Financial Crisis Lessons Learned and Policies Aimed at Strengthening the Resilience of the Banking Sector Nora Manova Trajkovska Senior Adviser Analyst Financial Stability Unit Financial Stability, Banking Regulations and Methodology Department 23rd Annual BSCEE Conference, Ohrid, Macedonia 15-17, June 2010

Agenda Financial crisis overview Macedonia – macroeconomic and financial sector profile Macedonia and the crisis Importance of the stress-testing Stress-testing at the NBRM Conclusions

About the Recent Financial Crisis Each crisis has its own unique set of characteristics Unwritten rule: often the next crisis will emerge from an a sector or a region where we least expected it

The Achilles’ heel of the Pre-Crisis Global Financial System The pre-crisis financial system was characterized by the following weaknesses: too much leverage in the banking and financial system and not enough high quality capital to absorb losses excessive credit growth based on weak underwriting standards and under pricing of liquidity and credit risk insufficient liquidity buffers and overly aggressive maturity transformation, both direct and indirect (for example, through the shadow banking system) inadequate risk governance and poor incentives to manage risks towards prudent long term outcomes, including through poorly designed compensations systems inadequate cushions in banks to mitigate the inherent pro-cyclicality of financial markets and its participants too much systemic risk, interconnectedness among financial players as well as common exposures to similar shocks, and inadequate oversight that should have served to mitigate the too-big-to fail problem

What We Have Learned? For Regulators and Supervisors following lessons emerge: First, there is a need to refine the regulatory framework to avoid distorted incentives Second, supervisors and regulators need to have the incentives and resources to look hard and deep at possible flaws in the risk management systems of the institutions they oversee An important third set of lessons relates to how to cope with the outcomes of crises of this new type

Financial Sector Reform Agenda Reform agenda must be focused on all four key pillars of financial system stability: Sound regulation Effective supervision Good governance and risk management in financial institutions Appropriate resolution frameworks

Regulations For the financial and regulatory framework, there are five areas that should be on top of the reform agenda for regaining financial stability: Increasing the quantity and quality of capital and liquidity in the banking system Expanding the regulatory perimeter to cover all systemically important institutions, markets, and activities Dealing with excessive pro-cyclicality in the financial system Improving financial disclosure Ensuring more effective cross-border regulation, supervision, and resolution of systemically important institutions like those too big to fail

Supervision Regulation has to be accompanied by a strong supervisory regime… we cannot rely on rules alone The supervisors need to have clear objectives and mandates, operational independence and adequate resources An appropriate mix of supervisory approaches and techniques, including on and off-site work focusing on identifying emerging risks at the firm level and system-wide A wide range of remedial actions that can be taken if regulated firms do not play by the rule

Risk Management and Governance Institutions need robust internal risk management systems accompanied by a culture of strong corporate governance in the individual institutions Board oversight of risk management policies and processes is the foundation of the bank’s internal defense mechanism The board is expected to determine the risk appetite of the firm, nurture the appropriate risk culture in the light of the firm’s risk profile, and assure that the bank does not take on excessive risk

Resolution Having appropriate resolution mechanisms for failing institutions, particularly to deal with systemically important firms Regulators could find ways to “discourage” institutions from becoming “too important to fail” by either imposing additional capital requirements based on their contribution to systemic risk, or by applying a leverage ratio on a group wide basis and heightened supervisory oversight

The Macroeconomic Profile of Macedonian Economy Amidst Crisis Mild contraction of the economy on the backdrop of the crisis (0.7% real GDP fall), partly as result of prudent policies and not having large imbalances prior to the crisis ...Moderate recovery expected in 2010, with GDP growth being forecasted at 1% Labor market resilient to the economic contraction, but unemployment rate extremely high (around 32%), mirroring structural problems After the pickup in inflation in 2008, pressures receded in 2009, amidst falling import prices and subdued demand (-0.8% average inflation)...In 2010, inflation to be held in interval of 1%-1.5%, driven by supply side factors Sharp downward adjustment of CAD in 2009 (leveled at 7.3%, compared to 13% of GDP in 2008), implied by the falling demand and lower energy prices...CAD to gravitate around 6% of GDP in 2010 Capital inflows slowed, but abundant enough to enable accumulation of reserves...same pattern expected in 2010, thus keeping foreign reserves at comfortable level External indebtedness increased in 2009 by 7 pp of GDP (gross external debt/GDP of 57.9% of GDP), but it is still at a relatively prudent level and with favorable structure (large share of intercompany lending and trade credits)

Financial Sector Overview (1) Financial intermediation picked up during last several years …72.2% -2009 (68.2%-2008) Bank-driven system, banks comprise around 90% of financial system assets and their main business focus is collecting deposits and granting loans Non banking financial institutions have minor systemic importance, low level of financial innovations

Financial Sector Overview (2) Increased (but still low) turnover of inter-bank market during last year, and illiquid secondary short-term securities’ market Domestic companies are not involved in issues of long term securities (non active primary capital markets) In the course of 2009 domestic investor have had larger impact on the capital market developments due to the passive performance of foreign investors and their withdrawal from the market …. in the previous years the stock exchange movements were highly influenced by the behavior of foreign institutional and individual investors

Stable Banking System in the Time of Crisis (1) The banks in the Republic of Macedonia proved to be prudent in their operations and managed to remain stable Banking system is consisted of 18 banks and 10 savings houses Total sector assets around EUR 5 billion Further deepening of financial intermediation, 66% at the end of 2009 (62.9% at the end of 2008) 14 banks dominantly owned by foreign shareholders (mainly from EU countries) representing 93% from the total banking system assets Banks’ solvency remains relatively high – CAR 16.4% (8% legally prescribed minimum)

Stable Banking System in the Time of Crisis (2) Mainly domestic funding (deposits of non-financial entities are around 70% of total assets; around 98% are resident deposit; 67% are household deposits) Loan to deposit ratio almost unchanged- 92.5% (2009), 92.8% (2008) Stable liquidity position (share of liquid assets in the total assets equaled 25.7% and provides satisfactory level of coverage of household deposits -53.7%, as well as, of the short term obligations - 37.5%)

Stable Banking System in the Time of Crisis (3) The dynamics of banks’ lending activity decelerated (34.4% - annual growth rate of credits to non-financial entities for 2008, while at the end of 2009 this growth rate was reduced down to 3.5%) Credit risk the most important risk in Macedonian banks operations The share of non-performing loans in total loans is 9.1%-2009 (6.8% at the end of 2008) Indirect credit risk is highly present (60% of loans are indexed to foreign currency and about 85% of total loans are with adjustable interest rate) Banks’ profitable operating continued in 2009, although at a lower level compared to the previous year

Was the Macedonian Banking System Affected by the Global Financial Crisis? (1) Macedonian banking system remained stable and resilient after the first wave of the global financial crisis Global crisis had no direct negative effects on the banks in Macedonia due to several factors:

Was the Macedonian Banking System Affected by the Global Financial Crisis? (2) Relatively high “closure” of the Macedonian banking system relative to the global financial flows and focus on domestic market Its conservativeness, i.e. its orientations towards traditional banking activities (collecting of deposits and placement of loans Macedonian banks are not exposed to subprime, structured credit derivatives and other related complex products and they had no credit exposure to the financial institutions affected by the crisis Low dependence on foreign sources of financing

Was the Macedonian Banking System Affected by the Global Financial Crisis? (3) Even though, some indirect effects especially in the course of 2009 were evident – through following channels: Real sector Psychologically induced pressures Limited access to finance for the banks

NBRM Measures to Enhance the Banking Sector’s Resilience to Stress (1) Tightening of the treatment of the banks’ claims on the basis of credit cards and overdrafts when determining the banks’ solvency (increase in the weight from 100% to 125%) Limiting the risks of the rapid household credit growth by introducing an obligation for allocation of compulsory deposit by banks and savings houses within NBRM, in case of higher growth of the household credits than the allowed growth rates Intensified contacts with banks Lowering the limit for the exposure to the first-class banks

NBRM Measures to Enhance the Banking Sector’s Resilience to Stress (2) Daily monitoring of the level of the households’ deposits within banks in the Republic of Macedonia Setting the minimal liquidity level required for covering of the bank’s liabilities that will due in the next 30 and 180 days, individual for Denar and foreign currency Possibility for banks foreign currency assets to be deposited within NBRM instead of their placement in the foreign banks’ abroad

Stress Tests and Crisis - What We Have Learned? What have stress tests shown us? Often, stress tests did not stress the right areas or not enough But, …. stress test should be catalyst for further analysis

Increased Interest in Stress - Testing Increased importance of stress-testing, especially as a consequence of the current turmoil At the level of individual financial institutions, stress-testing should be part of their internal risk management and should supplement other risk management approaches and measures At macro level, stress-testing should help regulators address structural vulnerabilities and overall risk exposure in a financial system In our country, the main promoter of the stress test was the IMF with its FSAP mission in 2003

Stress-Testing of Banking System Particularly deterministic stress test Scenario analysis and sensitivity tests Micro and macro perspective Stress tests at individual banks (bottom-up approach) Stress tests at NBRM (top-down approach)

Stress-Testing at Individual Banks Banks are required, at least annually to conduct stress test for their most important risk factors Through stress tests banks assess the shocks’ effects on CAR, profitability position and credit portfolio Reporting to Risk Management Committee and/or other governing bodies Notification to NBRM on the stress test results In 2008, during FSAP mission bottom-up stress tests were performed by few large banks

Stress-Testing at the NBRM (1) Used for macro prudential analysis and shock absorption capacity Conduct on quarterly basis – standard tests and ad hoc simulations High-degree of conservatism in assumptions (extreme shocks) Measuring effects on aggregated basis and for individual institutions (simplicity, one round effects, low time consumption)

Stress-Testing at the NBRM (2) Partial publication of results in different NBRM reports Some of the reports are submitted to the management and to the NBRM Council for review and adoption Stress –test conducted on individual banks are shared with the relevant portfolio manager in the Off-Site Supervision Department and with the management of the On-Site and Off-site Supervision Department

Variety of Stress Test Simulations Stress-test simulations for the resistance of the banking system and individual banks to following hypothetical shocks on: Isolated credit risk on overall credit portfolio Combination of credit risk, foreign exchange rate and interest rate risk Different credit portfolio segments Concentration risk Liquidity risk

Additional Stress Test Simulations On ad hoc basis: Combination on liquidity and credit risk (bankruptcy of international active banks) Stress Test Simulations for the Resistance of the Banking System to the Shocks Connected with the Debt Crisis in Greece

Isolated Credit Shock and Combination of Credit, Foreign Exchange and Interest Rate Shock (1) This stress test analysis is based on the application of eight hypothetical simulations: Three simulations for isolated credit shock (increase in the credit exposure in the risk categories C, D and E by 10%, 30% and 50%) Fourth simulation as a combination of the credit and interest rate shock (increase in the credit exposure in the risk categories C, D and E of 30% and increase in the domestic interest rates of 5 percentage points)

Isolated Credit Shock and Combination of Credit, Foreign Exchange and Interest Rate Shock (2) Fifth scenario as a combination of credit and foreign exchange shock (increase in the credit exposure in the risk categories C, D and E of 50% and depreciation in the Denar exchange rate compared to the Euro and the US Dollar of 20%) Sixth simulation as a combination of shocks on the side of the credit risk, the foreign exchange risk and the interest rate risk (increase in the credit exposure in the risk categories C, D and E of 50%, depreciation of the Denar exchange rate compared of the Euro and the US Dollar of 20% and increase in the domestic interest rates of 5 percentage points)

Isolated Credit Shock and Combination of Credit, Foreign Exchange and Interest Rate Shock (3) Seventh simulation, appreciation of the Denar exchange rate relative to the Euro and the US Dollar in the amount of 20% Eight simulation (increase in the credit exposure in the risk categories C, D and E of 50%, depreciation of the Denar exchange rate compared of the Euro and the US Dollar of 20%, increase in the domestic interest rates of 5 percentage points and increase of Euribor and Libor of 2,5 percentage points)

Isolated Credit Shock and Combination of Credit, Foreign Exchange and Interest Rate Shock (Results)

Shocks on Different Credit Portfolio Segments Shock – gradually worsening of the credit portfolio quality, by individual activity or by each credit products offered to households by applying two scenarios: Migration of 10% of the credit exposure of each risk category to the next two higher risk categories, distributed equally Redistribution of 30% of the credit exposure of each risk category to the next two higher risk categories Purpose: potential adverse effect of the credit exposure migration (for both the total exposure and the exposure by sector and activity) from the existing to the higher risk categories on the capital adequacy and the exposure risk Results as of March 31, 2010: Entire credit portfolio: CAR 16.7% (before shock) 14.6% (after I scenario) and 10.6% (after II scenario) Exposure to households: the largest impact on CAR emerges from exposure on the basis of consumer loans and credit card loans Exposure to corporate sector: industry and wholesale and retail trade are activities with the largest influence on CAR

Concentration Risk Simultaneous reclassification in the risk category C of the five largest credit exposures to non-financial entities, including connected entities Size of shock: impairment of total credit exposure Results as of March 2010: CAR from 18.4% to 15.4%

Liquidity and Credit Risk Simulations Testing on domestic banks’ resistance on bankruptcy of international active banks: Default of foreign parent entity of domestic bank Default of a large foreign correspondent financial institution Measurement of effects on CAR and on profitability Assessment of effects on liquidity Results: Larger effects on liquidity than on CAR and profitability

Stress Test Simulations for the Resistance of the Banking System to the Shocks Connected with the Debt Crisis in Greece Two transmission channels: domestic legal entities net exporters to Greece domestic legal entities debtors to Greece Two simulations: Moderate Extreme Results: relatively high resistance of the Macedonian banks’ to the plausible adverse effects from the debt crisis in Greece

Stress Test Simulations for the Resistance of the Banking System to the Shocks Connected with the Debt Crisis in Greece

Conclusions – Financial Crisis (1) We certainly hope the worst is behind us The crisis has hit ordinary people very hard Regulators should restore the trust in the financial system and the financial stability framework through set of policies Lessons from the crisis should be drawn and applied through policies Modest reforms that maintain a pretense of progress but continue business as usual are not sufficient

Conclusions – Financial Crisis (2) Corrective action is still needed and the lessons we are learning are ongoing Stress testing is important risk management tool for further analysis Banks must have a comprehensive stress tests for counterparty credit risk

Conclusions – Financial Crisis (3) Macedonian banking system remained stable and resilient after the first wave of the global financial crisis Global financial crises had no direct negative effects on the banks in Macedonia

Conclusions – Financial Crisis (4) If regulatory standards had been higher, as the BCBS in now proposing, the crisis would have been less severe and the burden on the public sector and taxpayers would have been lower Banking system remains essential for the recovery and for long-term prosperity As a regulators our mandate is to make it function properly!

Sources www.imf.org www.bis.org www.nbrm.gov.mk

Thank you for your attention! ManovaN@nbrm.gov.mk www.nbrm.gov.mk