loans: 8.2 percent per annum (which will somewhat offset the exchange loss).
- Institutional response:
  - The bank in question has initiated constitutional proceedings against the law.
  - The CBM is charged with implementation and required to introduce detailed regulations but did not initiate the legislation and does not agree with it.
  - CBM concern: law seeks to alter retrospectively the terms of an agreement freely entered into by a bank and its customer, potentially resulting in losses to a bank.

### Supervision funding and staffing
- Funding:
  - CBM seeks to ensure cost of supervision is covered in full by the industry and, in practice, appears to be fully funded by the industry.
  - Supervision expenses are covered by fees charged to the industry.
  - Fee basis: assets (0.065 percent) and is recalculated monthly, based on prudential reports submitted by the banks.
- Salaries and recruitment:
  - Governor is responsible for setting salary levels in the CBM.
  - CBM salaries are higher than public sector but generally lower, in some instances considerably lower, than those in the industry.
  - Within CBM, salaries in banking supervision are 30 percent higher than in other areas in the central bank.
  - Recruitment difficulties due to insufficient remuneration and weaker benefits (as noted in Paragraph 9 and staff exit interviews).
- Staffing levels and turnover:
  - Recent turnover has been negligible; during the recession the CBM recruited experienced staff from within the industry.
  - Around the time of the banking crisis of 2008–2009, a number of senior supervisors left; one vice governor resigned citing “imbalances between powers and responsibilities.”
  - Earlier in 2015, three persons left the Banking Supervision Department partially due to establishment of three new banks.
  - Current vacancies in banking supervision: seven.

### Assessors’ view on supervisory staff quality
- Supervisory staff are well trained, highly knowledgeable, and professional (assessors’ opinion).
- Despite some past departures, the CBM was able to recruit experienced staff during the recession.

### Recommendations on staff protection and resourcing
- The decision requiring the CBM to supervise implementation of a law that seeks to retrospectively alter loan agreements freely entered into, with potential losses to one bank, could be seen as compromising its operational independence. It should not be used as a precedent for any further similar legislation.
- The CBM should seek to fill current vacancies as a matter of urgency and to provide career paths for specialist staff.
- Staff protection legislation should be extended to cover omissions made by staff while discharging their duties in good faith and to the supervisor itself.

### New bank licensing: recent changes and concerns
- New entry:
  - Three new banks were established in the past year and one more application is currently being considered.
  - Change in number of banks: from 11 banks to 14 banks.
- Context and concerns:
  - Occurs when demand for credit is low, bank liquidity is high, profitability is low, and existing banks are coping with high levels of NPLs.
  - CBM states all new banks met necessary licensing criteria.
  - Each bank submitted detailed three-year business plans that, on the face of it, appeared feasible.
  - Assessors recommend a more rigorous assessment of business plans given current business climate and potential overlap in identified banking opportunities.
- Licensing practices:
  - CBM has recently rejected a license application because the applicant would not provide audited accounts for a company involved in the ownership structure.
  - Up to 12 prospective applicants withdrew from the process at early stages in recent years.
  - All directors and chief executives of prospective banks must be approved in advance by the CBM.
  - No requirement for approval of other senior management posts (left to directors), though the CBM should consider prior approval for senior management posts such as chief financial officer, chief risk officer, and internal auditor.
- Recommendations on licensing:
  - The CBM should adopt a more rigorous approach to assessment of bank license applications, particularly to their business plan.
  - In addition to approving directors and chief executives, the CBM should consider approving other senior posts, such as chief financial officer, chief risk officer, and internal auditor.

### Supervisory approach, processes, and risk-focus
- Supervisory scope and resources:
  - On-site and off-site oversight appears effective, subject to absence of effective consolidated supervision.
  - Oversight is confined to the solo bank only; absence of consolidated supervision affects both downward supervision and wider group supervision.
  - Example: Atlas Bank had a banking subsidiary in Moscow that was never inspected by the CBM, nor were its records included in off-site prudential reports.
- Staffing in supervision:
  - Currently five portfolio managers cover the banks and are responsible for both on-site and off-site supervision.
  - Support by experts in specific risk areas (credit risk, liquidity risk, operational risk, internal controls, internal audit, etc.).
  - Credit risk expert team did not have an expert on real estate evaluations, relying on valuations provided by banks.
- Risk-based supervision:
  - Systemically important banks defined as any bank with a 10 percent or more market share receive most attention, as do problematic banks.
  - All banks are subject to annual inspection; some are full-scope but mostly targeted inspections (targeted inspections generally cover a wide range of risks and may include stress testing).
  - Capital adequacy and credit risk are inspected yearly.
  - Inspection process supported by a detailed on-site inspection manual and by the “Decision on Basics of the Internal Control System in Banks.”
- Reporting, monitoring, and analysis:
  - On-site inspection program drawn up annually at the latter end of the previous year and factors in ownership, previous inspections, CAMELS rating, macro environment, etc.
  - Prudential returns received on a regular basis: daily (liquidity) to three monthly (balance sheet, income statement, etc.).
  - Findings of on-site and off-site inspections are fed into a CAMELS report updated quarterly; each component rated 1 (lowest risk) to 5 (highest risk).
  - Portfolio managers produce monthly and quarterly off-site reports monitoring indicators: past due loans, nonperforming loans (NPLs), restructured loans, profitability, liquidity, etc.; indicators compared to system averages and outliers pursued.
  - CBM prepares a quarterly report covering all banks with market share, asset structure, bad debts and provisions, restructured loans, sectoral distribution, deposit maturity structure, ownership structures, and capital ratios.
- Stress testing:
  - CBM undertakes stress testing; latest stress test carried out in 2014 using baseline and adverse scenarios.
  - Inputs based on on-site and off-site examinations and macroeconomic scenarios.
  - CBM requires banks to have forward-looking stress testing and assesses these on-site.
  - Recommendation: methodology and rigorousness of stress testing should be strengthened.
- Assessors’ view:
  - On-site and off-site regimes carried out to a satisfactory degree; analyses appeared relevant and to the point.
- Recommendations on supervisory approach:
  - Where relevant, include group structures in the on-site and off-site supervisory regime.
  - Recruit real estate valuation experts in the context of on-site inspections.

### Consolidated supervision: gaps and implications
- Legal and practical gaps:
  - No system of effective consolidated supervision in practice despite provisions in the Banking Law and the “Decision on Methods for the Preparation of the Consolidated Financial Reports of the Banking Group.”
  - Company law does not define ‘holding company,’ hindering recognition of holding companies.
  - CBM devised its own definition of financial holding company: “financial holding means a joint stock company or limited liability company which has participations in the capital or voting rights of banks or other parties offering financial services, if it controls at least one bank.”
  - Consolidated supervision defined too narrowly, concentrating on accounting consolidation and insufficiently on group-wide risk management, contagion, and reputational risk.
  - No explicit law enabling CBM to review activities of parent companies and affiliated companies to determine impact on safety and soundness of the bank.
  - For companies owned by banks, supervisory colleges address some aspects; where parent is a nonbank, absence of identifiable group company structures hinders review.
- Case example (Bank A):
  - Consolidated supervision would currently apply in just one case: a medium-sized domestic bank (Bank A).
  - Bank A previously had a banking subsidiary abroad and currently owns a 32 percent stake in a small Montenegro insurance company.
  - Bank A is part of a wider group engaged in banking, real estate, television, universities, pension funds, and insurance, controlled by one individual who owns 70 percent of the shares in the bank (and 20 percent of a small domestic bank (Bank B)).
  - Cross-shareholdings between Bank A and Bank B: each less than 10 percent.
  - Another large domestic bank (Bank C) has nearly a 5 percent stake in Bank A; some owners of Bank C own about another 15 percent of Bank A.
  - Given this structure, effective supervision is difficult.
  - Article 24 of the Banking Law identifies “the ownership structure of a bank disables effective bank supervision” as grounds to refuse a license application.
- Reporting and consolidation practice:
  - Neither annual audited accounts nor prudential reports submitted by Bank A to the CBM are consolidated.
  - In solo accounts, investments in the Russian bank subsidiary and Montenegro insurance company are listed as investments deducted from capital for CAR calculations.
  - Consequently, key ratios are not calculated on a consolidated basis: capital, large exposures related-party lending, and liquidity.
- Concerning exclusion:
  - Article 134 of the Banking Law permits an exclusion (subject to central bank agreement) where a foreign subsidiary is located in a jurisdiction with legal impediments to submission of data required for consolidated reports.
  - This exclusion is, on the face of it, contrary to good practice because consolidated supervision requires free flow of information.
  - CBM position: they do not allow establishment of foreign subsidiaries in countries that prevent free flow of information; exclusion intended for situations where legislation changes in a foreign jurisdiction after a Montenegro bank is already established, creating impediments. In such cases, CBM would consider ordering sale of shares in the subsidiary.

*Source: _cr16201 - 12. Article 83 of the LCBM and article 106 of the Banking Law provide legal protection to*

### 45. Taking all these issues into account, the absence of effective consolidated supervision

### _cr16201 - 45. Taking all these issues into account, the absence of effective consolidated supervision

### Consolidated supervision: findings and recommendations
- Finding: "Taking all these issues into account, the absence of effective consolidated supervision could give rise to systemic risk in the banking sector."
- Recommendations:
  - The CBM should implement consolidated supervision in the sense that (a) it should look beyond the narrow accounting procedure and assess potential group-wide risk including reputational and contagion risk; and (b) calculate prudential ratios on a consolidated basis.
  - It should seek to have incorporated into national business law the concept of a holding company, whose general activity is the holding of capital in other companies.
  - Examine the interconnectedness of Banks A, B and C with a view to identifying common risks and how these risks might be mitigated. In particular, the CBM should examine potential large exposure risks and related-party lending across the three banks. It should also assess the reputational and contagion risks arising from banks’ associated companies.
  - Seek the deletion of article 134 of the Banking Law, i.e., allowing for the exclusion from consolidated reporting of a subsidiary in a jurisdiction where there are legal impediments to the submission of data and information to the parent bank, to ensure that this exclusion is not available while granting permission to a Montenegro bank to establish in such a jurisdiction.

### Corrective and sanctioning powers of supervisors: findings
- Letters with corrective measures and on-site examination reports are sent to banks’ Boards; Boards are given eight days to respond.
- Since 2010, there have been seven occasions where banks were required to introduce fresh capital or increase the solvency ratio.
- Historical corrective measures applied by the CBM include appointment of an interim administrator in 2001 and 2003; appointment of an authorized representative (a CBM employee) to attend Board meetings in 2009; ordered replacement of a chief executive; ordered increases in capital; restricted certain activities; and prompt finalization and follow-up of examination reports.
- The CBM does not have the power to impose monetary fines directly; fines must be imposed through the Court of Misdemeanors. The CBM has used the Court of Misdemeanors on 10 occasions; fines range from EUR 3,000 to EUR 15,000. When a bank incurs a fine, its chief executive automatically incurs a fine ranging from EUR 500 to EUR 1,000.
- The CBM can require offending banks to make one-off payments to the Deposit Protection Fund (DPF). The payments range from 0.1 percent to 1.00 percent of the bank’s own funds. (The upper limit has recently been increased to 1.5 percent of own funds).

### Corrective and sanctioning powers: recommendation
- The CBM should seek powers to impose monetary fines in its own right. These should be at significantly higher levels than apply in the Court of Misdemeanors.

### Home-host relationships: findings
- Legal basis for information sharing: Articles 9 and 31 of the CBML govern CBM’s ability to share information with fellow supervisors.
- Banking group structure: 7 of Montenegro’s 14 banks have foreign parents (6 banks, 1 investment company). Four of these Montenegro banks are regarded by Montenegro authorities as systemically important (defined as having 10 percent or more of the share of the banking market). Of the seven foreign owners, two are from Austria and one each from France, Hungary, Serbia, Slovenia, and Turkey.
- Montenegro subsidiaries represent only a very small portion of parent banking groups’ business, ranging from under 0.2 percent to just over 3 percent.
- Case example: Atlas Bank subsidiary in Moscow had its license revoked by the Central Bank of Russia (CBR) in May 2014 in connection with AML activities; revocation was challenged and license restored; subsidiary was sold to a bank registered in Austria at par value with payment by installments over an eight-year period. The CBM had signed an MOU with the CBR, but the CBR did not advise the CBM of its intention to revoke the license despite MOU provisions for exchange of information.
- Supervisory college participation: CBM is a member of three supervisory colleges (leads: Central Bank of Hungary (OPT Group), Bank of Slovenia (NLB Group), National Bank of Serbia (Group Komercijalna Banka)). CBM has observer status only in relation to the OPT Group. Austria initially did not consider Montenegro’s professional secrecy provisions equivalent to EU directive, but EU authorities wrote in April 2015 that Montenegro confidentiality rules did meet EU standards. Austria has now invited the CBM to be a member of respective colleges. CBM does not participate in the Société Générale Group supervisory college, as Banque de France does not believe the Montenegro subsidiary to be of significance. The CBM does not have an MOU with Austria, but it does with France.
- Supervisory colleges follow EBA guidance; CBM exchanges information on planning/coordination of supervisory activities and emergency situations and has shared such information with colleges organized by Austria, Hungary, Serbia, and Slovenia.
- Foreign supervisors have access to subsidiaries and branches in Montenegro for supervisory activities; Bank of Slovenia, National Bank of Serbia, and Central Bank of Hungary have performed on-site inspections. CBM has joined some of these supervisors on on-site inspections (e.g., Slovenia and Serbia).
- Joint exercises: joint ICAAP and SREP exercises based on the EU Capital Requirements Directive are carried out.
- CBM has not developed bank or group resolution plans with resolution authorities or supervisory authorities in home-country jurisdictions.
- MOUs: CBM has signed MOUs with Albania, Belarus, Croatia, Macedonia, entities of Bosnia and Herzegovina (Republic of Srpska and the Federation of Bosnia and Herzegovina), and a multilateral agreement with supervisors in South Eastern Europe (Albania, Bulgaria, Cyprus, Greece, Macedonia, Romania, and Serbia).
- Domestic coordination: CBM’s Supervision Department has an MOU with the securities regulator, but not with the insurance regulator. An MOU with the insurance regulator is expected to be signed shortly. Prudential-level contact among the three regulators appears infrequent and ad-hoc despite banks’ engagement in securities business and one bank’s share in an insurance company.

### Home-host relationships: recommendations
- The CMB should continue to pursue France to become a member of the Société Générale supervisory college. In particular, it should seek to be party to the resolution plans with the resolution authorities in all relevant countries, given the systemic importance of these banks to the Montenegro economy.
- The Supervision Department should seek to engage with the insurance and security regulators on a more formal basis and to conclude the signing of an MOU with the insurance regulator as a matter of urgency.

### Corporate governance: findings
- Legislative basis for corporate governance in banks is detailed and reasonably comprehensive. Banks and CEOs (who in instances were also directors) displayed understanding of the Board’s role (risk appetite, overseeing bank strategy).
- Statutory functions (internal control, compliance) were understood; optional committees (e.g., risk management) were less certain.
- Board involvement increased since the property price collapse; increased meetings and lower referral thresholds for loan approvals were observed.
- Basel Committee guidance (BCBS Guidelines—Corporate Governance Principles for Banks, July 2015) recommended as a starting point for supervisor guidance.
- Directors are appointed for four years, renewable; there is no overall time limit on total service.
- The CBM ordered the replacement of an executive director in 2010; the removal was unchallenged.
- Internal audit and compliance functions are required and report to an audit committee, but both functions are carried out on a solo bank basis only. Inspection reports noted weaknesses in internal controls and internal audit, partly due to lack of internal audit expertise (including IT).
- No specific section in the on-site inspection manual devoted to corporate governance, but examiners routinely examine Board minutes, evaluate risk-management practices, and assess internal audit and compliance work.
- Montenegro has not implemented the Financial Stability Board’s standards for compensation; a Banking Law revision expected to be completed by end-2016 proposes implementation. Currently, shareholders fix compensation for Board members; Boards set salaries for bank employees. Some banks have remuneration committees. Excessive or imprudent remuneration practices do not appear to be an issue.
- No specific regulations require banks to notify the supervisor as soon as they become aware of material information that may negatively affect the fitness and propriety of a Board member or senior management; CBM assesses eligibility conditions based on inspection information and other available information.
- Regular contacts between the supervisor and senior management are maintained via portfolio managers and Supervision Department management. The Board is required by law to respond to inspection reports.

### Corporate governance: recommendations
- The CBM should consider providing guidance to banks on expectations for sound corporate governance.
- The CBM should consider placing a limit on how long directors can remain on banks’ Boards. A maximum of two renewable periods (i.e., up to 12 years in all) is recommended.
- The internal audit function in banks should be extended to total group activities and not confined solely to the bank.
- The CBM should consider introducing a specific section in the on-site inspection manual devoted to corporate governance.
- The CBM should consider introducing a specific rule requiring banks to notify the CBM as soon as they become aware of any material information that may negatively affect the fitness and propriety of a bank’s Board member or a member of senior management.

### Capital adequacy: regulatory framework and key statistics
- Minimums and approaches:
  - Minimum absolute capital: €5 million.
  - Minimum CAR: 10 percent of RWAs for all but one bank, which has a minimum ratio of 12 percent.
  - CBM implemented simple approaches under Basel II since 2011: standardized approach for credit risk, basic indicator approach for operational risk, simple maturity approach for interest rate risk and commodities risk, and risk weight approach for forex risk.
  - No active trading book; forex risk is the main market risk.
  - No bank currently uses internal ratings-based approaches (credit risk), internal models approach (market risk), or the standardized approach or AMA for operational risk.
  - Banks allowed to use external ratings by S&P, Moody’s, and Fitch; CBM has not undertaken independent due diligence on these agencies.
- Table 2 (Composition of Regulatory Capital and Risk-Weighted Assets):
  - Percent to Total Capital: Tier 1 capital 86.1, Tier 2 capital 13.9, Total Reg. Capital 100.0.
  - Percent to Total Risk-Weighted Assets: Tier 1 capital 14.2, Total Reg. Capital 16.5.
  - RWA for credit risk 98.57
  - RWA for market risk 0.03
  - RWA for operational risk 1.40
- CBM conservative requirements:
  - Minimum CAR of 10 percent.
  - Capital for operational risk at 18.75 percent of average net income (before provisions and without taking into account extraordinary items) of the previous three years.
  - Capital for country risk where exposures to certain countries can attract an additional risk weight up to 300 percent (in addition to the risk weight for credit risk).
  - Deduction of investment in immovable property and fixed assets that are in excess of 25 percent of bank’s own funds.
  - CBM has required higher capital ratio (12 percent) for some banks based on risk profile.
- ICAAP and Pillar 2:
  - Banks maintain ICAAP and maintain capital to cover materially important risks; ICAAP is forward-looking and considers strategic plans, macroeconomic factors, loan growth expectations, future sources and uses of funds, and dividend policy.
  - Banks review and revise internal capital adequacy assessments at least once a year, or more frequently after significant changes.
  - CBM evaluates ICAAP through SREP annually during on-site inspections.
  - Banks maintain additional capital under Pillar 2 for interest rate risk in the banking book, country risk, liquidity risk, residual risk, concentration risk, strategic risk, reputation risk, and other risks, including at times an ad hoc additional capital of x percent of RWAs. Banks’ methodologies are vetted during annual on-site inspections; CBM may require higher capital for Pillar 2 risks.
- Deviations from Basel II capital item treatment:
  - Hybrid debt allowed as tier 2 capital is not required to be discounted during the last five years of maturity (currently, no bank has raised capital through hybrid debt).
  - Fixed asset revaluation reserve need not be discounted (by 55 percent as applicable for latent reserves).
  - Deferred tax assets and significant investment in the equity of restructured borrowing entities are not required to be deducted.
- Risk weight practices:
  - Risk weights assigned to credit risk exposures are consistent with or more conservative than Basel II in almost all cases.
  - Exceptions: lower risk weights for nonperforming assets (100 percent instead of 150 percent and 50 percent instead of 100 percent, depending on provisions) and national discretion to assign a 50 percent risk weight for exposures secured by commercial real estate (as against 100 percent or the risk weight determined by external rating). Basel II allows this discretion for commercial real estate only for jurisdictions with well-developed and long-established markets.

*Source: _cr16201 - 45. Taking all these issues into account, the absence of effective consolidated supervision*

### 78. While the CBM has required a higher capital for operational risk than under the Basel

### 78. While the CBM has required a higher capital for operational risk than under the Basel framework

### Operational risk capital adequacy
- Banks are using the BIA approach to calculate RWAs for operational risk.
- RWAs for operational risk is 1.40 percent of total RWAs.
- The low profitability of the banking system has attributed to low levels of RWAs for operational risk compared with an average of between 5 percent and 7 percent observed during the Basel Committee’s calibration exercises for Group 2 banks.
- A low RWA’s for operational risk may not be providing necessary incentives for banks to manage this risk; the CBM can review the adequacy of capital held for operational risks.

### Supervisory powers and responses to capital deterioration
- The CBM can initiate supervisory responses whenever a bank breaches the minimum requirements.
- The CBM has in recent past invoked supervisory powers to respond to declining capital levels before they breached the minimum requirement.
- Banking Law provisions:
  - Interim administration can be imposed if own funds and/or solvency ratio are below a half of the prescribed level (article 120).
  - Bank’s license can be revoked if solvency ratio is below one quarter of the prescribed level (article 129).

### Recommendations (capital, Pillar 2, SREP)
- The CBM should review the eligible items of capital and risk weights assigned to specified exposures, and bring these in alignment with Basel II.
- While Pillar 2 and the SREP processes are well established, the CBM can consider further improving Pillar 2 implementation by developing additional supervisory guidance and benchmarks referencing methodologies for assessing Pillar 2 risks and assigning appropriate levels of additional capital.
  - This can promote consistency among banks’ Pillar 2 practices.
  - Consider extending this to the systemic or internationally active banks.

### Risk management framework and regulatory requirements
- Laws and regulations set out requirements and responsibilities for Boards and senior management; CBM is empowered to supervise risk management.
- CBM has issued detailed regulations on major risks: credit risk, market risk, operational risk, interest rate risk in the banking book, liquidity risk and country risk.
- Required elements of banks’ risk management systems include (at minimum): objectives and strategies; risk-management policies and procedures; defined powers and responsibilities; review of exemptions; ethical code of conduct; approval processes for new products/services; efficient and safe IT systems; periodical stress testing; contingency plans; robust internal audit; effective internal controls appropriate to size, complexity, and risk level.
- Boards must adopt a risk-management strategy spanning not less than three years, reviewed at least annually; strategy must include objectives, business activity composition, expected risk-return relationships, and criteria/methods for establishing risk-management frameworks.
- Risk management policies/procedures must cover risks to be addressed, identification methods, limits and controls for individual and aggregate exposures, reporting framework to Board and senior management, connection with activities in dependent legal persons and entities subject to consolidated supervision; review at least annually.

### Supervisory on-site practices
- On-site examinations assess effectiveness, adequacy, and compliance of banks’ risk-management strategies, processes, and procedures.
- Supervisors review risk strategy, risk appetite, identification/measurement/monitoring/controls, documentation and communication, internal governance (including compliance and internal audit), business organization, and capital allocation against risk.
- Supervisors evaluate adequacy and quality of reporting to management and the Board on material risks.
- During on-site examinations, supervisors determine whether bank capital is sufficient for the bank’s risk profile and may require:
  - Increase in own funds,
  - Higher solvency ratio and/or other capital adequacy indicators than prescribed.
- During the last five years, the CBM has required four banks to maintain higher capital or raise additional capital to match their risk profiles.
- Recent years: banks have been having excessive liquidity and this risk was not a matter of concern.
- Banks are not using models for measuring/monitoring risk for regulatory and internal needs; relying on simple and conventional methodologies.

### Governance and organizational weaknesses (areas for improvement)
- a) Fit-and-proper norms for Board appointments do not adequately ensure Boards have sound collective knowledge and understanding of major risks the bank is exposed to.
- b) No bank has established a risk management committee of the Board, though most have a dedicated risk management unit/department; the head of risk management does not always have direct access to the Board or the audit committee; risk management function is subject to oversight by the CEO or executive director.
- c) Appointment of chief risk officers (CRO) requires CBM prior approval, but removal can happen without CBM prior approval; CBM is informed of removal when the bank seeks approval for appointment of the new CRO.
- d) Requirement to identify and account for risks in new product approval processes does not explicitly extend to internal pricing and performance measurement.

### Other risks, stress testing, recovery and operational risk supervision
- Banks must address material risks not directly covered in laws/regulations (including reputational and strategic risk); these must be accounted for in ICAAPs.
- Guidance allows banks either a flat capital add-on (say 5 or 10 percent) or using own methodology for assessing capital needs for these risks.
- Banks required to undertake periodical stress testing for material risks:
  - At least once a year in context of ICAAP.
  - At least quarterly and report results to the CBM.
- Stress testing outcomes feed into banks’ assessment of capital requirements, ICAAPs, capital plans, strategies, and risk-management strategies; CBM reviews assumptions and outcomes during annual inspections and SREPs.
- Banks have not developed recovery and resolution plans to address stress at the institutional level.
  - CBM plans to comply by 2017, aligning with EU jurisdiction designs as appropriate.

### Operational risk data, outsourcing concentration and contingency planning
- CBM and banks can improve information systems to support proactive management and supervision of operational risk.
- CBM has yet to establish a comprehensive off-site supervisory framework for periodic monitoring or assessment of operational risk.
- Improvements needed in banks’ information systems to support:
  - compiling and analyzing operational risk data,
  - monitoring operational risk,
  - facilitating reporting to Boards and senior management.
- CBM should consider improving the database on operational risk events and losses in banks to promote better operational risk management and supervision.
- Common points of exposure to operational risk across banks pose system vulnerability:
  - Banks have outsourced products/services including core banking solutions to a limited number of entities/service providers, posing concentration risk.
  - CBM is aware of this concentration.
  - CBM should require banks to consider alternate options (including in-house) and develop contingency plans; CBM must formulate its own contingency plans for potential stress events in this area.

### Interest rate risk in the banking book
- CBM has required all banks to establish systems for measuring interest rate risk in the banking book.
- All banks have relied on the CBM methodology in its decision on the “Minimum standard for managing interest rate risk in the banking book,” based on the modified duration approach for measuring economic impact of a parallel 200 bps interest rate shock on rate sensitive assets and liabilities.
- Suggested improvements to CBM methodology:
  - Provide explicit guidance for plotting each type of RSA and RSL (e.g., inclusion of cash, non-interest bearing demand deposits and placements, Nonperforming assets (NPAs), subordinate debts).
  - Require banks to measure exposure for each RSA and RSL relying on respective maturities/reprising dates and yields.
  - Require reckoning the economic value impact of the standard shock on the bank’s equity (common equity Tier 1 (CET1) capital) and the income impact.

### Market risk
- Banks do not have a material exposure to market risk.
- Absence of active securities, foreign exchange, commodities, and interest rate markets means banks have very little or no exposure to market risks other than foreign exchange risk from net open positions.
- CBM requires banks whose net aggregate positions (long or short, whichever is higher) are more than 2 percent of own funds to maintain capital for market risk.

### Recommendations (governance, operational risk systems, contingency plans)
- Ensure an improved governance framework for risk management in banks, as detailed above.
- Require improvements to banks’ information systems to monitor and report operational risk events and losses to develop the operational risk database, to promote better operational risk management in banks and in their supervision.
- Require banks to develop appropriate contingency plans to address common points of exposure to operational risk arising from product procurement and outsourcing of services; the CBM is to formulate its own system-level contingency plans for addressing any potential stress events in this area.

### Credit risk: scale and supervisory practices
- Credit risk is the largest risk for banks in Montenegro.
- Asset composition:
  - Loans and receivables from banks and clients account for about 70 percent of total assets.
  - Investment in securities (largely government securities, held to maturity) about 11 percent.
  - Cash/balances with the central bank about 14 percent.
- Loans to residents are about 82 percent of total loans:
  - 43 percent to legal entities.
  - 39 percent to individuals.
- RWAs for credit risk account for almost 99 percent of total Pillar 1 capital requirements.
- During on-site examinations, supervisors examine risk management strategy, policies and procedures for adequacy relative to bank size and business plans; supervisors have full access to all information, records, and staff involved in credit risk.

### Weaknesses in operating environment and credit infrastructure
- Weaknesses diluting effectiveness of credit risk management and CBM supervision include:
  - Non-availability and reliability of borrowers’ audited financial statements.
  - Inability to independently verify or establish connectedness among counterparties—particularly nonresident counterparts.
  - Scope for excluding or discounting certain exposures while measuring credit risk.
  - Quality of valuation and time to realize collateral.
  - Third-party initiated modifications to bank-borrower contracts that adversely impact credit discipline.
- Law on Accounting and Auditing audit requirements:
  - Joint stock companies, large legal entities, and parent legal entities that, jointly with subsidiaries, meet any two of the criteria for large legal entities need independent external audit.
  - Criteria for large legal entities (meeting any two out of three):
    - having the average number of employees more than 250;
    - having aggregate annual revenue of more than EUR 50,000,000;
    - having aggregate assets of more than EUR 43,000,000.
- Anecdotal evidence suggests entities that meet audit criteria are about 10 percent of registered legal entities.
- Among those required to have external audit, about 75 percent to 80 percent of the financial statements bear a qualified audit opinion.
- These factors impair banks’ ability to assess debtors’ creditworthiness and to identify nonperforming assets (NPAs).

### Limitations of registries and impact on identifying related parties
- Banks and the CBM verify ownership structures in the Central Registry of Business Entities (CRBE) and the Central Depository Agency (CDA).
- CRBE contains ownership data including nonresident owners and functions/authorizations of natural persons in a legal person.
- CDA provides data on ten largest shareholders, number of shares and percentage ownership in joint stock companies, including nonresident shareholders.
- For transactions with nonresident legal persons, banks require data from the registry of the country of the nonresident.
- Limitations:
  - CRBE database is not amenable to comprehensive search; reliance does not assure identification of all connected legal entities.
  - CRBE and CDA contain data only for domestic entities; identification of foreign (nonresident) connections may not be complete.
- These features adversely affect banks’ and CBM’s ability to independently identify and verify connected counterparties and related parties, limiting comprehensive aggregate measurement of large exposures and related-party exposures.

*Source: IMF staff assessment excerpt.*

### 101. Banks invariably collateralize their credit risk exposures by obtaining a charge on real

### Banks invariably collateralize their credit risk exposures by obtaining a charge on real estate properties, including residential and commercial real estate.

### Collateral, recovery outcomes, and market factors
- Recovery of dues by foreclosing collateral takes about five years.  
- Cost of recovery is around 25 percent.  
- Recovery rate in respect of bankruptcy proceedings is less than 50 percent.  
- Anecdotal evidence and interactions with a cross section of banks, auditing firms and legal firms and professionals inform the above findings.  
- A cultural factor in Montenegro: residents evince low interest in buying foreclosed properties, which adversely affects banks’ ability to efficiently foreclose and recover dues, particularly for loans secured by real estate.

### Risk management and supervisory scope
- Banks manage risks on a solo basis; the Central Bank of Montenegro (CBM) regulates and supervises banks on a solo-bank basis.  
- Implication: effectiveness of prudential requirements and supervision for the banking system—especially management and supervision of credit risk, the dominant risk—is constrained.

### Stress testing requirements
- Banks are required to perform stress testing of their exposure to credit risk at least once a quarter.  
- Banks must: identify potential events or future changes in economic conditions that could adversely affect credit risk exposure; assess capacity to sustain such changes; prepare action plans to respond to unfavorable stress test results.  
- Banks’ stress testing results are submitted to the CBM every quarter.  
- CBM reviews design, assumptions, results, and responses during annual on-site examinations.

### Recommendations (from paragraph 104)
- Take the initiative to promote improvements in the operating environment to facilitate more meaningful assessment and management of credit risk by banks and its supervision by the CBM.  
- Extend the prudential norms currently applicable to solo banks to the consolidated bank.  
- Review and revise:  
  - banks’ public disclosure requirements for their credit risk exposures to include explicitly large exposures, related-party exposures, and risk concentrations; and  
  - the CBM’s public disclosures of banks’ large exposures, related-party exposures, and risk concentrations.

### Problem assets, provisions, and reserves — system outcomes
- Transfer of assets to special purpose vehicles or to parent banks reduced reported NPLs at system level to 16.45 percent as at end June 2015 (from 21 percent in end-2010).  
- NPLs at individual banks ranged from 5.45 percent to 34.97 percent.  
- Transfers shifted NPLs to books of different entities but did not remove NPLs from the system as a whole.

### Prudential framework for identification and measurement of problem assets
- Framework gaps result in incorrect presentation of level and quality of nonperforming assets because:  
  - reclassification may be based on types of collateral irrespective of borrowers’ ability to repay;  
  - lack of adequate clarity and consistency for restructuring or rescheduling loans and their prudential treatment; and  
  - lack of adequate clarity on reclassification of nonperforming assets to lower risk categories.  
- A loan can be treated as a performing loan for up to 180 days past due (DPD) or assigned a better asset classification status where criteria might otherwise require classification as nonperforming.  
- Banks may assign a better grade than the lowest grade even though loans have been nonperforming for several years.  
- Some permitted items of prime and adequate collateral may not be high quality in terms of recoverability with minimal delay, loss, or cost.

### Asset classification rules (CBM)
- Banks assign balance sheet and off-balance-sheet items to five asset classification categories (A to E) based on qualitative and quantitative criteria; banks may assign better grades for loans backed by specific collateral types.  
- Criteria include debtor’s credit capacity, regularity in meeting obligations, collateral quality, and other relevant factors.  
- Quantitative DPD criterion is binding except where banks hold “prime” or “adequate” collateral:  
  - Prime collateral allows retention in category A up to 180 DPD.  
  - Adequate collateral allows assignment of one-level better asset classification category than unsecured NPA.  
- Banks must undertake individual evaluation for all exposures in excess of EUR 50,000; portfolio approach allowed for exposures less than that amount.  
- Loans in categories C to E are treated as NPLs.  
- Some items counted as prime or adequate collateral may not truly reflect high recoverability (examples listed for prime and adequate collateral in the source).

### Prudential asset classification and provisioning norms (Table 3)
- Asset classification categories, qualitative and quantitative norms, and provisioning requirement (Art 48)–in percent:  
  - A (Art 33): <= 30 DPD; <=60 DPD; Provisioning requirement 0  
  - A if fully covered by prime collateral: < 180 DPD; NA; Provisioning requirement 0  
  - B1 (Art 34): >30 <=60 DPD; >60 <=90 DPD; Provisioning requirement 2  
  - B2 (Art 34): >60 <=90 DPD; >90 <=150 DPD; Provisioning requirement 7  
  - C1 (Art 35): >90 <=150 DPD; >150 <=270 DPD; Provisioning requirement 20  
  - C2 (Art 35): >150 <=270 DPD; >270 <=365 DPD; Provisioning requirement 40  
  - D (Art 36): >270 <=365 DPD; >365 <= 455 DPD; Provisioning requirement 70  
  - E (Art 37): >365 DPD; > 455 DPD; Provisioning requirement 100

### Prudential provisioning practice, reserves, and supervisory treatment
- CBM requires banks to maintain the higher of regulatory and accounting provisions in a manner that does not interfere with compliance with accounting standards.  
- Banks must set aside additional reserves (post tax appropriation) when accounting provisions for impairment are lower than regulatory provisions for NPAs; these additional reserves are not counted as capital for capital adequacy.  
- When banks do not hold adequate provisions (and additional reserves) for NPAs, the shortfall is deducted from capital by supervisors while computing capital adequacy.  
- For computing provisions for NPAs, provisioning is computed with reference to the exposure (balance sheet plus off-balance-sheet exposures) without allowing any benefit for collateral.

### Treatment of exposures to a single counterparty and classification consistency
- Prudential regulations require applying the lowest asset classification category assigned to a counterparty to all other exposures to that counterparty, but allow exemptions that can be material.  
- Banks can assign a better asset classification to exposures or portions covered by “prime” or “adequate” collateral if:  
  - the collateralized exposure has not received the lowest classification;  
  - the bank can justify higher classification on the basis of recoverability; and  
  - more than 90 percent of exposure to the counterparty has been classified as category A or B.  
- Banks are allowed to assign a single loan to different asset classification categories.

### Restructured/rescheduled loans (RRL) — ambiguities and supervisory gaps
- Regulatory framework for prudential treatment of restructuring/rescheduling is ambiguous and can be implemented differently, allowing incorrect measurement and assessment of asset quality. Areas of ambiguity include:  
  - Asset classification of RRL when restructured (may be retained or upgraded).  
  - Asset classification when RRL is not to be treated as RRL per regulations (for example, restructuring for reasons beyond borrower’s control, or interest reduction/capitalization for reasons other than deterioration of borrower’s credit capacity).  
  - Asset classification status of new dues under revised terms (may differ from past dues).  
  - Upgrading asset classification after three months’ timely repayment under new terms (upgrade by one stage or more).  
  - Asset classification status of RRL placed under “sustainable financial restructuring” and subsequently restructured/rescheduled again.  
- CBM has not issued regulation or guidance for reclassifying a nonperforming exposure as performing exposure, leaving scope for varied interpretation and practice; loans that have been NPLs for several years may be graded above the lowest grade.

### Adequacy of provisioning rates and recommended review
- Current provisioning rates were established in 2012; CBM is yet to assess adequacy of provisioning rates with reference to actual losses encountered while resolving NPAs.  
- Doing Business 2015 Report indicates cost of recovery of collateral in Montenegro is about 25 percent and rate of recovery in bankruptcies is less than 50 percent.  
- Loss rates differ by borrower sector, region, and type of credit risk mitigant (collateral, guarantor).  
- CBM can undertake a study of actual recoveries/loss rates by sector, collateral nature and location, and time taken to collect/recover to inform adequacy of provisioning rates.  
- CBM can also review concentration that banks and the banking system are exposed to through the collateral route (land and real estate are primary sources of collateral).

### NPL strategies and supervisory oversight
- Banks are required to develop a comprehensive three-year strategy for dealing with NPLs and determine annual operating objectives related to reducing NPL levels.  
- Banks must submit to CBM: (a) an adopted NPL resolution strategy; and (b) annual operating objectives by January 31 for the relevant year.  
- Supervisors analyze NPA management strategies and progress, review progress during on-site examinations, and frequently require banks to reclassify or make additional provisions for NPAs.

### Recommendations (from paragraph 115)
- Clarify and improve prudential norms for identification, classification, and reclassification of nonperforming assets, including norms for uniform classification and RRLs, mainly by delinking asset classification from collateral.  
- Undertake a study of the adequacy of provisioning rates for various asset categories with reference to actual recoveries/loss rates by borrowers’ operating sector, nature and location of collateral, and time taken to collect or recover.

### Concentration risk and large exposure limits
- CBM has prudential requirements pertaining to name concentration, but not for other types (sectoral, geographic).  
- Regulations require banks to analyze concentration of exposures to collateral providers, unfunded credit protection providers, and underlying assets (securitization, open investment funds) and report significant findings to CBM.

### Prudential limits for large exposures (Table 4)
- Single large exposure: 10% or more (as percentage of own funds)  
- Maximum exposure to a single counterparty or group of connected counterparties: Not more than 25% (of own funds)  
- Sum of all large exposures: Not more than 800% (of own funds)

### Connected counterparties, measurement, and compliance issues
- Definition and guidance for identifying connected counterparties is clear in law and regulations, covering control and economic dependence.  
- CBM does not have explicit discretionary power to apply the definition case-by-case, but supervisors can include recommendations in inspection reports or post-inspection letters.  
- CBM regulations allow banks to exclude certain items of exposures while assessing and managing credit risks; permitted exemptions apply across the board (including computing large exposures and related-party exposures and some measurement and provisioning for NPAs).  
- These exemptions lead banks to underestimate overall exposure to credit risk and shift CBM focus toward net (lower) exposures instead of gross exposures.

### Variance from Basel large exposure approach and supervisory findings
- Methodology for computing exposures allows banks to exempt, deduct, or discount exposures when measuring/reporting large exposures; this is at variance from Basel requirements and the revised 2014 Basel approach.  
- CBM does not recognize exposures to central governments and public sector enterprises as large exposures, though Basel norms require doing so.  
- Review of gross large exposures shows some banks may effectively breach prudential limits on exposures to a single counterparty or group of connected counterparties; average gross large exposure per counterparty is above 25 percent of own funds in two banks (CBM expert review based on available secondary data, excluding exposures to central governments, regional governments, and public sector enterprises).

*Source: _cr16201 - 101. Banks invariably collateralize their credit risk exposures by obtaining a charge on real estate properties, including residential and commercial real estate.*

### 121. Regulations require banks to perform stress testing of the loan portfolio without

### _cr16201 - 121. Regulations require banks to perform stress testing of the loan portfolio without

### Stress testing of loan portfolios and risk concentrations
- Regulations require banks to perform stress testing of the loan portfolio without specifying that banks should stress large exposures or risk concentrations.
- Banks are required to identify potential events or future changes in economic conditions that could have adverse effect on their exposure to credit risk and assess their capacity to sustain such changes.
- The CBM supervisors independently perform stress testing of banks’ risk exposures every quarter, which include stress on large exposures and failure of largest borrowers.
- The CBM can improve the scope and effectiveness of stress testing in banks by explicitly requiring banks to perform stress tests on their risk concentrations, including, for example, by name, sector, geographic, and collateral concentrations.
- Table 5 (December 2014) — selected presentation of gross to net exposures and average gross exposure per large exposure:
  - Gross to net exposures: Nil, 7, 1, 2, 1, 11
  - Average gross exposure per large exposure: 8, Nil, 1, 1, nil, 10
- Supervisory practice:
  - Supervisors review and discuss concentration risks with banks, particularly in the context of their ICAAPs.
  - Ten of the 11 banks that were operating in December 2014 are maintaining additional capital for concentration risk under Pillar 2.
  - Coverage of concentration risk under ICAAP and SREP is largely focused on name concentration; additional capital requirements tend to be determined by banks’ internal methodologies, which includes the Herfindahl-Hirschman Index (HHI).

- Recommendations:
  - Revise the exposure measurement norms to be in compliance with the Basel norms in this regard and commence monitoring name-risk concentrations both on gross and net exposure bases.
  - Improve regulatory framework for identifying, measuring, monitoring, and managing direct and indirect risk concentrations, including sectoral exposures, geographic exposures, and exposure to residential and commercial real estate. This should also include explicit requirements for stress testing banks’ exposure to risk concentrations.
  - Enhance CBM monitoring and supervision of all types of risk concentrations.
  - Improve the scope and effectiveness of stress testing in banks by explicitly requiring banks to perform stress tests on their risk concentrations, including, for example, name, sector, geographical, and collateral concentrations.

### Transactions with related parties — definition, limits, and governance
- Definitions and guidance:
  - The definition and guidance for identifying bank-related parties is clear in law and regulations, but need to be broadened to fully align with Basel norm.
  - The definition of bank-related parties does not include the major shareholders, Board members, senior management and key staff of the bank’s subsidiaries, affiliates and single points of entry, as well as their direct and related interests, and their close family members.
  - The CBM does not have explicit power to exercise discretion in applying this definition on a case-by-case basis.
- Transaction coverage:
  - The definition of “transactions” in law and regulations does not explicitly mention service contracts, construction contracts, lease agreements, derivative transactions, borrowings and deposits with/from bank-related parties.
  - CBM maintains that expressions such as operations, activities and transactions imply all transactions with bank-related parties and that all transactions are checked and operations with bank-related parties are noted in the Examination Report.
- Prudential limits (Table 6) — limits as percentage of capital funds (1/As percentage of capital funds, not more than):
  - Aggregate exposure on all related parties: 2
  - Aggregate exposure to each member of top management and their respective relatives: 0.02
  - Aggregate exposure to legal entities controlled by each member of top management: 0.1
  - Exposure to ONE employee (excluding member of top management): 0.01
  - Exposure to ONE shareholder without qualified participation and the legal entities controlled by that shareholder: 0.1
  - Aggregate exposure to shareholder with qualified participation and the legal entities controlled by that shareholder; legal entities controlled by controlling parties; and legal entities controlled by the bank: 0.2
- Observed divergences from BCPs:
  - The prudential limit for aggregate related-party exposures at 200 percent of capital funds is a wide divergence with BCPs (CP 19 (AC1) suggests 25 percent of a bank’s capital for a group of connected parties).
  - Aggregate gross and net exposures to related parties are already in excess of the prudential limits suggested under the BCPs in nine banks; effective exposure to a single related party might also be in excess in a few banks.
- Distribution of banks’ aggregate exposures to all related parties (Table 7):
  - Gross: Less than 25% of capital funds: 2; 25% to less than 50%: 4; 50% to less than 75%: 4; 75% to less than 100%: Nil; 100% & above: 1
  - Net: Less than 25% of capital funds: 2; 25% to less than 50%: 7; 50% to less than 75%: 2; 75% to less than 100%: Nil; 100% & above: nil
- Delegation of powers for related-party transactions (Table 8):
  - Lending: No delegation or NA: 4; up to 2% of own funds: 3; 2 to 5%: 1; 5 to 10%: 2; 10% and more: 3
  - Non-lending: No delegation or NA: 9; up to 2% of own funds: 2; 2 to 5%: nil; 5 to 10%: nil; 10% and more: 2
  - Write-off: No delegation or NA: 11; up to 2% of own funds: 2; 2 to 5%: nil; 5 to 10%: nil; 10% and more: nil
- Governance weaknesses:
  - Transactions with bank-related parties can be undertaken in effect without the Board’s prior approval in nine banks, despite legal/regulatory requirement for prior approval.
  - Article 2 of the Decision on minimum standards on operations with bank-related parties requires Board approval, but banks set internal thresholds for Board prior-approval which vary and may permit significant exposures without prior Board approval.
  - A newly established bank has assumed an exposure of about 300 percent of own funds on a single bank-related party without apparently breaching any prudential requirement.
- Supervisory practice:
  - Supervisors assert that despite exemptions in measuring exposures, all transactions with related parties are in compliance with legal and regulatory requirements regarding terms and absence of interested parties in approvals; however, article 2 does not prohibit interested parties from managing or monitoring the exposure or transaction.
- Recommendations:
  - Undertake a comprehensive revision of the legal and regulatory frameworks to bring the various elements of assuming and managing bank-related-party exposures and entering into transactions with these parties in compliance with Basel requirements. Also, review and revise the prudential limits, reporting and disclosure requirements pertaining to bank-related-party exposures and transactions.
  - Clarify and, ideally, specify the maximum limit up to which a bank can lend or transact with a bank-related party without obtaining its Board’s prior approval.

### Liquidity risk: monitoring, contingency planning, and funding risk
- International activity and foreign exposures:
  - The CBM has not identified any bank in Montenegro as an internationally active bank.
  - Data indicate some banks can be perceived as internationally active: Seven banks have foreign assets in excess of 20 percent and 12 banks have foreign liabilities in excess of 20 percent (Table 9).
- Foreign assets and liabilities (Table 9, June 2015):
  - FA/TA: less than 5%: 3; 5 to 10%: 2; 10 to 15%: nil; 15 to 20%: 1; >20%: 7; Total: 13
  - FL/TL: less than 5%: Nil; 5 to 10%: Nil; 10 to 15%: 1; 15 to 20%: Nil; >20%: 12; Total: 13
- Significant currency exposures (Table 10, June 2015):
  - The second major currency is the U.S. dollar (USD).
  - As per Basel, when more than 5 percent of a bank’s total assets or total liabilities are denominated in any currency, that is a significant currency.
  - Six banks have more than 5 percent of their assets and liabilities denominated in foreign currencies; most have USD assets or liabilities.
  - FCA/TA: less than 5%: 7; 5 to 10%: 3; 10 to 15%: nil; 15 to 20%: 1; >20%: 2; Total: 13
  - FCL/TL: less than 5%: 7; 5 to 10%: 3; 10 to 15%: nil; 15 to 20%: 1; >20%: 2; Total: 13
- Monitoring maturity mismatches:
  - The CBM’s prudential requirements for liquid assets indicator and maturity mismatches are set at the aggregate level for all currencies.
  - The CBM does not effectively monitor maturity mismatches on the basis of contractual maturities.
  - Guidance to banks for plotting assets/liabilities (including off-balance-sheet commitments) under time–bands is limited, leaving room for bank-specific methodologies and assumptions.
  - Supervisors review assumptions and methodologies but additional guidance would achieve more consistent methodologies.
  - Supervisory data show a positive maturity mismatch position in banks, while some banks’ publicly disclosed data reveal a negative mismatch for the same time band(s), suggesting need to review and revise supervisory approach.
  - Basel expects supervisors to monitor both contractual and behavioral maturity mismatches; CBM should strengthen monitoring of both.
- Liquidity contingency plans (LCPs):
  - CBM reviews LCPs for adequacy and appropriateness.
  - LCPs from banks with parent banks usually include parent support as a main element.
  - LCPs from domestic banks often indicate dependence on reserves maintained with the CBM and borrowing from the CBM, cash balances/deposits with other banks (including Nostro accounts), sale of investments in government securities, and lines of credit from foreign banks.
  - These domestic-bank strategies rely mainly on CBM reserves and lending, which may be inadequate if the entire banking system were under stress.
  - CBM should undertake periodical assessment of feasibility of individual bank plans during market stress and stress across banks; findings could inform CBM’s contingency plans for addressing liquidity stress across banks.
- Funding risk and nonresident deposits:
  - Nonresident deposits are an important source of funding for some banks.
  - On average, 19.6 percent of deposits in the banking system belong to nonresidents and the proportion has been relatively stable over the past five years.
  - Most banks have the share of nonresident deposits just below 20 percent with only a few banks deviating from the norm.
  - The banking system’s longer-term liquidity is less resilient to stress situations and vulnerabilities to elevated funding costs are high.
  - Funding risk is sizable in an environment of increasing deposit competition and low profit margins.
  - CBM analyses can be made more comprehensive by including establishment of funding limits and funding concentration limits and their periodical monitoring, requiring banks to establish and maintain relationships with liability holders, diversification of sources of funding, and review and assessment of liquidity and marketability of liquid assets at times of market stress.
- Stress testing for liquidity:
  - Laws and regulations require banks to conduct periodical stress testing, using several types of stress scenarios, including assumption of changes in market and other factors which may have a material impact on bank’s operations.
  - Stress tests are intended to assess impact on banks’ cash flows and liquidity.
  - During on-site examinations, supervisors review procedures for liquidity stress testing, dynamics of stress testing, scenarios and assumptions, results, and options banks plan to use to raise liquidity during stress situations.

- Recommendations:
  - Assess liquidity risks in banks with reference to each significant currency; strengthen monitoring of liquidity risks in banks as reflected by their maturity mismatches, both under contractual and expected maturities.
  - Undertake periodical assessment of the feasibility of liquidity contingency plans of individual banks, particularly during times of market stress or stress across banks. The findings of this review could also inform the CBM’s contingency plans for addressing liquidity stress across banks.
  - Develop and implement a more comprehensive assessment of funding risk in banks.

*Source: _cr16201 - 121. Regulations require banks to perform stress testing of the loan portfolio without (IMF staff report content).*

### 138. While the requirements relating to disclosure and transparency reflect good practice,

### _cr16201 - 138. While the requirements relating to disclosure and transparency reflect good practice,

### Disclosure and transparency — implementation gaps
- Broad pattern: banks owned by parent banks tend to have extensive disclosure, including individual risk and its management, and would in general comply with Pillar 3 requirements; some other banks’ disclosure does not meet legislative requirements.
- Specific noncompliance examples:
  - Article 13 of the Decision on Public Disclosure of Data and Information by Banks requires disclosure of the method used for calculating the capital requirement for operational risk; some banks only refer to the presence of operational risk without specifying the calculation method.
  - Atlas Bank does not publish consolidated accounts.
  - Another bank’s accounts were not accompanied by an auditor’s statement.
- The “Decision on Public Disclosure of Data and Information by Banks” (2011) omits certain now-standard requirements (for example, explicit reference to disclosure of related-party lending), although IFRS/IAS require such disclosure.

### Auditor qualifications, bank cases, and capital metrics
- Bank A:
  - Until recently was a 100 percent owner of a foreign subsidiary and owns a 32 percent stake in an insurance company.
  - Publishes solo bank accounts only; no consolidated accounts.
  - Auditors qualified 2014 results on multiple counts:
    - understatement of provisions of EUR 5.1 million;
    - concerns about its investment of EUR 5.3 million and deposits of EUR 10.4 million with its foreign subsidiary;
    - concerns about a deposit of EUR 3.3 million deposited in a bank currently in liquidation in Bosnia and Herzegovina.
  - Own funds recorded in the accounts amounted to EUR 29.3 million.
  - The CAR at the same date (calculated on a solo basis, with the investment in the foreign subsidiary deducted from own funds) was 10.3 percent, marginally above the minimum requirement of 10 percent.
- Bank D (medium-sized domestic bank):
  - Auditors qualified 2014 and previous years’ accounts.
  - 2014 qualification related to under-provisioning in the amount of EUR 1.2 million and concerns about accounting treatment of loan-related fees.
  - Auditors referenced breach of the central bank’s requirements on related-party lending.
  - The auditor of Bank D did not advise the CBM in advance of the intention to qualify the accounts, in breach of article 98 of the Banking Act (which requires the auditor to notify the CBM of material issues arising in the bank).
- Bank B:
  - Auditor’s report for the 2014 annual accounts qualified for reasons relating to under-provisioning in respect of loans and an investment.
- Supervisory stance and communication:
  - The CBM is aware of qualified accounts and states it makes its own calculation for regulatory capital.
  - CBM views auditors as adopting a conservative approach to asset valuations.
  - CBM meets the auditing profession periodically on general accounting issues but does not meet individual auditors very frequently regarding individual bank accounts.
  - CBM was aware of the intention of Bank A's auditor to qualify in the context of intensive regulatory involvement with that bank.
- Systemic implication:
  - Presence of qualified auditor’s opinions in a number of banks could impact public confidence in those banks and the banking system as a whole.

### Recommendations (regulatory actions proposed)
- The CBM should review banks’ annual accounts more closely to ensure that their disclosure regime meets the necessary legal requirements.
- The CBM should initiate a more intensive dialogue with individual audit firms, both on a bilateral basis and on a tripartite basis (involving the bank in question), to address and resolve auditors’ qualified opinions. This aligns with the intent of Principle 27 (Financial Reporting and External Audit), including:
  - meeting periodically with external audit firms to discuss issues of common interest relating to bank operations (Essential Criterion 8);
  - requiring the external auditor to report to the supervisor matters of material significance.
- The CBM should update its “Decision on Public Disclosure of Data and Information by Banks” to include a greater range of disclosures, such as related-party lending.

### Appendix I — Exemptions, deductions, and discounts allowed while measuring exposures (selected provisions)
- A. Items exempted for asset classification and provisioning:
  - other short-term, highly liquid instruments with original maturity up to three months or less, for which a low level of risk from change in value exists;
  - derivative instruments used as hedging instruments;
  - investment in immovable properties, properties, and plant and equipment;
  - financial assets included in the trading book;
  - guarantees received;
  - collateral received.
- B. Items exempted or deducted fully for calculation of exposures to a single party or group of connected parties:
  - spot foreign exchange transactions: exposures incurred in the ordinary course of settlement during the two working days following payment;
  - spot transactions for purchase or sale of securities: exposures incurred in the ordinary course of settlement during five working days following payment or delivery of the securities, whichever is the earlier;
  - exposures arising from delayed receipts of funds and other exposures arising from customer’s activity and maturing at the latest on the following business day, in case of providing payment services, including money transfer services, as well as clearing and settlement services in local or foreign currency, financial instruments clearing, correspondent banking, and custody services;
  - intra-day exposures to institutions providing payment services, including money transfer services, clearing and settlement services in local and foreign currency, and correspondent banking services;
  - exposures constituting claims on central governments, which, unsecured, would be assigned a zero risk weight according to the “Decision on capital adequacy of banks”;
  - exposures secured by unconditional guarantees of the central governments or public sector entities, where unsecured claims on the entity providing the guarantee would be assigned a zero risk weight according to the “Decision on capital adequacy of banks”;
  - exposures to regional governments or local self-governments, or guaranteed by them, where unsecured claims on those entities would be assigned a zero risk weight according to the “Decision on capital adequacy of banks”;
  - exposures secured by certificates of deposit, issued by the lending bank, its parent undertaking or its subsidiary and lodged with either of them;
  - exposures arising from undrawn credit facilities that are classified as low-risk off-balance sheet items under Article 13 of the Decision on capital adequacy of banks, provided that an agreement has been concluded, under which the facility may be drawn only if it has been ascertained that it will not cause exceeding of large exposure limit under Article 58, paragraph 1 of the Banking Law;
  - covered bonds falling within the terms of Article 46 of the Decision on capital adequacy of banks.
- C. Items deductible at 80 percent for calculation of single-party/group exposures:
  - exposures guaranteed by regional governments or local self-governments, if unsecured claims to those entities would be assigned a 20 percent risk weight according to the Decision on capital adequacy of banks;
  - exposures of the bank, including also equity participation or other types of investments, to its superior bank, subsidiaries of superior bank and its subsidiaries if they are subject to consolidated supervision in accordance with the applicable regulations in the European Union or equivalent supervisory standards on consolidated basis applied in a third country.
- D. Items deductible at 50 percent for calculation of single-party/group exposures:
  - exposures secured by mortgage or fiduciary on residential property which fall within 35 percent risk weight requirements under the Decision on capital adequacy of banks;
  - exposures secured by mortgage or fiduciary on commercial property, which fall within 50 percent risk weight requirements under the Decision on capital adequacy of banks.

*Source: _cr16201 - 138. While the requirements relating to disclosure and transparency reflect good practice,*

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