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«© 2003 International Monetary Fund November 2003 IMF Country Report No. 03/374 Former Yugoslav Republic of Macedonia: Financial System Stability ...»

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© 2003 International Monetary Fund November 2003

IMF Country Report No. 03/374

Former Yugoslav Republic of Macedonia: Financial System Stability Assessment,

including Reports on the Observance of Standards and Codes on the following topics:

Banking Supervision, Payment Systems, Monetary and Financial Policy Transparency,

and Anti-Money Laundering and Combating the Financing of Terrorism

This Financial System Stability Assessment paper for Former Yugoslav Republic of Macedonia was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on September 29, 2003. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Former Yugoslav Republic of Macedonia or the Executive Board of the IMF.

The policy of publication of staff reports and other documents by the IMF allows for the deletion of market-sensitive information.

To assist the IMF in evaluating the publication policy, reader comments are invited and may be sent by e-mail to publicationpolicy@imf.org.

Copies of this report are available to the public from International Monetary Fund ● Publication Services 700 19th Street, N.W. ● Washington, D.C. 20431 Telephone: (202) 623 7430 ● Telefax: (202) 623 7201 E-mail: publications@imf.org ● Internet: http://www.imf.org Price: $15.00 a copy International Monetary Fund Washington, D.C.



Financial System Stability Assessment Prepared by the Monetary and Financial Systems and the European I Departments Approved by Ulrich Baumgartner and Susan Schadler September 29, 2003 The Financial System Stability Assessment (FSSA) is based on the work of the joint IMF-World Bank Financial Sector Assessment Program (FSAP) missions to the former Yugoslav Republic of Macedonia (FYR) Macedonia in May–June 2003. The team met with senior government officials, including the Minister of Finance and the Governor of the National Bank of the Republic of Macedonia (NBRM), as well as with staff of the Ministry of Finance (MOF) and the NBRM, of agencies involved in regulation and supervision of the financial system, banks and other financial institutions, and other private sector participants.

The FSAP team consisted of Messrs. Hormoz Aghdaey (World Bank, Mission Chief) and Marc Quintyn (IMF, Deputy Mission Chief), Philip Schellekens, Anita Tuladhar, and Judit Vadasz (all IMF), Robert Gourley, Peter Kyle, Rodney Lester, Svitlana Lewis, Melinda Roth, Hannah Thomas, Jasminka Varnalieva, Richard Zechter (all World Bank), Paul van Sluijs (The Netherlands Bank, banking supervision—IMF expert) and Nick Roberts (Reserve Bank of Australia, payment system—IMF expert). Mr. Kevin Ross (IMF resident representative) participated in some meetings.

Development of the Macedonian financial system shows the marks of the country’s turbulent first decade of independence. Intermittent conflicts and disturbances have had an adverse impact on the development of the institutions necessary to support the transition to a market economy and on the governance of those institutions.

As a result, the financial system is still very small and its role as intermediator of financial flows limited.

Nonetheless, soundness of the banking system has been improving in recent years. A core group of banks with relatively prudent and sound practices is emerging. The entrance of foreign strategic investors, in combination with enhancements in regulation and supervision, has fostered this process. However, the system remains vulnerable to weak governance in smaller banks and weaknesses in the banks’ balance sheets. Macroeconomic vulnerabilities could stem from the effect on banks of potential exchange rate instability, or a dramatic reversal in donor support.

The mission’s recommendations are aimed at two levels. At the general level, corruption, money laundering, and weak implementation and enforcement of laws need to be addressed as preconditions for improving the integrity of the financial system and its role in the economy. Specific recommendations with respect to the operation of the financial system include (a) strengthening the regulatory framework for banking;

(b) sharpening banking supervision practices in the direction of risk-based assessments and to enhance governance practices; (c) establishing a framework for emergency lending at the NBRM; (d) developing a government securities market as the basis for financial market development; (e) developing supervisory capacity for the insurance market and the planned pension fund market; and (f) cautious development of the second pension pillar, given its potential impact on the country’s fiscal position.

The main authors of this report are Marc Quintyn and Judit Vadasz.

FSAPs are designed to assess the stability of the financial system as a whole and not that of individual institutions. They have been developed to help countries identify and remedy weaknesses in their financial sector structure, thereby enhancing their resilience to macroeconomic shocks and cross-border contagion.

FSAPs do not cover risks that are specific to individual institutions such as asset quality, operational or legal risks, or fraud.


–  –  –


I. Overall Assessment of Stability and Development Issues

A. Context for Financial Intermediation

B. Vulnerabilities and Soundness of Banking

C. Broader Framework for Finance

D. Nonbank Financial System

II. Overview of the Financial System

A. Financial Institutions

B. Markets and Infrastructure

C. Recent Economic Developments

III. Vulnerabilities and Soundness of the Financial System

A. Macroeconomic Sources of Risk to Financial Stability

B. Risks and Vulnerabilities

Governance issues

Balance sheet weaknesses

C. Stress Testing

IV. Managing Risks and Addressing Vulnerabilities

A. Prudential Regulation and Supervision

B. Management of Systemic Liquidity

C. Financial Safety Nets

Deposit insurance

Emergency lending facility

V. Improving the Foundations for Intermediation

A. Problems with Intermediation

B. Market Development

C. Developing the Pension System

D. Legal and Judicial Framework

E. The Anti-Money Laundering Framework

Text Tables

1. Financial System Structure, 1998–2002

2. Comparison of the Macedonian Banking System with Selected Central and Eastern European Countries

3. Basic Economic Indicators, 1998–2002

4. Financial Soundness Indicators, 1998–2002


1. Main Recommendations

-3Annex Observance of Financial Sector Standards and Codes: Summary Assessments...............29 I. Basel Core Principles for Effective Banking Supervision

II. CPSS Core Principles for Systemically Important Payment Systems

III. Code of Good Practices on Transparency in Monetary and Financial PoliciesMonetary Policy

IV. Code of Good Practices on Transparency in Monetary and Financial PoliciesFinancial Policies (Payments system, Banking Supervision, and Deposit Insurance)

V. FATF Recommendations for Anti-Money Laundering and Combating the Financing of Terrorism

Annex Tables A.1. Recommended Actions to Improve Compliance with the Basel Core Principles...........33 A.2. Recommended Actions to Improve Observance of CPSS Core Principles and Central Bank’s Responsibilities in Applying the CPs

A.3. Recommended Actions to Improve Observance of IMF’s MFP Transparency Code Practices—Monetary Policy

A.4. Recommended Actions to Improve Observance of IMF’s MFP Transparency Code— Financial Policies

A.5. Recommended Actions to Improve Compliance with the FATF 40+8 Recommendations48


–  –  –

1. FYR Macedonia has not yet fully recovered from the breakup of Yugoslavia and the subsequent economic and political upheavals. Following independence in 1991, the country had to cope with the loss of its foreign exchange deposits held in the National Bank of Yugoslavia, a breakdown in its trade linkages due to the embargo on Yugoslavia, the blockade by Greece, the 1999 Kosovo conflict, and the internal civil strife in 2001.

2. These intermittent conflicts and disturbances have had an adverse impact on the development of the institutions necessary to support the transition to a market economy and on the governance of those institutions. By many accounts, there has been a significant degree of corruption in the public sector, manifested in the use of public office for private gain. Corruption and bad governance in the wider economy have been compounded by the chosen methods of privatization. The judicial system is considered to be ineffective, because of excessive politicization, lack of independence, and intimidation of the judges, as well as deficiencies in the procedures and operations of the courts.

3. Weak institutions and governance have taken a significant toll on economic development and growth in the past decade. Indeed, FYR Macedonia does not present an environment conducive to attracting investment, whether foreign or domestic. As a result, FYR Macedonia is only midway in the transition to a stable market-oriented economy.

4. Not surprisingly, these deficiencies have also had a negative impact on financial sector development and on intermediation. On the one hand, financial integrity has often been threatened by opportunities for corruption and abuse, diverting resources away from potentially productive uses in the economy. On the other hand, it has been difficult for banks to develop lending activities in an environment of weak corporate governance and legal uncertainty.

5. To address these deficiencies at their roots, a two-pronged strategy is needed.

Remedying weak financial intermediation and regaining the confidence of the population and foreign investors is both a matter of preserving macroeconomic stability and addressing the problems of governance and corruption. The government has taken steps in both areas. These efforts are seen as the keystone for building a sound and stable financial system that, in turn, can actively contribute to economic development and growth.

B. Vulnerabilities and Soundness of Banking

6. Despite the difficult environment, the soundness of the Macedonian banking system has been improving in recent years. The sector is still small and relatively underdeveloped. Most of the deposits and assets are concentrated in the top three banks.

These three banks are gradually emerging as a core group with relatively prudent and sound banking practices. The entrance of foreign strategic investors, following these banks’ privatization, has fostered this process.

-6More than a decade of political and economic upheaval notwithstanding, Macedonia’s macroeconomy has been relatively stable. The economy is recovering very slowly from the current recession due to the lingering effects of the security situation in

2001. Although the economy remains fragile and potentially volatile, there appear to be no immediate macroeconomic threats to the stability of the financial system. Nonetheless, the authorities need to remain vigilant for potential risks that could stem from exchange rate instability in a highly euroized environment, or a drastic reduction in donor support.

8. The financial system remains vulnerable to weak governance in smaller banks and also to weaknesses in the banks’ balance sheets. Weak governance in smaller banks is mainly a result of practices during the early transition years. Some banks still have a dispersed ownership structure with one strong manager. Others have a weak management structure. In a few banks, the ownership structure is nontransparent. The authorities do not have the full range of legal instruments to address these problems, but in the short term they are recommended to attract reputable strategic investors to help overcome these weaknesses.

Balance sheet weaknesses are reflected in the high percentage of nonperforming loans (NPLs).

9. Banking is characterized by high real interest rates, large spreads, and a limited appetite for lending. Interest rate spreads are above 8 percentage points, reflecting lack of competition, inefficient operations (overstaffing), and high credit risk. Most banks are expanding lending only modestly, reflecting their own weak balance sheets as well as a legal environment not conducive to repayment and loan recovery.

10. Euroization of bank assets and liabilities is substantial. About 64 percent of deposits and 40 percent of banks’ total loans are denominated in foreign currency.

Foreign currency deposits are subject to the same reserve requirement as denar deposits.

Although banks are adequately hedged against foreign exchange risks (supervisors monitor the open positions closely), they are exposed to potential credit risks from borrowers who are not foreign exchange earners. To monitor this risk, the NBRM will require banks to set up a reporting system to gauge their borrowers’ foreign exchange exposure.

11. Stress tests indicate that the banking system is relatively resilient to the direct effects of individual shocks, with credit risk having the greatest impact. However, the combined effects of an exchange and interest rate shock, together with a drop in credit quality could result in significant strain on the system. Larger banks appear more vulnerable than smaller banks, because they are lending more actively and because of lingering portfolio problems.

12. Deficiencies in the framework for the banks’ liquidity management are developmental in nature but need to be addressed to avoid systemic problems. Issues to be addressed include expanding the range of eligible instruments for collateral to access the central bank and supporting secondary market development by reducing the frequency of central bank bill auctions. Some banks are vulnerable because of the presence of sizeable

-7individual deposits on their balance sheets. The interbank market is still too shallow for the larger banks.

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