CENTRAL BANK OF MONTENEGRO ANNUAL REPORT 2010

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2 CENTRAL BANK OF MONTENEGRO ANNUAL REPORT 2010 Podgorica, 2011

3 PUBLISHED BY: WEB SITE: CENTRAL BANK COUNCIL: TRANSLATED BY: DESIGNED BY: PRINTED BY: PRINTED IN: Central Bank of Montenegro Bulevar Svetog Petra Cetinjskog Podgorica Telephone: , Fax: Radoje Žugić, MS, Governor Milojica Dakić, MS, Vice -Governor Velibor Milošević, MS, Vice -Governor Asim Telaćević Milivoje Radović, PhD Milorad Jovović, PhD Srđa Božović, PhD Central Bank of Montenegro, Translation Services Division Andrijana Vujović Studio MOUSE 100 copies Users of this publication are requested to make reference to the source of information whenever they use data from the Report.

4 ABBREVIATIONS AFS BIS CBM CDS CPI DNS EC ECB EFSE EONIA EPCG ESCB EU EUR EUROFIMA FDI FED FSI GDP IDA IMF KAP MFI MONSTAT NPI RTGS S&P SAA UN USD VaR Annual financial statement Bank for International Settlements Central Bank of Montenegro Credit default swaps Consumer Price Index Deferred Net Settlement European Commission European Central Bank European Fund for Southeast Europe Euro OverNight Index Average Electric Power Company of Montenegro Europe System of Central Banks European Union Euro European Company for the Financing of Railroad Rolling Stock Foreign direct investments Federal Reserve System Financial stability indicator Gross domestic product International Development Association International Monetary Fund Aluminium Plant Podgorica Microcredit financial institution Statistical Office of Montenegro National Programme for Integration Real-Time Gross Settlement Standard and Poor s Stabilisation and Association Agreement United Nations US Dollar Value at Risk

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6 CONTENTS FOREWORD BY THE GOVERNOR OF THE CENTRAL BANK OF MONTENEGRO 6 1. MACROECONOMIC ENVIRONMENT AND THE ECONOMY Macroeconomic Environment Banking System Real Sector Trends in the Most Important Sector of Montenegrin Economy Real Sector Indicators as the Result of Processing Annual Financial Statements IMPLEMENTATION OF THE CBM POLICY IN THE REPORTING YEAR The CBM Policy in the Reporting Year Activities on the Implementation of the CBM Policy Monetary And Financial Stability Payment System Foreign Exchange Reserve Management CBM Vault Operations EU Accession and Cooperation with International Financial Institutions Human Resources Management Public Relations and Transparency CBM as a Socially Responsible Institution CBM`S Financial Performance in CBM Profit and Loss Account of the as at 31 December Balance Sheet of the Central Bank as at 31 December Report on Changes in Capital as at 31 December MACROECONOMIC FORECASTS FOR Macroeconomic Indicators Forecast Inflation Forecast in Montenegro s GDP Projection for Projection of other Macroeconomic Aggregates for The Impact of the Macroeconomic Environment on the Attainment of the CBM Objectives and Policies The Effects of Expected Macroenvironment on Monetary and Financial Stability CENTRAL BANK OF MONTENEGRO POLICY FOR Central Bank of Montenegro Policy for Guidelines for carrying out the Central Bank Policy in ANNEXES 77

7 6 Central Bank of Montenegro Annual Report 2010 FOREWORD BY THE GOVERNOR OF THE CENTRAL BANK OF MONTENEGRO The year 2010 was very challenging for the Central Bank of Montenegro s (CBM) operations. The crisis was still very much felt in the real economy and the financial system, and functioning of the economy was hampered by inadequate sectoral structure established during the boom period. The number of insolvent enterprises and unemployment increased, consequently leading to growing bad assets in the banking system. In such circumstances, the CBM had to protect the stability of the banking system and prevent growing bad assets from jeopardizing banks on one hand, while on the other hand it had to facilitate the position of the corporate sector and households and try to influence the renewal of lending activity. The regulatory and institutional framework for securing financial stability, with the banking system stability being its core segment, was rounded off in 2010 with the adoption of the following financial sector laws: Central Bank of Montenegro Law, Financial Stability Council Law, Law Amending the Banking Law, Law Amending the Bank Bankruptcy and Liquidation Law, and Deposit Protection Law. The new CBM Law sets out new objectives and functions, but also provides the CBM with new monetary policy instruments. In addition, a new CBM management assumed their function in the middle of October. Starting from the status quo, the primary CBM objective was to work on the implementation of the aforesaid set of laws with a view to additionally strengthening the regulatory and institutional framework. Activities on drafting the necessary secondary legislation were particularly intensified in the second half of the year in order to meet the timeframe requirement for harmonizing the Central Bank regulations with international regulations and the new obligations arising from the CBM Law. In parallel with the creation of the regulatory framework, current problems emerged as the result of the recession-driven factors in the banking system and failures in the financial supervision which the crisis revealed. Encouraging fact is that the Montenegrin economy has been gradually recovering as of the second half of 2010, this being based on the revival of industrial production, positive trends in tourism, trade, forestry and certain segments of transportation. Inflation was at a record low due to a significant decline in aggregate demand, thus indicating a slow pace of recovery. An ongoing increase in savings is a sure indicator that the confidence crisis is behind us. The process of restructuring in 2010 was dynamic, but has not been completed yet. Structural problems in the balance sheets of banks are still present despite efforts made to resolve them. Stability and solvency of the banking sector was ensured owing to significant capital injections in However, restructuring and refinancing of the growing non-performing loan portfolio, caused by deteriorated liquidity of the corporate sector, has not been completed and will have to be strongly addressed in Starting from the strategic commitment of Montenegro to achieve full membership of the European Union, the Central Bank continuously worked on the harmonization of both primary and secondary legislation with the acquis communautaire and relevant international standards. The CBM also participated in completing the EU questionnaire, drafting of strategic documents, and meetings of the Enhanced Permanent Dialogue with the EU.

8 Foreword by the Governor of the Central Bank of Montenegro 7 Operating on the principles of transparency, the Central Bank provided objective and comprehensive information on its objectives and activities to both domestic and international public. Thus the Central Bank contributes to raising awareness and economic knowledge in the society and a better understanding of the importance and role of the Central Bank as an independent institution responsible for maintaining monetary and financial stability and soundness of the banking system. As an institution with social responsibility towards its employees and the society as a whole, the Central Bank gave a major contribution to the attainment of objectives of a modern civil society through numerous and various activities, primarily those of a humanitarian character, and the rounding off of its internal procedures. Special attention was paid to human resources as a critical factor to successful business. Substantial resources and attention were allocated for professional development and motivation of employees. Over two-thirds of the CBM employees today have a university or higher education degree, which is the most important pledge for our future successful functioning. When it comes to expectations for the upcoming year 2011, all projections indicate that the macroeconomic environment will be very challenging.the announced economic growth, if achieved, will definitely have a positive effect on monetary and financial stability, yet these will be rates of growth significantly lower than those recorded in the pre-crisis years. Expectations of rising inflation, an increase in employment coupled with the present concerns about the launching of the investment cycle, and regularity of the public debt servicing indicate the complexity of the macroeconomic environment in which the banking sector and the Central Bank will respectively function and operate. In 2011, the Central Bank will round off the process of harmonizing its operations with the new laws by adopting the necessary secondary legislation. The Central Bank s priority will undeniably be the maintenance of the financial system stability. To that end, the Central Bank will strengthen the supervision of systemically important banks. In case of any potential threats to the solvency ratio, the Central Bank will insist on recapitalization of banks, removal of bad assets and other necessary measures. Supervision plays an important role in maintaining stability, efficiency and soundness of individual banks and the banking system as a whole. Economic cycles will continue in the future, exerting different potential impact on the banking system, but the Central Bank will continue developing action plans in case of any systemic disturbances and adverse developments to address such challenges. Going forward, the Central Bank will continue with its efforts and comprehensive actions to contribute, to the extent possible, to further strengthening of the financial sector, thus indirectly having positive effect on the real economy. The banking system rehabilitation, although burdened by the legacy of noneconomic behaviour in the past period and still facing certain challenges, both internal and external, will also have a prevailing effect on the recovery of Montenegro s economy, and consequently on all elements of the society s development. Governor Radoje Žugić

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10 1MACROECONOMIC ENVIRONMENT AND THE ECONOMY

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12 Macroeconomic environment and the economy Macroeconomic Environment Following negative trends throughout most of the economic sectors and a 5.7% decline in GDP in 2009, Montenegro s economy started with a gradual recovery, in particular in the second half-year This was a result of an increase in overall industrial production, positive trends in tourism, trade, forestry and certain transportation segments. This period was also characterized by a low annual rate of inflation of a mere 0.7%. Although it has exited recession, Montenegro s economy remains vulnerable, in particular if considering liquidity problems in the real economy, insufficient credit support, potential effects of necessary structural reforms, and the provision of capital required to intensify economic activity. Added to this are the labour market trends showing an increase in unemployment, that is, a decline in employment, which is to a great extent a result of delayed effects of the crisis and the resolving of piled up problems in large production systems. The annual CPI inflation amounted to 0.7% in December 2010, this being the lowest rate ever to have been recorded in Montenegro, either measured by the retail price index or the cost-of-living index. The report of the Food and Agriculture Organization of the United Nations indicates that the food prices were at their record highs in December 2010 and at the beginning of If global oil and food prices continue growing, significant price increases could be expected in Montenegro which, unlike some of the countries in the region, did not record any significant upsurges in these Graph 1.1 prices in Consumer prices (annual change in %) The annual core inflation amounted to 0.41% in 2010, thus being 0.33 percentage points lower than overall annual inflation. During 2010 (except in August and November), the annual core inflation was lower than overall inflation, with a negative sign in the first five months of the year and in July. After a significant divergence from the overall inflation in Q and the first seven months of 2010, an increase in the prices of certain products from the core inflation basket made the core inflation rate closer to that of the overall inflation (Graph 1.1). Source: Monstat and CBM calculations

13 12 Central Bank of Montenegro Annual Report 2010 Fiscal policy was also hampered by numerous problems in the real economy. Total revenues of the Budget and State Funds, as per preliminary data of the Ministry of Finance, amounted to EUR 1,337.0 million in This is the year-on-year decline of 13.1%, yet a 2.3% increase in relation to the plan for Total Budget expenditures amounted to EUR 1.406,9 million or 46.5% of the estimated GDP for In comparison with 2009 and the plan for 2010, the Budget expenditures were 0.8% and 1.2% higher, respectively. Expenditures that recorded the main divergence from the plan in term of their increase were expenditures for gross salaries, social insurance, and pension and disability insurance, whereas the capital budget recorded a decline. The Budget of Montenegro recorded a EUR 84.6 million deficit in 2010, which is 2.8% of GDP. Table 1.1 Public debt structure, in millions EUR Total public debt Domestic debt External debt Public debt and debt of public companies Source: Ministry of Finance 1, % of GDP % of GDP % of GDP 1, % of GDP The public debt of Montenegro, as per the Ministry of Finance s data, amounted to EUR million or 42.0% of the estimated GDP for Compared to end-2009, the public debt rose by 11.4%. The currency structure of the public debt is favourable. The entire domestic debt is in euros, as is the major portion of the external debt (89%), whereas a part of the obligations toward the Paris Club, as well as the obligations for IDA credits and the debt to EUROFIMA are in other currencies. Total issued guarantees as at end-2010 amounted to EUR million, so the total public debt amounted to 53.8% of GDP. This brings us to the conclusion that the share of public debt in Montenegro s GDP is smaller than in the majority EU Member States. However, there is still some concern about an accelerated increase of public debt in GDP and a potential risk of activation of some guarantees. The average number of employed persons in 2010 amounted to 161,742, thus being 7.1% lower than the average number of employees a year earlier. The month-on-month decline in employment was particularly obvious in April (7.6%) which, in addition to the moving of a certain number of employees from the production sector (Aluminium Plant Podgorica (KAP), Bauxite Mines, Steelworks) on the Employment Agency s records was primarily due to the methodological changes in the employment records. An average number of employees rose in four out of fifteen sectors, these being: trade (by 2.2%), financial intermediation (5.6%), other public utility and personal services (by 14.6%), and the real estates and lease (by 25.9%). As per the Employment Agency s records, the number of registered unemployed persons averaged 31,864 in 2010, which is 12.3% more than a year ago. The highest number of unemployed people was recorded in April 2010 (33,188) and this was the highest number of unemployed people since June 2007 (33,393).

14 Macroeconomic environment and the economy 13 The unemployment rate, which is announced by the Employment Agency of Montenegro, rose in December 2010 to 12.16%, which is 0.73 percentage points more than in December The Labour force survey that is published by Monstat on quarterly basis shows the year-on-year unemployment growth in the first three quarters of Such labour market trends had very adverse effects on the regular servicing of loans by the household sector. Monstat data show that an average salary in Montenegro in 2010 amounted to EUR 715, being 11.2% higher than the year before 2. An average salary without taxes and contributions totalled EUR 479, showing the year-on-year increase of 3.5%. The current account deficit declined in 2010 due to faster recovery of merchandise and services export over imports which also led to gradual economic recovery. However, it should be taken into account that the reduced external imbalance is largely a result of the crisis adjustments rather than improved competitiveness of the Montenegrin economy. The key reason for the current account deficit, same as in the past years, is an insufficient volume and a small share of merchandise exports in overall trade. Preliminary data indicate that the current account deficit in 2010 is 13.6% lower than in the previous year, amounting to EUR million. Despite the year-on-year decline, the Graph 1.2 share of the current account deficit in GDP Current account structure, in thousand EUR remained high, 25.6%. The deficit was largely covered by net FDI inflows that accounted for 17.9% of GDP and net portfolio investments that contributed 6.2% in GDP. Deficit in the goods account amounted to EUR 1.31 billion, that in the income account was EUR 20.8 million, whereas the services and current transfers accounts recorded surpluses of the respective EUR million and EUR million. Net FDI inflow in 2010, as per preliminary data, amounted to EUR million or 49.1% less than in Although being lower than in the previous year, this is a rather large FDI inflow considering the fact that there were no major privatisations in Source: CBM 1 Monstat`s survey shows that the unemployment rate at end-september 2010 (latest available data) amounted to 19.2%. 2 It should be noted that due to the taxation of other personal income, meal and holiday allowances, MONSTAT changed the methodology of calculation of wages and salaries in 2010 to cover the aforesaid earnings. This largely accounts for the statistical increase in gross wages and salaries in the reporting year of 11.2%. 3 If we were to exclude the FDI inflow arising from privatisation and recapitalisation of EPCG and the amount of the debt transformed into capital, then the recorded net FDI inflow in 2010 would be 12.3% larger.

15 14 Central Bank of Montenegro Annual Report Banking System The banking system gradually stabilized in Banks made significant efforts to restructure their portfolios which resulted in recapitalisation of the banking system of EUR 71.4 million. The aggregate capital adequacy (solvency) ratio amounted to 15.85% in 2010 showing the year-on-year increase of 0.10 percentage points (15.75% at 2009 year-end). Total own funds of banks amounted to EUR million and total risk weighted assets were EUR 2,143.0 million. Graph 1.3 Solvency ratio and its elements Banks total capital amounted to EUR million as at 2010 year-end, but regardless of substantial recapitalisation, total capital declined as a result of incurred losses by EUR 20.8 million or 6.28% as compared to the previous year. Despite the fact that seven banks reported profit, high levels of loss in four banks led to the reported loss of EUR 81.7 million at the entire banking system level at 2010 yearend. Such a high loss resulted from the high amount of past due loans and high operating expenses of banks which amounted to EUR million at 2010 year-end. Graph 1.4 Average liquid funds in the country and abroad Liquidity of the banking system was satisfactory in Banks average liquid assets amounted to EUR million. Their annual increase amounted to EUR million or 24.9%. Increase in liquid assets, both in the country and abroad, was affected by prudent and conservative lending policy of systemically important banks. Key liquidity indicators reported annual growth, which resulted from an increase in banks liquid assets (Graph 1.5). Daily and ten-day liquidity indicators were significantly above the prescribed minimum. Source: Banks daily reports Total loans amounted to EUR 2.199,9 million at end-2010 and they showed the year-on-year decline of 8.25%. Observed by banks, three banks reported a decline, while eight banks reported growth in lending activity in 2010.

16 Macroeconomic environment and the economy 15 The main reasons for the decline in lending activity were: Graph 1.5 Selected liquidity indicators, in % still present high operating risk high dispersion of illiquidity in the real sector, defaults in payment of previously granted loans which resulted in a high share of non-performing assets, inadequate maturity match of sources and placement of funds, high interest rates, absence of lending activity in three large banks (eight banks reported aggregate growth of loans granted of 13.3%), high amount of foreign indebtedness of a number of companies, and the lack of quality projects. With regard to the maturity match of total loans, long-term loans accounted for 78.45% and shortterm loans made up 21.55%, thus speaking in favour of a continuous increasing trend of long-term loans in total loans (they increased by 3.69 percentage points). The most important loan beneficiaries were private companies and natural persons (with credit cards) with their share of 93.76% in total loans granted in Loans granted to private companies amounted to EUR 1.2 billion at 2010 yearend (54.50% of total loans), and loans granted to natural persons amounted to EUR million (39.26% of total loans). Banks total deposits amounted to EUR million at 2010 year-end and they showed the yearon-year decline of 1.91%. Deposits of natural persons increased by almost 13%, which is an indicator that the confidence crisis present as of Q and partly 2009 has passed. The main cause of deposit decline was a decrease in public sector deposits 4, which amounted to 22.2%, as well as a decline in corporate deposits of 13.9%. The decline in deposits of these two categories resulted from the difficulties these sectors were faced with. The most important banks depositors were natural persons (53.2%) and private companies (24.6%). Maturity structure of deposits deteriorated, since demand deposits increased from 36.6% (2009) to 40.94%. Deposits in EUR were dominant in currency structure, while deposits in other currencies made up 3.32% of total deposits. Credit-deposit relationship at the system level was negative, amounting to EUR million. The most evident negative relationship of loans and deposits was in trade, construction and services sectors, as well as in tourism and hotel management industries. The most important net lenders at the aggregate level were financial and energy sectors. 4 Public sector includes Government, government agencies, funds and municipalities.

17 16 Central Bank of Montenegro Annual Report 2010 Table 1.2 Net position of placements and sources of funds by sectors, in thousand EUR Sector/industry Loans % Deposits % Net position 1 Agriculture, hunting, fishing, etc. 9, , ,599 2 Mining 37, ,206 3 Energy 16, , ,993 4 Construction 177, , ,496 5 Trade 503, , ,468 6 Services, tourism, hotel management 162, , ,387 7 Transport, warehousing, telecommunications 66, , ,794 8 Finance 36, , ,113 9 Real estate trade 66, , , Administration, other public services 67, , , Households 863, , , Other 192, , ,533 Total 2,199, ,789, , Real Sector Trends in the most important sector of Montenegrin economy Industrial output in Montenegro grew by 17.5% in 2010, thus stopping the biannual declining trend and consequently contributing to Montenegro s economy exiting recession. The respective increases in mining and quarrying and electricity, gas and water supply amounted to 58.7% and 51.1%, while manufacturing industry recorded a 3% decline. Observed by branches, the highest increase was recorded in Extraction of energy Graph 1.6 producing materials (96.1%), Manufacturing Industrial output of machinery and equipment, other (53%) and electricity, gas and water supply (51%). The branches severely affected by the crisis were the manufacturing of leather and leather products with a decline in production of 76.9%, as well as the manufacturing of rubber and plastic products (-40.4%), manufacturing industry, other (-23%), the manufacturing of transport equipment (-20.3%) and the manufacturing of textile and textile products (-14.8%). Moreover, there is a disturbingly high decline in the manufacturing of basic metals and metal products (14.7%), as the result of a high share of this branch in total industrial production. Source: Monstat

18 Macroeconomic environment and the economy 17 Trends in tourism were better than expected. In 2010, according to Monstat data, the number of tourists visiting Montenegro amounted to 1,263 thousand or 4.6% more than in The number of tourist overnights amounted to 7,964.9 thousand, or 5.5% more than in the previous year. The number of domestic tourists overnights increased by 15.3%, while foreign tourists accounted for 6,977.9 thousand overnights, or 4.2% more than in The majority of overnight stays was in seaside resorts (96%), followed by mountain resorts (1.5%), the capital city (1.4%) and other tourist resorts (1.1%). An increase in overnights in 2010 was recorded by tourists from Russia (14.9%), Ukraine (87.2%), France (20.6%), Germany (38.2%), the United Kingdom (45.3%) etc. As regards forestry, some 256,410 m³ of wood products were produced in 2010, which is 18.4% more than in the previous year. Construction showed recovery in the last quarter of According to preliminary Monstat data, the total value of the performed construction works in 2010 amounted to EUR million, being 13.1% higher in relation to the comparative period of the previous year, whereas measured by effective working hours, it declined by 0.8%. The value of new contracts on buildings amounted to EUR 51.1 million, which is 9.1% more than in the same period of 2009, and the value of new contracts on other buildings amounted to EUR 99.8 million or 5.7% more than in the previous year. As for transport, means of transport showed different results. According to Monstat data, the number of passengers in road transport declined by 20.7% in relation to the 2009, and the road freight transport declined by 7.1%. Railway passenger transport declined by 8.6% (measured by passenger kilometres), while railway freight transport increased by 49.9% (measured by tonne kilometres). The total number of passengers in air transport amounted to 1,205.5 thousand or 26% more than in 2009, and the air freight transport increased by 46.1%. Marine freight transport (measured by tonne miles) declined by 12.4% in relation to the comparative period of Total turnover in ports amounted to 1,758.7 thousand tonnes or 18.7% more than the turnover recorded in In 2010, total turnover in retail trade increased by 1.6% as compared to the turnover recorded in 2009, while the sale and purchase of products from agriculture, forestry and fishing was 16.6% lower in relation to Real Sector Indicators as the Result of Processing Annual Financial Statements In 2010, the Central Bank of Montenegro continued with the project of processing annual financial statements (AFS) of legal persons in Montenegro that are obliged to submit these reports to the Commercial Court in Podgorica in line with the Business Organisation Law and the Accounting and Auditing Law. By 28 February 2010, legal entities submitted their AFS for 2009 to the Commercial Court, of which the Central Bank of Montenegro processed AFS 5. It has to be noted that, for the first time this year, there were no unprocessed AFS due to incorrectly or inadequately completed forms, 5 The remainder of 88 AFS refers to non-corporate legal persons: insurance companies, NGOs, broker-dealr firms, and the like.

19 18 Central Bank of Montenegro Annual Report 2010 which points to the significant improvement in compiling submitted financial reports. Good quality in compiling financial statements is very important since AFS are used for the compilation of the Montenegrin GDP, thus inaccurate financial reports may lead not only to incorrect forecasts of this macro-aggregate, but to wrong analytic conclusions stemming from non-quality statistical base. The same goes for any type of macro level analysis, like trends in short and long term indebtedness of some sectors, their liquidity, profitability, which may lead to misinformation in the bank awareness on a client s creditworthiness, increasing the asymmetry between banks (both national and international) and clients legal persons, affecting risk growth and contributing to an increase in interest rates and non-performing assets in the banking sector. Since the percentage of processed AFS is lower in comparison with the total number of registered legal persons obliged to submit these statements, aggregate indicators obtained after the processing of the submitted, i.e. appropriately completed AFS can be taken with reservations with respect to being representative for the Montenegrin economy. The results obtained through the processing of AFS show that the financial crisis heavily affected the results in the corporate sector in Montenegro, resulting in net loss of EUR million, while it recorded a net profit of EUR 7.25 million in A significant decline of the recorded financial result is primarily reflected in a decline in revenues of EUR 1,310.6 million (17.2% decline at the annual level) due to lower domestic and external demand. The Montenegrin economy was characterised by a significant decline at the sectors level, thus 7 out of 16 sectors recorded loss in Breakdown by sectors shows that the highest loss was reported in manufacturing industry (EUR million), recording the continued increase of 29.2% in relation to The growth in loss was recorded in the mining and quarrying, real estates, hotels and restaurants and construction, indicating that sectors were significantly affected by the economic crisis even in The financial result in the mining and quarrying is of particularly concern, as it recorded a net loss of EUR 41.4 million at end -2009, being almost four times higher in relation to loss recorded in 2008 when it amounted to EUR million. Moreover, real estates continued the uptrend in recording adverse financial results, with a net loss of EUR million at end-2009, which is almost double the loss recorded in 2008 (EUR million). On the other hand, transport, warehousing and communications sectors recorded the highest positive results in relation to 2008 of EUR million profit although 23.9% lower in relation to Balance sheets of legal persons in 2009, observed by geographical area, showed a significant decline in financial position of municipalities that so far have been considered as leaders: Podgorica, Herceg Novi, Kotor and Bar. Niksic is still the municipality which, due to the fact that it is the home of the systemic companies that experienced troubles in 2008, reported the highest loss at the municipality level of EUR 46.1 million. Podgorica recorded the most significant decline and reported EUR 11.9 million loss in relation to net profit of EUR 52.1 million recorded in The analysis of eight financial indicators (net profit margin, return on total assets, return on equity, overall liquidity ratio, liquidity ratio which does not treat stocks, level 2 liquidity ratio (so called Acid Test) and ratio of covering total liabilities with assets and own capital), as shown in table below, clearly shows the implications of the crisis to the deterioration of the Montenegrin economy. The decline in

20 Macroeconomic environment and the economy 19 revenues is particularly worrying and, together with a significant decline in liquidity, started to have adverse effects not only to regular servicing of financial obligations, but also to the solvency of the Montenegrin corporate sector. Table 1.3 Selected indicators in operation of Montenegrin legal persons (Net profit (loss)/ Total income)* Net profit (loss) / Total assets Net profit (loss) / Total assets and liabilities Liquidity ratio 1=turnover assets / short-term liabilities Liquidity ratio 2=(turnover assets - stocks) / short-term liabilities Liquidity ratio 3= Cash and cash equivalents / shortterm liabilities Indebtedness ratio 1= total liabilities / total assets Indebtedness ratio = total liabilities / total capital General conclusion for the output of the Montenegrin economy in 2009 is that it was strongly affected by the global financial crisis and that, due to declined aggregate demand and the available income at both domestic and international markets, revenues abruptly declined and final products stocks and unfinished production largely accumulated. A positive trend was noticeable through the stagnant corporate sector indebtedness, i.e. the creation of a more favourable relation between companies` own funds and those obtained from short-term and long term sources of financing. U 2010, the Ministry of Finance submitted requests for initiating proceedings against companies that did not submit their financial statements on time. Thus the total fines charged to companies operating in Montenegro amounted to EUR thousand. The execution of concrete sanctions, which foresees criminal charges against companies that have not either made requested corrections timely or removed irregularities in their financial statements for the previous year, has been announced to continue in In this respect, it would be positive to continue with such practice as this should lead to a significant improvement in the quality of financial reporting.

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22 2IMPLEMENTATION OF THE CBM POLICY IN THE REPORTING YEAR

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24 Implementation of the CBM Policy in the reporting year The CBM Policy in the reporting year At its meeting held on 23 December 2009, the Council of the Central Bank of Montenegro established the Central Bank of Montenegro Policy for In line with the constitutional obligations and statutory authorities and accountability for monetary and financial stability and the banking system functioning, and adhering to the principles of transparency and independence, in 2010, the Central Bank of Montenegro (CBM) shall: 1. Maintain the banking stability and continuously monitor the banking system condition and, if needed, take corrective measures, promote the strengthening of corporate governance and risk management in banks, continue implementing internationally accepted banking standards and principles. 2. Continuously monitor and analyze the situation in the Montenegrin economy and the global and regional trends, focus on preserving financial stability, and communicate recommendations for boosting economic growth and maintaining financial stability. 3. Improve and maintain a sound and efficient national payment system. 4. Continue improving the management of international reserves and risks associated with their investment, with the main objective to ensure the safety of investments, without jeopardizing liquidity, as well as analyzing new investment opportunities. 5. Improve the quality of international payment transactions through ongoing monitoring and compliance with best banking practices and standards. 6. Enhance cooperation with international financial institutions, international organisations, central banks, and actively participate in Montenegro s EU accession process. 7. Continue with focused activities on the information system development and upgrade, professional advancement of employees, communication with domestic and professional public, as well as the promotion of the central bank s role as a socially responsible institution Activities on the implementation of the CBM Policy Activities implemented in 2010 with regard to the Central Bank s policy were in line with the constitutionally defined Central Bank s responsibility for monetary and financial stability and functioning of the banking system. Incorporation of such a clear provision on financial stability in the Constitution of Montenegro is one of the rare cases in Europe. This emphasizes the fundamental importance of financial stability and creates a strong basis defining contribution of all other authorities involved in the preservation of financial stability.

25 24 Central Bank of Montenegro Annual Report Monetary and financial stability The global financial crisis unrevealed significant deficiencies in the financial supervision which did not manage to prevent the accumulation of huge risks in the financial system and the emergence of one of the biggest crisis in the history. In such new circumstances, activities have been taken at the global scale to find the way to improve the functioning of the financial system control, which would affect the assessment of the financial system vulnerability, identification and supervision of the activities in that respect and promotion of coordination and exchange of information between authorities in the financial sector. One of the new circumstances in this field was the establishment of adequate new bodies for the implementation of the aforesaid target (the Financial Stability Board; the European Systemic Risk Board; Domestic Standing Groups, and the like). The financial crisis pointed to the need to establish a similar body at the national level of Montenegro. For the purpose of attaining such objective and full harmonisation with similar activities at international level, the Financial Stability Council Law was adopted. The Financial Stability Council that is established under this law aims to prevent or mitigate systemic risks in the financial system of Montenegro as a whole and to ensure the preservation of the financial system stability and avoid effects of factors that may lead to a widespread financial crisis. Members of the Financial Stability Council are: the Central Bank Governor, the Minister of Finance, the President of the Council of the Insurance Supervision Agency and the President of the Securities and Exchange Commission. The Council is chaired by the Central Bank Governor and the Central Bank performs administrative and technical operations for the Council in the manner that does not jeopardise the achievement of the principle of independence of the Central Bank Monetary policy The attainment of objectives and the exercising of the CBM functions is achieved pursuant the new CBM Law (OGMN 44/10 and 46/10). This law created the legal prerequisites for the harmonisation of the status, goals, functions and organisation of the Central Bank of Montenegro with Article 143 of the Constitution of Montenegro, which strengthens the governance and management of the Central Bank in an optimum manner, and simultaneously ensures the preservation of the Central Bank s independence. This law harmonised attaining of the Central bank functions and its operations with the general principles for operation of the national central banks laid down in relevant EU regulations, such as provisions of the Treaty on the Functioning of the European Union (Articles 119 and 123, Articles ) and provisions of Protocol 4 of the Statute of the European System of Central Banks and the European Central Bank. In line with the new CBM Law, the Parliament of Montenegro appointed the first Governor of the Central Bank in the middle of October The adoption of the new CBM Law has brought new functions and instruments open market operations, short-term liquidity facility, the last-resort lending which will strengthen the CBM capacity to act in a crisis situation.

26 Implementation of the CBM Policy in the reporting year 25 In the situation of a limited monetary policy, the supervision has additionally become significant due to prudential policy management, and/or passing of supervisory measures that can also influence the realisation of the CBM objectives. In a sustainable and long-term economic policy of Montenegro, monetary policy is aimed at preserving and enhancing financial stability. Table 2.1 shows possible CBM monetary policy instruments and objectives: Table 2.1 Monetary policy instruments and objectives Monetary policy instruments Indirect objective Main objective of monetary policy Reserve requirement rate Money supply Price stability, (lending activity, liquidity) Liquidity loans Liquidity Banking sector liquidity / financial stability Lender of last resort Liquidity Financial stability Open market operations Prices and availability of funds Price stability and financial stability The existing monetary policy instruments are reserve requirements, loans for maintaining liquidity, last-resort lending, and open market operations. The CBM influences the cash potential of banks through an increase or a decrease of the reserve requirement rate and a widening or narrowing the deposit base for its calculation, influencing thereby the level of lending activity in the system, which further influences on aggregate demand and prices. This channel of transmission is not efficient since its effects are slow, and only in long period these effects are not significant. Liquidity loans and the last-resort lending are instruments guaranteeing the liquidity of the system. In case of liquidity reduction and for the purpose of preserving system stability, CBM may approve intraday, overnight, 15-day and 6-month loans (90 days + 90 days). These loans are used for overcoming short-term liquidity problems in the banking system and their disbursement will begin as of 2011, due to the fact that the legal framework was completed in July 2010 and secondary legislation was adopted in The function of the lender of the last resort will be used for overcoming liquidity problems that may jeopardise the financial system stability and it will be implemented since Open market operations represent an instrument used to influence the cash potential in the system through the purchase or sale of securities, to reduce the pressure on liquidity in the system or the level of prices (thought lending activity). This instrument in the Montenegrin economy is rather limited both with regard to the sources and its scope, and its implementation will also start in Besides the aforesaid regular instruments of the Central Bank which directly influence the objective, the indirect role of this institution becomes important nowadays as its credibility and reputation shape overall public opinion. Transparency of the Central Bank becomes an additional instrument which affects economic development through the creation of expectations of commercial players.

27 26 Central Bank of Montenegro Annual Report 2010 Reserve requirement policy In the crisis period (during 2009), the reserve requirement rate was reduced and some facilities were introduced with regard to the allocation of reserve requirements to include new deposits, all this to act counter-cyclically on the economy (banks were relaxed by liquidity and lending potential). Such a policy remained in Reserve requirement amounted to EUR million at end-december 2010, and it showed the yearon-year decline of EUR 8.2 million or 4.8% (Table 2.2) Table 2.2 Reserve requirement, deposits, borrowings, in thousand EUR III VI IX XII III VI IX XII Reserve requirement Total deposits 1, , , , , , , ,790.4 Total borrowings The share of reserve requirement in total deposits of banks declined from 9.5% (2009) to 9.2% (2010) (Table 2.3). Table 2.3 Reserve requirement/ total deposits and borrowings of banks, in % Description/Period III VI IX XII III VI IX XII Reserve requirement/total deposits Reserve requirement /(Total deposits + borrowings) Table 2.4 shows that the reserve requirement to total deposits and/or banks assets in Montenegro was amongst the lowest in the region, but it significantly exceeded the level prescribed by the European Central Bank. Table 2.4 Reserve requirement to total deposits and banks assets at 2010 year-end, in % Reserve requirement Deposits Reserve requirements Assets Bosnia and Herzegovina 26.4% 15.7% Montenegro 9.2% 6.6% Croatia 10.2% 7.0% Macedonia 13.3% 8.1%

28 Implementation of the CBM Policy in the reporting year 27 The structure of reserve requirement has not significantly changed as compared to Seven banks used the possibility to allocate portion of reserve requirements in the form of T-Bills in Banks allocated EUR 38.4 million at 2010 year-end from the reserve requirements for the purchase of T-bills or 18.5% of total allocated reserve requirements. Some 74.2% was allocated to the reserve requirement account in the country and 7.3% to the Central Bank account held abroad Banking system supervision and regulation Supervision of the banking system represents the key activity of the Central Bank. It was carried out through direct and/or indirect (on-site and/or off-site) inspections, regular and/or extraordinary inspections, and full scope and/or targeted inspections aimed at intensified monitoring of systemically important banks and banks that are under the Central Bank measures. In carrying out its supervisory activities, special focus was put on the implementation of international standards and efficient supervisory principles and/or supervisory oversight of the capital adequacy assessment process, review of the system of internal controls, comprehensiveness of risk assessment in banks and assessment of achieving and quality of the supervisory function of the board of directors to eliminate uncontrolled risk appetite. Cooperation with regulatory and supervisory bodies of the remaining part of the financial system in Montenegro was intensified in 2010, as well as that with home supervisors, particularly through the planning of joint inspections and exchange of data and information in accordance with the signed MoUs, aimed at synchronising supervisory activities both nationally and globally. Supervisory activities in the following period will focus on further strengthening of capacities and the improving and strengthening of the supervisory function in order to implement the new regulatory framework, and on full harmonisation of laws and regulations with relevant EU rules and internationally recognised banking standards. A portion of these activities will be developed also within the Twinning Project Strengthening of Regulatory and Supervisory Capacities of Financial Regulators in Montenegro funded by the European Commission and within the project of the European Central Bank Strengthening of Macro and Micro Prudential Supervision in Candidate and Potential Candidate Countries for EU accession Supervision of the banking system Supervisory activities conducted in 2010 represented the continuation of diagnostic assessments that began in October 2009 and which served as the basis for extraordinary on-site inspections of all banks in the system. These inspections were aimed at disclosing financial situation of banks through the insight in the balance sheet and off-balance sheet exposures and at assessing the key risks and banks sensitivities to negative events that may have or have already had impact on capital, earnings and liquidity and at assessing the ability of banks to execute their obligations on time. The Central Bank provided safety and stability of the banking system through its regulatory and supervisory activities in 2010 when a set of prudential measures of counter-cyclical character was developed. Simultaneously, the Central Bank imposed adequate measures through its supervisory

29 28 Central Bank of Montenegro Annual Report 2010 activities against banks applying poor banking practices in risk management and demanded from them to ensure adequate level of liquidity and capital. Stress testing results of the banking system sensitivity to crisis showed that four banks needed to provide additional capital. Another two banks performed recapitalisation, although the diagnostic assessment findings and stress testing results did not point to the recapitalisation need. In 2010, nine on-site inspections were performed, of which one was full scope and eight were targeted inspections. The inspections included all systemic banks focusing on credit risk, liquidity risk, capital adequacy and compliance. Banks with small market shares and lower levels of risk profile were continuously monitored through off-site inspections resulting from submitted operating reports. Pursuant to the Banking Law (OGMN 17/08 and 44/10), if the Central Bank determines the irregularities in a bank s operations, it may take measures for the purpose of bank rehabilitation. During 2010, the CBM introduced four measures against the banks: two written warnings and two orders where banks were instructed to remove certain irregularities in their operations. One written warning issued to the bank based on the disclosed irregularities requested the following: Establish monthly reporting to the Central Bank on operations of the bank and activities taken by the Board of Directors, Remove from the balance sheet assets classified as loss (E), Submit the adopted business strategy, strategic capital plan and annual plan for 2011 no later than by 31 January 2011, Submit the internal acts aimed at establishing independence in taking over and managing credit risk and submit evidence on activities taken no later than by 31 January 2011, Establish effective and efficient internal controls system in the bank. Bank s Board of Directors should submit monthly reports to the Central Bank on activities taken to establish the internal control system. For the purpose of removing irregularities disclosed in the report that the bank submitted to the Central Bank, it was ordered to the bank in the second written warning to increase the amount of own funds. The Central Bank ordered the bank to take the following activities due to disclosed high risk profile and inadequate credit risk management: Submit a written strategy of the bank to the Central Bank that refers to objectives, risk management, improvement of earnings and overall condition of the bank and projections of the balance sheet and profit and loss statement by the end of 2010; Terminate accepting new time deposits from natural persons if by the end of month the bank does not take or realise activities to reduce expenses based on deposit interest rates paid; Pay cash amount to Deposit Protection Fund, and Replace executive director.