Bosnia and Herzegovina: Financial System Stability Assessment

EXECUTIVE SUMMARY Economic and financial activity in Bosnia and Herzegovina (BiH) remains stuck in a low gear since the global financial crisis, reflecting weak external demand, tighter funding conditions, and deep seated structural issues. A high system-wide NPL ratio—14 percent at end-2014, about two thirds of which are provisioned—reflects the impact of the crisis, low growth since then, and a history of lax lending policies. Bank governance problems, related-party loans and inadequate corporate resolution and insolvency frameworks are obstacles to addressing asset quality problems and re-establishing bank profitability. Institutional fragmentation is delaying much-needed financial sector reforms. Aggregate solvency and liquidity indicators appear broadly sound, but significant pockets of vulnerability exist. The banking system is more than 80 percent foreign-owned banks. The average regulatory capital adequacy ratio exceeded 16 percent as of end 2014. However, the dispersion among banks is wide, ranging from about 7 percent to 48 percent. Vulnerabilities are concentrated within domestically-owned banks, some of which are struggling to meet capital requirements, while some others are relying on public support. Stress tests indicate that these banks have large concentration risks and low liquidity ratios. While the insurance sector is small, a number of companies have thin solvency margins. FSAP team access to supervisory data—at the individual bank level, aggregated along group of banks, and system wide level—was exceptionally good. Decisive and timely actions to deal with weak banks are critical for preserving financial stability. A comprehensive strategy—backed by a credible diagnostic assessment—is needed soon to either facilitate the recovery of these banks (if practicable) or to resolve them in a cost-effective manner that is also consistent with maintaining the stability of the financial system and protecting insured depositors. The timetable for these steps should be spelled out clearly and effectively communicated, and consideration should also be given to a credible and transparent public backstop to deal with potentially systemic cases. Banking and insurance oversight improved since the 2006 FSAP, but a number of important shortcomings remain that have contributed to the vulnerabilities of the financial sector. Cooperation among the various oversight institutions is complex, having potential repercussions in times of stress. Lack of adequate governance and risk management has contributed to the current number of problem banks. The administrative powers of the agencies to sanction and fine supervisory board members and significant owners are inadequate. Moreover, the identification of ultimate beneficial owners of banks is problematic and related-party lending and group exposures are obscure. There is a need to further strengthen the supervisory board selection process and internal audit functions of state banks. The prudential framework for the insurance sector should be updated to improve its risk sensitivity. Consumer protection and financial literacy in the insurance industry are weak and should be improved. The legal framework governing creditor/debtor relationships is comprehensive; however, neither debt resolution nor bankruptcy liquidation work effectively, impeding NPL resolution.