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National Bank of Serbia governor paints banking landscape – Q&A

In a wide-ranging question-and-answer session, governor Jorgovanka Tabaković reveals shifting sands in the Serbian banking system, efforts to boost domestic sources of finance, capital market reform, Basel III and Vienna initiatives.

How would you characterize the NBS’s overall approach to bank regulation? How has it evolved over the past five years? What are the key challenges facing the NBS in relation to bank regulation?

Faced with challenges that characterize our macroeconomic environment, primarily non-performing loans (NPLs) largely inherited from previous years and the pronounced FX credit risk in our banking sector, the National Bank of Serbia has over the past years striven to preserve and succeeded in preserving banking sector stability by pursuing a counter-cyclical regulatory policy.

This approach implies the adoption of restrictive regulatory measures in the period of expansion and their orderly relaxation in the period of crisis, with a view to easing the financial cycle effects on banks as the main intermediaries between capital, on the one hand, and citizens and the corporate sector, on the other.

In this regard, conservative pre-crisis policies regarding capital, regulatory provisions and liquidity played an important role in effective overcoming of negative effects of the global financial crisis which hit Serbia’s banking sector, and represent one of the key factors behind solid capitalization and liquidity of the banking sector, and the full loan loss provisioning.

NBS governor 
Jorgovanka Tabaković 

At the same time, over the past years, the NBS has taken big steps towards harmonizing its legal framework with universally accepted banking standards – Basel II, including EU regulations implementing these standards. In June 2011, the NBS adopted a set of six decisions implementing Basel II standards in Serbia. In accordance with these regulations, since late 2011, Serbian banks have been implementing Basel standards in calculation of capital and capital requirements, and the management of risks they are exposed to.

Clearly, this change also altered the way in which the NBS supervises banks – the concept of risk-based supervision – and greater emphasis was placed on the assessment of risk of individual banks and timely preclusion or mitigation of those risks with the potential to jeopardize financial stability.

The rules on necessary reserves calculation and allocation, amended in late 2011, represent another significant improvement which boosted the stability of the entire financial system. Furthermore, amendments of December 2012 laid the blueprint for more effective resolution of NPLs, which are one of the key challenges in the banking sector.

The NBS is currently considering the manner and timeframe for the most adequate implementation of Basel III standards in Serbia and will draft a strategy for Basel III implementation by end-2013. The strategy will cover all areas of new standards and present the timeframes for the adoption of individual minimum capital and liquidity requirements, in addition to the already adopted measures.

In what respects has the NBS’s regulatory stance been influenced by the dominance of foreign-owned lenders in the Serbian banking system? How has it been affected by the problems suffered in their home market by the parent banks of several leading Serbian lenders? How has the NBS’s response compared with that of regulators elsewhere in SEE/CEE?

Within the context of the presence of foreign-owned banks and the effects of the financial crisis, it is important to mention the new rules of the Basel III accord and their implementation as of January 1, 2014, particularly bearing in mind that the change in business models of banking groups and their subsidiaries began with the publication of the first drafts of these documents.

Most conclusions regarding current and future changes are applicable to almost all banks in the local market, regardless of their size or the country of origin.

New Basel III measures did not have much impact on business models of Serbian banks, but we can certainly see more cautious behaviour of banks in capital management. It is important to note that regulatory capital in the Serbian market traditionally consists of only core capital – usually in the form of share capital and unallocated profits – and supplementary capital – usually made up of subordinated liabilities subject to strict conditions harmonized with EU directives.

In addition, Serbia traditionally has low and stable leverage values, which is one of the reasons why measures of the Basel III accord did not significantly and directly affect banks in Serbia.

In regard to Basel III measures introduced to promote the formation of capital reserves in good times, which can be used in the periods of stress, note that Serbian banks have been required, for quite a number of years already, to allocate necessary reserves which enable the coverage of potential losses on a pro-active basis.

In the period of crisis, by relaxing regulations in terms of calculation and allocation of necessary reserves, the NBS strove to act in a counter-cyclical way, which certainly produced a positive effect on the stability of the overall financial system. Partly owing to the above NBS measures, Serbia’s banking sector remains highly capitalized.

From the aspect of liquidity, new Basel III measures have already had some impact on banks’ business models. Given the planned introduction of new liquidity ratios in line with the Basel III accord, most domestic banks belonging to a banking group are already obliged under their parent banks’ requirements to calculate and maintain the ratios within the prescribed bounds.

Hence, the proportion of financial assets is rising, while Serbian banks are less dependent on sources of funding obtained from the group but instead increasingly rely on sources of international financial institutions. In March 2012, Austrian supervisors adopted recommendations to strengthen local stable sources of funding, which had a similar effect on the operation of Austrian banks in Serbia, as well as liquidity measures under the Basel III accord.

However, I wish to underline that the slowdown in bank lending, even stagnation in some cases, was not caused only by the announced introduction of new measures under the Basel III accord, or other measures of European supervisory authorities, but was primarily due to the macroeconomic situation and caution on the part of banks, i.e. their reluctance to lend to clients not identified as high quality.

How effective have the Vienna Initiatives been in addressing conflicts between home & host regulators? Does the NBS support multilateral efforts to limit deleveraging in the Balkan region?

From our perspective, the importance of the Vienna Initiative for the region of central, eastern and southeastern Europe is indisputable. This platform enables the exchange of opinions between domestic and foreign supervisory authorities and other important stakeholders, but also joint action and coordination of activities with a view to managing the financial crisis.

In this way, the Initiative gives active contribution to the preservation of financial stability in participating countries, and strengthens the resilience of national financial systems and the European financial system with regard to systemic risks.

What first started as the Vienna Initiative in March 2009 evolved into the programme of support to the country’s financial stability, which involved 27 оf 33 banks in Serbia’s banking sector, with 18 banks belonging to foreign banking groups.

Though foreign banking groups committed to maintaining their exposure to Serbia in 2009 and 2010 at the December 31, 2008, level, the NBS lowered this requirement to 80% of this level in April 2010. Furthermore, all participants were obliged to maintain capital adequacy and liquidity ratios at the prescribed levels, take part in stress tests and offer to clients the possibility to reschedule loans.

In the course of this two-year programme, the exposure of only one banking group fell below the prescribed level, which is why the NBS excluded this group from the programme. All other participants complied with all their commitments. Maintaining the exposure of banking groups to Serbia positively affected the preservation of financial and macroeconomic stability and preservation of trust in the domestic banking sector.

I wish to underline that during the programme implementation there was no conflict between the NBS as the local regulator and other parent regulators. On the contrary, cooperation was highly successful.

The NBS supports cross-border forums also because our banking sector is in majority ownership of foreign banking groups – 75% of total assets. Therefore, only through cooperation and coordination with foreign supervisors and their banking groups is it possible to efficiently strengthen financial stability in our country.

In accordance with this commitment and in cooperation with the IMF, in March 2013 the NBS organized the Belgrade Initiative, as a national cross-border cooperation forum. The main topics at the forum included the strategy of banking groups in Serbia, funding challenges, long-term domestic sources of lending, development of the domestic capital market, and issues of regulations and the strategy for NPLs resolution.

After the Belgrade Initiative ended, the NBS prepared the proposal of the new strategy for NPLs resolution in Serbia.

What is the current outlook for the Serbian banking sector in terms of credit expansion, profitability, etc?

The Serbian banking sector currently includes 30 banks, of which 21 are in majority foreign ownership. The majority of foreign-owned banks are members of banking groups from 11 countries and they account for 74.7% of total balance-sheet assets, 78.3% of total loans and 70.3% of total deposits in the Serbian banking sector.

However, this does not mean that the Serbian banking sector is insufficiently fragmented as the top-five banks hold 50.0% of total balance-sheet assets, 52.4% of total loans and 49.8% of total deposits.

The Serbian banking sector could not escape the effects of the global financial crisis, but it has remained stable, largely owing to the accumulated liquidity and capital buffers. The Serbian banking sector was adequately capitalized in both 2012 and 2013 – its capital adequacy ratio was at an all-time high above the national regulatory minimum of 12% and the Basel standard of 8%.

Also, during this period, own sources of funding grew at a pace sufficient to maintain their share in total liabilities at 20.8% (end-September 2013). The capital adequacy ratio rose from 19.1% at end-2011 to 19.9% on September 30, 2013. Banking-sector liquidity was also satisfactory in both 2012 and 2013, the average liquidity ratio in September being 2.51 compared with the regulatory minimum of 1.0.

High banking-sector liquidity is further indicated by the fact that liquid assets made up in September 35.9% of total balance-sheet assets and 58.2% of short-term liabilities.

Profitability of the Serbian banking sector increased significantly in 2012. Net pre-tax profit came at RSD11.7 billion (€102 million), nearly nine times the amount in 2011. In the year to September, net pre-tax profit came at RSD17.03 billion (€147 million), marking an increase on the same period a year earlier.

However, when talking about profitability, we must not forget that it is inextricably linked with the outlook for lending activity. Focusing on less risky assets, banks are increasingly inclined to invest in dinar debt securities that bear lower interest rates.

Since 2009, banks have been reluctant to lend, but this is by no means a characteristic of Serbia only. Since there was no major decrease in the exposure of domestic banks towards their parents, the excess liquidity has been invested in the most liquid and traditionally the least risky instruments, such as one-week repo securities of the NBS, Treasury bills of the ministry of finance and short- and medium-term bonds of the Republic of Serbia.

If from the perspective of banks this means lower risk, it may also mean lower potential profit. Let me conclude by saying that the outlook for banking-sector profitability depends critically on the sustainable recovery of domestic and global economies, as well as on finding a viable solution to the problem of NPLs and a full recovery of lending activity.

When does the NBS expect to see NPL levels stabilize and even start to reduce? What are the key challenges facing lenders in Serbia?

NPLs, i.e. gross loans past their due for more than 90 days, represent a constraining factor in maintaining stability of the banking sector. At end-September 2013 they amounted to RSD401.6 billion (€3.5 billion) and the gross NPL ratio came at 21.06%.

The most significant sector, both in terms of the volume of loans granted and in terms of its share in total NPLs, is the corporate sector, notably companies engaged in manufacturing, trade and construction. Gross NPL ratio for the household sector is stable and below average. It currently stands at 9.4%.

Committed to finding a systemic solution to the issue of NPLs, the NBS executive board adopted in December 2012 a decision amending the decision on risk management for banks, permitting banks to assign receivables due from legal entities to other legal entities which no longer have to be engaged primarily in financial activity and not related to the bank.

At the same time, the executive board adopted amendments to the decision on the classification of bank balance sheet assets and off-balance sheet items, relaxing the classification criteria for loans that are not regularly serviced and introducing special criteria for receivables restructured in accordance with the law on bankruptcy and the law on consensual financial restructuring of companies.

These measures are yielding their first, albeit modest, effects. Some banks have seized the opportunity to clean up their portfolios by selling NPLs to other legal entities and have used the acquired funds for financing healthy projects.

However, a long-term solution to the issue of NPLs hinges not only on the clean-up of bank balance sheets but also on the recovery of domestic and foreign demand, and the implementation of structural reforms and fiscal consolidation measures at home.

The achieved stability of the exchange rate and the fall in inflation, as well as the lowering of money-market dinar interest rates are important preconditions for both healing of credit activity and preventing of further build-up in NPLs, i.e. for stabilizing their volume.

In addition, an improvement in risk-assessment procedures applied by banks could help prevent further expansion of the bad-loans portfolio. Should this be accompanied by a rise in total credit activity, the share of NPLs will start to decline.

However, none of the above activities can effectively resolve the problem of the current stock of NPLs. Therefore, a viable NPL resolution requires a comprehensive clean-up of bank balance sheets, supported by a broad-based economic recovery, both at home and worldwide, as the latter would boost domestic and foreign demand and help the corporate sector overcome illiquidity issues and switch to sustainable business models.

Of course, an important factor in this respect is the existence of a proper regulatory framework, which was discussed in the Belgrade Initiative meeting.

The key challenges faced by lenders in Serbia are similar to those faced by their regional peers, deleveraging being recognized as the most widespread risk in the region. Though subsidiaries of foreign banks hold around 75% of the domestic banking-sector assets, the extent of deleveraging in Serbia has so far matched the level recorded in other countries of the region.

On the positive side, the financial effects of deleveraging were offset by an increase in the domestic sources of funding, namely household deposits.

In addition to deleveraging, one of the risks specific to the Serbian financial system is the high level of deposit and credit euroization. While Serbian banks’ balance sheets have a balanced currency structure – currency structure of their assets and liabilities being similar – non-financial sectors hold unmatched currency positions, and are highly exposed and vulnerable to exchange rate volatility.

It was in fact due to the euro dominance in total loan portfolio that the depreciation of the dinar served as one of the main drivers of NPL growth. As euroization also undermines the efficiency of the monetary policy transmission mechanism, together with the government, the NBS adopted the strategy of dinarization in order to promote the use of local currency in the deposit and credit segments of the market.

Does the NBS expect and/or support further consolidation in the Serbian banking sector?

The spillover of the global crisis to the Serbian financial system and the overall economic environment caused some of the foreign bank groups to re-examine their presence in the Serbian market, and also reflected on our plans regarding the consolidation of state-owned banks.

The government stake in the ownership structure of banks in Serbia could be considered an “as is” situation at the time the global economic crisis broke out in 2008 and, in light of this, it can be seen as a necessity that has persisted to this very day. Strategic decisions regarding the shares of banks owned by the Republic of Serbia were focused on the continuation of the consolidation and privatization processes.

The strategy envisaged the sale of the government’s controlling stake in banks via an international public tender and the sale of banks in which the Republic of Serbia held a minority stake in capital. It was also planned that the government should retain its stake in a certain number of banks until 2011 and at the same time strengthen their market position, enhance corporate governance and improve their profitability, efficiency and competitiveness.

During the financial crisis, foreign investors either lacked interest in bidding for government stakes in banks or the bidders were not reputable enough, and, at the same time, there was a significant drop in the prices of shares and a sharp deterioration in market capitalization of these banks.

The legacy of state-owned banks indisputably testifies to the existence of certain problems in terms of corporate governance and operational efficiency of some state-owned banks. Hence, the business results of these banks are below average for the banking sector or weaker than the results of banks in majority foreign ownership, which is why the government decided to recapitalize them.

All of this points to the need for further consolidation of this part of the Serbian banking sector, though the position and status of these banks will ultimately be decided by the government as the majority shareholder.

What do you see as the next stage of development for the Serbian financial sector and capital markets? What role can/should the NBS play in fostering that development?

[International financial institutions] have ... expressed their interest in issuing dinar bonds, which the NBS endorsed by amending its regulations, given that this could generate multiple positive effects on the capital market and help attract new investors.

Further, a decision by an AAA-rated institution to issue long-term dinar bonds could reflect positively on the country’s risk premium. In addition, the introduction of master repo operations for financial transactions between banks, planned for early 2014, would create a basis for the development of a whole range of different FX hedging instruments.

Naturally, financial market growth prospects depend on both international and local developments, and what the NBS can do is create a favourable investment climate, upgrade market infrastructure, and maintain a stable and sustainable macroeconomic environment.