FINANCIAL SECTOR OUTLOOK: Fin nci l Syst ms in th W st rn B lk ns – Pr s nt nd Futur JUNE 2016 Standard Disclaimer This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Execu- tive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data presented in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Copyright Statement The material in this publication is copyrighted. Copying or transmitting portions or all of this work without permission may be a violation of the law. The International Bank for Reconstruction and Development/ The World Bank encourages dissemination of its work and will normally grant permission promptly to reproduce portions of the work. For permis- sion to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, http://www.copyright.com/. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrights@worldbank.org Table of Contents Abbreviations  6 Executive Summary  7 I. Snapshot of the Western Balkans (WBS) Financial Systems  9 A. Macroeconomic Situation and Prospects in the WBS 10 B. Structure of the WBS Financial Systems 12 C. Banking Sector Performance 13 D. Efficiency of Banking Sectors 18 E. Access to Finance 20 F. Banking Sector Regulation and Oversight 26 G. Cross-border Collaboration and Supervision 26 H. Financial Stability Frameworks 28 I. Financial Safety Nets 28 J. Conclusions 31 II. A Glimpse into the Future: Using Scenarios to Explore Challenges and Opportunities in a Changing World  33 A. Why Scenarios? 34 B. Scenario Development Process 34 III. Uncertainties as Elements of Change  35 A. Geo-Pol-Economic Uncertainties 38 B. Financial Market Uncertainties 40 C. Fintech Uncertainties 42 D. EU and Euro Area Uncertainties 43 IV. 2025 Scenarios on the World around the Western Balkans Financial Systems   46 A. Overview 47 B. Shifting Orange 50 C. Unsettling Grey 53 D. Orderly Blue 56 V. Conclusions and Next Steps  59 ANNEX 1: Scenario Analysis Methodology  64 ANNEX 2: Scenario Configuration on the Uncertainty Continuum  65 Acknowledgements  69 4 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Figures Figure 1: Real GDP growth (annual %) 10 Figure 2: Current account balances, percent of GDP 11 Figure 3: Fiscal deficit to GDP 11 Figure 4: Assets as a share of GDP (2014) 12 Figure 5: Credit and deposit as a share of GDP 13 Figure 6: Banks’ external and internal funding (% of GDP) 14 Figure 7: External Positions of BIS-reporting Banks, 2014:Q1-2015:Q2 14 Figure 8: Loan to deposit ratio (%) 14 Figure 9: Funding structure of banks, Q2 2015 14 Figure 10: Private Sector Credit growth, y-o-y, percent 15 Figure 11: Non-performing loans (% of total loans) 17 Figure 12: Interest rate spread (weighted average lending rate minus deposit rate,%) 19 Figure 13: Spread decomposition, 2014 19 Figure 14: Spread decomposition by bank ownership, 2014 20 Figure 15: Account (% age 15+, 2014) vs GDP per Capita (Constant 2011 PPP, 2014) 21 Figure 16: Account ownership (% 15+) 21 Figure 17: Gender gap, account at a formal institution (percentage points) 22 Figure 18: Account penetration (% ages 15+, 2014) 22 Figure 19: Modes of withdrawal 23 Figure 20: ATMs and bank branches 23 Figure 21: Saving vs Lending 24 Figure 22: Motivations for saving 24 Figure 23: Percent of firms identifying access to finance as a major constraint 24 Figure 24: Sources of financing of new investments 24 Figure 25: Value of collateral needed for a loan (% of the loan amount) 25 Figure 26: Proportion of loans requiring collateral (%) 25 Figure 27: Credit depth of information index (0=low to 8=high) 26 Figure 28: Strength of legal rights index (0=weak to 12=strong) 26 Figure 29: Key steps in scenario analysis 34 Figure 30: Stakeholder and Expert Consultations 36 Figure 31: Key areas of uncertainty 37 Figure 32: Results from regional stakeholder survey 44 Figure 33: Crude oil, USD/barrel 47 Figure 34: Quarterly average 3M LIBOR 47 Figure 35: Developing Countries’ Sovereign Debt Spreads against US treasuries 48 Figure 36: GDP Growth - Advanced Economies 48 Figure 37: GDP Growth - Emerging Economies 48 Figure 38: 2025 Nominal GDP 49 Figure 39: Shares of GDP growth 2015-2025 49 Figure 40: Shifting Orange Growth: Advanced and Emerging 50 Figure 41: Shifting Orange: Nominal GDP 50 Figure 42: Shifting Orange Commodities (2005 = 100) 51 Figure 43: Shifting Orange Financial Landscape 51 Figure 44: Unsettling Grey Growth: Advanced and Emerging 53 Figure 45: Unsettling Grey: Nominal GDP 53 Figure 46: Unsettling Grey: Commodities (2005=100) 54 Figure 47: Unsettling Grey: Financial Landscape 54 Figure 48: Real Growth: Advanced and Emerging 56 Figure 49: Orderly Blue: Nominal GDP 56 Figure 50: Orderly Blue: Commodities (2005=100) 57 Figure 51: Orderly Blue: Financial Landscape 57 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 5 Tables Table 1: The Structure of Financial Systems in the WBS (2014) 12 Table 2: The Performance of Financial Systems in the WBS (2015) 16 Table 3: Overview of deposit guarantee schemes in the Western Balkans 29 Table 4: Overview of resolution systems in the Balkans 30 Table 5: Key uncertainties in detail 36 Table 6: What if? Select Issues Requiring Particular Attention of Financial Sector Policymakers and Regulators in Each Scenario 62 Boxes Box 1: Demographics in the Western Balkans 44 6 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Abbreviations ALB Albania AQR Asset Quality Review BiH Bosnia and Herzegovina BIS Bank of International Settlement BoA Bank of Albania BRICS Brazil, Russia, India, China and South Africa CBM Central Bank of Montenegro CBK Central Bank of Kosovo CDS Credit Default Swap CEE Central and Eastern Europe CESEE Central, Eastern and Southeastern Europe CRD Capital Requirement Directive DIA Deposit Insurance Agency EBA European Banking Authority ECB European Central Bank ELA Emergency Liquidity Assistance EU European Union FDI Foreign Direct Investment FSAP Financial Sector Assessment Program FSC Financial Stability Committee FSI Financial Stability Indicators GDP Gross Domestic Product IFS International Financial Statistics KSV/KOS Kosovo LIBOR London Interbank Offered Rate FYR MKE/MKD Former Yugoslav Republic of Macedonia MNE Montenegro MREL Minimum Requirement for Eligible Liabilities NBFI Non-Bank Financial Institutions NBS National Bank of Serbia NBRM National Bank of the Republic of FYR Macedonia NMS New Member States NPL Non-performing loan OECD Organization for Economic Co-operation and Development PTA Preferential Trade Agreements RA Resolution Authority RoA Return on Assets RoE Return on Equity SAP Stabilization and Association Process SDG Sustainable Development Goals SEE6 South Eastern Europe Countries (Albania, Bosnia and Herzegovina, Kosovo, FYR Macedonia, Montenegro, Serbia) SIFI Systemically Important Financial Institution SLR Strength of Legal Rights SME Small and Medium-sized Enterprise SOE State owned enterprises SRB Serbia SRM Single Resolution Mechanism SSM Single Supervisory Mechanism WBS Western Balkans WDI World Development Indicators WEO World Economic Outlook Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 7 Executive Summary Financial systems in the Western Balkans continue Over the longer term, prospects for the financial to face a number of challenges to financial sector systems in the Western Balkans are significantly development and stability in both the short- dependent on external events. Reflecting that the and medium term. The size and structure of the outcome of a number of external critical uncertainties financial sector varies considerably across Western will shape the future of Western Balkan financial Balkan countries and is primarily bank-based with systems — notably in the global economy and different degrees of concentration. While banking financial markets, the European Union (EU), as well sectors have developed rapidly, nonbank financial as technology-based innovation — a fundamental services have remained relatively shallow. Financial question emerges as policy makers and regulators intermediation in the Western Balkans remains consider their options: What could the world around low when compared to other countries in Central, the financial systems of the Western Balkans look like Eastern and Southeastern Europe (CESEE). The in 2025? Acknowledging existing uncertainties, three depth of the financial sector measured by private scenarios were developed to facilitate a conversation sector credit to GDP stands at an average of 45 at the regional and national level on possible policy percent with particularly low levels in Kosovo and responses. Albania. Foreign bank dominance contributed to more efficient and deepened financial systems but The dynamism of the global economy in the Shifting also increased exposure to external risks. Orange scenario presents many opportunities for countries in the region but might also require much A new set of global rules, weakened asset quality rethinking of conventional assumptions. With the and profitability, a new perspective on exchange center of gravity no longer in the advanced countries rate risk exposures, and a shift in funding structures the Shifting Orange scenario is characterized by towards domestic deposit mobilization are among growth of multidimensional capital flows and major the key features of the post-crisis reality. The new players in the banking foreign direct investment impact of these challenges is compounded by the (FDI) scene. Balancing tensions between regulation lower growth scenarios under which financial systems and innovation while helping regional financial in the region are operating. Following stagnant or systems leapfrog in terms of depth and inclusion declining credit conditions in recent years, lending is key in this scenario. Moreover, managing risks recovered slightly during 2015 in most Western and opportunities arising from the relaxation of the Balkans countries. The banking sector is still dealing global regulatory environment, as well as ensuring with the aftershocks of the global financial crisis that that the ‘new’ financial system has become a positive have weakened financial sector asset quality and force for growth and stability in 2025, should be of profitability. At the end of 2015 non-performing particular focus in this world. Finally, international loans (NPLs) stood at an average of 13.9 percent and partnership ‘diversification’ beyond the EU merit return on assets (RoA) at 1 percent with considerable consideration in the context of this scenario. variations across the region. Although the banking systems - dominated by foreign banks - appear The turmoil in the global economy reflected in broadly sound, significant pockets of vulnerability the Unsettling Grey scenario raises problems exist among domestically-owned banks. Protracted for the financial system, stemming from a low risks stem from the large stocks of foreign exchange growth environment and assumed political lending to unhedged borrower and foreign bank fragility, including in the EU. Building oversight deleveraging. Against this backdrop, post-crisis capacity, improving bank resolution regimes and trends towards domestic resource mobilization are strengthening coordination structures at the regional encouraging but need further improvement in an and European level are crucial in such an adverse environment where uncertainty related to external environment. Swift reaction to funding risks stemming funding sources prevails. from parent bank deleveraging and retrenchment 8 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future will be important. There is a need for strengthened implications and ‘strategic action’ at the national corporate governance regimes in a world with level. The issues and questions are highlighted in increasing state involvement in the banking sector. the ‘world’ where they are most critical - which does Public banks or domestic development banks not preclude their relevance for other scenarios - and could play an increasing role to facilitate long-term revolve around the following policy areas: (i) bank finance and counterbalance cyclical effects, however regulation, supervision and coordination, (ii) financial distortions in their institutional and governance intermediation, (iii) regulation and supervision of setup need to be avoided. Moreover, in a scenario new entrants/players, (iv) financial sector stability and where core EU countries revert to national currencies, security, and (v) financial infrastructure. Comparing the question of currency ‘affiliation’ becomes key. the appropriate responses across scenarios will Balancing the financial stability challenges presented provide insights on key policy areas that need to by this world with the aim of increasing financial be addressed no matter what the future looks like depth and inclusion poses a substantial challenge. and can shed light on policy areas paid insufficient Finally, considering measures to avoid contagion as attention to in the current policy dialogue. The risk perceptions about emerging market countries scenarios can also serve to test policy options become heightened will be important for the region under consideration and inform the development in Unsettling Grey. of financial sector strategies that contribute to the country’s overall success in sustainable and inclusive The positive evolution of the EU economy and growth. integration in the Orderly Blue scenario would offer countries in the region many opportunities for banking and capital markets integration. Advantages from tailoring relevant EU directives and regulations to country specific contexts versus full transposition requirements at accession stage will need to be balanced carefully. In this world the Basel-driven regulatory environment brings benefits in terms of a safer and sounder financial system. At the same time its potential unintended effects imply higher compliance costs and capital requirements which could have a detrimental effect on bank FDI and credit lines, on which the region is quite dependent. Tightened global liquidity conditions require further emphasis on domestic resource mobilization. In this scenario, further steps would be required by policymakers and regulators to ensure that credit growth is supportive of private sector activity—even in the context of restrained foreign bank activity. Limited innovation in financial services and payment systems in this scenario should be considered an opportunity for small countries to become pioneers, rather than seen as a constraint. The scenarios are intended to facilitate a conversation at the regional and national level on possible policy responses to each of the scenarios. While the regional level discussion provided a useful validation of the scenarios and a starting point for analyzing implications for actions, the greatest value to be derived from the scenarios will be at a national level aimed at informing financial sector strategies and action plans. Each scenario spotlights different challenges and opportunities that would be useful for financial policymakers and regulators to consider. The illustrative examples in Table 6 of Chapter V are meant as a starting point for exploration of scenario Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 9 I. Snapshot of the Western Balkans (WBS) Financial Systems 10 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future A. Macroeconomic Situation and Prospects in the WBS Following a decade of conflicts, Western Balkan area debt crisis, deteriorated the growth dynamics countries accomplished robust economic growth significantly and caused a double-dip recession in in the 2000s. With the materialization of the peace the region. Overall, the recession lasted longer than dividend, Western Balkan countries experienced in other emerging markets and new member states, rapid structural transformations towards market- and stalled the poverty reduction trend through based economies, became more open to the world, increases in already high unemployment. and prioritized macroeconomic stability including sharp inflation reduction. As a result, the average Despite modest post-crisis recovery, the region GDP growth exceeded 4 percent annually between continues to struggle with structural problems 2002 and 2008, per capita income in the region that undermine economic growth. Western Balkan almost tripled, and poverty declined considerably economies continue their post crisis recovery with an notwithstanding the rise in income inequality. average growth rate of 2.1 percent in 2015. While lagging behind the rest of the region, Serbia and This growth pattern was domestic demand driven Bosnia and Herzegovina (BiH), heavily hit by the floods and externally financed, hence was hampered in 2014, are recovering faster than expected (see significantly by the global financial crisis and Figure 1). Western Balkan economies experienced subsequent euro area debt crisis. Accompanied by a considerable rebalancing following the recession. abundant global liquidity conditions and low interest Current account imbalances narrowed somewhat in rates, capital account liberalization bolstered external most countries, but remain high at an average of 6.3 inflows to the region while increased integration with percent of GDP in 2015. While average fiscal deficit the EU strengthened trade and financial linkages. remain almost unchanged compared to 2014 at 3.8 Accordingly, the region started to incur large current percent, developments have been heterogeneous account deficits and became heavily dependent on across the region. Continued fiscal consolidation capital inflows and remittances to finance domestic efforts in 2015 narrowed deficits considerably in most demand driven economic growth. Reversal of capital countries. The exception was Montenegro, where the flows and weak external demand, stemming from deficit widened sharply (from 3.1 to 7 percent of GDP) the global financial crisis and subsequent euro following a spike in capital expenditures, repayment Figure 1: Real GDP growth (annual %) 5 4 3 2 1 0 2012 2013 2014 2015e 2016f -1 -2 -3 -4 ALB BiH KSV MKE, FYR MNE SRB Source: Country authorities, World Bank estimates and projections. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 11 Figure 2: Current account balances, percent of Figure 3: Fiscal deficit to GDP GDP MNE ALB KOS BIH SRB MKD SEE6 Percent of GDP 2014 2015 0 8 -5 7 -10 6 -15 5 4 -20 3 -25 2 2007 2009 2014 2015f 2016f 2017f -30 1 -35 0 MNE ALB SRB MKD KOS BIH SEE6 -40 Percent of GDP Source: World Bank calculations based on data from central banks Source: Ministries of Finance. and national statistical offices. of public arrears, and revenue underperformance. Against this backdrop, further financial deepening High unemployment, especially among youth, and and improved financial stability are essential to low productivity of capital are among the factors that boosting sustainable growth. The growth potential constrain income growth in the medium-term.1 in the region is hampered by weaknesses in financial sector development and stability, with high costs Prospects for the region remain significantly of intermediation and high levels of NPLs. Further dependent on external developments—but also challenges are posed by growing risks in domestic progress on structural reform agendas. Continued banks in select countries, shallow non-bank financial dependency on external inflows, trade and sectors, and weaknesses in bank regulation and remittances as well as limited fiscal buffers threaten oversight. External factors that have an impact on the sustainability of economic growth given regional financial systems in the region include the global and global uncertainties. On a country-level, high market outlook, external borrowing risks and debt and large current account deficits will continue constraints, EU regulatory and supervisory reforms to dampen economic prospects in the region unless and parent bank capital constraints. Addressing there is marked progress on structural reforms. existing financial stability challenges while Moreover, the Western Balkans remain vulnerable identifying opportunities for further financial sector to political cycles, which may threaten current development will help ensure that the Western reform momentum in consolidating public finances, Balkan economies have the financial sectors they addressing rigidities in capital and labor markets, need, and will allow entrepreneurs to better invest refining the legal system, progressing on institutional in productive (and tradable) sectors, creating more quality, improving the business environment, and jobs to support export-led growth. restructuring remaining state-owned enterprises (SOEs). Aside from the ‘slow but steady’ emigration of domestic populations to third countries, the attention of policymakers in the region, and in the EU, has also turned to the challenge of rising transit migration through the region to the EU. 1 South East Europe Regular Economic Report No. 9: Rebalancing for Stronger Growth, World Bank, Spring 2016. 12 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future B. Structure of the WBS Financial Systems Figure 4: Assets as a share of GDP (2014) (see Figure 4). Financial sectors in the Western Balkans are bank-centric, with relatively minor levels of capital market activity, negligible penetration of 120 insurance products, and generally insignificant non- bank financial institutions. Banking sector assets 100 represent between 70 and 92 percent of financial 80 sector assets. The importance of the banking sector is the lowest in Kosovo, with around 70 percent of 60 financial system assets, due to the significant role that pension funds play in complementing the pay- 40 as-you-go government funded system (see Table 1). 20 Banking sectors in the region are dominated 0 by foreign banks. Foreign banks from euro area ALB BiH KSV MKE MNE SRB countries dominate.2 In terms of total banking assets, in five of the Western Balkans countries between 80 Financial Sector Assets/GDP Banking Sector Assets/GDP and 90 percent are controlled by foreign banks. Serbia Source: IFS, National authorities and World Bank staff calculations is the exception, where state-owned commercial banks control about 20 percent of the banking sector and the level of foreign bank ownership is lower at The size and structure of the financial sector varies 75 percent. Concentrations differ across the region, considerably across the Western Balkan countries with around two thirds of total assets in the hands of and is primarily bank-based. In terms of size, on the three largest banks in FYR Macedonia, Kosovo average, the region’s financial sector assets are equal and Albania; and moderate concentration in Serbia, to 93 percent of GDP. Levels of financial sector depth Montenegro and BiH at around 45 percent of total vary across the region ranging from 81 percent of assets owned by the largest three banks. GDP in Kosovo to 103 percent in Albania and Serbia Table 1: The Structure of Financial Systems in the WBS (2014) ALB BiH MKD KOS MNE SRB No. % of No. % of No. % of No. % of No. % of No. % of total total total total total total assets assets assets assets assets assets Commercial banks 16 90.3 26 86.3 15 86.8 10 70.3 12 87.6 29 91.8 Private 16 90.3 24 83.9 14 83.6 10 70.3 12 87.6 23 74.1 Domestic 2 11.7 8 5.9 2 3.4 2 6.7 5 18.0 2 5.8 Foreign 14 78.7 16 78.0 12 80.2 8 63.6 7 69.7 21 68.3 State-Owned* - - 2 2.4 1 3.3 - - - - 6 17.6 Other depository institutions 126 0.7 - - 4 0.6 - - - - - - (savings and loan associations) 2 Austrian banks are most prevalent. Italian banks (Unicredit and Banca Intesa) have large market shares in Serbia and BiH and, to a lesser degree, in Albania. Greek banks hold significant market shares in Albania, Macedonia, and Serbia. NLB Bank from Slovenia has a significant presence across the region except in Albania. French banks hold important market shares everywhere except BiH. Germany’s ProCredit bank dominates the market in Kosovo, while Hungary’s OTP bank has a large market share in Montenegro. In addition to European banks, banks from Turkey hold smaller but significant market shares in Albania and Kosovo and have started operations in BiH and Montenegro. The state-owned Russian Sberbank is also present in BiH and Serbia. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 13 ALB BiH MKD KOS MNE SRB No. % of No. % of No. % of No. % of No. % of No. % of total total total total total total assets assets assets assets assets assets Non-bank financial institutions 827 8.9 583 13.7 106 12.5 75 29.7 51 12.4 2,853 8.2 Insurance companies 10 1.7 25 5.1 15 3.6 13 3.1 11 4.7 25 5.2 Pension funds 3 0.0 1 1.0 4 7.3 2 24.1 2 0.0 6 0.7 Leasing companies** - - 7 1.9 8 0.9 - - 5 2.1 16 2.0 Securities industry - - 24 0.1 7 0.0 - - 11 0.1 28 n/a MFIs (non deposit-taking)** - - 19 2.5 - - 18 2.5 5 1.1 2 0.0 Financial auxiliaries 784 n/a 449 n/a 41 n/a 42 n/a - - 2,757 n/a Investment funds 2 4.5 34 3.1 13 0.4 - - 10 3.8 13 0.3 Fund management companies 1 n/a 24 n/a 12 0.1 - - 7 0.6 5 0.0 Other** 27 2.7 - - 6 0.0 - - - - - - Total financial system 969 100 609 100 125 100 85 100 63 100 2,882 100 Source: World Bank calculations based on data from central banks and national statistical offices *FYR Macedonian development bank is included as it falls under supervision of the central bank. **Since 2005, the Serbian microcredit organizations have conducted their activities via licensed banks as lending activities are restricted to banks. Albanian MFIs and leasing companies are reported under category 'Other'. *** There is no trading at the Tirana Stock Exchange (the only licensed stock exchange in Albania). C. Banking Sector Performance Figure 5: Credit and deposit as a share of GDP Lending remains banks’ main activity accounting for almost two thirds of total banking sector assets in the region. Albanian banks have the most diversified 100 portfolio with loans making up 44 percent of banking 80 sector assets at end-2015. 60 Post-crisis trends suggest a shift in the funding 40 structures of Western Balkan banks towards 20 domestic deposit mobilization. Between 2008 0 and 2015, Bank of International Settlement (BIS)- ALB BiH KSV MKE MNE SRB reporting banks reduced their cross-border exposure in the Western Balkans by an average of almost 6 Private Credit/GDP 2008 Private Credit/GDP 2014 percent of GDP. Cross-border deleveraging impacted Deposits/GDP 2008 Deposits/GDP 2014 all countries across the region, its effects were most pronounced in new EU member states. In the same Source: IFS, WEO, national authorities period, domestic deposits grew to an average of 10 percent of GDP (see Figures 6 and 7). Deposits remain Financial intermediation in the Western Balkans the largest funding source for banks, accounting for remains low when compared to other countries in between 55 percent (Serbia) and almost 80 percent CESEE. The depth of the financial sector measured (Kosovo and Albania) of total liabilities (see Figure by private sector credit to GDP stands at an average 9). This shift is also reflected in the average loan- of 45 percent, with particularly low levels in Kosovo to-deposit ratio continuing its generally moderate and Albania (compared to around 93 percent in downward movement towards average levels of the euro area). The trend over the past six years around 89 percent. Besides continuous growth of has shown slight improvement in financial sector domestic deposits, the downward trend is due to deepening overall, with the exception of Montenegro more cautious new loan extension and sluggish where credit to the private sector has contracted by credit demand (see Figure 8). around 35 percent of GDP since 2008 (see Figure 5). 14 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Figure 6: Banks’ external and internal funding Figure 7: External Positions of BIS-reporting (% of GDP) Banks, 2014:Q1-2015:Q2 60 4 40 2 0 20 -2 0 -4 2008 2009 2010 2011 2012 2013 2014 2015 -6 Int. claim, % of GDP (WBS average) SRB MKE ALB MNE BiH CESEE Deposits/GDP (WBS average) 2014 Q3 2014 Q4 2015 Q1 2015 Q2 Total Source: IFS, BIS locational statistics, WB staff calculations Source: IFS, BIS locational statistics, WB staff calculations Figure 8: Loan to deposit ratio (%)3 Figure 9: Funding structure of banks, Q2 2015 200 100 80 150 60 100 40 50 20 0 0 ALB BIH KOS MKD MNE SRB ALB BiH KSV MNE MKE SRB Household deposits Corporate deposits 2012 2013 2014 2015 Peak level since 2006 Government deposits Foreign liabilities Capital and reserves Other Source: IFS, national authorities and World Bank staff calculations Source: IFS, national authorities and World Bank staff calculations There is a need to further improve banks’ funding local capital markets as well as adopting policies to bases through domestic resource mobilization, foster greater domestic savings by households. in an environment where uncertainty related to external funding sources prevails. The reorientation Capital markets can play a key role in complementing of funding towards domestic sources is encouraging. bank-centric financing. Compared to other parts of However, domestic savings are likely not to be the world, Western Balkan businesses – similar to most sufficient to offset the reduction of foreign funding countries in Europe - remain heavily reliant on banks as credit growth picks up again. Moreover, domestic for funding and relatively less on capital markets. deposits are predominantly short term in maturity. On Stronger capital markets would complement banks average, the share of long-term deposits makes up as a source of financing, and would (i) unlock more only 23.4 percent of total deposits, while long-term investment for all companies, especially SMEs, and loans represent around 75 percent of total loans. for infrastructure projects; (ii) attract more investment Resource mobilization is a particular challenge for into the region from the rest of the world; and (iii) local banks, with higher funding and operating costs make the financial system more stable by opening up and weaker client base. Solutions to mitigate potential a wider range of funding sources.5 shortcomings to this effect may include developing 3 Total deposits are computed as the sum of demand deposits (IFS line 24), other deposits (IFS line 25), and liabilities to non-residents (IFS line 26). Total credit equals claims on other sectors (IFS line 22s). 4 In this context, long-term deposits and loans are defined as deposits and loans with a maturity larger than one year. 5 http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=COM:2015:63:FIN&from=EN (EU Green Paper on capital markets). Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 15 Given that the countries in the region are relatively and market intermediaries to operate in each other’s small in terms of economic size and population national market, thereby creating a vastly larger base, there is a compelling case for regional ‘common’ market, without sacrificing any institutions integration of capital markets. Stock markets or independence. exist in all of the Western Balkan countries, except Albania and Kosovo, but the value traded is minimal. Following stagnant or declining credit conditions Equity markets remain underdeveloped with only in recent years, lending recovered slightly during a limited number of companies listed, and there is 2015 in most Western Balkans countries. Post-crisis no liquidity of the secondary markets. On the debt tightening of credit standards and the deterioration side, in general, government bond markets exhibit in parent funding conditions have reduced the more development, with corporate bond markets supply of credit across the region. With economic still being negligible in size. As to the demand side, growth firming up in 2015, credit growth has been the investor base across countries is still narrow. In strong in FYR Macedonia and Kosovo. In the rest general, direct retail investor participation is very of the region (except Albania) lending has recently limited and institutional investors (mutual funds, shown signs of growth, although at a slow pace pension funds and insurance companies) while (see Figure 10). Findings of a recent survey6 among growing, have not reached significant size, neither banks suggest that developments in the region are in terms of assets under management nor relative heterogeneous. In Kosovo, supply conditions have to the economy. Consideration could be given to eased amid a strong revival in retail credit growth an EU-style model, where efforts were made to link- and falling NPLs. In Serbia, growing optimism on the up national exchanges and harmonize legislation demand side continues to be constrained by a much and regulation across the entire region, but without slower improvement of lending conditions on the requiring any country to give up their national stock supply side. At the same time in Albania, conditions exchanges or their rights to regulate their home on both the demand and the supply side remain markets. Instead, a so-called ‘passporting’ framework tepid. has been put in place that allows for issuers, investors Figure 10: Private Sector Credit growth, y-o-y, percent 40.00 30.00 20.00 10.00 0.00 -10.00 -20.00 Aug-12 Aug-14 Aug-15 Aug-16 Aug-09 Aug-10 Aug-11 Aug-13 Feb-15 Feb-16 Dec-16 Feb-10 Dec-10 Feb-11 Dec-11 Feb-12 Dec-12 Feb-13 Dec-13 Feb-14 Dec-15 Jun-14 Dec-14 Jun-15 Jun-16 Feb-09 Dec-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-09 Oct-10 Oct-11 Oct-12 Oct-13 Oct-14 Oct-15 Oct-16 Oct-09 Apr-16 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14 Apr-15 Apr-09 ALB BiH KSV MKE, FYR MNE SRB Source: IMF International Financial Statistics and WB staff calculations 6 EIB CESEE Bank Lending Survey, H2 2015. 16 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future While banks in the Western Balkans remain overall Protracted risks stem from large stocks of foreign well-capitalized and liquid, risks to financial exchange lending to unhedged borrowers, stability in the region persist, including weaknesses foreign bank deleveraging as well as downsizing. in some domestic banks. Commercial banks in the In Albania, FYR Macedonia and Serbia foreign region remain reasonably liquid and well-capitalized, currency lending remains high, at 40 to 70 percent though high NPLs and the resulting provisioning of total lending, posing risks to unhedged borrowers may erode some banks’ earnings and capital buffers. in the event of nominal exchange rate depreciations/ Capital adequacy of the system reached an average devaluations. Local savings patterns mirror the of 16.9 percent as of end-2015, which should be high levels of foreign currency lending accounting sufficient to absorb identified risks in the system. for between 42 percent (FYR Macedonia) and as Questions about the health of some domestically much as 67 percent (Serbia). Most countries in owned banks in the region – in particular in BiH and the region continued to see reductions in foreign Montenegro - need to be addressed. This has been bank funding, albeit at a slower pace. Regulatory confirmed by two recent failures of domestic banks reforms and strengthened supervisory mechanisms in BiH/Republika Srpska. In Serbia, failure of three under the European Banking Union have created state-owned banks in 2012 and 2013 have raised pressures on some of the parent banks to shrink their concerns about the oversight and governance of the balance sheets, reduce the amount of capital held remaining state-owned banking sector. in subsidiaries, or even to go as far as to sell their subsidiaries. Rising uncertainty about the soundness Strong competition, low post crisis profitability, of leading banks in Europe active in the Western new regulatory pressures and difficulties in Balkans poses a significant threat. The prolonged obtaining funding – in particular for local banks - uncertainty surrounding the Greek macroeconomic may require further consolidation of the banking adjustment program and its impact on Greek banks sectors in the region. In BiH and Montenegro are still present in affected countries. especially, the number of banks operating remains remarkably high at 26 and 15 banks respectively High but slowly declining NPL levels continue while profitability remains subdued raising the to pose serious threats to the banking sector question of bank consolidation going forward. The and continue to burden bank balance sheets, Central Bank of Montenegro (CBM) has issued four undermine profits and capital, and suppress new new banking licenses in the past 1.5 years. Against lending—and more generally, impede banks’ this backdrop, a more conservative approach to ability to boost economic activity and growth. evaluation of business plans and issuance of new NPLs remain high at a regional average of 14 licenses would appear warranted. percent with particular high levels in Albania and Table 2: The Performance of Financial Systems in the WBS (2015) ALB BiH KOS MKD MNE SRB Regulatory capital to risk-weighted assets 15.7 15.0 19.0 15.5 15.5 20.9 Liquid assets to total assets 32.3 26.4 44.9 28.2 24.8 34.3 Bank nonperforming loans to total loans 18.2 13.7 6.2 10.3 13.4 21.6 Bank provisions to nonperforming loans 70.8 71.2 115.1 108.4 48.4 114.2 Return on assets – ROA 1.2 0.3 2.9 1.1 -0.1 0.32 Return on equity – ROE 13.2 2.4 26.4 10.4 -0.7 1.58 Source: IMF FSI, national authorities Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 17 Serbia at 18 and 22 percent respectively (see Figure as the Vienna Initiative. In Serbia and Albania 11). NPLs are concentrated in the corporate sector. comprehensive strategies were adopted to address On average, NPLs across the region declined by the large share of distressed assets within the banking about 1 percentage point in 2015 year-on-year, with system. A recent asset quality review (AQR) of 14 banks the sharpest decline registered in Montenegro and revealed further re-classification and adjustment Albania. NPLs in Albania have decreased primarily needs. In FYR Macedonia and Albania, regulators due to a Bank of Albania regulation requiring have taken measures requiring banks to write-off banks to write-off NPLs older than 3 years, while in fully provisioned NPLs older than two and three years Montenegro large NPL portfolios were off-loaded respectively. In Kosovo, a newly introduced private to dedicated special purpose vehicles belonging bailiff system has been supporting enforcement of to parent banks. In Serbia, NPLs increased by 1 collateral recovery attributing to a decrease of NPL percentage point to around 22 percent due to re- levels. In BiH, the authorities in RS took measures classifications following the recently completed asset to strengthen the corporate bankruptcy and out of quality reviews of 14 banks. In Kosovo, NPLs remain court restructuring proceedings. The newly adopted significantly lower than in neighboring countries at Insolvency Law in RS foresees more efficient and 6.2 percent end 2015. Weaknesses in corporate and cost-effective procedures related to sale of assets of personal insolvency and creditors’ rights regimes, a debtor and collection of proceeds as well as clearly legal ambiguity/barriers regarding the sale of NPLs, defined, shorter deadlines in the newly introduced weaknesses in regulatory NPL classification and restructuring process (pre-bankruptcy proceedings). provisioning standards, and the absence of legal In Montenegro, a law on voluntary financial frameworks sufficient for corporate out-of-court debt restructuring known as the ‘Podgorica approach’ restructuring, need urgent policy attention across the was adopted in 2015 providing a framework for region. This is not only essential for healthy credit out-of-court restructuring of economically viable growth in the banking system, but also necessary to companies, including through purchases of debtors’ bring a lot of idle assets back into the productive claims supported by tax and supervisory incentives. economic sphere. In 2013, CBM introduced a requirement for banks to prepare a multi-year NPL resolution strategy All countries have taken steps in improving their including annual operational targets and quarterly NPL resolution frameworks, either through own reporting against those targets. initiatives or through regional cooperation such Figure 11: Non-performing loans (% of total loans) 30.00 25.00 20.00 15.00 10.00 5.00 0.00 ALB BIH KOS MKD MNE SRB EU 2012 2013 2014 2015 Peak since 2008 Pre crisis level (end 2007) Source: National authorities, World Development Indicators (WDI) 18 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future The June-July 2015 events of the Greek crisis 2015 as a result of a modest economic recovery and tested the stability of the financial sectors in provisioning catching up with NPL levels. Profitability the Western Balkans. There are three Greek bank indicators increased compared to the previous subsidiaries in Albania, two in FYR Macedonia, period, as RoA in the region improved to 1.3 percent and four in Serbia. The Greek bank subsidiaries in 2015 (0.9 percent in 2014), while RoE improved are independent legal entities (i.e. they are not to 8.4 percent in 2015 (7.1 percent in 2014). Kosovo branches of the parent bank), and are thus separately stands out with its RoE reaching 26.4 percent in capitalized. Although currently stable and not in December 2015 while its RoA improved to 2.9 need of external funding, recent events highlighted percent. Montenegro’s banking system, on the other that the persistence of uncertainties regarding the hand, has been more significantly impacted by the Greek crisis may still trigger an adverse fallout. crisis, suffering large and ongoing losses between During the recent events, there were many instances 2009 and 2012, and continued low profitability of slight impairment of confidence (despite the levels turning negative again at the end of 2015 due authorities’ pro-active measures), resulting in limited to a persistently high backlog in NPLs, increasing depositor outflows from these institutions. The competition in the banking sector, and slow deposit withdrawals remained, nevertheless, within economic recovery. While the profitability of banks the banking systems as they were transferred from in the region prior to the crisis was unsustainable the Greek bank subsidiaries to other banks. and “inflated” by the lending and economic boom, today’s profit levels are weak in comparison to The authorities took a number of ring-fencing normal expectations for banks in emerging/middle measures to mitigate possible contagion. All income countries. countries increased their monitoring efforts and deployed pro-active communication strategies. Although high compared to other countries in In Albania, the regulator imposed higher capital CESEE, interest rate spreads have followed a requirements and limited the dividends that gradual declining path in most countries. Interest subsidiaries could pay to their parent banks. The Bank rate spreads, calculated as the difference between of Albania issued an order prohibiting commercial lending and deposit rates, have declined in most banks from transferring money to banks in Greece. In countries in the region compared to 2012, with FYR Macedonia, the Central Bank adopted temporary the exception of Albania and Montenegro. On precautionary measures to restrict capital outflows average the interest rate spread in the Western from the country to Greek entities affecting not only Balkans accounted for 5.6 percent in 2015 (down banks but also corporates. These have since been from 6.2 percent in 2014). Spreads in 2015 were lifted. National Bank of Serbia (NBS) has also taken lowest in BiH and Serbia, at 4.3 and 4.4 percent measures to limit spillovers potentially materializing respectively. The highest spread of 6.9 percent was through Greek-owned subsidiaries operating in the registered in Montenegro followed by Kosovo and country. Albania. Lowest spreads were registered in Serbia and FYR Macedonia, at around 4.2 percent (Figure 12). Spreads in Kosovo significantly exceeded the regional average reaching over 8 percent in 2012 D. Efficiency of Banking Sectors but have recently shrunk considerably to around 6.5 percent, reaching an average rate closer to other peers in the region. After a sharp decline following the onset of the financial crisis, bank profitability has shown An interest rate spread decomposition7 is a useful improving tendencies across the region (except exercise to gain insights into underlying bank Montenegro). Bank profitability had declined sharply trends – including efficiency and profitability. over the past several years, and continued to weaken The spread can be decomposed (from a throughout 2012 and 2013 in some countries due straightforward accounting identity) into profits, to weakened asset quality and subdued economic provisions, overheads, and reserves. A regional environment. This pattern reversed in 2014 and exercise, conducted based on 2014 data, points 7 The decomposition approach draws on Randall, 1998 (IMF WP/98/59). The simplified approach applied for decomposing interest rate spreads is the following: Il-id=il*RR + Prof/Dep + Overheads/Dep + Provisions/Dep - Non-Intr.Income/Dep , where: ‘Il’ is the derived lending rate; ‘id’ is the derived deposit rate; ‘Prof’ is before tax profit; ‘Overheads’ are operational costs of the banks; ‘Provisions’ are loan loss provisions from the income statement; ‘Non-Intr.Income’ is non-interest income; ‘Dep’ are deposits averaged over two year period due to discrepancy between stock and flow approach with the rest of the variables. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 19 Figure 12: Interest rate spread (weighted average lending rate minus deposit rate,%)8 10 8 6 4 2 0 ALB BiH KSV MKE MNE SRB 2012 2015 Source: National authorities to the negative effect of high NPLs on the spread The contribution of operational costs has increased composition (see Figure 13). The interest rate in almost all countries with the exception of Kosovo, spread decomposition shows that in most countries, implying that the operational efficiency of banks spreads are not in principle driven by profits, but by has declined. Across the region, banks continue operating costs and provisions associated with the to derive a large percentage of their income from deterioration in banks’ asset quality in the wake of non-interest income, highlighting the importance of the global financial crisis. By contrast, in Kosovo and fees and commissions for banks’ profitability on the Albania, the profit margin plays a significant role, one hand, and the charges that are imposed on the accounting for around a third of the total spread. consumer on the other. Figure 13: Spread decomposition, 2014 16 1.7 12 3.2 Reserves CB 8 1.0 0.5 2.7 1.7 0.7 Profit margin from 0.5 0.8 10.6 4 0.8 1.3 1.2 0.7 lending activities 1.1 5.2 4.7 3.9 3.5 2.5 Provisions 0 -0.7 -0.9 -3.1 -4 Overheads -11.2 -8 Interest rate spread -12 ALB BIH KSV MKD MNE SRB Source: World Bank staff calculations based on BankScope data. 8 Defined as spread between weighted average interest rate on new loans minus weighted average interest rate on new deposits. 20 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Figure 14: Spread decomposition by bank ownership, 2014 12 8 Reserves 4 Profit margin from lending activities 0 Provisions -4 Overheads -8 Interest rate spread -12 Foreign Foreign Foreign Foreign Foreign Foreign Domestic Domestic Domestic Domestic Domestic Domestic ALB BIH KSV MKD MNE SRB Source: World Bank staff calculations based on BankScope data. In almost all countries in the region, foreign countries compared to the (developing) ECA average owned banks have lower interest rate spreads. of 51 percent, according to the Global Findex Survey Spread decomposition shows that in Albania, 2014. Account penetration ratios in all countries in Serbia and FYR Macedonia foreign owned banks the region (except Albania) are higher relative to their have lower spreads compared to domestic banks income levels. Despite this positive picture, most of due to lower contribution of loan loss provisions. In the countries in the region significantly lag behind Montenegro, foreign owned banks appear to have new EU member countries and other advanced higher operational efficiency which enables them countries in financial inclusion (see Figure 15). to set lower spreads (see Figure 14). No linkages appear to exist between the size of banks and the Since the last Findex survey in 2011, account spread among the region. However, larger banks penetration increased on average by 6 percent appear to have higher operational efficiency - using in the region. With the exception of BiH and FYR economies of scale and having lower operational Macedonia, all countries have seen improvements costs - compared to smaller banks in the region.9 in financial inclusion. In particular, the account This can be noticed by the lower contribution of the penetration ratio in Serbia increased by more than operational costs to the interest rate spread in the 20 percentage points, while Albania had the second larger banks. largest increase after Serbia mostly due to the base effect. Thanks to these performances, the region’s account penetration increased by 6 percentage points on average between 2011 and 2014 (see E. Access to Finance Figure 16). There is considerable disparity in account Households penetration with respect to gender, while differences stemming from income levels and The Western Balkans financial inclusion level is living areas are relatively small. On average, about relatively higher than the region’s income level 54 percent of women have an account at a formal suggests, but lags behind new EU member financial institution in the Western Balkans, compared countries.10 On average 59 percent of the adult to the ECA average of 47 percent. Yet, crucially, the population has an account in Western Balkan gap between female and male access is high, at 11 9 The size of banks is determined according to their nominal value of assets. Banks are divided in large and small sized groups depending whether their asset value is below or above the median bank asset value of each country, respectively. 10 Bulgaria, Croatia, Romania. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 21 Figure 15: Account (% age 15+, 2014) vs GDP per Capita (Constant 2011 PPP, 2014) 120 100 R² = 0.7314 80 SRB MKD 60 WBAvg MNE BIH KSV 40 ALB 20 0 0 10000 20000 30000 40000 50000 60000 Source: Global Findex Database, WDI Figure 16: Account ownership (% 15+) 100 80 60 40 20 0 2011 2014 Source: Global Findex Database percent points, with the female population being Montenegro being exceptions on former and latter highly constrained especially in Kosovo, BiH, and respectively (see Figure 18). FYR Macedonia (see Figure 17). Usage statistics show that this gap arises mostly from the fact that women Western Balkan countries use bank branches for use their accounts much less for receiving wages financial transactions significantly more than their than men, in line with relatively low female labor comparators do. ATMs and bank tellers are the main force participation in these countries. Meanwhile, modes of withdrawal in the Western Balkans with 47 the overall state of financial inclusion (better than and 44 percent of account holders using them on developing ECA, but lagging behind the new EU average respectively according to the Global Findex member states) does not alter much with income 2014 (see Figure 19). While the ratio of ATM users level and living area in the region, with Albania and is lower than both ECA and new EU member state 22 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Figure 17: Gender gap, account at a formal institution (percentage points) 25 20 15 10 5 0 -5 Source: Global Findex Database Figure 18: Account penetration (% ages 15+, 2014) 100 80 60 40 20 0 Bosnia and… Bosnia and… ECA ECA WBAvg WBAvg NMS NMS Kosovo Kosovo Serbia Serbia Albania Albania Macedonia, FYR Macedonia, FYR Montenegro Montenegro Poorest 40% Rural Source: Global Findex Database averages, the picture is exactly opposite for the choosing bank tellers as the main mode of financial usage of bank branches (see Figure 20). The average transactions, partly due to both cultural and security- number of ATMs per 100,000 adults in the region related considerations. in 2013 is 4411, compared to 67 for ECA and 83 for new member states. The number of bank branches Overall, lending activity is high while savings per 100,000 adults is 41, significantly higher than remain limited. The lending performance of Western ECA and new EU member states averages of 22 and Balkan countries is somewhat comparable with new 12 respectively. On an individual country basis, the EU member states, with more than 13 percent of the pattern is rather mixed with FYR Macedonia and population on average borrowing from a financial Kosovo favoring ATMs and Montenegro and Serbia institution in 2014. In contrast, only an average of 11 World Development Indicators 2013. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 23 Figure 19: Modes of withdrawal 100 80 60 40 20 0 Bosnia and… Bosnia and… Bosnia and… ECA ECA ECA WBAvg WBAvg WBAvg NMS NMS NMS Kosovo Kosovo Kosovo Serbia Serbia Serbia Albania Albania Albania Macedonia, FYR Macedonia, FYR Macedonia, FYR Montenegro Montenegro Montenegro Main mode of withdrawal: Main mode of withdrawal: Main mode of withdrawal: ATM (% with an account, age bank teller (% with an other (% with an account, age 15+) [w2] account, age 15+) [w2] 15+) [w2] Source: Global Findex Database Figure 20: ATMs and bank branches 100 80 60 40 20 0 ECA ECA WBAvg WBAvg NMS NMS Kosovo Kosovo Serbia Serbia Albania Albania Macedonia, FYR Macedonia, FYR Bosnia and Herzegovina Bosnia and Herzegovina Montenegro Montenegro Automated teller machines (ATMs) (per Commercial bank branches (per 100,000 100,000 adults) adults) Source: World Development Indicators 9 percent of the population saved at a financial According to the Survey, countries in the region institution in the region, almost 18 percentage points have different motivations for saving. For instance, lower than the average of new EU member states while most Serbians save for old age, Albanians save (see Figure 21). These numbers are unsurprising as more for education, highlighting the need for tailor- Western Balkan countries have very low savings rates made policies for each country to increase domestic and high current account deficits. Considering that savings (see Figure 22). The growth of the financial 30 percent of the population saved in 2014, and 9 sector since the 2000s has contributed to greater percent used financial institutions, there is potential access to finance, but also exposed vulnerabilities for gains from financial inclusion improvements to and risks. Rising levels of household indebtedness strengthen financial intermediation. The Global raise questions on their debt service capacity and Findex Survey 2014 highlighted an interesting pattern stress the importance of robust monitoring and in the savings behaviors of Western Balkan countries. consumer protection arrangements. 24 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Figure 21: Saving vs Lending Figure 22: Motivations for saving 30 25 25 20 20 15 15 10 10 5 0 5 ECA ECA WBAvg WBAvg BiH NMS BiH NMS Kosovo Kosovo Serbia Serbia Albania Albania Macedonia, FYR Macedonia, FYR Montenegro Montenegro 0 Saved at a financial Borrowed from a financial Saved to start, operate, or expand a farm or business institution (% age 15+) institution (% age 15+) (% age 15+) Saved for old age (% age 15+) Saved for education or school fees (% age 15+) Source: Global Findex Database Source: Global Findex Database Firms The credit crunch has made it extremely difficult informal sector. Access to finance appears particularly for new firms to emerge and grow. Demand side constrained in Kosovo, where 45 percent of firms data shows that access to financial services remains identified access to finance as a major constraint, a key obstacle in the Western Balkans. Enterprises but less so in Albania and Montenegro (see Figure identify it as the third largest business environment 23) where there is greater reliance on internal funds constraint shortly after tax rates and the impact of the to finance their investments (68 percent). The most Figure 23: Percent of firms identifying access to Figure 24: Sources of financing of new finance as a major constraint investments 80 100 80 60 60 40 40 20 20 0 0 ALB BIH HRV KSV MKD MNE SRB Other (%) Equity or Stock Sales (%) Supplier Credit (%) Banks (%) Financed internally (%) Source: Enterprise Surveys (2013) Source: Enterprise Surveys (2013) Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 25 important source of external financing are banks. At value is high, at 235 percent of the loan amount on the same time, the proportion of new investments average. This is mostly a result of higher perceived financed via banks remains low at an average of 15 firm risk (both due to corporate governance percent. Small and medium sized enterprises (SMEs) problems and low profit prospects) but challenges in – the backbone of the Western Balkan economies collateral enforcement and liquidation processes are - continue to have limited access to credit, which is also among contributing factors. associated with high cost and stringent conditions. SMEs suffer from structural capacity constraints The region saw some progress in the reform and higher levels of informal transactions, reducing agenda in recent years, but more remains to be the quality of financial information. Most banks done, especially on legal rights. Deteriorated have not yet introduced delivery models, which financial intermediation channels show that are appropriate to the characteristics and risks of economic and institutional challenges remain to this market segment. Alternative financing sources be addressed in the short term. All Western Balkan are limited. Improvements in credit reporting and countries showed an improvement in the credit financial reporting would help reduce information depth of information index12 in the last three years asymmetries. Financial institutions should be (see Figure 27). However, the region was unsuccessful encouraged to develop delivery models tailored in increasing the strength of legal rights (SLR) index, to the characteristics of SMEs. Public support which measures the degree to which collateral and instruments could be improved to ensure the bankruptcy laws protect the rights of borrowers and effectiveness and efficiency of their interventions. lenders, and thus facilitate lending. The SLR index amounted to only 7.5 out of 12 in 2014, showing that High collateral requirements hinder firms’ access urgent reform is necessary in this area. This would to credit. On average 85 percent of corporate loans also facilitate NPL resolution, and address the issue in Western Balkan countries require collateral, and its of high collateral requirements. Figure 25: Value of collateral needed for a loan Figure 26: Proportion of loans requiring (% of the loan amount) collateral (%) 100 300 75 200 50 100 25 0 0 Source: Enterprise Surveys (2013) Source: Enterprise Surveys (2013) 12 The credit depth of information index measures rules affecting the scope, accessibility, and quality of credit information. 26 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Figure 27: Credit depth of information index Figure 28: Strength of legal rights index (0=low to 8=high) (0=weak to 12=strong) 8 14 7 12 6 5 10 4 3 8 2 6 1 0 4 2 0 Credit depth of information index (0=low to 8=high) 2011 Credit depth of information index (0=low to 2011 2014 8=high) 2014 Source: World Bank Doing Business Survey Source: World Bank Doing Business Survey F. Banking Sector Regulation and Oversight Financial sector authorities across the region are to restructure viable borrowers, eliminate NPLs, and making progress in strengthening banking sector recapitalize if necessary. Supervisors need to enforce regulation and oversight. All supervisory agencies loan classification, realistic collateral valuation, in the Western Balkans are moving toward risk-based and provisioning requirements more stringently. supervisory regimes, as well as implementation of Rigorous enforcement, coupled with implementation Basel II and Basel III requirements. Moreover, all of recapitalization plans where necessary, will have implemented International Financial Reporting encourage banks to resolve or write off problem Standards (IFRS) for banks. However, countries are at loans more efficiently. However, until recently, different stages of implementation. Further progress regulators in most countries have offered some form is needed in implementation of risk-based regulatory of forbearance (for instance, on provisioning) in case and supervisory practices as well as linking regulatory of loan restructuring. This treatment may encourage capital requirement to commercial banks’ market and banks to sustain viable borrowers, but could delay credit risk. Additional focus should be directed to the much needed balance sheet adjustment of troubled implementation of new standards, such as enhanced banks, while at the same time preventing lending to supervision of systemically important banks, and new borrowers. recovery and resolution planning. Regulation in the areas of corporate governance and identification of ultimate beneficiary owners and related-party lending should also be strengthened. G. Cross-border Collaboration and Supervision The main challenge for regulators across the Western Balkans is balancing the need for a stringent approach to supervising banks burdened The establishment of the Single Supervisory with high levels of NPLs, while promoting debt Mechanism (SSM) and Single Resolution restructuring for viable businesses. With the level of Mechanism (SRM), two of the three building blocks NPLs rising and economic growth feeble, supervisors of the EU Banking Union, is set to have a number need to find a balanced approach to incentivize banks of implications for banking systems in the Western Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 27 Balkans. The SSM and SRM has resulted in four In October 2015, the EBA signed a memorandum different supervisory and resolution arrangements of cooperation with five Western Balkans impacting banks operating in the Balkans: (i) supervisory authorities (except Kosovo), systemic euro area headquartered entities (around establishing a framework for cooperation and 60 percent of total banking assets in the Western information sharing designed to strengthen Balkans) for whom the European Central Bank (ECB) banking regulation and supervision of banks is indirectly the ‘home supervisor’ and the Single operating in the EU and in the Western Balkans Resolution Board the “home resolution authority”, countries. On the national level, cross-border (ii) subsidiaries of euro area headquartered entities supervisory cooperation, which is critical given the deemed as ‘less significant’, and therefore not falling dominance of foreign banks, is improving. The under direct supervision of the SSM and as a rule Western Balkans supervisory authorities have signed not under the resolution scheme of the SRB, (iii) a number of MoUs with other supervisory authorities subsidiaries from non-SSM jurisdictions (including in Europe and are participating in some supervisory Russia and Turkey), and (iv) domestic banks. Benefits colleges. However, gaps remain. As confidentiality are seen in positive spill-overs to the extent that the rules are now assessed to meet EU standards it is Banking Union leads to sounder banking system and expected that participation in respective colleges stronger supervision as well as creation of a level will improve. There is also a need to expand bilateral playing field across borders and simplified ‘home- information sharing efforts with EU and non-EU host’ interactions. Potential challenges stem from supervisory agencies. In particular cooperation with ensuring an adequate level playing field given the Austrian authorities needs to be enhanced. BiH is new four-tier approach as well as ensuring adequate so far the only country in the region that has signed cooperation and communication.13 a MoU with the Austrian Financial Market Authority (FMA). Good progress has been made regarding supervisory cooperation in the context of the SSM Following the 2008-2009 crisis, the Vienna but further efforts are needed to strengthen and Initiative as a public-private platform has served improve cross-border supervisory cooperation an important role in safeguarding the region and planning. There are a number of provisions from disorderly deleveraging. The Initiative was in the Capital Requirements Directives (CRD) and launched at the height of the first wave of the global Regulation (EU) No 575/2013 (CRR) which set out financial crisis in January 2009. It brought together all requirements for cooperation with third countries the relevant public and private sector stakeholders including college participation, information of EU-based cross-border banks active in emerging exchange, and equivalence of third countries. Five Europe, which own much of the banking sectors countries in the region successfully passed the in that region and also hold a significant part of European Banking Authority (EBA) assessment on government securities. Key objectives of the Vienna the equivalence of confidentiality regimes in 2015, Initiative are: i) avoiding disorderly deleveraging, ii) hence paving the way for its supervisory agencies’ ensuring that potential cross-border financial stability formal participation in supervisory colleges on cross- issues are resolved, and iii) achieving policy actions, border banking groups. Further assessments are notably in the supervisory area, that are taken in foreseen on equivalence of prudential requirements the best joint interest of home and host countries. applicable to institutions established in third For these purposes, regular meetings are held with countries, and the equivalence of consolidated the participation of the World Bank, the EBRD, supervision regimes applicable in third countries, the EIB, the IMF, the European Commission, other allowing third countries among others to benefit relevant EU institutions (e.g. the ECB), main cross- from the same, often more favorable, treatment border banking groups, and home and host country applied to EU exposures, meaning lower risk weights authorities, setting up platforms where private and would be applicable.14 public sector decision makers meet to exchange experience and discuss appropriate actions on relevant areas. Occasional Paper Series No 164, Financial stability challenges in EU candidate and potential candidate countries, ECB, 2015. 13 https://www.eba.europa.eu/documents/10180/983359/EBA-Op-2015-19+%28Opinion+on+cooperation+with+third+countries+- 14 +Art+161+%287%29%20CRD%29.pdf 28 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future H. Financial Stability Frameworks All Western Balkan countries have made progress imbalances that preceded the recent crisis was the in improving their financial stability frameworks. reserve requirement. NBS published a consultation Steady progress is measured in terms of strengthening document on the framework for macro-prudential crisis planning and information sharing (typically policy in March 2015, outlining the main objectives, through Financial Stability Committees), macro- instruments, and decision-making process. In Albania prudential supervision frameworks, and emergency and FYR Macedonia, the legal and institutional liquidity assistance facilities. framework for macroprudential policy is generally strong. Both have used macroprudential tools in the Financial Stability Committees should be further past to manage the credit cycle. strengthened and include all relevant financial safety stakeholders as members. Each country Decisive and immediate actions are required has formed a Financial Stability Committee (FSC) to deal with weak banks. An AQR of 14 banks to facilitate communication and information sharing recently concluded in Serbia revealed a decrease amongst the domestic financial sector authorities. of the capital adequacy ratio of all participating One weakness is that in Kosovo, FYR Macedonia, and banks of 1.76 percent when taking into account the Montenegro, the FSC does not include the deposit offsetting between impairment reinforcements and insurance agency. These bodies should be members banks’ prudential loan-loss reserves. Similar to the of FSCs and planning mechanisms, because case of Serbia, recent Financial Sector Assessment crisis preparedness and facilitation of decision- Programs (FSAPs) conducted in BiH and Montenegro making in a crisis can have a significant impact on recommended AQRs to be conducted for weak deposit insurance funding. In some countries, the banks posing a risk to financial stability. Based on the effectiveness of FSC’s could be improved through results, the respective supervisors should develop the sharing of more detailed, institution-specific time-bound supervisory action plans, requiring information and open discussions of key emerging capital increases by shareholders where necessary. In macro and micro risks. parallel, resolution plans for vulnerable banks should be prepared aiming to minimize the use of public An emergency lending facility is needed in BiH and resources. the arrangements require further strengthening in other countries. FYR Macedonia, Serbia and Albania all have adequate Emergency Liquidity Assistance (ELA) frameworks in place. ELA arrangements I. Financial Safety Nets are lacking in BiH due to mandate limitations in the currency board arrangement. Kosovo and To improve crisis readiness and conform to Montenegro have limited official capacity to lend international standards, authorities should ensure to banks due to the lack of national currencies. In that deposit insurance systems are adequately Montenegro, ELA is currently prescribed under the funded and the legal system is able to resolve CBM Law and the special draft resolution law (lex failing banks. Deposit insurance systems are not specialis), it should instead be brought under a single designed to cope with systemic banks or a systemic framework and follow best international practice. crisis. For these cases, a bank resolution framework In Kosovo, the authorities have made efforts to in line with international best practices is needed and strengthen the ELA framework. Further steps will deposit insurers need a credible line of emergency be needed in both countries to ensure adequate funding to cover shortfalls of the fund. resources for ELA as well as the development of operational procedures. Deposit insurance systems are in place in all six countries and are relatively well developed (see The authorities should set up more comprehensive Table 3). All operate under the narrow mandate of macroprudential frameworks. In terms of crisis a pay-box, except for Serbia. The use of a flat rate prevention efforts, macro-prudential supervision deposit insurance premium (as opposed to risk- needs to be strengthened across the region. This based premiums) in most coutnries is prudent given is particularly relevant as Montenegro, Kosovo the Deposit Insurance Agencies’ (DIAs’) relatively and BiH have no control over monetary policy. recent establishment and the need to build up The only instrument used by the respective central deposit insurance funds. All countries upgraded banks in the period of strong build-up of systemic their deposit insurance frameworks since the crisis Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 29 through an increase in coverage for the purpose of to improve this. It is important that coordination with restoring public confidence in the banking system other financial safety net participants is enhanced, and adjusting the national regulations with the EU including by DIAs’ becoming members of Financial acquis communautaire. They are financed by annual Stability Committees. In addition, most DIAs in the premiums from member banks, and in some cases region are missing an official target ratio. The absence supported by a standby credit line with the EBRD of coverage for legal entities in Albania and FYR and a statutory provision for back-up funding from Macedonia is a material weakness in the safety net the government. for depositors, as it contravenes a primary objective of deposit insurance—to protect small, financially Further improvements are recommended in a unsophisticated depositors including SMEs —as well number of areas. In some cases, direct or backup as European Union guidance on coverage. (government) funding of the deposit insurance systems still needs to be strengthened, especially in Across the region, there remain significant gaps BiH and Kosovo where the agencies have no statutory in the frameworks for resolving failing banks. power to access funds from the government. The Resolution, as opposed to liquidation, allows a current timeframes for payout are too long compared bank’s critical functions to continue and lowers the to good practice; the procedures for insured deposit ultimate cost of bank failures (for taxpayers) through, calculations, mechanism for automated payout, and for instance, transferring and selling assets and auditing requirement, all need further strengthening liabilities of a failed bank, establishing a temporary Table 3: Overview of deposit guarantee schemes in the Western Balkans Mandate Coverage Target Level Type of Premium ratio deposits Albania (ADIA) Paybox 2.5 million lek n/a Individuals Flat rate (approx. EUR 17,800) BIH (DIA) Paybox KM 50,000 Set semi-annually via Individuals/- Flat rate (0.26% of eligible (approx. EUR financing assessment but no legal entities deposits annually) 28,500) official target level exists Kosovo (DIFK) Paybox 3,000 EUR The target size of the DIF is Individuals/- Risk-based premium (between set in the law at a minimum legal entities 0.3 and 1.5 % of insured of five per cent of the total deposits, starting 1. January of insured deposits. 2016 between 0.45 and 1.5% However, the current policy of insured deposits) on target size is 8 – 9 percent which equals to the total amount of insured deposits for two small banks Montenegro Paybox 50,000 EUR 10% of guaranteed deposits Individuals/- Flat rate (initial premium EUR (FZDCG) legal entities 50,000; 0.5% of total deposits annually) FYR Macedonia Paybox 30,000 EUR in n/a Individuals Flat rate (0.5% of eligible (FODSK) Macedonian deposits annually) Denar equivalent Serbia (AOD) Paybox+ 50,000 EUR in 5% of total insured deposits Individuals/- Flat rate (initial: 0.3% of the loss Serbian Dinar legal entities cash portion of minimum initial minimizer equivalent capital of the bank); • regular: payable on a quarterly basis at the level of 0.2% of the total insured deposits held by the bank, and • extraordinary: maximum 0.4% of total insured deposits held by the bank over one year 30 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future bridge institution, forcing debt write-downs or debt- resolution authority for banks but lacks a formal equity conversions on bank creditors, and overriding mandate. the rights of shareholders. The ultimate objective of the bank resolution framework is to maintain the In the wake of the financial crisis, international value of borrower-lender relationships and the trust principles for the resolution of systemic banks of depositors, as well as to safeguard interbank were created. The “Key Attributes of Effective markets and payment systems, while imposing Resolution Regimes for Financial Institutions (KA)” market discipline to avoid excessive risk taking by issued by the Financial Stability Board in 2011 provide banks. BiH and FYR Macedonia do not have sufficient the international standard for resolution regimes for frameworks for dealing with failing banks, other financial institutions and are key to addressing the than open bank “administration” and bankruptcy/ moral hazard and systemic risks associated with liquidation. Reforms of the banking laws in BiH are institutions that are too big and/or too complex and currently underway, including strengthening the interconnected to fail. What holds true for complex bank resolution framework. In Kosovo, available systemically important financial institutions (SIFIs) at tools as well as the timeframe and requirements for the international level may also apply to national big least-cost resolution need to be clarified. The bank players, albeit under different terms. In the EU, the resolution framework in Serbia was substantially BRRD provides the new legal basis for bank recovery strengthened in 2015 to make bank resolution more and resolution. effective and aligned with the EU Bank Recovery and Resolution Directive (BRRD), however without The eventual transposition of the BRRD into providing for special resolution funding. The new national legislation can address many of the Bank Resolution Department is operational and shortcomings of bank resolution frameworks. resolution plans for systemically important banks The BRRD was adopted in the EU in June 2014, are currently being prepared. Albania has a special and had to be transposed by Member States into bank resolution regime largely based on modern national law by January 2015 (bail-in provisions by principles, but significant gaps remain in the area of 2016). The BRRD broadly regulates the following resolution planning, funding and powers to ensure four key elements: i) the preparation and prevention fast, decisive implementation of resolution action. of resolution via recovery and resolution planning; In Montenegro, the CBM functions as the de facto ii) enhanced early intervention measures by the Table 4: Overview of resolution systems in the Balkans Bank Resolution Resolution tools Funding Source Resolution framework Authority governed by Albania BoA Purchase and Assumption, Use of DIF, government Special Bank Resolution Bridge Bank, Liquidation and Regime Depositor Reimbursement BiH X Liquidation and Depositor DIF (for insured Bankruptcy and Reimbursement depositors in liquidation) Insolvency Laws Kosovo CBK Purchase and Assumption, DIF (for insured Special resolution scheme Bridge Bank, Liquidation and depositors in liquidation) (Banking Law) Depositor Reimbursement Montenegro X Liquidation and Depositor DIF (for insured Bankruptcy/insolvency laws Reimbursement depositors in liquidation) FYR Macedonia X Liquidation and Depositor DIF (for insured Bankruptcy/insolvency laws Reimbursement depositors in liquidation) Serbia NBS Purchase and Assumption, Use of DIF, government Special Bank resolution outside liquidation bail-in, regime in Law on Banks Asset separation, Bridge Bank, Liquidation and Depositor Reimbursement Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 31 supervisor; iii) the application of special resolution resolution fund and ultimately public backstop) tools and powers in the case of an actual bank could be beneficial. Financial markets in the region failure instead or in addition to liquidating (part of) will need more flexibility and time to establish the bank; and last but not least iv) cooperation and instruments that qualify for Minimum Requirement coordination between national authorities. for Eligible Liabilities (MREL). External bail-inable instruments created on the local market, and also Countries implementing the BRRD will still have “internal bail-in” from parent for subsidiaries, should to make decisions on certain aspects where the be considered. Adjusting the liability structure of the Directive leaves room for discretion. The BRRD system is complex and costly, though unavoidable foresees the establishment of a resolution authority if reliance on the use of taxpayer’s money is to be (RA) to be operationally and functionally separated overcome. from the supervisory functions. It sets out three main conditions to determine whether resolution authorities should take resolution actions. First, the determination has to be made that the institution J. Conclusions is failing or likely to fail. Second, there must be no reasonable prospect that alternative private sector Financial systems in the region are primarily bank- measures would prevent the failure. Third, resolution based with differing degrees of concentration. action must be in the public interest. A resolution Financial sectors in the Western Balkans are bank- action is especially problematic if the Resolution centric, with relatively minor levels of capital Fund, or taxpayers’ money, is misused due to a wide market activity, negligible penetration of insurance definition and “creative interpretation” of “public products, and generally insignificant non-bank interest test“, “resolution objectives” and “systemic financial institutions. Banking sectors in the region stability”. In order to achieve the objectives of are dominated by foreign banks. Serbia is the resolution, the RA is given four “resolution tools”: exception, where state-owned commercial banks the bail-in tool and three transfer tools, including control about 20 percent of the banking sector and the sale of business to a private acquirer, the bridge the level of foreign bank ownership is lower at 75 bank, and the asset separation tools. The BRRD percent. Concentration differs across the region requires banks to hold a minimum requirement of with around two thirds of total assets in the hand of eligible liabilities (MREL) to ensure banks actually the three largest banks in FYR Macedonia, Kosovo have sufficient bail-inable instruments. It does not, and Albania and moderate concentration in Serbia, however, regulate the type of instruments for which Montenegro and BiH at around 45 percent. Financial bail-in would be technically feasible, or when and intermediation in the Western Balkans remains low for which instruments bail-in would severely damage when compared to other countries in CESEE. The financial stability. depth of the financial sector measured by private sector credit to GDP stands at an average of 45 A number of issues need to be considered in tailoring percent with particularly low levels in Kosovo and the BRRD to the country specific circumstances Albania. The banking sector is still dealing with of the Western Balkans as well as other small the aftershocks of the global financial crisis that countries in the region. The creation of a separate have weakened financial sector asset quality and legal resolution entity might not be feasible for small profitability. At the end of 2015 NPLs stood at an countries due to institutional and staffing constraints. average of 13.9 percent and RoA at 1 percent with Hence, the creation of a resolution unit, e.g. within considerable variations across the region. Although the supervisory authority, could be considered. Even the banking systems - dominated by foreign banks if synergies between resolution and supervision exist - appear broadly sound, significant pockets of when they are part of the same authority, a clear vulnerability exist among domestically-owned banks. functional and organizational separation should be Following stagnant or declining credit conditions in implemented. The trigger for resolution (‘public recent years, lending recovered slightly during 2015 interest) should be clearly specified and defined, in most Western Balkans countries. Post-crisis trends e.g. by including a reference to ‘critical function and suggest a shift in the funding structures of Western financial stability’. While least cost in terms of ‘less Balkan banks towards domestic deposit mobilization. costly than liquidation’ is safeguarded under the ‘no creditor worse off principle’ in the BRRD framework, In the near term, policymakers and regulators introduction of a least-cost-test from the perspective in the region face a number of challenges with of state support (deposit insurance fund, potential regard to supporting economic growth, expanding 32 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future financial inclusion, and maintaining financial which is associated with high cost and stringent stability. Across the region, high levels of NPLs need conditions. SMEs suffer from structural capacity further urgent policy attention by strengthening the constraints and higher levels of informal transactions, corporate and personal insolvency and creditors’ reducing the quality of financial information. Most rights regimes as well as regulatory classification and banks have not yet introduced delivery models provisioning standards. Deleveraging remains a risk which are appropriate to the characteristics and as some parent banks plan to further scale back their risks of this market segment. Alternative financing presence in the region as a result of continued market sources are limited. As the shift in banks’ funding and regulatory pressures. Shifts in banks’ funding models towards increased deposit mobilization is models, increased competition as well as low bank mainly short term in nature, diversification of funding profitability levels in some countries in the region, sources will be key when it comes to the provision of may require further bank consolidation to adjust to term financing aimed at fostering investments and the new circumstances. Given the high dependency ultimately economic growth. In this context, capital on foreign currency lending and borrowing, active market development is key to mitigating potential policies to increase the use of local currencies should shortcomings in the context of required funding be pursued both to reduce financial stability risks diversification. Improvements in credit reporting and and to afford greater degrees of policy freedom financial reporting would help reduce information to monetary authorities. Moreover, it is essential asymmetries. Finally, public support instruments that the financial safety net is further strengthened could be improved to ensure the effectiveness and by building up financial and institutional capacity efficiency of their interventions. of the deposit insurance systems and developing a comprehensive resolution regime to deal with While the snapshot in Chapter 1 focuses on near the weakest banks. In terms of crisis prevention term challenges and policy responses with regard efforts, macro-prudential supervision needs to be to financial sector development and stability, strengthened across the region. This is particularly the following chapters look more broadly at the relevant as Montenegro, Kosovo and BiH have no external context and take a longer term view on control over monetary policy. An emergency lending challenges and opportunities that could present facility is needed in BiH, while in other countries, the themselves over the next decade. It does so not by arrangements require further strengthening. proposing a single forecast, or view of the future, but by exploring key uncertainties and applying the tool Banking regulation and oversight have improved of scenario thinking to create three different visions over the last decade, but a number of important for the world around the Western Balkans financial shortcomings in some segments remain. Further systems in 2025 aimed at informing the development progress is needed in implementation of risk-based of financial sector strategies that contribute to the regulatory and supervisory practices as well as country’s overall success in sustainable and inclusive linking regulatory capital requirement to commercial growth. banks’ market and credit risk. Regulation in the areas of corporate governance and identification of ultimate beneficiary owners and related-party lending should also be strengthened. While the EU Banking Union will lead to sounder banking system and stronger supervision as well as creation of a level playing field across borders and simplified ‘home- host’ interactions, potential challenges stem from ensuring an adequate level playing field between supervised entities as well as ensuring adequate cooperation and communication. Financial inclusion levels of households in the Western Balkans is relatively higher than the region’s income level suggests, but significant gender gaps exist in some countries. As to enterprise finance, the credit crunch has made it extremely difficult for new firms to emerge and grow. In particular SMEs – the backbone of Western Balkan economies - continue to have limited access to credit, Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 33 II. A Glimpse into the Future: Using Scenarios to Explore Challenges and Opportunities in a Changing World 34 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future A. Why Scenarios? B. Scenario Development Process Scenario analysis is a powerful tool that can help The scenarios were developed based on a rigorous policymakers prepare for a range of possible consultation process. The complete scenario- alternative futures. Scenarios represent a coherent building process is summarized in Figure 29. The set of intersections of how the different uncertainties scenarios were prepared by the World Bank Group could play out. They are plausible yet challenging through consultations with a number of external stories about the future which address core issues stakeholders including development partners as well (or “central questions”) of importance to a particular as technical experts from relevant authorities in the set of stakeholders. By giving diverse stakeholders a region (in particular central banks and ministries of shared basis for discussion, scenarios enable creative finance) at each stage of the process. Following the thinking about how to shape future responses identification of 14 key areas of uncertainty that could proactively. They also encourage discussion prove to be major drivers of change in the region of ‘stretch’ outcomes, unintended effects from and the ‘stretch’ continuum of outcomes, scenario combinations of factors, and second- and third-order plots were developed and tested (see Chapter III consequences that may flow from them. By making for further detail). Finally, the completed scenarios uncertainty explicit, they tease out preconceptions were presented at a regional workshop in Vienna, and help decision-makers consider how they and which gathered senior policymakers and financial others might react to the different ways in which future regulators. The aim of the workshop was not for events could unfold. Once described, scenarios the participants to review or endorse the scenarios can be used to initiate dynamic conversations but for the group to discuss possible implications about opportunity, risk management, contingency for financial systems at the regional level. Because planning, strategy testing and collaborative action. of the limited scope for policy at the regional level, More details on the scenario analysis methodology however, the ultimate goal of the scenario-building and its use are presented in Annex 1. exercise is to provide a basis for exploring country- specific policy options and regulatory strategies. Figure 29: Key steps in scenario analysis interviews with stakeholders to identify critical uncertainties/ Developing Testing predetermined Scenario Scenario Regional factors Plots Plots Workshop • An extensive • Based on identified • Consultations with • Regional Workshop consultation process uncertainties, three stakeholders in with Western Balkan with internal and scenarios were August/September senior policymakers external stakeholders developed between 2015 on the scenario and financial regula- was held between June/August 2015 plots tors held in November April/May 2015 providing a comprehen- 2015 exploring the followed by a set of sive description of how possible implications workshops during the the future would look for the region summer to identify the under each in 2025 COUNTRY PILOT key uncertainties that Focused on will provide the exploring country- building blocks for specific policy scenarios options and regulatory strategies Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 35 III. Uncertainties as Elements of Change 36 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future A key step in any process of thinking about the to represent the key areas of uncertainties affecting future is to identify the most decisive elements the region’s financial systems. It was focused on the of change and their degree of uncertainty over broad context (economic, political and market) and the next ten years. This chapter briefly reviews the derived from extensive consultations with regional continuum of uncertainty for each of the 14 different stakeholders, international organization partners and elements of change that were identified as most experts—both inside and outside the World Bank relevant to the scenario development exercise (see (see Figure 30). Table 5). This list of elements of change was designed Table 5: Key uncertainties in detail GEO-POL- GLOBAL FINANCIAL FINTECH EU AND EURO ECONOMICS MARKETS ADOPTION AREA Geo-political Global banking Payment systems EU enlargement appetite development landscape and FDI evolution Economic growth Capital markets Financial service EU and euro area consoli- path innovation dation (incl. banking union) Centers of gravity Banking regulation for the global economy Trade patterns Monetary dynamics Energy commodity Sovereign debt markets markets/prices Figure 30: Stakeholder and Expert Consultations EXPERTS The scenario analysis benefited from inputs and insights of a number of experts in the World Bank Group with relevant expertise (including experts from GFMDR, GMFDR, DECPG, GTCID, ECACE, ECCU4 and GFADR) REGIONAL STAKEHOLDERS Albania Bosnia and Herzegovina Kosovo Republic of Macedonia Montenegro Serbia EXTERNAL STAKEHOLDERS Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 37 The elements of change are grouped into three sets of global change and one set of uncertainties more specifically related to the EU. Detailed descriptions of each uncertainty and its impact on the Western Balkans region were prepared to serve as underlying building blocks for the scenario development process. The following pages contain an excerpt of the underlying analysis including a series of facts, thoughts, and questions designed not as a comprehensive review of the issues but rather as a guide to exploring uncertainty around key elements of change. Figure 31: Key areas of uncertainty -pol Economic Geo s ption Financ do ial M hA ark Tec et in s d Euro an zone EU F n Balkans Re ster gio e W n Country Specifics Following the identification of the 14 elements of change, end-points for each uncertainty were determined to define the different possible extremes for each of the ranges in the 2025 scenarios. The identified continuums of uncertainty then serve two related purposes: first they provide a dashboard for thinking about change drivers in the relevant context for the region’s financial systems; second they become the building blocks to construct a set of internally coherent and plausible stories of the future. It is worth noting that the left or right position of the end points does not have any meaning of its own. This section presents them very briefly and Annex 2 shows how they play out in each of the scenarios. 38 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future A. Geo-Pol-Economic Uncertainties LEFT END-POINT RIGHT END-POINT Strong Economic Growth Weak Emerging Centers of Gravity Advanced Convergent Geo-politics Divergent Liberal Trade Patterns Protectionist Low Energy Price High Economic Growth From the early 2000s onwards - when global growth is important because economic dynamics will be started to be driven by the strong performance a major factor determining the global structure of of a few large emerging countries - a growth ‘soft powers’ by 2025. It complements the economic differential of several percentage points appeared growth uncertainty (which looks at the size of the world between emerging and advanced countries. This economy). At one end of this uncertainty continuum came to be seen as the “new normal”. But recent the center of gravity of the global economy moves developments have put that notion in question and back towards advanced countries and at the other it highlight the high level of uncertainty around global continues to shift towards developing and emerging economic growth dynamics. Reflecting the fact that countries. prospects for the financial systems in the Western Balkans are significantly dependent on external economic dynamics this uncertainty is highly relevant. Geopolitical Dynamics It focuses on the pace of growth and complements the next uncertainty (that considers the composition In line with shifts in the world economy, geo- of the world economy). The range of economic political clout has shifted east in the last decade. growth outcomes can be simply viewed from strong India and particularly China have been increasing to weak. On the one side of the spectrum economic their voice and weight in international politics as they growth is strong with resumption of strong growth grow richer, and continue to forge new relationships in China and increased US productivity while on the with countries around the world. How this evolves other end the 2015-2025 decade is counted as a lost and how the United States and other powers respond decade for the global economy. will be a driver of change with many ripple effects. Given the regional focus of this report, Russia’s geo-political interests and strategy is of particular Center of Gravity in the World Economy importance. This uncertainty is important as the geography of the Western Balkan countries exposes Until recently, high-income countries dominated them to the political and economic repercussions of the global economy. But the composition of the geopolitical tensions. The opposite end points for global economy has been changing fast in favor of this uncertainty continuum are viewed as convergent emerging and developing economies. This geo- and divergent geopolitical dynamics. economic shift has already had visible effects in international negotiations and the emergence of new “trade influence” zones. It is also worth noting Trade Patterns that the reshaping of the global economy is not just a story of nation states. It is also a corporate story— For decades, global trade in goods and services with major enterprises (private, quasi-private and expanded more than twice as fast as global state-owned) from emerging economies becoming GDP due to dramatic decreases in transport major players in their industries. This uncertainty and communication costs as well as lower trade Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 39 barriers (the combination of these factors is usually seen as an integral part of globalization). In the recent crisis, the volume of global trade shrank by almost 20 percent and it remains to be seen how the trade/ GDP ratio evolves and if trade flows become more regionally fragmented or globalization resumes. While the volume and value of trade flows will also depend on many other factors, it is greatly affected by trade policy and tax decisions (by individual countries and through bilateral and multilateral agreements). How this uncertainty plays out in the continuum from increased protectionism to further liberalization is important because it will determine market access and competitiveness of the Western Balkans, and therefore their export opportunities. Commodity Markets (Energy)15 Commodity markets have shown great volatility in recent years. While the magnitude of the impact of commodity price changes on these variables differs across countries, the impact of price changes is significant in virtually all countries. In addition, the asymmetry of the effects of oil price swings and the concentration of gains from high oil prices in a few countries impact the distribution of savings and reserves around the world. The uncertainty affects both demand and supply. Countries in the Western Balkan region rely heavily on imported hydrocarbons. Therefore, trends and fluctuations in energy prices will have direct impacts on the countries’ macroeconomic stability and development prospects. Endpoints of the uncertainty continuum range from low energy prices due to significant improvements in energy efficiency and increased supply from renewable sources on the one hand to a rise in prices due to strong growth and related energy demand in many large emerging economies without improvements in energy efficiency. 15 The uncertainty focuses on energy because that market has shown particular volatility and wide-ranging implications. 40 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future B. Financial Market Uncertainties LEFT END-POINT RIGHT END-POINT Expansionary Global Monetary Dynamics Contractionary Sought Sovereign Debt Shunned Loose Banking Regulation Tight Expanded Banking Landscape Concentrated Deepened Capital Markets Unevolved Global Monetary Dynamics Sovereign Debt In response to the 2008 global financial crisis, Sovereign debt levels around the world have countries have mainly relied on monetary increased significantly in recent years. The financial policy to stimulate the economy. Central banks, crisis resulted in a general “flight to safety”, causing especially in developed countries, reduced interest interest rate spreads of developing countries to rise rates significantly, followed by quantitative easing sharply. As markets calmed, spreads declined but programs when conventional policies did not prove remained at levels high enough to lead to large effective enough. Interest rates have now been inflows of funds into emerging markets, generally close to zero for several years in many countries, providing higher yields. While this has resulted in with wide-ranging implications for security markets, relatively easy financing conditions in developing pension funds, and investors in general who, in countries, the reaction to the Federal Reserve search of higher returns, have created new financial System’s announcement that it would start tapering flow patterns. Abundant liquidity on the back of its quantitative easing program in 2013 shows monetary easing supported developing countries’ that emerging markets, including Western Balkan growth performance as it resulted in the availability countries, remain exposed to risks emanating from of low-cost but short-term finance--and created high-income countries. The uncertainty continuum vulnerabilities often associated with credit booms. ranges from sovereign debt being shunned to being This uncertainty is important because the small size sought after in global markets. of financial markets in the Western Balkan countries as well as their monetary policy regimes makes their evolution dependent on broader monetary and Banking Regulation exchange rate dynamics. The uncertainty continuum ranges from contractionary to expansionary After the 2008 financial crisis, governments across monetary policies. Plausible 2025 outcomes for the world initiated financial reforms designed to this area of uncertainty lie anywhere between the provide greater transparency of transactions and following end-points: (i) interest rates have remained reduce risk in order to make financial systems low in major developed markets with negative real more stable and better regulated. The Basel III rates in a number of major economies, leading to an Accord strengthens bank capital requirements and unprecedented one and a half decades of low rates increases bank liquidity reserves, and has been (‘world of negative return’); and (ii) interest rates implemented in a number of countries. In the EU, increased in developed countries leading to large the relevant Capital Requirements Regulation and quantities of capital being repatriated. Capital Requirements Directive include a large Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 41 number of options allowing for national discretion. which pushed the corporate sector to shift towards The financial crisis underscored the potential value bond financing. Especially in emerging markets, of strengthened, coordinated regulation but there the outstanding debt of non-financial companies is also growing fatigue with large, rigid bureaucratic has increased markedly. The greater dependence solutions and concerns that regulatory reforms on bank lending makes the European economy, do not reflect specific country situations and are especially SMEs, more vulnerable when bank crowding out the space for innovation related to lending tightens, as happened in the financial crisis. instruments and intermediation mechanisms. The This uncertainty is important because the small size uncertainty continuum ranges from tightened of capital markets in the Western Balkans countries Basel-type regulations becoming widely adopted implies that their evolution will have considerable and implemented across countries—including dependence on broader capital market dynamics. through the EU Banking Union—providing a basis The uncertainty continuum ranges from unevolved for expanded regulatory coordination to regulatory to further deepened capital markets. loosening and fragmentation generating wide- ranging perceptions of risk across countries and room for regulatory arbitrage. Global Banking Landscape Global financial integration has increased substantially over the last two decades—including an increasing role of foreign banks across the world. While foreign bank penetration may have led to more efficient intermediation and risk sharing, and the development of domestic financial sectors through increased competition, it has also increased exposure to external crises. Hence, the 2008 financial crisis and its aftermath had significant effects on the global banking landscape. Large reductions in cross- border bank flows (mainly due to the retrenchment of European banks) took place as banks sought to restore balance sheets. Retrenchment to home markets also reflected weakened demand, increased sovereign/country risks, and an adjustment to regulatory reforms. Countries in the Western Balkans have significant reliance on foreign banks and their capital inflows—both through FDI and credit lines. The dynamics of banking FDI and cross-border credit is an important uncertainty. The continuum ranges from further retrenchment – in particular of Western European parent banks - towards home markets to expanded banking cross-border flows and FDI. Capital Markets Development Capital markets have expanded around the world in recent decades and while the 2008 crisis represented a set-back, there has been a strong recovery since, particularly in stock markets. Stricter regulations and market pressures caused bank deleveraging in the aftermath of the crisis 42 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future C. Fintech Uncertainties LEFT END-POINT RIGHT END-POINT Lively Financial Service Innovation Inhibited Cutting-edge Payment Systems Traditional Innovation in Financial Services Modern information technologies have allowed This uncertainty is important because consumer financial services providers to serve previously trends spread rapidly across countries and financial underserved segments of the population, while services in any country will find either strong pressure improved technologies for credit reporting and or resistance emerging from behaviors elsewhere. borrower identification have dramatically reduced Potential benefits, including for financial inclusion, the cost of financial intermediation. Digital are huge but the fast development of whole new channels within banks have grown continuously segments of finance raises challenges for regulatory and significantly – outpacing all other channels and architecture, financial stability, and security. The changing the traditional sources of competitive uncertainty continuum ranges from traditional advantage for banks. Besides the traditional banking payment systems continuing to prevail to cutting business, nontraditional providers of financial services edge ones spreading widely. such as money transfers, savings, and lending have surfaced as a result of increased digitization. Some of these are new companies such as peer-to-peer lending firms like Kickstarter or Lending Tree. Others are nonfinancial institutions (or “nonbanks”) setting up a finance arm, such as e-commerce sites like eBay (owner of PayPal) or Alibaba, internet intermediaries like Google, electronics and software developers like Apple, and telecom operators like Safaricom. How fast and widely the range of financial services provided by banks and alternative providers will expand is a key factor affecting the evolution of the financial systems in the region. This uncertainty is also important because it could radically challenge regulatory mandates. The uncertainty continuum ranges from inhibited to lively tech-based adoption of innovations in financial services. Payment Systems The use of non-cash payments has grown rapidly with the introduction of plastic cards. More recent technological advances in the way information is stored, the physical form of the payment mechanism, and biometric account access and authentication are creating efficiencies, reducing transaction costs and times at the point of sale. Mobile money transfer services have already transformed the landscape for domestic remittances in several African countries. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 43 D. EU and Euro Area Uncertainties LEFT END-POINT RIGHT END-POINT Forward EU Consolidation Backward Accelerated EU Enlargement Stalled EU Financial and Monetary Consolidation To address institutional shortcomings revealed the region as a whole but should be used to draw by the 2008 financial crisis the EU has embarked specific implications for individual countries. The root on a process leading to Banking and Capital cause of the less certain aspects of demographics Markets Unions. Euro area stability and how much, (notably migration) are covered in broader if any, progress will have been made on an EU-wide uncertainties including economic growth dynamics financial architecture is an important uncertainty and EU enlargement. But recent development with as the financial market development strategies of the influx of refugees into the EU and its periphery both new EU members and non-EU countries in clearly complicate this picture and will have an effect the region, including the Western Balkans, will be on migration prospects and options for Western greatly influenced by the evolution of EU financial Balkan citizens (see Box 1). and monetary policy. The uncertainty continuum ranges from EU financial and monetary integration Finally, in order to validate the choice of key proceeding forward or being forced by events to elements of change as context for the Western retreat backwards. Balkans financial systems, regional stakeholders completed an anonymous online survey in July 2015. This exercise also served to inform EU Enlargement the scenario-building process, and encouraged stakeholders to think about which specific relevant The European Union enlargement agenda aspects of the future are more susceptible to change. presently includes the Western Balkans, with Eighteen respondents from financial regulators each country at a different stage of the process. and policymakers across the region completed the This uncertainty is of significant relevance to survey. Uncertainties were rated on a scale from one Western Balkan countries as EU membership is to six with respect to their relevance and uncertainty. a major determinant of the future options of the The results are summarized in Figure 32. Although region. In 1999, the EU established the Stabilization all uncertainties were rated medium- to highly- and Association Process (SAP), with the goal of relevant and medium- to highly uncertain, sovereign facilitating the accession process of Western Balkan debt features more prominently as a highly relevant countries. The SAP is governed by the Stabilization and uncertain issue. This may be due to the fact and Association Agreements, which tailored to that the Greek sovereign debt crisis was at its peak each country’s needs, identify common political and when the survey was conducted. Other prominent economic goals and foster regional cooperation. uncertainties that emerged from the survey were The uncertainty however is broader and it affects EU consolidation process and trends in commodity the broader appetite for EU enlargement. The markets. It is interesting to note that financial continuum of uncertainty ranges from stalled to innovation was perceived as relatively less uncertain accelerated EU enlargement. and relevant than the majority of other uncertainties indicating that regional stakeholders might not Besides these key uncertainties, it is worth pay sufficient attention to the opportunities but noting that demographic characteristics are also threats such as cybercrime arising from new a fundamental factor to be considered—both technologies. The dominant uncertainty identified because of its more certain and uncertain aspects. in the ‘other’ category was political instability in They were not treated as a contextual uncertainty for individual countries of the Western Balkans. 44 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Box 1: Demographics in the Western Balkans Age dependency ratio of Western Balkan Countries The size of the population in 2025 is reasonably predictable MNE and even more so the size of the working-age population. BIH MKD Urbanization rates are also relatively certain over the next decade. Differences across countries are significant and ALB gradual trends towards greater urbanization in countries with KSV larger rural shares would seem to be subject to minor variations. Migration rates (gross and net) are an area of greater uncertainty—and recent developments and considerations around migration policy options set in motion by the influx of refugees underscore that. Plausible outcomes range from significant numbers of migrants returning to their home countries to fresh emigration. Remittances implications include ‘guest workers’ retirement and the question of where they settle. 2005 2015 2020 2025 Source: World Bank, World Development Indicators The scenarios are intended to facilitate a The authors are very grateful to the participants of conversation at the regional and national level the seminar for their thoughtful contributions and on possible policy responses to each of the insights. Seminar participants were not asked to vet scenarios. As a first step, a high-level seminar or endorse the scenarios - which are just a device was held in Vienna on November 13, 2015 with for exploring future possibilities, not for predictions - regional stakeholders and international partners. but to take them as a given and use them to explore Figure 32: Results from regional stakeholder survey Relevance Economic Growth 3 EU Enlargement Sovereign Debt Global Monetary Banking Regulation Banking Landscape EU Consolidation Commodities (energy) Trade Trends Geo-Politics … Capital Market 2 Payment Other Composition of the Mechanisms Innovation in World Economy Financial Services 1 1 2 3 Uncertainty Source: World Bank staff calculations based on survey results. Chart scaled from 1-6 to 1-3 for visualization purposes. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 45 potential implications. Discussions revolved around topics including regional integration, management capabilities and corporate governance, technology, and the building of a robust economic and financial sector structure. EU integration and harmonization was recognized as an important anchor of reform in the region. However, regardless of the fate of the EU in different scenarios, cross-country harmonization will keep playing an important role in attracting and facilitating investments, as well as transferring knowledge. Finally, as was the case with the survey, there was surprisingly little emphasis placed by participants on the role of technology and how it might affect financial systems and regulatory mandates. Keeping this initial discussion at a regional level provided a valuable perspective that enriches the thinking that could be done at the level of individual countries. It also gave a strong sense of the importance at both levels of action now to ensure that all countries in the region arrive at 2025 with financial systems that are ready to make the best possible contribution to economic growth and prosperity. But the greatest value to be derived from the scenarios is at a national level—where most policies and regulations are set. 46 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future IV. 2025 Scenarios on the World around the Western Balkans Financial Systems Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 47 A. Overview The three scenarios differ both in terms of of gravity of the world economy has definitely shifted the overall pace of economic growth and of to China and, notably, all other emerging countries. the location of the global expansion of GDP— summarized simply by looking at the growth paths Commodities in general and oil prices in particular over the next decade of the countries that today also show marked differences in the three we call “advanced” or “emerging/developing”. scenarios. One of them has oil prices rising steadily Comparing the scenarios from this perspective while in another one we see them crawling around suggests a greater potential variability of growth the recent bottom—with obvious implications in rates (from the current, 2015 level) for emerging terms of resource transfers between oil importers economies than for advanced economies. Both and exporters; and financial stocks in the hands of groups of countries see growth set-backs in one of the latter. the scenarios while in each of the others the relative performance of advanced and emerging differs. The scenarios have a particular focus on the financial and monetary dimensions of the global A broad look at the world is provided by singling economy. From that perspective there are two out the two largest global economies (China indicators that illustrate important differences across and the USA), then the European Union and scenarios. First, interest rates (illustrated in Figure by then considering the rest of the advanced and 3-month LIBOR rates): two of the scenarios present emerging worlds. Using that lens for 2025, in very different money worlds—one of persistently low two of the scenarios the USA remains the largest and another one of rapidly rising interest rates— economy, in one of them with the EU close in terms while the third scenario shows interest rates evolving of aggregate GDP size, while in the third scenario modestly upwards. Second, sovereign debt spread China is the largest single-country economy and averages—as an indication of the global market the “rest of emerging” block has also significantly appetite for debt issued by emerging countries— increased its share of the world economy. The and, hence, the price they must pay to mobilize scenarios differ both in terms of the incremental funding: in one of the scenarios the spreads narrow value added generated over the next decade and to historical lows while in another they climb to the relative contribution to that growth by different historical highs (Figure 35). In the third scenario they countries/blocks. In one of the scenarios the center increase steadily but stay within a moderate range. Figure 33: Crude oil, USD/barrel Figure 34: Quarterly average 3M LIBOR 125 6 100 4 75 50 2 25 0 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 Crude Oil Orderly Blue Historical Orderly Blue Unsettling Grey Shifting Orange Unsettling Grey Shifting Orange Source: WEO Database and World Bank staff calculations Source: ICE Benchmark Administration Limited (IBA) World Bank staff calculations 48 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Figure 35: Developing Countries’ Sovereign Debt Spreads against US treasuries 600 There are other major differences across scenarios but they do not lend themselves to quantification: the EU’s internal evolution (progress 400 towards consolidation—including a banking union— characterizes one of the scenarios while a stalled enlargement process features in another scenario); 200 strengthening of banking regulation (its unintended consequences a significant feature of one scenario), the global landscape for banking FDI (two scenarios 0 see further retrenching and one envisages expansion), deepening of capital markets (in one scenario), and 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 innovation in payment systems and financial services Historical Orderly Blue more generally (rapid technology adoption is a salient characteristic of one of the scenarios). Unsettling Grey Shifting Orange Source: World DataBank and World Bank staff calculations Figure 36: GDP Growth - Advanced Economies Figure 37: GDP Growth - Emerging Economies 8% 8% 6% 6% 4% 4% 2% 2% 0% 0% -2% -2% 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Orderly Blue Unsettling Grey Orderly Blue Unsettling Grey Shifting Orange Shifting Orange Source: World Bank staff calculations Source: World Bank staff calculations Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 49 Figure 38: 2025 Nominal GDP Figure 39: Shares of GDP growth 2015-2025 40 75 30 Trillion USD 50 Trillion USD 20 25 10 - - Orderly Blue Unsettling Grey Shifting Orange Orderly Blue Unsettling Grey Shifting Orange United States Rest of the World Emerging European Union Rest of the World Advanced China China Rest of the World Advanced European Union Rest of the World Emerging United States Source: World Bank staff calculations Source: World Bank staff calculations 50 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Shifting Orange The global economy is on a roll—and the center of gravity is no longer in the old advanced countries. 2015 did not mark the end of the “emerging golden age” but a pause in their growth march. By 2025 though, the term “emerging coun- tries” made no sense any longer as quite a lot of those formerly called emerging were now well-established upper-middle income countries. Trade is again a ma- jor driver of economic activity and supply chains keep getting more global. China is an important part of the story but resumed thereafter—as the economy finally shifted far from the only one—Poland and Turkey, towards a better balance between investment alongside Colombia and Indonesia, are among and consumption. Just as important, the quality non-BRICs16 performing strongly. In China, the of investment improved steadily. This changed its growth slowdown of 2015/2016 turned out to be a import demand pattern and had many implications process of adjustment and a strong, steady growth for its evolving landscape of trading partners. Figure 40: Shifting Orange Growth: Advanced Figure 41: Shifting Orange: Nominal GDP and Emerging 10% Rest of the World Emerging 5% Rest of the World Advanced China 0% European Union -5% United States 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 - 25 50 Advanced Economies 2015 2025 Trillion USD Emerging Economies Source: WEO Database and World Bank staff calculations Source: WEO Database and World Bank staff calculations 16 BRIC is a grouping acronym that refers to the countries of Brazil, Russia, India and China. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 51 Productivity growth, consumer confidence in aims--defusing Western influence, but in a more the US, and a steady decline of debt levels in cosmopolitan way than had been represented by the Southern Europe (after a debt workout for Greece BRICS—a grouping it allowed to fade by neglect. was finalized in 2016) have meant that the 2020- 2025 period has been one of economic stability Growth outside the high-income countries has and growth. By 2025 China has the world’s largest not been significantly more energy efficient than GDP (it had headlined as #1 in 2014 … but only in the past, so energy demand was strong after in now-discredited purchasing power parity (PPP) 2017. The increase of supplies from the Middle East terms), the US has surpassed the whole of the EU’s (reflecting subsiding tensions in the region) was not GDP, and the three of them together represent 60% enough to keep prices down; the oil price increased of the global economy. India has been growing fast steadily from 2016 on; in 2025 it is above $100/barrel and is in the midst of a momentous transformation, and seems poised to continue increasing. This gave but still as a much-smaller economy—albeit larger Russia fiscal breathing room and led the new Kremlin than Germany and Japan. leadership to focus more on economic reforms than foreign policy. The G8 never met again and the G7 had its last meeting in 2019 after these summits seemed High energy prices have also meant that financial to be increasingly powerless gatherings. The EU surpluses are again concentrated, and underpin managed to stay together but had to face the reality another source of international expansion of of different visions, scale down integration ambitions Russian and other non-Western banks, supported Figure 42: Shifting Orange Commodities (2005 Figure 43: Shifting Orange Financial Landscape = 100) Shifting Orange 250 Banking Regulation 5 200 4 3 150 2 Financial 1 Service 0 Banking FDI 100 Innovation 50 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 Capital Market Non-Fuel Index Crude Oil (petroleum) Depth Source: WEO Database and World Bank staff calculations Source: World Bank staff calculations and agree to special arrangements—notably starting by Sovereign Wealth Funds. Interest rates finally with the UK (where the narrow outcome of the ‘Brexit’ started to increase in earnest—in both nominal referendum did not manage to settle the issue) which and real terms—after 2017. The “search for yield” complicate further enlargement. dynamic of institutional investors is less of a feature of global markets, but growth and relative stability China launched its new international leadership around the world make sovereign debt from many strategy with the occasion of the G20 presidency countries attractive. in 2016—when it proposed the Hangzhou Initiative—a major reform of the group to make In terms of financial markets, the growth of it more legitimately inclusive. Its strategy, besides multidimensional capital flows, major new players the expanded role for the G20, involved the launch in the banking FDI scene and the wish by newly of a “new G5” dialogue (rumors had it that this and prosperous countries (and, of course, China) to the demise of the G7 were not coincidental) with diminish the role of the New York/London financial the US and EU, plus Japan and India. The inclusion axis meant supporting the growth of Dubai and of the latter two reflected one of China’s other Costa Rica alongside Hong Kong and Singapore 52 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future as alternatives. It also quietly undermined the Basel process by ignoring much of the guidance emerging from there, pushing for more flexible global financial regulation and the adoption of a more diverse set of rules reflecting country—and regional—differences. While it was not an intended consequence, regulatory arbitrage has been rampant since the early 2020s. Aggressive digital and online banking strategies (including “hosting” of small “community payment unions”) by a few banks proved successful and a major strategic differentiator. Many banks hung on to what proved a perishable notion of customers wanting ‘brick and mortar’ bank branches and failed to adapt quickly enough. The late 2010s saw the emergence of many financial service innovators responding to a willing-to-experiment attitude by some regulators in major countries and regulatory loopholes (often in-between regulatory silos) in others. Many new options emerged reflecting local circumstances—and paved the way for international “umbrella” systems that use Blockchain-based platforms and/or distributed ledger approaches. Access to credit was changed forever by new players: Lending Club had paved the way in the US when it had $2billion turnover in 2016 with Alibaba rumored to have done even more lending business, by 2020 a few sophisticated crowd funding/lending platforms were quickly becoming major international players and/or franchises. Reality had swept away doubts on crowd-funding by 2020 (just as a decade earlier Wikipedia had done with knowledge). Non-bank mobile payment mechanisms have spread widely. Credit cards are going the way of the music CD—replaced by crypto transfers and the financial version of the Internet of Things. Social media platforms have added financial options that have been eagerly embraced by young users—a glimpse of that could be gained back in 2015 by looking at the wildfire-speed popularity of Venmo (that taps into networks like Facebook) among college students in the US. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 53 Unsettling Grey The world economy has had a ‘lost decade’ featuring: a divergent but generally bleak set of economic performances by countries in Europe; a major set-back in China (the ‘hard-landing’ included a banking crisis, a wealth management product bubble burst and local government fiscal and debt chaos); and secu- lar near-stagnation in US (the ability to take hard, far-sighted decisions severely handicapped by partisanship in Congress). India could not find a way to decou- ple itself from all of that and experienced growth well below the high expecta- tions of the start of the Modi period while Brazil hosted the Olympics and is still stuck in a crisis from which it has had two false recoveries, and which seems to have no end in sight. Both commodity exporters and manufacture has been under severe constraints for so long that exporters among emerging economies have austerity is no longer a term under discussion—more suffered from ripple effects from weakness in the lavish alternatives are not at all viable. Corporations Chinese economy and the lack of demand from with significant cash reserves wield great power and Europe. Most countries with significant population have extracted juicy concessions from cash-strapped growth have seen their per capita incomes stagnate— governments by offering upfront payments. or even decline. Public expenditure in many countries Figure 44: Unsettling Grey Growth: Advanced Figure 45: Unsettling Grey: Nominal GDP and Emerging 10% Rest of the World Emerging 5% Rest of the World Advanced China 0% European Union -5% United States 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 - 25 50 Advanced Economies Trillion USD Emerging Economies 2015 2025 Source: WEO Database and World Bank staff calculations Source: WEO Database and World Bank staff calculations 54 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future In 2025 the US continues to be the largest economy stronger fundamentals have allowed it to muddle in the world—20% larger than the EU and more through the decade with slow but steady growth. than 50% larger than China. Unfortunately, this is not due to a strong performance of the US economy Many countries around the world with fragile but of even weaker situations elsewhere. Trade has political situations have seen instability and even continued to grow slightly faster than the anemic turmoil. And the world has no functioning global GDP pace but there has been creeping protectionism engagement platform: the G20 has proven ill-suited (including through local content regulations) and a and is just going through summit motions without greater share of trade exchanges has taken place impact; the UN is paralyzed by rhetoric (the beautifully within preferential trade agreements (PTAs)—eroding convoluted sustainable development goals (SDGs) part of the benefits of globalization but at the same that were agreed in 2015 have not been pursued in time it has created some new opportunities for any practical way) and by paralyzing Security Council enterprises focusing on regional markets. vetoes. China ‘stuck to its knitting’ as economic, Figure 46: Unsettling Grey: Commodities Figure 47: Unsettling Grey: Financial Landscape (2005=100) Unsettling Grey 250 2015 Baseline Banking Regulation 200 5 4 3 150 2 Financial 1 Service 0 Banking FDI 100 Innovation 50 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 Capital Market Depth Non-Fuel Index Crude Oil (petroleum) Source: WEO Database and World Bank staff calculations Source: World Bank staff calculations It is a world in which most countries forgo social and inter-regional problems require the environmental protection to avoid any further leadership’s full attention and do not create a dampening of economic growth and investment favorable environment for global assertiveness. in renewable energy sources has suffered from low energy prices, fiscal constraints and corporate In Europe, worsening economic performance balance sheet pressures. The Middle East has in Italy and in some of the most recent entrants remained mired in intractable tensions which have to the euro area, together with a lack of final kept their oil supply from increasing in any reliable resolution of the debt situation in Greece (where way—this combined with weak demand has left 2025 the economy showed no signs of recovery by end- oil prices above their 2015 lows but volatile (prices 2016) forced consideration of an alternative to dropped below $30/barrel in 2020) and still well the euro and generated much capital flight from below the budget break-even point of oil-dependent the weaker euro nations. A two-euro approach was countries. The financial reserves of Gulf countries introduced in 2017 but by 2019 it had proven not have been largely depleted and weak oil/gas prices viable and Germany led the way back to the old have severely undermined the Russian economy. In national currencies—goodbye ECB! The 2016 Brexit this context, the Kremlin exhibited further populist referendum did not really manage to settle the issue belligerence (in Georgia and Moldova … besides which remains a source of uncertainty and budget Ukraine) which strained relationships even further. cuts in Brussels killing any appetite for further Moreover, Turkey’s balance of payments problems enlargement or deeper integration, and by 2025 the have proven to be a major constraint requiring a EU has evolved into a multi-tier agglomeration (no painful adjustment in the late 2010s while Poland’s longer a community) of nations. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 55 Persistently low interest rates have put great pressure on pension funds and insurance companies—which have become a major new area of consumer protection concern. In that uncertain and volatile financial market environment, relaxation of regulatory pressure on banks has been required—Basel had to address the trade-off between safeguarding risk and producing banking paralysis and BIS prescriptions have proven very divisive. Many countries (in part influenced by the situation in Europe) have introduced capital controls and measures to ring-fence their financial systems. Together with the generalized market view that sovereign debt (except for the few countries considered ‘safe heaven’) is “junk”, this environment makes it difficult and expensive for countries to obtain external finance, unless their financial and fiscal discipline earns them stand-out credibility. Risk levels have been high throughout the decade and many large banks continue retreating towards their core markets—closing down or selling subsidiaries. HSBC’s exit from Brazil in 2015 was just the first step in a broader retrenchment and, in Europe, by 2020 the previously adventurous Austrian banks had already cut in half the number of countries where they have a presence. With their banking landscape looking bleaker, many countries resorted to state-owned banking initiatives—which only exceptionally appear to provide more than a poor patch-up solution. Impetus for innovation in financial services and payment systems has been dampened by economic weakness and by major waves of cyber-crime and terrorist hacking. Only piecemeal innovation is taking place on capital markets, financial services and payment systems and it revolves around low-end products of the m-Pesa type and reducing transaction costs for remittances 56 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Orderly Blue This is a world that favors incumbents—including both the old advanced countries and well-established international banks. The G7 remains predominant politically and economically—reflecting the strength of the US economy (not least through a new productivity impetus) and, finally, a graduation from recovery to steady growth in Europe. Growth has moderated overall for emerging and developing countries that in the early 2000s had been growing fast—with averages masking periods of significant set-backs for a number of major countries (including Brazil and Russia which took longer than was expected in 2015—the latter especially hampered by persistently low oil prices). Low oil prices have been a major help to India—which has been the decade’s world fastest growing country. The net global effect has been modest growth over a distant memory—as the growth path divergence is the decade and the annihilation of what in 2015 among individual countries not categories. Poland, seemed like the “new normal” growth differential for instance, has grown steadily at rates even higher between advanced and emerging countries. In than the EU average while Turkey has had more of a 2025 the “two-speed economy” notion has become stop-and-go performance. Figure 48: Real Growth: Advanced and Emerging Figure 49: Orderly Blue: Nominal GDP 10% 5% Rest of the World Emerging Rest of the World Advanced 0% China European Union -5% United States 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 - 25 50 Advanced Economies Trillion USD Emerging Economies 2015 2025 Source: WEO Database and World Bank staff calculations Source: WEO Database and World Bank staff calculations Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 57 The resumption of solid growth in Europe, and countries in MENA. The end result has been that oil continued, steady growth in the US underpin the prices have remained in a narrow range around $35/ resurgence of the G7 and associated institutions— barrel—not having recovered from the 2015-2016 while China made little progress during the troughs as much as other commodities have. decade in terms of its GDP catching up with that of the US. Not unrelated, the Annual Meetings of the Modest increases in interest rates in advanced World Bank and IMF have regained their prominence countries have lessened the “search for yield” as a global point of encounter, and the leadership pressure and made markets more selective in succession in both institutions did not offer a break their perceptions of sovereign debt risks—as with the past—by 2025 C. Lagarde has been twice evidenced by the widened range of credit default re-elected as MD of the IMF and L. Summers is in his swap (CDS) levels. Figure 50: Orderly Blue: Commodities Figure 51: Orderly Blue: Financial Landscape (2005=100) Orderly Blue 250 2015 Baseline Banking 200 Regulation 5 4 150 3 2 100 Financial 1 Service 0 Banking FDI 50 Innovation 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 Non-Fuel Index Crude Oil Capital Market Depth Source: WEO Database; World Bank staff calculations Source: World Bank staff calculations second term at the helm of the World Bank. Trade 2017 was an important year for Europe. It started volumes have grown at a slower pace than global with the Greek debt workout being finally digested GDP, as the ‘re-shoring’ of manufacturing to the US by all concerned (after Greece implemented and Europe has been facilitated by rapidly expanding reforms, regained credibility and managed to adoption of robotics and new technologies (notably reactivate its economy in 2016). In the middle the rapid spread of additive manufacturing—which of the year the G8 process was reactivated—with in its infancy used to be called 3-D printing). There Russia participating in a high-spirited summit in Italy has been some narrowing of wage differentials and in recognition of the EU-Russia rapprochement and a reversal of the trend in labor unit costs to the invited to host the 2019 summit. This helped create advantage of advanced countries and higher-income a stable environment in Europe and open the door emerging countries. for efficiency-inducing pan-European infrastructure projects. Elsewhere the alliance between India and In the absence of the pressures from economic the US has become closer. China has been focused on crisis, environmental concern has again moved to solving internal challenges (including those resulting the front of policy and public opinion concerns in from an economic set-back in 2016-2018) and it is many countries, and new efforts to improve energy less visible in the international arena--focused on efficiency and foster development of renewable economic diplomacy in pursuit of specific interests energy sources in high-income countries have rather than global prominence. And tensions in the proven fruitful. Together with growth hiccups among Middle East have lessened. emerging countries, this has kept demand for energy commodities in check. Supply has benefited from a more stable situation in a number of oil-producing 58 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Three more countries were granted EU accession before 2025 and several more are close to that milestone. Renewed faith in the euro area has made possible progress towards banking and capital market unions in the EU, moving ahead of the 2015 road map pace. Addressing the need for critical mass for capital market operations in smaller EU members and members-to-be, the Vienna Financial Center was fully operational by 2020 and has proven a successful platform for corporate listings and public and private debt issues—with security pricing and CDS levels rewarding good governance and transparency. The resumption of economic growth in advanced countries has dampened the anti-growth criticism of strict banking regulations that was emerging when major economies seemed to be gravitating towards secular stagnation. The Basel approach has taken strong roots and implementation has proceeded apace. Together with renewed anti- money laundering efforts combating the financing of terrorism, regulatory dynamics have had the effect of accelerating concentration and consolidation of the banking industry in the EU and elsewhere— as compliance costs become prohibitive for small banks. International banks are further curtailing activities outside their home bases; but retrenching by major Western banks from emerging markets stopped well short of the worst 2015 fears in CESEE. Alignment of views between major Western country regulators and large banks has resulted in financial service and payment innovations being rolled out cautiously—and they are reaching the consumer mainly through incumbent financial institutions. Large banks that developed a sophisticated hybrid of in-person and on-line banking are doing particularly well. However, in countries adopting Basel-type regulations often the unintended effect has been a proliferation of regular financial services being offered by non-banking institutions and “shadow banking institutions”. Meanwhile, consumer interest in more novel approaches to payments and crowd- lending was dampened by a series of high-visibility Ponzi schemes and other cyber-fraud. Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 59 V. Conclusions and Next Steps 60 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Financial systems in the Western Balkans continue —including in the EU. Finally, Orderly Blue provides to face a number of challenges to financial sector many opportunities for the region with its positive development and stability in both the short- and evolution of the EU economy and integration medium-term. Tackling these challenges is urgent processes. and will determine each country's ability to make the most of whatever shape the world takes by 2025. The initial discussion at the regional level provided Across the region, high levels of NPLs need urgent a strong sense of the importance at both levels of policy attention by strengthening the corporate and action (regional and national) to ensure that the personal insolvency and creditors’ rights regimes region arrives at 2025 with financial systems that as well as regulatory classification and provisioning are ready to make the best possible contribution to standards. Further deleveraging remains a risk as economic growth and prosperity. It also provided a some parent banks plan to further scale back their valuable perspective and insights on the importance presence in the region as a result of continued of coordination and cooperation within the region. In market and regulatory pressures. Shifts in banks’ exploring possible implications of the scenarios for funding models, increased competition, as well low the financial systems in the region a number of key bank profitability levels in some countries in the questions and issues were identified in discussions region, may require further bank consolidation to with internal and external stakeholders - including adjust to the new circumstances. The development as part of the discussions held with regional of regional capital markets to provide stable and policymakers and financial regulators during the longer-term funding alternatives is key to mitigating regional high-level seminar in Vienna in November potential shortcomings in this context. Given the 2015. The key issues are: high dependency on foreign currency lending and borrowing, active policies to increase the use of • Global financial market dynamics: local currencies should be pursued both to reduce Developments in the global financial markets financial stability risks and to afford greater degrees have a significant impact on the region because of policy freedom to monetary authorities. of the small size of their financial markets as well as monetary policy regimes being dependent Over the longer term, the outcome of a number on broader monetary and exchange rate of critical uncertainties in the external context dynamics. The question of currency ‘affiliation’ will shape the future of the Western Balkans becomes key in the Unsettling Grey scenario, financial systems – creating new opportunities where core EU countries revert to national and challenges. The uncertainties explored in this currencies. Orderly Blue highlights managing report focus on dynamics outside the region with risks and opportunities arising from further particular relevance for the Western Balkans financial tightened Basel-type regulations becoming systems. They cover both global factors—such as widely adopted and implemented across economic dynamics, geopolitics, financial markets countries—including through the EU Banking and technology-based innovation—and dynamics Union. While Shifting Orange raises important more specifically related to the EU. Acknowledging strategic questions in a world where regulatory existing uncertainties and thinking through how they loosening and fragmentation generates wide- could shape the future options for policy makers and ranging perceptions of risk across countries and regulators to manage national financial systems is a room for regulatory arbitrage. As countries in valuable preparation for the eventualities of change. the Western Balkans have significant reliance on foreign banks and their capital inflows, the This report presents three scenarios that were dynamics of banking FDI and cross-border credit developed to explore different possible ways poses an important uncertainty. In Unsettling in which these uncertainties could play out and Grey (and to some extent in Orderly Blue), swift drive change. Each of the scenarios sketches out reaction to funding risks stemming from parent the characteristics of a different shape the world bank deleveraging and retrenchment would could take in 2025. The dynamism of the global be important. There is a need for strengthened economy in the Shifting Orange scenario presents corporate governance and resolution regimes as many opportunities for countries in the region but well as diversification of funding sources including might also require much rethinking of conventional via regional capital market development and assumptions. Conversely, the turmoil in the global domestic resource mobilization. Public banks or economy in the Unsettling Grey scenario presents domestic development banks could also play an many challenges for the region given the low increasing role to facilitate long-term finance and growth environment and fragile political situation counterbalance cyclical effects, however distortive Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 61 effects in their institutional and governance setup World Bank therefore aims to organize scenario would need to be avoided. analysis workshops at the national level with the aim of supporting financial sector policymakers and • Financial innovation: For policymakers regulators in using the scenarios and thinking around and regulators financial innovation can raise the uncertainties and change that underpin them. issues of mandate adequacy as well as the need to balance tensions between regulation and In particular, the scenarios can serve in testing innovation while helping the regional financial policy options under consideration and inform systems leapfrog in terms of depth and inclusion. the development of financial sector strategies This is of particular importance in the case of that contribute to the country's overall success the Shifting Orange scenario. There needs to be in sustainable and inclusive growth. Each scenario further emphasis placed on dealing with large- spotlights different challenges and opportunities scale cyber threats. that would be useful for financial policymakers and regulators to consider. In exploring policy responses • EU integration and regional coor- to the implied challenges and exploiting the dination: While EU integration and harmoni- opportunities, the illustrative questions in Table 6 are zation is recognized as an important anchor of meant as a starting point for exploration of scenario reform in the region, cross-country harmoniza- implications and ‘strategic action’ at the national tion can play an important role in attracting and level. The issues and questions are highlighted in facilitating investments, as well as transferring the ‘world’ where they are most critical, this does not knowledge—independent of the fate of the EU in preclude their relevance for other scenarios. They each scenario. Providing a regional platform for revolve around the following policy areas: (i) bank regulators and policy makers to facilitate a joint regulation, supervision and coordination, (ii) financial discussion would be of significant value. In all intermediation, (iii) regulation and supervision of scenarios such a forum would help the region co- new entrants/players, (iv) financial sector stability ordinate and cooperate to the mutual advantage and security, and (v) financial infrastructure. of all countries. There would be additional value Comparing appropriate responses across scenarios in using cooperation to create a positive regional will provide insights on key policy areas that need to "brand" that would help overcome the otherwise be addressed no matter what the future looks like, limited visibility of individual countries. and shed light on policy areas that are not given sufficient attention in the current policy dialogue. • National policies: Although the scenarios Moreover, the scenarios can help test policy options intentionally differ from each other in terms of the under consideration and inform the development mix and nature of challenges and opportunities, of financial sector strategies that contribute to the the discussion during the regional seminar country's overall success in sustainable and inclusive pointed strongly to the differential effect that growth. national policies and decisions could have. By 2025 the progress on structural reforms made by each country, including in the financial sector, will determine how they fare--in absolute and relative terms. Countries that have progressed with structural reforms will be better equipped to address challenges and benefit from opportunities in any of the scenarios. While the regional level discussion provides a useful validation of the scenarios and a starting point for analyzing implications for actions, the greatest value to be derived from the scenarios will be at a national level to inform financial sector strategies and action plans. It is the country level where most policies and regulations are set and, therefore it is in that context that exploring key uncertainties highlighted in this report and drawing the implications emerging from each scenario will offer most value. Going forward, the Table 6: What if? Select Issues Requiring Particular Attention of Financial Sector Policymakers and Regulators in Each Scenario 62 POLICY AREAS SHIFTING ORANGE UNSETTING GREY ORDERLY BLUE Bank Regulation, • How to manage risks and opportunities • How to address weaknesses in the local • What steps does it take to ensure institu- Oversight and arising from the loosed and fragmented banking sector and high backlog of tional capacity/resource adequacy of financial Coordination global regulatory environment in this non-performing loans stemming from this regulators/supervisors in light of accelerated Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future world? ‘lost decade’- world? EU integration towards banking and capital markets union? • How to balance the tension between • How to deal with FX lending risks in the regulation and innovation to help regional wake of a severe exchange-rate deprecia- • How to deal with the risks of disorderly financial systems leapfrog in terms of tion and consequent losses for banks? deleveraging of western parents and banking depth sector consolidation? • What does it take to strengthen and inclusion? corporate governance of banks? • How to ensure coordination related to • How to approach new dynamics in capital markets development among key • How to enhance coordination of home home-host interactions? What will be regional stakeholders? and host authorities related to decisions required to ensure cooperation and on the disposal of foreign subsidiaries as • What new and differentiated positions exchange of information between disinvestment occurs? vis-a-vis EU/EMU membership (full member- regulatory and supervisory agencies within ship vs giving up national policies, which and across jurisdictions? facilitate absorption of losses, too early) • How best to approach international should be considered? partnership 'diversification' beyond the EU? Platform facilitating regional integration and harmonization? Financial sector • How to leverage financial inclusion and • With the retreat of foreign banks at the • How to deal with negative effects of intermediation efficiency improvements stemming from start of the 2015-2025 decade not having banking sector consolidation/concentration (credit growth/intermedi- financial innovation? been reversed, what are the options to on competition/cost of credit? ation and non-bank avoid a slump in the availability of credit? • What macro prudential tools are • What steps could be taken to ensure that financial sector develop- required to manage boom cycles? • What macro prudential policy tools are credit growth is supportive of private sector ment) needed to manage bust cycles? activity—even in the context of restrained • How to create a level-playing field foreign bank activity? between similar financial services? • Do public banks or domestic develop- ment banks have a role in filling the gap in • Could microfinance and leasing sectors play • How to leverage recurrent payment lacking credit intermediation? How to a role in filling the gap of smaller banks? streams, such as Government to Person avoid distortive effects with regards to (G2P) and remittances? • How to advance the legal and regulatory their setup? framework for capital market development? • How to gain visibility in the new investor • How to best balance the major stability landscape? • How to build up the institutional investor challenge this world provides with the aim base? of increasing financial depth and inclusion? • How to foster transparency and integrity of capital market data? POLICY AREAS SHIFTING ORANGE UNSETTING GREY ORDERLY BLUE Regulation and • How to regulate new (digital) financial • How to set up institutional, supervisory • Proportionality & risk-based approach: How supervision of new service providers commensurate with their and governance frameworks of public to design regulation and supervision of entrants/players risks and activities? banks/domestic development banks? nonbank service providers commensurate with their risks and activities? • How to address data protection, sharing • How to design government support and ownership as well as digital financial programs and instruments aimed at • How to set up institutional arrangements for Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future consumer protection issues? addressing market failures? non-bank financial institutions (NBFI) regula- tion and oversight in a world of expanding • What needs to be considered when • What does it take to strengthen NBFIs and ‘shadow banks’? designing regulatory mandates and financial consumer protection regimes? strengthening supervisory capacity to match the new financial player landscape and associated risks? Financial sector • What Anti-Money Laundering/Combat- • What measures are needed to address • What measures are needed in supervising stability and security ing the Financing of Terrorism policies the increased sovereign-bank nexus? and regulating the shadow banking system? need to be introduced in relation to digital • What does it take to strengthen the • How much of a priority should being ready financial services and new players and existing financial safety net? for large-scale cyber threats be? products? • What currency 'affiliation' and other • What will it take to address regulatory options are there as core EU countries arbitrage arising from loosened bank revert to national currencies? regulation? • How to avoid contagion including bank runs as risk perceptions about emerging market countries become heightened? Financial • How to strengthen infrastructure to • What steps are needed in financial • What steps are needed in financial Infrastructure support responsible digital lending? infrastructure development underpinning infrastructure development in light of (secured transactions safe and efficient transactions and increasing regional and EU integration? • What will it take to ensure interoperabili- framework, credit lowering the costs and risks to fi¬nancial ty among digital services providers, and • How can small countries become pioneers reporting system, service providers? between them and traditional financial in a world of limited innovation in financial insolvency regime and service providers? services and payment systems? payments systems) 63 64 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future ANNEX 1: Scenario Analysis Methodology What is scenario analysis? responses of the organization(s) concerned to each of the plausible future scenarios. As a methodology, scenario analysis does not • Comparing possible responses. Finally, the attempt to predict the future; rather, it aims to stretch responses to the different scenarios are compared. the boundaries of the plausible. Scenarios explore a Two elements in the comparison require special few diverse eventualities of how the world might look attention. First are the actions that can be found if the most uncertain and important drivers unfold in in all responses and tend to be associated with different ways. low risk. Second are the responses that differ among scenarios. Responses in these fields may The basic process of scenario analysis includes the require further assessment to understand how following steps: the impact of change on these variables can be managed. • Identifying predetermined factors, namely future developments that are predetermined, that Why scenario analysis? is, will take place in any scenario. As an example, population growth is a variable that tends not to change quickly. Scenario analysis is used as a complement to • Identifying critical uncertainties. These are areas forecasting. It helps explore a longer term horizon in which the future is uncertain and can easily flip- and recognizes the uncertainties faced by financial flop. An example of a highly critical uncertainty in policymakers and regulators in the region. Trend many countries is the type of government: right analysis is based on the assumption that the factors or left wing. that drove change in the past will continue to drive it in the future. Scenarios, on the other hand, are not predictions, but hypothesis of different futures • Developing scenario plots. A scenario is defined specifically designed to highlight the risks. by combining a small number of sets of critical uncertainties. A comprehensive description of how the future would look under this scenario is Who uses scenario analysis? then developed. These futures must be plausible. • Consultation. A rigorous consultation process Scenario thinking was originally used by the US will be carried out to clarify the scenarios and to military in World War II. Subsequently, corporations make them representative. This process involves began using this methodology to guide their presenting the scenarios to a large number strategic directions in the medium and long term; of people who have expertise relevant to the Royal Dutch/Shell is probably the most well-known. scenario exercise, collecting their comments, The World Bank Group uses elements of scenario and subsequent incorporating the comments in thinking in crisis simulation exercises. More recently the framework and scenario stories. Part of the the Organization for Economic Co-operation and consultation phase is further research in areas in Development (OECD) used scenarios as a basis for which new or more knowledge will improve the a policy discussion at its 2015 Ministerial Meeting. quality of understanding. • Assessing the implications of different scenarios. An assessment is made of the best possible Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 65 ANNEX 2: Scenario Configuration on the Uncertainty Continuum 66 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Shifting Orange Geo-politics Convergent Divergent Economic Growth Strong Weak Centers of Gravity Emerging Advanced Trade Patterns Liberal Protectionist Energy Price Low High Global Monetary Expansionary Contractionary Sovereign Debt Sought Shunned Banking Regulation Loose Tight Banking Landscape Expanded Concentrated Capital Markets Deepened Unevolved Financial Service Innovation Lively Inhibited Payment System Cutting-edge Traditional EU Consolidation Forward Backward EU Enlargement Accelerated Stalled Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 67 Unsettling Grey Geo-politics Convergent Divergent Economic Growth Strong Weak Centers of Gravity Emerging Advanced Trade Patterns Liberal Protectionist Energy Price Low High Global Monetary Expansionary Contractionary Sovereign Debt Sought Shunned Banking Regulation Loose Tight Banking Landscape Expanded Concentrated Capital Markets Deepened Unevolved Financial Service Innovation Lively Inhibited Payment System Cutting-edge Traditional EU Consolidation Forward Backward EU Enlargement Accelerated Stalled 68 Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future Orderly Blue Geo-politics Convergent Divergent Economic Growth Strong Weak Centers of Gravity Emerging Advanced Trade Patterns Liberal Protectionist Energy Price Low High Global Monetary Expansionary Contractionary Sovereign Debt Sought Shunned Banking Regulation Loose Tight Banking Landscape Expanded Concentrated Capital Markets Deepened Unevolved Financial Service Innovation Lively Inhibited Payment System Cutting-edge Traditional EU Consolidation Forward Backward EU Enlargement Accelerated Stalled Financial Sector Outlook: Financial Systems in the Western Balkans – Present and Future 69 Acknowledgements The Financial Sector Outlook: Financial Systems BiH), Belma Colakovic (Central Bank of BiH), Deniz in the Western Balkans – Present and Future was Deralla (Bank of Albania), Eva Doda (Ministry of developed by the World Bank Group’s Finance & Finance of Albania), Nikola Fabris (Central Bank of Markets Global Practice. Montenegro), Mentor Geci (Central Bank of Kosovo), Marjan Gjermeni (Bank of Albania), Zdravko Grubac The main authors comprises Johanna Jaeger (task (Ministry of Health and Social Welfare of Republika team leader), Cevdet Unal, Jane Bogoev and Pamela Srpska), Mariya Hake (National Bank of Austria), Lintner. Enrique Rueda-Sabater supported the Shkendije Himaj (Central Bank of Kosovo), Anna Ilyina development of the scenarios. The core team also (IMF), Slavica Injac (Banking Agency of Republika included Jasmina Mrkonja and Luis Alton. The team Srpska), Ana Ivkovic (National Bank of Serbia), Milica is grateful to Ellen Goldstein (Country Director, South Kilibarda (Central Bank of Montenegro), Daehaeng Eastern Europe), Aurora Ferrari (Practice Manager, Kim (IMF), Srdjan Kokotovic (Ministry of Finance Finance and Markets Global Practice) and the South of Serbia), Edvard Kotoric (Banking Agency of Eastern Europe Country Management team for the Federation of BiH), Agim Krasniqi (Ministry of their guidance in the preparation of this report. The Finance of Kosovo), Aneta Krstevska (National Bank team is thankful to the World Bank Financial Sector of FYR Macedonia), Erjon Luci (Ministry of Finance Advisory Center (FinSAC) for their support in hosting of Albania), Bojana Mijovic (Ministry of Finance of the high-level regional seminar in Vienna. FYR Macedonia), Zlatko Milikic (Ministry of Finance of Serbia), Hekuran Murati (Ministry of Finance of The team is particularly grateful to Aquiles Almansi, Kosovo), Ingrid Orgocka (Deposit Insurance Agency Ilias Skamnelos and Desiree van Welsum for their of Albania), Vesna Papic (Central Bank of BiH), Tanja insights and time throughout the development of Pavlovic (Banking Agency of the Federation of the scenarios. The team would also like to thank BiH), Zeljka Rakocija (Banking Agency of Republika (in alphabetical order) Ruvejda Aliefendic, Gallina Srpska), Francisco Ramon-Ballester (European Andronova Vincelette, Rinku Chandra, Syzana Central Bank), Snjezana Rudic (Ministry of Finance Dautaj, Wolfgang Fengler, Indermit Gill, Katia of Republika Srpska), Petar Sekulic (National Bank D’Hulster, Michael Edwards, Keler Gjika, Ayhan of Serbia), Ivana Selakovic (National Bank of Serbia), Kose, Matija Laco, Igor Matijevic, Fernando Montes- Klodian Shehu (Bank of Albania), Barbara Stearns- Negret, Franziska Lieselotte Ohnsorge, John Pollner, Blaesing (European Commission), Mila Strazivuk Blerta Qerimi, Martin Raiser, Roberto Rocha, Gabriel (Ministry of Finance of Republika Srpska), Dragana Sensenbrenner, Hilda Shijaku, Bojan Shimbov, Marc Strika (Ministry of Finance of Republika Srpska), Peter Stocker, Dusko Vasiljevic, Hans Timmer, Danijela Tabak (EBRD), Lence Tagsovska (Ministry of Finance Vukajlovic-Grba for their insights and support during of FYR Macedonia), Mile Tamanovic (Banking Agency the preparation of the scenarios. The team is also of Republika Srpska), Erald Themeli (Bank of Albania), grateful to Nurgul Irsalieva and Lejla Zaimovic for Nedzad Tuce (Banking Agency of the Federation of their administrative support in preparation of the BiH), Gert Wehinger (OECD), Niklas Westelius (IMF), seminar in Vienna (all World Bank Group). Johannes Wiegand (IMF), Endrita Xhaferaj (Albanian Association of Banks), Albulena Xhelili (Central Bank The work on the scenarios was conducted in of Kosovo), Adela Xhemali (Ministry of Finance of consultation with regional stakeholders and other Albania). development partners. The team would like to thank the participants of the consultation rounds and high- We are also grateful to Jerry Caprio, Stjin Claessens, level seminar (in alphabetical order): Natasha Ahmetaj Charles Collyns, Alessandro Magnoli, Jim O'Neill, (Bank of Albania), Milica Arnaudova Stojanovska Beatriz Reyero and Liliana Rojas-Suarez for taking (National Bank of FYR Macedonia), Natasa Atlagic the time to share their valuable perspective in the (Ministry of Finance of Republika Srpska), Zlatko scenario development process. Bars (Banking Agency of the Federation of BiH), Martin Blushi (Deposit Insurance Agency of Albania), Nusreta Cerkez (Ministry of Finance of Federation of