CENTRAL BANK OF MONTENEGRO ANNUAL REPORT 2007

Transcription

1 CENTRAL BANK OF MONTENEGRO ANNUAL REPORT 2007 Podgorica, 2008

2 PUBLISHED BY: WEBSITE: CENTRAL BANK COUNCIL: TRANSLATED BY: DESIGNED BY: Central Bank of Montenegro Bulevar Svetog Petra Cetinjskog Podgorica Telephone: , Fax: Ljubiša Krgović, MS, President Milojica Dakić, MS Petar Drakić Velibor Milošević, MS Krunislav Vukčević Radmila Savićević Franjo Štiblar, PhD Central Bank of Montenegro, Translation Services Division Andrijana Vujović PRINTED BY: Opus 3 PRINTED IN: 150 copies Users of this publication are requested to make reference to the source of information whenever they use data from the Report.

3 CONTENTS FOREWORD BY THE PRESIDENT OF THE COUNCIL OF THE CENTRAL BANK OF MONTENEGRO vi 1. ACTIVITIES OF THE COUNCIL OF THE CENTRAL BANK OF MONTENEGRO AND THE AUDIT COMMITTEE IN CBM Council Activities in Audit Committee Activities OVERVIEW OF MACROECONOMIC ENVIRONMENT BANKING SECTOR SUPERVISION AND REGULATION Supervision of the Banking Sector Supervision of the Banks Exposure to the Risk Measures against Banks Issuing Licenses, Permits and Approvals Changes in Regulatory Framework PAYMENT SYSTEM OPERATIONS Payment Operations Regulation and Supervision Indicators of RTGS and DNS systems availability Enforced Collection FINANCIAL AND BANKING OPERATIONS Foreign Exchange Reserves Management International Payment Operations and Correspondent Relationships Banking business and services Vault 38

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5 6. MACROECONOMIC ANALYSES AND RESEARCH Reporting on Macroeconomic Developments Implemented projects OTHER IMPORTANT ACTIVITIES OF THE CENTRAL BANK International Cooperation Internal Audit IT Support Human Resources Management Public Relations MACROECONOMIC ENVIRONMENT IN MONTENEGRO IN Prices Monetary developments Banking System Payment system operations Results of Processing Annual Financial Statements Fiscal policy Public Debt Financial Markets External Developments IMPORTANT EVENTS IN THE FINANCIAL SYSTEM IN ANNEX 97

6 FOREWORD BY THE PRESIDENT OF THE COUNCIL OF THE CENTRAL BANK OF MONTENEGRO The year 2007 was a year in which Montenegro developed intensive international cooperation and faced the challenges thereof. Montenegro became the 185th member of the IMF and the World Bank and the 40th member of the Council of Europe Development Bank. Montenegro and the European Union signed the Stabilisation and Association Agreement, the European Bank for Reconstruction and development adopted the first Strategy for Montenegro, the Central Europe Free Trade Agreement (CEFTA) came into effect, and the Board of Executive Directors of the World Bank endorsed a four-year Country Partnership Strategy for Montenegro. The Constitution of Montenegro was also passed, defining, inter alia, the new role of the Central Bank of Montenegro as the institution responsible for monetary and financial stability and the functioning of the banking system. With regard to the macroeconomic environment, Montenegro experienced powerful economic growth, a record inflow of foreign direct investments and tourism revenues, a fiscal surplus, an ongoing decline in unemployment and external debt, an increase in inflation, a noticeable decline in the stock exchange indices, and a very dynamic development of the banking system. Global oil and other raw material prices were reflected primarily in the increase in inflation, the rapid growth in credit and a record current account deficit, all accompanied by intensive investment activities. Such trends, however, did not have any serious effects on investors` confidence, as confirmed by the higher credit rating assigned to Montenegro. The main features of the Montenegrin banking sector in 2007 were an increase in the number of banks and micro-credit financial institutions, a rapid increase in the volume of activities, a worryingly high rate of credit growth, the banks` increased foreign borrowing, and the inadequate maturity structure of banks` funding sources and placements. Such developments resulted in a higher degree of banks` exposure to risk. However, banks also faced other numerous adverse macroeconomic implications: the increased current account deficit, inflationary pressures, a growing private external debt, and the like. Therefore, the Central Bank of Montenegro undertook a set of initiatives aimed at maintaining stability on the banking market. Among these being, a change in the organisation of the banking supervision department, amendments to the regulations governing banking activities, an improvement in the functioning of the Regulatory Credit Bureau and allowing banks` to access information stored in its database, stress testing of the banking system and individual banks, and the implementation of certain measures aimed at curbing the growth in credit, including the tightening of the reserve requirement policy, the implementation of prudential measures primarily aimed at better risk management, as well as introducing administrative restrictions on credit growth. The conceptualization of the aforesaid measures involved a prudent consideration of a target rate for credit growth (40%) that will not restrict economic growth. Therefore, it is reasonable to expect that Montenegro will have the highest credit growth rate in the region in the following year. Data for the first quarter of 2008 indicates that the CBM measures were successful, that is, the rate of credit growth reduced from 36.1% in the first quarter of 2007 to 9.8% in the corresponding quarter of the current year. The lending interest rates continued declining and the real interest rate was remarkably low. This decline was at a somewhat slower pace than in previous years, but this was to be expected considering the increase in international reference interest rates, the huge demand for credit, and an increase in inflation. vi

7 During the year, the Central Bank of Montenegro developed intensive cooperation with international institutions which was mainly determined by Montenegro s membership of the IMF and the WB. As the fiscal agent of the Montenegrin Government and the depository institution of the aforesaid international institutions, the Central Bank of Montenegro undertook the necessary steps with regard to paying the membership quota, the preparation of all documentation required for the closing of the accession procedure and the fulfilment of all pertinent obligations. The Central Bank of Montenegro also made a significant contribution to Montenegro`s path towards EU accession and this included participation in the following: the implementation of European Partnership recommendations (participation in the drafting of the EPAP), preparation of the National Program for the Integration of Montenegro into the EU, preparation of the Annual Progress Report of Montenegro in the process of EU accession, preparation of the Economic and Fiscal Programme (EFP), involvement in the Enhanced Permanent Dialogue with the EU, and the preparation of other documents within the Central Bank of Montenegro`s jurisdiction which are important for the process of European integration. With a view to rasing awareness and monitoring economic trends in Montenegro in order to provide high quality economic policy recommendations, the Central Bank performed regular macroeconomic research and carried out numerous important projects. Thus, we initiated and implemented the first survey of its kind to obtain empirical research on the average housing prices in Podgorica which formed the basis for the production of the real estate price index (REPI), calculated the core inflation rate for the first time, performed inflation forecasting using the fan chart model and undertook an analysis of the potential effects of capital market developments on the banking sector. The Central Bank paid special attention to the professional development of its employees with a view to ensuring better monitoring of the accelerated economic growth of Montenegro and the fulfilment of the country`s future obligations on its path to the EU. We will face great challenges in 2008 such as trying to achieve lower inflation and maintain financial stability in a situation of increased public spending, an expected increase in electricity and oil prices, and the like. In addition, another great challenge will be reducing the foreign trade deficit considering the low level of competitiveness of the Montenegrin economy, the high rate of consumption and the expected large inflow of foreign direct investments. The real challenge that the Central Bank of Montenegro will face in 2008 is the fulfilment of its primary constitutional obligation, this being the maintenance of monetary and financial stability and the stability of the banking system, considering its limited authority. It is expected that the positive effects of the measures already undertaken with a view to curbing credit growth and strengthening the banks` stability, especially the reduction of the operating risk in banks will be evident in In addition, a new Law on the Central Bank of Montenegro is expected to be passed during the year. The Council of the Central Bank of Montenegro President Mr. Ljubiša Krgović vii

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9 ACTIVITIES OF THE COUNCIL OF THE CENTRAL BANK OF MONTENEGRO AND THE AUDIT COMMITTEE IN

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11 1.1. CBM Council Activities in 2007 Although the Council of the Central Bank of Montenegro did not hold any meetings in the period following the termination of its mandate and the reappointment of the Council members, the Central Bank fulfilled all its functions in this period. Through the Chief Economist s regular reporting on developments in the real, monetary and fiscal sectors and balance of payments trends, the Council warned against the potentially adverse effects of a too rapid expansion of economic activity. As the term of office of the Council members expired on 15 March 2007 and their reappointment occurred on 8 May 2007, there was no April meeting of the Council. Therefore, the Council did not fulfil its obligation prescribed in Article 28 of the Law on the Central Bank of Montenegro to hold regular meetings, at least once a month. The Council granted licences to one bank, The First Financial Bank AD Podgorica, and a micro-credit financial institution KLIKLOAN D.O.O. Podgorica. During the reporting period, the Council paid special attention to all activities pertinent to the drafting of the new banking and payment system laws. With the proposals for a new banking law submitted to the competent authorities for adoption, the Council also initiated the adoption of the regulatory framework required for: - f ur ther implementation of modern banking standards and the new concept of capital adequacy requirements, - expanding the banking market by allowing the establishment of foreign bank branches without the status of a legal person, - the establishment of a better quality corporate governance in banks, - the fulfilment of the risk-based supervision function. The Council also adopted the text of the National Payment System Law regulating payment system operations through the implementation of international standards. The banking sector also experienced a dynamic growth in activities viewed through an increase in both deposits and loans. The Council assessed that too high a rate of growth in lending was unsustainable considering the maturity mismatch between the sources of funds. Therefore, in line with the powers vested by the law to maintain a sound banking system and with a view to preventing any adverse developments in the banking system, the Council passed measures aimed at curbing credit growth. Through the monthly reports of the General Manager, the Council monitored the Central Bank s operations and the implementation of the planned activities and developments in the monetary and financial system affecting the management and operations of the Central Bank. Special attention was paid to monitoring the developments on the capital market in order to ensure timely responses to them, and to prevent volatile movements, on this market affecting the banking sector. As a part of its legal authorizations, the Council adopted the Economic Policy Recommendations for 2008 which, with a view to providing a more comprehensive overview of the expected economic developments and the preparation of the economic policy for 2007, were submitted to the Government of Montenegro. The Council decisions have the character of general acts and were published in the Official Gazette of the Republic of Montenegro, and the public was regularly informed about the meetings held and all other important decisions passed by the Council in the reporting period through the media and the Central Bank s web pages. ACTIVITIES OF THE CBM COUNCIL AND THE AUDIT COMMITTEE 11

12 1.2. Audit Committee Activities The Audit Committee, as an operating body of the Central Bank of Montenegro Council, held eight meetings in at which it: - considered the Internal Audit Department plan and its implementation, recommendations and communicated their opinion on internal audit reports, primarily the annual report for 2006, the proposed internal audit plan for 2007 and the proposed internal audit plan for the period ; - considered reports on the status of the internal and external audit recommendations and communicated advice to the President of the Central Bank Council and the Council; - m o ni tore d t h e reliabili t y, t imeliness, and comprehensiveness of financial and other operational reports of the Central Bank of Montenegro through an analysis of the Bank s financial plan for 2008, the proposed measure regarding the use of the Special reserve fund, a draft Decision on the Central Bank chart of accounts and the financial reports of the Central Bank in 2007.; - provided conclusions, proposals, and recommendations to the Council and its President which referred to the improvement of the efficiency and effectiveness of the system of internal controls and internal audit in the Central Bank of Montenegro; CENTRAL BANK OF MONTENEGRO ANNUAL REPORT 2007 The Audit Committee contributed to the improvement of the procedure for the selection of an external auditor, pointed out the need to establish and improve the system of reporting through the preparation of quarterly reports in line with the Accounting Charter. 1 The Audit Committee Rules of Procedure prescribe at least one meeting per quarter. 12

13 OVERVIEW OF MACROECONOMIC ENVIRONMENT 2

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15 Last year can be viewed as a very successful and it showed continued expansion. The major trends that characterized 2007 were: high GDP growth, a budgetary surplus, a record inflow of foreign direct investments, an increase in the numbers employed as well as the very dynamic development of the banking system. However, the price of such an accelerated gorwth was paid in partial deterioration of macroeconommic stability, primarily reflected in increase in inflation, the current account deficit, and too rapid credit growth. Montenegro became a full member of the International Monetary Fund and the World Bank in According to preliminary estimates, GDP rose by 7% in The GDP increase was mostly driven by an increase in services, particularly in tourism, trade and financial intermediation. The core inflation rate was 3.2%. Whenever there is a large difference between the core and current inflation rate, there are restricted opportunities to influence the reduction of inflation using economic and monetary policy measures. The Central Bank of Montenegro has already taken one set of measures under its competence. We managed to restrict credit expansion through these measures, which will have an impact on the reduction in aggregate demand. Further scope, if there is a need, for having a possible influence on the inflation rate, should be primarily looked for in the fiscal policy domain. This means that an extremely high increase in either public expenditure or salaries could be counter-productive. Also, if there are inflationary pressures, there is still room to temporarily reduce certain categories of taxes and excise duties. Inflation was on an increase and amounted to 7.7%, measured by the cost-of-living index. The average annual inflation rate amounted to 4.2%. The reasons for this increase in inflation are both internal and external. The most important external reasons are connected with the increase in oil and food prices on the world markets. On the one hand, the internal reasons are the result of removing price disparities (increases in electric power prices and fixed telephone service charges), and on the other, the immediate consequence of significantly increased aggregate demand. It should be also taken into account that anti-monopolistic policy still does not function satisfactorily. However, it should be also borne in mind that the inflation rate was on the increase in almost all countries in 2007, both developed and in transition. Also, it should be kept in mind that it is of great importance for Montenegro to remove all price disparities before it joins the European Union, in order for us to qualify in the shortest possible term for membership of the European Monetary Union. Such a policy necessarily leads to a somewhat higher inflation rate. In any event, the experience of some Baltic republics, which met the inflation criterion for years and after entering the evaluation process for joining the European Monetary Union could not manage to meet the same criterion, can be quite instructive. Almost all of the monetary aggregates reached record levels. The money in circulation (monetary aggregate M21) was 71.8% higher, while the disbursed loans increased by 165% and deposits and household saving rose by 94% and 104%, respectively. The banks` assets amounted to almost EUR 3 billion and deposits exceeded the amount of EUR 2 billion. The maturity structure of deposits improved but it is still not satisfactory. The banking system proved to be, besides tourism, probably the most important initiator of economic growth. The loans growth rate was too high last year and it led to a series of negative effects. A significant portion of loans was used for the purchase of imported consumer goods which led to deterioration of the current account deficit. The huge credit expansion led to an increase in aggregate demand which again led to additional inflationary pressures. In a huge credit expansion environment, there is a danger of granting a portion of the loan to clients with a somewhat poor credit solvency. The maturity structure of banks` sources and investments is also a potential problem. Also, if certain signs of an overheated economy do exist, an extreme credit expansion may cause a deterioration of the situation. Such a high credit expansion could not have been financed from domestic sources (deposits and capital), therefore, OVERVIEW OF MACROECONOMIC ENVIRONMENT 15

16 for the first time in 2007 we experienced the situation of having more disbursed loans than deposits. The logical consequence was an increase in banks` foreign borrowing. Thus, the CBM passed the necessary measures aimed at restricting credit expansion. Most of the countries in the region also apply similar measures aimed at restricting credit growth. In addition to applying the aforementioned measures, it is reasonable to expect that Montenegro will have the highest credit growth rate in the region in 2008 as well. Thus, there is enough space for such measures and they are not expected to restrict economic growth. The lending interest rates continued their downtrend. The average weighed effective interest rate at end-2007 was 9.09% and in comparison with end-2006, it was 0.85 percentage points lower. The interest rates downtrend was somewhat slower than in previous years, but such a situation was expected, taking into consideration the growth of international reference interest rates, the high demand for loans as well as the growth in inflation. The real interest rate was low and amounted to only 1.4% at end Tourism remains the branch with the most dynamic development and it also affects the accelerated growth of other related branches. Tourism development is very important, for it largely influences the development of transportation, telecommunication, foodprocessing and furniture industry, as well as a whole set of other branches. The tourism industry in Montenegro recorded twodigit rates of increase for the fifth year in a row, and a positive trend is certainly the fact that the average number of tourist overnight stays increased. The number of tourists who visited Montenegro in 2007 and the number of recorded overnights were 18.8% and 23% higher than in 2006, respectively. For the first time since 1989 more than a million tourists (1.13 million) visited Montenegro. Thus, we are approaching the record number from 1989 and it could probably be exceeded in However, for the purpose of sustainable tourism development, it is essential to improve the infrastructure, preserve environment and strive to reactivate other types of tourism, besides coastal tourism. The level of economic activity in construction was somewhat lower than in the previous year, and this was largely the consequence of the high volume of activity in this sector at that time. The extremely high value of contracts concluded in the last quarter of the year suggest that a high level of activity in this sector should be expected in CENTRAL BANK OF MONTENEGRO ANNUAL REPORT 2007 A budgetary surplus was recorded for the second year in a row, amounting to EUR million (primary budget) or 7.4% of GDP. This is a record amount and such a trend can be regarded as quite positive. A budgetary surplus is an important prerequisite for system sustainability in euroised/dollarised economies. Also, we consider it positive that the budget, for the first time, consisted of the current budget, the capital budget and the budget of government funds. Industrial output was stagnant. This year s industrial output only showed that in small economies such as the Montenegrin one, problems existing only in few enterprises can significantly affect overall volume of industrial production. Due to numerous interruptions in the production of electric power, a fall of 27.4% was recorded in this field. Had the electric power production been at the last year s level, the level of industrial production would have been some 6.5% higher in Certainly, an encouraging fact was the resurgence in industrial production in the last quarter of Observed as a whole, growth in economic activity was recorded in transportation. Generally speaking, the condition of the transportation infrastructure is not satisfactory, but the official announcements and signed contracts for further investing in the transportation infrastructure in 2008 are encouraging. The level of economic activity in forestry was lower, and the main reason was the delay in signing concession agreements in forestry. After the upsurge of stock exchange indices at the beginning of 2007, their value started to decline from mid-may. In relation to their maximum value at end-2007, the stock exchange indices were some 23% to 34% lower. This confirmed our hypothesis that shares were overvalued, and that some readjustment was necessary. What is positive, is that the price adjustment was gradual, not a one-off shock. It also proved that the Montenegrin economy was dependant on the capital market to a small extent, for it would not be possible to achieve a high rate of growth in an environment of a dramatic fall in stock exchange indices. The net outflow of portfolio investments was EUR 5 million and it showed that a number of foreign investors withdrew from the Montenegrin capital market. The current account deficit is above all expectations and has become worrying. According to preliminary estimates for 2007, 16

17 it was over EUR 1 billion or around 45% of estimated GDP. Even though it is largely a consequence of accelerated growth, what is worrying is the fact that it is less covered by the inflow of foreign direct investments and that the share of private external debt is becoming higher. The FDI net inflow covered only 52% of the current account deficit in 2007, while the same coverage was 88% in The main reasons that led to an increase in the current account deficit were: the low competitiveness of domestic producers, the high level of imported electric power, an increase in global oil prices, the high FDI inflow, excessive consumption, the high growth rate of disbursed loans and so on. In a euroisation environment, the current account deficit has fewer risks than when a country has its own currency, but the options for their elimination are also narrowed since exchange rate policy can not be used. The growing deficit is often an indicator of growing imbalances: an excessive capital inflow, an overestimated value of property (securities and real estate), overheating of the economy and a deterioration in the balance sheet of the economy (an increase in indebtedness in the balance sheets). The foreign direct investments inflow is record-breaking. The FDI net inflow amounted to EUR 529 million and it was 12% higher when compared to the previous year. However, we cannot be fully satisfied with the recorded FDI inflow structure since over half of the inflow was in the field of real estate and related businesses. This is an indicator that tourism is the field in which Montenegro has significant comparative advantages, but it is of great importance to increase the FDI inflow in other service and production industries. According to preliminary data from the Ministry of Finance, the public debt of Montenegro amounted to EUR million at end-2007, which is 32.4% of the estimated GDP for The Maastricht criterion relating to public debt prescribes an upper allowed limit of 60% of GDP. External debt amounted to EUR million or 20.3% of GDP. The current level of indebtedness is acceptable and according to this indicator, the situation is better than in most EU member states. A deficit was only recorded in one of the balance of payments sub-account, while all the other sub-accounts recorded surpluses. This is the visible trade balance and the deficit exceeded EUR 1.5 billion. What is particularly worrying is the fact that exports decreased (- 4.5%) while imports grew sharply (44%). The structures of imports and exports balance are also unfavourable. In the structure of exports, basic raw materials represent two thirds of the exports. On the other hand, consumer goods prevail in imports, but an increase in the import of capital investment goods is also evident. OVERVIEW OF MACROECONOMIC ENVIRONMENT 17

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19 BANKING SECTOR SUPERVISION AND REGULATION 3

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21 3.1. Supervision of the Banking Sector The changes made in the organization of the CBM Bank Supervision Department in 2007 influenced the enforcement of supervision efficiency and the development of the risk based supervision concept, with the dominant role of the portfolio management approach in bank supervision. The bank supervision is organized in two segments, aiming at precise division between specialized supervisions for the individual risk and control of the general environment and systemic risk. Supervision of the banking sector was focused on the increase of targeted in relation to full scope examinations, aimed to the continuous risk monitoring to which the banks are exposed, through the integration of on-site and off-site examinations. The quality of performed examinations and the coverage of supervised risks are improved as a result of supervisors specialists trainings for monitoring the individual types of risks and of a more intensive monitoring of banks which are important for the system, observed from the aspect of their market share as well as form the aspect of evaluation of different areas of each bank individually. In comparison with 2006, when ten full-scope and three targeted examinations were performed, the number of examinations increased in 2007 (five full-scope and sixteen targeted). Special attention is dedicated to the preparation phase of examinations, especially through better use of Regulatory Credit Bureau resources and continuous monitoring of credit risk, improvement of the reporting system and use of the stress testing results of banks. The solvency and the legality of bank operations were examined by the rating system on the basis of CAMELS methodology. Although the loan portfolio interest rates of banks were high, significant results (observed by the coverage) were achieved and expressed through the percentage of the coverage of the loan portfolio and off-balance liabilities of banks during the examination. Coverage of the loan portfolio ranged from 51% to 76%, while the average coverage of the off-balance liabilities of banks amounted to 55%. 2 Operational risk, especially in the IT system of banks, adequacy of system of the management s reports and functioning of the internal supervision system were subjected to examination in eight banks. Market and solvency risks were examined in all banks through full-scope as well as through six targeted examinations. Special attention was focused on rating the quality and reliability of risk measurement techniques used by banks. Recommendations for their improvement were provided. Examination covered also the control of compliance, i.e. implementation of the Decision on Calculation of Effective Interest Rate, implementation of the Decision on Reserve Requirements that the Banks Hold with the Central Bank of Montenegro, as well as the implementation of the Law on Prevention of Money Laundering and Terrorism Financing. During 2007, stress testing of the banking system and individual banks were performed by the module for testing different types of the risk which banks encounter. Bearing in mind the importance of the bank supervision system, CBM established organizational unit for stress testing and systemic risk supervision. Regulatory Credit Bureau operations and the quality of its reports are significantly improved for the needs of supervision and external beneficiaries of Regulatory Credit Bureau data. Start of the data exchange between CBM and MFIs in 2008 will terminate the four-year project. BANKING SECTOR SUPERVISION AND REGULATION 2 Percentage refers to the off-balance liabilities which are examined. 21

22 3.2. Supervision of the Banks Exposure to the Risk Credit Risk Bearing in mind high growth of loans (165% annually), credit risk represent the most significant risk in Montenegrin banking system. The analysis of the loan portfolio of banks showed that most of the banks do not perform real classification of assets exposed to the risk and, consequently, do not calculate the adequate amount of reserves for asset items. Total non-performing assets of banks (C, D, E) amounted to EUR 75.4 million at end 2007 and made up 2.53% of the total assets. During one-year period, non-performing assets increased by EUR 46.7 million or 163.5%. At the same time, share of non-performing assets in total assets increased by 0.53 percentage points. Non-performing assets categories, apart from the doubtful assets, recorded growth in one-year period. Substandard assets increased by EUR 44.8 million or 193%, loss assets (E) by 126%, while doubtful assets (D) recorded decrease by 3.37%. Criticized assets (B, C, D, E) amounted to EUR million at end 2007 and in one-year period it increased by EUR million or 187%. Criticized assets made up 21.64% of total assets. The level of criticized assets was high and it amounted to 216% of the total capital and reserves and recorded growth of percentage points at the annual level. Special mention assets represented 88.29% of criticized assets. In one-year period all categories of criticized assets, except doubtful (D) recorded growth. Loans classified into C, D and E categories amounted to EUR 71 million and they increased by EUR 46.8 million or % in a year. Share of these loans in total loans increased from 2.86% (end 2006) to 3.16%. Observed by banks, decline in share of nonperforming loans in total loans occurred in four banks. Share of loans classified in C, D and E categories in total non-performing assets (C, D and E) amounted to 94.15% and it increased in relation to end 2006 (84.54%). Table 3.1 Net position of the placement and sources of funds by industry, EUR thousand CENTRAL BANK OF MONTENEGRO ANNUAL REPORT 2007 Collateral Classification A B C D E 1 Loans 327,485 1,323, ,146 60,372 1,658 2,359 2,218,620 2 Matured receivables 20 17,018 7,463 4, ,107 3 Interest 55 5,061 3, ,808 4 Other receivables 42,642 2, ,135 5 Total ( ) 327,560 1,388, ,139 66,374 3,106 3,170 2,301,500 6 Assets for which reserves for loan losses 728, ,533 are not allocated 7 Assets balance items, total (5+6 ) 327,560 2,116, ,139 66,374 3,106 3,170 3,030,033 8 Guarantees 23,222 63,208 40,672 1, ,862 9 Letters of credit 229 3,434 1, , Other off-balance liabilities 4,031 29,690 10, , Off-balance items for which reserves are 27,482 96,332 52,612 1, ,664 alloc (8+9+10) 12 Off-balance items for which reserves are not allocated 1 3,075,219 3,075, Total off-balance items (11+12 ) 27,483 3,171,551 52,612 1, ,253, Total balance and of-balance items (7+13) 355,043 5,288, ,751 68,141 3,577 3,683 6,283, Total ballance and off-balance items for which reserves are not all (5+11) 355,042 1,484, ,751 68,141 3,577 3,683 2,480, Formed reserves 2,980 15,506 22,485 17,479 2,845 61,295 Coverage( 16/15 ) Total 22

23 Table 3.2 Key assets quality ratios, EUR thousand 31 December December 2007 % changes 2007/2006 Special mention assets B 195, , Substandard assets C 23,280 68, Doubtful assets D 3,702 3, Loss assets E 1,628 3, Total criticized assets (B+C+D+E) 224, , Non-performing assets (C+D+E) 28,610 75, Non-performing assets/ capital + reserves 16.53% 25.28% Non-performing assets/ total assets 2.00% 2.53% Criticized assets/ capital + reserves % % Formed reserves Total criticized loans (B, C, D and E) amounted to EUR million and made up 25.88% of total loans. In one-year period these loans increased by EUR 387 million or 199%. This increase was influenced by the growth of all categories of criticized loans, apart from the loans classified in category (D) which decreased by 11%. Loans classified in category (B) recorded the highest nominal growth (EUR 340 million) in one-year period, while loans classified in category (C) recorded the highest annual growth rate (224%). Share of criticized loans in total loans decreased by three percentage points in relation to the same period in Share of loans classified in category (A) in total loans increased by EUR 818 million or 156% in one-year period. Percentage of past due loans on the level of the system amounted to 3.71%, while the same indicator at end 2006 amounted to 7.61%. The largest part of past due loans (55.38%) refers to private companies day past due loans (on which the interest rate is calculated) made up 83.1% of past due loans and 90 day and more past due loans (on which the interest is calculated) made up 14.32%. Past due loans granted to natural persons made up 38.93% of total past due loans. Most of these loans (85%) were classified in day past due category. Most of the loans on which the interest is not calculated refer to loans granted to natural persons (78%). Taking into account the share of past due loans of certain categories in total loans as per beneficiaries, the highest past due percentage is realized by the category Government agencies (23.85%). Formed reserves for the losses on assets and off-balance items, amounted to EUR 61.2 million at end In one-year period these reserves increased by EUR 36.9 million or %. Reserves for loan losses amounted to EUR 52.2 million and made up 2.32% of total loans or 85.18% of total allocated reserves. Stress testing results confirmed that the credit risk is the most significant risk in Montenegrin banking system. Six stress scenarios that were realized influenced on: (1) restructuring of classified loans (A, B, C, D and E) and implementation of maximum prescribed reserves rates, (2) increase of non-performed assets (C, D, E) and required level of reserves, (3) implementation of maximum prescribed reserves rates on existing structure of loan portfolio, (4) increase of non-performing assets and required level of reserves, (5, 6) high exposures of banks (so called concentration risk). Assumptions on which stress testing was based did not influence the decrease of solvency ratio on the aggregate level under the prescribed minimum of 8% Country Risk Identification, measurement, control and monitoring of the country risk, which comprises political-economic risk and transfer risk are constituent parts of risk management of the banks. At end 2007, exposure of the banking sector based on deposits placed with foreign banks and the amounts on the correspondent accounts of foreign banks were the following: BANKING SECTOR SUPERVISION AND REGULATION 23

24 - Deposits and funds at the correspondent accounts of Montenegrin banks with foreign banks amounted to EUR 243 million or 115.3% of the first class capital of the banks in Montenegro, which amounted to EUR million; - Exposure of the banking sector abroad was mostly to the institutions from countries with high rating (AAA and AA) Solvency Risk Aiming to the adequate solvency risk management, CBM performs the insight in strategies of banks, policies and procedures for the solvency risk management, gap analysis, stress scenarios, insight in setting the bank s limits for the adequate maturity match of assets and sources of assets. CBM is also checking the maintenance of decade and daily solvency minimum. At end 2007, liquid banks assets amounted to EUR million which was by EUR million or 24.07% more than at the end of the previous year. Liquid assets/total assets ratio recorded the decline in relation to the previous year, but it was above the acceptable minimum amount of 15%. Observed on the system level, the value of liquid assets/total assets ratio amounted to 18.05% and compared to the previous year it decreased (the value of ratio at end of the previous year amounted to 30.26%). Eight banks in the system recorded decline of this ratio over one-year period. The level of liquid assets/short-term liabilities ratio recorded decline if compared to the same period of the previous year, which is the consequence of significantly slower growth of liquid assets in relation to short-term and total liabilities of banks (Table 3.3). Short-term loans/short-term liabilities ratio recorded growth over the same period and amounted to 54% at the aggregate level. This growth was influenced by the growth of loan portfolio over the previous year. Table 3.3 Movement of the aggregate level of liquid assets towards the short-term and total liabilities of banks, end-year Liquid assets (EUR 000) 433, ,343 Short-term liabilities (EUR 000) 808,470 1,686,188 Total liabilities (EUR 000) 1,282,654 2,739,426 Liquid assets/short-term liabilities 54% 32% Liquid assets/total liabilities 34% 20% CENTRAL BANK OF MONTENEGRO ANNUAL REPORT 2007 Table 3.4 Loans to deposits ratio in banks, end- year, in % Hypo Alpe-Adria Bank Invest Bank Montenegro Hipotekarna Bank Montenegrobank NLB Podgorička Bank Prva Bank CG - founded Crnogorska Komercijalna Bank Atlasmont Bank Komercijalna Bank Budva Opportunity Bank First Financial Bank 0.00 Total

25 At end 2007, loans to deposits ratio amounted to %. This points to the increase in crediting of banks from borrowings and capital. At the end of the previous year, value of this ratio amounted to 78.75%. Observed at the aggregate level, four banks in the system realized higher level of this indicator than the realized average (Table 3.4). The bank, which is the dependent party of the other bank, when determining total loan/total deposits ratio, has a possibility to decrease the total amount of the loan for the amount of longterm loans which are granted to that bank by its parent bank aimed at increase of the lending activity, according to the Article 16 of the Decision on Minimum Standards for Solvency Risk Management in Banks. Bearing this in mind, this ratio would be more favourable in four banks (Hypo Alpe-Adria Bank (87.91%), Montenegrobank NLB (100.93%), Podgorička Bank Societe Generale Group (81.78%) and Crnogorska Komercijalna Bank (83.07%), as well as at the aggregate level (88.61%). If we take also the subordinated debts in consideration, this ratio in Hypo Alpe-Adria Bank would be 72.66%, Crnogorska Komercijalna Bank 81.63%, and on the level of the system 87.89%. Table on the maturity match of financial assets and liabilities at the aggregate level indicates incompatibility in all periods from 8 to 365 days. Cumulative gap was negative over three consecutive periods of time. Total cumulative gap on the level of the system amounts to EUR million and represents 13.69% of total sources of funds, which is more than at the end 2006 when it amounted 10.39%. (Table 3.5) There was the adequate coverage of loans by deposit on the system level, while the growth of long-term loans was not followed by the growth of long-term deposits. In one-year period, total deposits on the level of the system recorded growth of 94.38%, while the growth of loans in the same period recorded higher value and amounted to %. (Table 3.6) During 2007, all banks in the system duly performed current obligations and maintained solvency above the prescribed minimum. In December 2007, banks reported funds surplus, which, at the aggregate level, amounted to EUR 423 million. (Graph 3.1) Table 3.5 Maturity structure of financial assets and liabilities at the aggregate level, EUR Financial assets in income statement 2 Financial liabilities in income statement 3 Difference days 8-15 days days days days days 1-5 years Table 3.6 Maturity coverage of loans by deposits, aggregate level, and year-end over 5 years total 606,205 42, , , , ,660 1,006, ,501 2,965, ,961 85, , , , , , ,007 2,708,150 a) Maturity gap 152,244-42,761-24, ,292-92,218-42, , , ,845 b) Cummulative gap 152, ,484 85,381-25, , ,434 70, , ,832 % of total sources of funds 5.62% 4.04% 3.15% -0.96% -4.36% -5.92% 2.60% 9.52% 13.69% Short-term loans (EUR 000) 355, ,090 Short-term deposits (EUR 000) 808,470 1,530,549 Coverage (%) Long-term loans (EUR 000) 298,156 1,342,523 Long-term deposits (EUR 000) 180, ,524 Coverage (%) BANKING SECTOR SUPERVISION AND REGULATION 25

26 Graph 3.1 Monthly surplus of banks funds, , EUR thousand Stress testing results of the solvency risk showed that Montenegrin banking system is moderately sensitive to the solvency risk, having in mind the evident problems which occurred in one large bank during the testing. Four stress tests were performed simulating the loss of depositors thrust in parent bank: (a) withdrawal of 20% of the total amount of deposit, (b) withdrawal of deposit of the biggest bank s depositor, (c) withdrawal of 50% of deposit of ten biggest depositors, and (d) withdrawal of 100% of state deposit. Banks ability to cover the loss was tested through the amount of free liquid funds, available liquid funds and liquid assets. as a whole. Stress testing results showed almost insignificant impact on solvency ratio on the level of the system. Namely, solvency ratio at the aggregate level is reduced from 17.1% to 16.8%, while in seven banks it was reduced in range from 0.1 to 0.9 percentage points. The level of foreign exchange risk is low. Since Euro is the official currency and payments are performed mostly in Euro, exposure of Montenegrin banking system to the direct foreign currency risk is limited. Namely, only 4.2% of the assets at the aggregate level are expressed in foreign currency with the highest exposure of the individual bank of 19.5%. Exposure of other banks in foreign currency ranges from 0.1 to 6.0%. Net open foreign exchange position on the level of the system is positive and amounts to EUR 138 thousand or 0.1% of the risk capital. Stress testing of the direct foreign exchange risk was based on the net open foreign exchange position (so called spot position), i.e. on the assumption that the risk capital will be adjusted for the amount of 10% of value (+,-) of the net open position, on the level of individual banks as well as on the level of the system. Stress testing results of the direct impact of the interest rate change on the sensitive assets and liabilities positions show almost insignificant influence on the solvency ratio on the level of the system. Solvency ratio on the aggregate level after the stress remained at the same level of 17.1, while in two banks it decreased by 0.1 and 0.6 percentage points, respectively. CENTRAL BANK OF MONTENEGRO ANNUAL REPORT Market Risk In 2007, total level of market risk was low, which was mostly influenced by the market limitation. Nevertheless, banks were obliged to identify measure, control and monitor the market risk and to set the minimum standards for the market risk management. The CBM examinations showed that interest rates and foreign exchange positions are the principal source of the market risk in Montenegrin banking system. Sensitivity of the assets and liabilities positions to the interest rate risk was tested by applying the increased amount of the interest rate of 1.5 percentage points to the cumulative difference (gap) of assets and liabilities positions sensitive to the changes of the interest rate on the level of individual banks and the system 3.3. Measures against Banks During 2007, CBM imposed measures against one bank, according to the Article 74 of the Law on Banks (orders for reduction of the lending activities and the plan for recapitalization, suspension of all future investments), because of the violation of the Law and other regulations in the volume which requests the immediate measures against irregularities and prevention of further growth of the risk profile of the bank. In addition, CBM (according to the Article 73 of the Law on Banks) requested from the banks to act according to the written agreement, acceptable for the CBM, in case when operational irregularities of banks are influenced by non-adequacy of the risk management system, as well by the lack of coordination between operations and law, regulations and rules and acts of the business 26

27 policy. The aforementioned agreements oblige banks to take over concrete activities and measures for the improvement of efficiency of the credit risk management system, solvency risk, market and operational risks as well as for the harmonization with the law and regulations referring to the prevention of money laundering and violation of the operational limits and non-adequate systems of internal supervision and internal audit Issuing Licenses, Permits and Approvals In 2007, CBM issued two licences for performing banking operations for one bank and one MFI. 3 Other requests, processed by CBM in 2007 are disclosed in Table Changes in Regulatory Framework During 2007, the most dominant activities referring to regulatory framework were focused on drafting the new Law on Banks which enabled further harmonization with EU regulations, creation of the positive environment for the start of implementation of Basel II supervision standards, as well as the elimination of irregularities which were disclosed in the existing legislation. Aiming at the expansive credit growth elimination and the enforcement of the management risk functioning in banks, the following Decisions has been enacted in 2007: - Decision on Amendments to the Decision on Minimum Standards for Credit Risk Management and Operations with Bank Related Parties - which, depending on the reached level of receivables on the basis of net loans and leasing operations as at 31 December 2007, limits the annual growth of this parameter in amount of 30%, 40%or 60% in The highest limitations refer to the largest banks because the negative consequences of credit expansion of those subjects would have the highest impact on safety and stability of the banking system; - Decision on Amendments to the Decision on Minimum Standards for Bank Capital, which, depending on the realised annual growth of receivables on the basis of net loans and leasing operations (over 60% or over 100%), prescribes the minimum amount of solvency ratio of 10%, i.e. 12% in 2008, by which the increased amount of banks capital provides the adequate protection of interests of depositors and other bank s creditors; - Decision on Amendments to the Decision on the Manner and Procedures of and Fees for the Bank Supervision, which enables CBM to publish on its web site the Table 3.7 Requests processed by CBM in 2007 Type of request No. of requests General managers appointing 4 Possession of fixed assets or keeping real estates on the basis of pledge 6 Approval for investing in fixed assets up to 30% of the first class capital 1 Establishment or cancellation of an organizational unit 38 Establishment of foreign bank s branches 1 Performing securities operations 2 Performing custody operations 1 Giving the consent to the statute, i.e. to the amendments to the statute of banks 11 Appointment of external auditors of banks and MFIs 6 Acquiring the qualified participation in bank s capital 1 3 First Financial Bank AD Podgorica with 100% of the foreign capital and MFI Klikloan doo Podgorica with the dominant domestic capital obtained the licence. BANKING SECTOR SUPERVISION AND REGULATION 27