Economic and Social Reforms for Peace and Reconciliation

Prepared by the World Bank

February 1, 2001

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Kosovo’s banking sector is underdeveloped by modern standards. Causes include weak resource mobilization, virtually no lending and few formal sector transactions. Banking sector weaknesses partly reflect the traditionally poor status of Kosovo (based on formal economic measures). Kosovo had the lowest per capita income in the former Yugoslavia,¹ reported to be US$700 in 1988, in contrast to Serbia’s at US$2,285, and the Yugoslav average of US$2,520. Confidence in the banking system steadily eroded in the late eighties and into the 1990s following the revocation of autonomous provincial status, the freezing of foreign currency deposits, and attempts to dismantle the local banking system.

Throughout the 1990s, most banks transferred hard currency to Serbia or to some of the socially-owned/State-owned² industries in Kosovo. Then Albanians and other non-Serb managers and workers were dismissed from these industries to facilitate the hiring of ethnic Serbs. As these companies began to physically deteriorate and resource transfers to Serbia became less frequent, the remaining banks left the Kosovo market. This pattern in the banking sector - along with the attempted legal liquidation of Bank Kos³ - became the financial counterpart of the de-industrialization of Kosovo following the revocation of its status as an autonomous province.

Prior to the 1999 conflict, Kosovo had five major banks and reportedly 54 branches of Serbian banks.⁴ However, assets, loans, deposits, capital, and other generally standard bank balance sheet data however were not reported - except for the "indigenous" Ekonomik Bank, a successor to the closed Bank Kos. If gauged by reporting standards found in other dinar-denominated economic areas, these data would have been meaningless even if reported.⁵ This is because assets and loans did not reflect loss provisioning or write-offs as is customary in international practice. Deposits would have reflected frozen foreign exchange deposits of about US$1 billion (transferred to Belgrade in 1990). On the other hand, capital would not have been adjusted for negative earnings retained over the years. Also, the downward impact of market-based valuations of fixed assets and their impact on net worth would not have appeared. Without these adjustments, balance sheet reporting would have overvalued the asset base, active funding sources, and banking system capital - even prior to the conflict.

Of the four major banks operating prior to hostilities, three were reported to be operating until late 1998/early 1999, though only on a limited basis:

• Bank Kos, which was deactivated in 1990, but served the larger industrial enterprises and agro-kombinats from 1961 to its deactivation - similar to the role played by the older Privredna Bank in former Yugoslavia in today’s Bosnia-Herzegovina and Croatia.

• Beobanka

• Ekonomik Bank, which replaced Bank Kos in Kosovo in terms of general target clientele, and still has basic operational infrastructure. Persistent asset stripping, equipment cannibalization, transfers of funds, and dismissals of ethnic Albanians from industrial enterprises - all rendered the bank’s activities progressively less important throughout the 1990s. By late 1999, Ekonomik Bank reportedly had only about Dinar 7 to 8 million in deposits (about DM 500,000, or less than US$300,000).

• Yugobanka, which operated throughout Yugoslavia prior to its break-up, and still operates in Serbia, though it is now defunct in Kosovo.

• Vojvidanska Bank, which, like Ekonomik Bank, possesses some infrastructure for basic payment operations, but is now closed.

As in the rest of the country, under the model of "social ownership," these banks traditionally served as captive finance companies. They loaned money to their socially owned enterprise owners and provided numerous services to their respective employees. These included accepting deposits, paying pensions, and providing other basic financial stewardship functions. Private sector accounts and shareholders were added in the 1990s, although their role was not significant because of the informalization of the economy. In general, the role of these banks diminished in the 1990s, as industries in Kosovo became increasingly run down, and ethnic Albanians and others found employment in the trade and service sectors (mostly in the gray economy). Bank branches from Serbia that operated in the market in the 1990s functioned more as unit banks, i.e., no or few branches. Their main objective was to transfer hard currency from Kosovo to the vaults in Belgrade or into accounts abroad. Most of these banks had closed and returned to Serbia by early 1999.

Almost no financial analysis was done to assess risk. Before the early 1990s, if enterprises needed additional funds, they would obtain them from the bank(s) they owned. This became more difficult in the 1990s after the imposition of sanctions. Industries then began to cannibalize machinery and equipment, running down their industrial assets. Political criteria became more important than commercial value in obtaining funds during periods of tight liquidity. Principal due was frequently rolled over without evidence of the debtor’s ability to repay. Interest was frequently capitalized. Banks also took out mortgages and liens on their borrowers’ assets to secure loans. These collateral values were dubious because of problems of "perfection" and the inability to assume ownership of properties used as collateral. Moreover, the judicial structure of the former system was not set up to enforce contracts or to resolve disputes in favor of creditors.

All of these factors contributed to a passive banking system, in which banks neither lent according to commercial criteria nor monitored for risk once loans were made. In cases where loans were granted to Albanian-owned enterprises, in the 1990s they were frequently not repaid (with the consent of bank management) based on the belief among ethnic Albanians in Kosovo that Serbia had already expropriated deposits and other funds from them (i.e., to finance wars and to ease the effect of sanctions in Serbia). Thus, principal repayments could potentially be subject to the same confiscatory practices in the future.

On the liability and cost side, banks provided safekeeping services for enterprises and households. However, as in the rest of Yugoslavia, foreign currency deposits were physically transferred to the vaults of the former National Bank in Belgrade in exchange for local currency. Hyperinflation from the late 1980s into the 1990s promptly erased Dinar values - and with it the savings and confidence of the public.⁶ Meanwhile, the conflicts in Croatia, Bosnia and Herzegovina and other parts of the former Yugoslavia⁷ in 1992 prompted the imposition of sanctions against the reconstituted Yugoslavia by official creditors. This manifested itself in the curtailment of international lending flows to Kosovo, a loss of liquidity in the banking system, and a virtual halt to banking operations. Moreover, in the 1990s because of prejudicial practices directed against ethnic Albanians (and other non-Serbs) in the industrial sector, a significant portion of the majority population in Kosovo engaged in private sector activity in the "gray" and "black" economy. Thus, the incentive structure prevailing in the 1990s constrained formal savings mobilization and prompted full-scale financial disintermediation. This led to the virtual disappearance of the banking sector in Kosovo.

Profile of the Current Banking Sector⁸

As of end 1999, there were no banks operating in Kosovo. One bank, the Micro-Enterprise Bank of Kosovo (MEB-Kosovo), with EBRD and IFC being equity participants, received approval to commence operations in January 2000. A second financial institution (technically a "non-bank"), the Grameen-Missione AMF, also obtained a license to operate as a micro-finance institution, although it was not active as of the second quarter of 2000. Preliminary licenses were approved by the licensing and supervisory authority in spring 2000 for four banks with a history of operations in Kosovo, but it is uncertain whether these banks would be able to qualify for permanent licenses.

By early 2000, deposit mobilization and lending were virtually nonexistent in the banking sector apart from the 2,000 or so accounts that had been opened with MEB-Kosovo.⁹ Basic transfers through the banks had been virtually stopped so the payment system could be reorganized. (These services are now beginning to be provided by the Banking and Payments Authority in Kosovo. However, in the absence of a functioning banking system, these services have generally been provided by travel companies at a 5 to 7 percent charge per transfer.) In late 1999-early 2000, the banks were characterized by:

• lack of meaningful monetary capital;

• real estate as the major asset on the balance sheet, but frequently damaged physically and overvalued in financially;

• a desire to re-create pre-1990 conditions and practices;

• a comparatively untrained labor force for modern banking;

• the intention to re-start operations as "large" banks; and

• virtual stoppage of operations.

Immediate problems include:

• The absence of banks that have been prepared to compete along commercial lines;

• The inadequacy or nonexistence of meaningful financial information and management systems in the banking (and enterprise) sector;

• The absence of financial intermediation (deposit-taking or lending) resulting from a lack of public confidence, past resource misallocation and politicization of bank lending, and the need for cash to finance trade and services in the largely informal Kosovo economy;

• The presence of only a small and costly range of banking services, namely transfers, which are provided more by travel companies or informally rather than through banks; and

A particularly severe problem – the lack of public confidence in banks – was revealed by a survey. It indicated that the population would refuse to place their significant informal savings in any institution except a foreign commercial bank. While the survey did not elucidate the meaning of "foreign commercial bank," ¹⁰ it did note an absence of confidence in foreign banks from Albania, FYR Macedonia, and Yugoslavia. (The survey was conducted prior to the opening of MEB-Kosovo).

There has been, perhaps unsurprisingly, little interest shown to date from international banks in investing in Kosovo. This could change over time once pilots are tested and successes are demonstrated. One such pilot is the Bank and EC supported line of credit for small and medium enterprises that has recently become operational (details can be found in a later section of this chapter). However, for the foreseeable future, efforts to establish a firm foundation for formal financial intermediation will be undermined by the widespread lack of public confidence. The revival of the banking industry will depend largely on regaining public confidence. This is closely linked to the quality and probity of banks and bank management, as well as the presence of an adequate banking supervision authority.

Banks in Kosovo lack modern management systems and personnel experienced in commercial banking consistent with international standards and market-based norms. Meanwhile, financially, the banks that operated before are insolvent because of the prevalence of bad (and immobile) assets and damaged real estate on their books. Consequently, they cannot obtain new licenses until they are in a position to comply with new licensing and regulatory requirements, introduced at the end of 1999. These requirements specify both managerial and financial restoration as prerequisites. Compliance with new regulations will almost certainly require new banks to enter the market. This would be either in the form of "greenfield" investment, or from a strategic investor reviving one or more "old" banks. Bank Kos had dozens of correspondent relationships, including several with major international banks. On the other hand, given the political risk and small size of the market, these and other prime-rated banks probably will not have an interest in investing in the Kosovo market any time soon. This has led to the need for a comprehensive strategy to develop the Kosovo banking system based on a sustainable and comprehensive incentive structure.

Strategic Goals and Objectives. Strategic goals and objectives for banking sector development depend on support for a wide range of structural reforms. As elsewhere, success in developing a viable banking sector depends on a number of factors. They include a sound legal and institutional framework to ensure incentives are in place for adequate resource mobilization; proper risk management guidelines and practices; and public confidence. To rebuild the banking system in Kosovo the following will need to be achieved:

• Focus on Restoring Sustainable Financial Intermediation. This will mean restoring confidence in a banking system so that meaningful resource mobilization and financial intermediation can occur.

• Rebuild the Banking System Based on Emerging Global Standards. This will depend on establishing a modern banking system and economy for Kosovo based on a suitable regulatory and institutional framework for market-based competition and incentives for sound management and governance - from foreign as well as local sources.

• Design Donor-Supported Projects to Be Consistent With Market-Based Principles. Donor assistance in providing needed intermediation and related services (through loan funds, technical assistance, and training) will achieve better results if project design is harmonized, and if commercial fundamentals are applied by enterprises and banks in concert with prevailing prudential regulations. Such an approach would also contribute to a meaningful and well-coordinated rejuvenation of the formal Kosovo economy, which would support the long-term goal of developing a viable and competitive private sector in a well-managed and increasingly diversified economy.

• Include Explicit Exit Strategies in Donor-Supported Projects. Donor assistance in helping to rebuild the banking system should consider the current weakness of the formal financial sector as an aberration. There is no guarantee that private banks, domestic or foreign, will invest soon and play their proper role in restoring financial intermediation. Nevertheless, attracting legitimate private investment and professional management in this sector should be the main objective, with donor programs serving as a bridge. Consequently, donor projects in the banking sector should be designed with an exit strategy. This strategy could be revised if adequate levels of investment and professionalization fail to materialize.

• Development of Human Capital. The well-known weaknesses of the Yugoslav banking system, the low level of banking activities in Kosovo over a decade and the exclusion of the majority ethnic population in the formal banking industry have resulted in a massive denuding of human capital in this sector. Training in modern standards of efficient and sound banking is urgently required. This will need to be provided through intensive, hands-on technical assistance to bankers and bank supervisors over a period of some years. Experience suggests that such investment in training have a high pay-off; indeed, however fine regulations, rules and manuals may be, critical to effectiveness is human skill, motivation and honesty. The entry of foreign banks will greatly contribute to human capital formation, but management contracts and twinning arrangements with nascent local banks should also be considered.

Progress in the Banking Sector: Regulations and Rules. Several years will be needed to reverse the problems facing Kosovo. This is because of the political divisions of the region, and the associated political risks that could unfavorably impact developments in the economy and banking sector. Key challenges for banking sector modernization include improving prospects for foreign investment, professionalizing the management of formal financial sector institutions and resources, and developing accountable and credible civil institutions that inspire confidence and are fiscally sustainable. All three are interdependent, and combined represent the necessary conditions to place the banking sector on the path of long-term commercial viability. Moreover, as deposits are mobilized and the banking system begins to make loans, interest rates will emerge and should be determined in as a market process. Building blocks for development of a stable banking sector include the following:

• Introducing incentives in the banking system to "formalize" the economy so as to increase savings mobilization and prudently managed lending;

• Developing standards for better information and disclosure, including improved accounting standards, strengthened internal audit functions, and adequate management information systems;

• Providing legal incentives for banks to take prudent financial risk by providing a better framework for secured transactions, contract enforcement, out-of-court arbitration, and timely dispute resolution based on clear, straightforward, transparent guidelines;

• Strengthening the role of banking supervision according to market-based and risk-based models;

• Developing banks’ general capacity for risk management, portfolio management, and asset-liability management - all of which are directly linked to improved governance and internal oversight;

• Adapting banking practices to international standards that address connected (related-party) lending, loan concentration and exposure, and new loan classification standards (both in the aggregate, and on a loan-by-loan basis);

• Introducing timely loan-loss provisioning (factored on a pre-tax basis) and write-offs accompanied by suspension/reversal of accrued interest income;

• Improving loan monitoring and administration, including better credit files and documentation for systematic follow-up; and

• Developing a fully functioning payments system.

Much has been accomplished in some of these areas, principally the establishment of an effective supervision system supported by modern laws and regulations and progress is underway in some of the other areas. The introduction of three key regulations¹¹ that establish new guidelines for market-based banking, unify the payments system, and call for basic banking supervision capacity represents a start. Time, experience, and investment will be required to meet the long-term challenge of constructing a viable institutional framework and a conducive environment for market-based banking.

To date, the regulations alluded to above, provide guidelines and parameters for bank governance, management, and operations. Work is also under way to draft new rules that touch on issues of commercial law - corporate/business organization, contract enforcement, property rights, privatization, dispute resolution, collateral, mortgages, bankruptcy and insolvency. This is expected to reinforce progress in reconstituting the formal banking sector. It should also ultimately help provide banks with incentives to lend in a manner that is risk-taking yet prudent. In addition to the introduction of sound banking legislation, the development of risk management capacity at the banks, and the evolution of effective supervision, other preconditions for public confidence and deposit safety are now being put in place.

Key features to the banking regulations include:

• Requirements to obtain and maintain a license;

• The right of foreign banks to operate, with associated cross-country supervisory requirements;

• The authority of the Banking and Payments Authority of Kosovo (BPK) to approve banks’ governing boards, conduct on-site inspections, request any/all information as needed for supervisory oversight, require prompt corrective action when regulatory capital falls to two- thirds or less of requirements, and to appoint receivers and liquidate;

• Minimum capital of at least DM 1 million as a "narrow" bank,¹² DM 3 million to provide basic banking services, and a higher minimum capital of DM 5 million to engage in non-DM currency futures trading, trust, investment/portfolio management, and securities underwriting and trading;

• Minimum capital adequacy requirements/ratios,

• Exposure and concentration limits on large loans;

• Restrictions on banks’ equity holdings in non-financial companies to 15 percent of regulatory capital per investment, and no more than 100 percent of regulatory capital in aggregate;

• Liquidity practices and risk management functions regarding interest rate, exchange rate, maturity, and asset-liability risks/gaps;

• Ownership, management, and governance guidelines based on prudent internal controls, modern management information systems, internationally accepted standards and qualifications of board members and managers, and legal, operational, financial and administrative autonomy for banks;

• Autonomous internal audit functions;

• External audits based on IAS on both an individual and consolidated basis, including assessments of the (non)viability of internal audit standards, guidelines, practices and information systems;

• Reporting to supervisory authorities to maintain a banking license;

• Prohibition on certain activities and fines and sanctions for violations; and

• Receivership and liquidation.

New licenses would be issued to newly established banks based on their demonstrated ability to meet minimum conditions specified in the new Regulation on Bank Licensing, Supervision and Regulation and accompanying requirements, as well as to comply with these on an ongoing basis.

As noted, the banks suffer from an extreme lack of public confidence in view of the effective confiscation of foreign currency deposits by the Belgrade authorities over the past decade and the weak management and capital positions of the banks themselves. The revival of the banking industry will depend crucially on regaining public confidence. This, in turn, depends on the quality and integrity of banks and bank management. Key policy steps consist of establishing effective banking supervision within the framework of a stringent banking law and, eventually, introducing limited deposit insurance. It appears likely that revived banking activity in Kosovo will originate from new entrants, whether foreign or domestic.

A new banking supervision department has been set up within the umbrella of the Banking and Payments Agency, which is also charged with operating the payments system. The supervision department has responsibility for: (i) licensing new banks; (ii) permitting banks to engage in new activities or offer new products; (iii) permitting mergers and consolidations of banks; (iv) providing guidance to banks on what the supervisor deems to be unsafe or unsound; (v) assessing the condition of individual banks and of the banking system; and (vi) initiating, pursuing and following up on corrective actions.

Policies and procedures related to direct supervisory activities are disclosed to banks and to the general public. Disclosure enables the public to gain a better understanding of the supervisor’s role. More importantly, informing banks of the supervisor’s expectations and of the consequences for failure to meet them is an effective supervisory technique to encourage voluntary compliance. This aspect of public interaction is managed in a manner that suggests UNMIK is promoting the stability and strength of the banking and financial sectors.

The supervision department is developing a basic policy framework utilizing a CAMEL-style¹³ evaluation system to guide supervisory decisions, and then to extend the scope to include a broader array of assessment factors and techniques, such as risk management and risk profiling. The manual delineates expectations regarding the standards of financial condition and management practices for financial institutions, as well as evaluation methodology. The manual focuses on risk management principles and other non-financial areas, such as corporate governance, transactions with affiliates and insiders, internal controls, and issues related to regulatory compliance, etc. The manual itself will become a more comprehensive supervisory policy manual containing principles-based guidance for the assessment of risk in individual institutions and the sector. It also facilitates consistent policy application throughout the range of supervisory activities, including licensing activities and procedures, on-site examinations, and off-site surveillance. In addition, it enhances the ability of the agency to design and initiate risk-appropriate corrective actions.

The framework of the manual allows the application of the appropriate principles and concepts to any institution - regardless of structural or operational differences. The manual details on- and off-balance sheet activities, management practices, related policies and regulations. The manual also describes a set of risk assessment principles and evaluation factors applicable to each area. Expectations for minimum risk management policies and practices are given. The advisory team assists in the implementation of these principles as part of its supervision of commercial banks. The advisors routinely test the policies during examinations to better tailor the policy and improve its practical application.

The development of the policy manual also serves as the basis for continued development of the organizational structure, creation of supervision programs/cycles, on-site examinations, off-site surveillance and risk profiling activities. Additionally, the principles in the manual help to guide decision-making with respect to licensing and problem bank management and resolution. It also provides the basis for periodic staff training as well as the foundation for a comprehensive training program. Lastly, the well-articulated policy structure, in conjunction with the legal and regulatory framework, provides a solid base on which the department can sustain sound financial sector management after the withdrawal of UNMIK.

BPK, as the licensing authority has the right to set criteria and reject applications for establishments that do not meet the standards set. The licensing process, at a minimum, consist of an assessment of the banking organization’s ownership structure, directors and senior management, its operating plan and internal controls, and its projected financial condition, including its capital base. In addition, UNMIK has the legal authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties. This review process is subject to policies that promote a competitive, market-based banking system.

With the legal and regulatory basis for licensing activities in place, the department now is focusing on the process of licensing, including the decisional framework, policies, tools and work products. The goal is to ensure that licensing activities are guided by the risk-based policies outlined in the policy manual, and decisions are consistent with market-based supervisory philosophies.

The supervision department has also developed an array of supervisory responses that allows it to respond to institutional and sector issues in a risk-appropriate manner. The policy framework includes an outline of possible actions or consequences that may be applied to an individual, an institution, or financial group, under specific conditions, practices or situations. This includes risk-appropriate measures for dealing with "problem banks," and procedures to liquidate insolvent institutions.

The issue of problem banks is of critical importance to the Kosovo financial sector, as banking weaknesses, unpaid frozen deposits, apparent fraud and other factors have eroded consumer confidence and inhibited the mobilization of savings for investment. While banks continue to report high capital ratios under FRY accounting rules, it is clear that when loan losses are recognized, banking institutions will experience dramatic declines in capital ratios, and bank failures and liquidations can be expected to increase.

Progress in creating a viable legal and regulatory framework will need to occur in tandem with the development of the banking supervision authority. A workable payments system, drafting of new accounting and audit standards, and commercial bank training are required to support the new banking system. In the process, risk management practices need to be introduced by the banks themselves. An important step towards restoration of financial intermediation is the institution of Bank/EC and donor-supported credit lines for SMEs from autumn 2000.

From a portfolio management standpoint, initially focus should be on asset-liability management, credit quality (including off-balance sheet exposure), and liquidity management. From a systems standpoint, focus would be on the introduction of an autonomous internal audit function, the installation of modern management information systems, and the implementation of regular reporting to BPK and within bank organizations themselves. Meanwhile, investment from donors in one or more new banking organizations is expected to establish fundamental competitive norms. Such institutions, as well as micro-finance institutions also supported by/with donor funds, would be expected to comply with the prudential regulatory norms drafted for the banking sector. Key components are expected to include:

• Lines of Credit. The introduction of donor-financed lines of credit should help to provide some lending capacity to the private sector. Most project designs to date have focused on micro-finance market. In fact, there is a gap in financing for small- and medium-sized enterprises with credit needs in the DM 50,000 to DM 500,000 range. Filling this gap will depend on a number of conditions, including the ability of these enterprises to demonstrate good management, personal financial risk, accountability, and commercial prospects for success. Larger enterprises probably will require different sources of financing - but only after restructuring strategies have been developed and legal claims/disputes have been resolved.

Successful project implementation will require the training of lenders to assess risk based on commercial terms and incentives. In the absence of a buoyant private banking market, technical assistance and training should play a key role in developing credit management skills. These would pertain to initial contact and assessment of firms through analysis of business plans, loan approvals, loan disbursements, monitoring the use of loan proceeds, maintenance of proper credit files and systems, and loan collection. When banks eventually become licensed, technical assistance and training would be needed to develop portfolio management capacity regarding prudential regulations, the avoidance of excess concentrations, asset-liability management, and other informational requirements for management and governance in a market-based system.

• Business Advisory Services. As part of the formalization of financial intermediation, many of the businesses seeking loans will need financial, operational, and managerial assistance. There is little doubt about entrepreneurial capacity in Kosovo. However, there are differences in the needs of firms operating in the formal economy, compared with those that have operated informally for 10 or more years. In a similar vein, larger corporations have needs that differ from owner-operated businesses and sole proprietorships in more transparent market-based economies. Business advisory services would provide some businesses with needed planning expertise--particularly after the last decade, when many businesses had little incentive to operate in the open. Establishment of a viable network of business advisory firms in Kosovo would go a long way toward helping firms to develop viable product and market strategies, and to maintain appropriate capital structures and liquidity management practices. These developments, in turn, would strengthen credit worthiness and enhance financial intermediation prospects for both businesses and banks.

• Out-of-Court Arbitration. More expedient out-of-court measures may need to be introduced to compensate for weakness in judicial capacity and differences between the emerging business sector framework in Kosovo and Yugoslav law. This approach would accelerate dispute resolution, in lieu of tying up claims in time-consuming court procedures. This might also alleviate some of the doubts creditors have regarding secured loans and collateral backing (along with contract enforcement measures). Clear guidelines would be needed to ensure rapid resolution. The guidelines would be developed as a precursor to creating the requisite judicial capacity to execute rules and regulations governing secured transactions.

• Accounting/Audit Standards and Professionalization. The introduction of accounting standards according to international norms is mandatory. This will require development of a new profession, with specific specialization needed for financial institutions based on a new accounting framework. This framework should be developed in concert with new banking regulations. The purpose would be to: generate more meaningful financial data for a market-based economy; facilitate bank supervision; and enhance financial disclosure for shareholders, depositors, lenders and regulators. At a minimum, technical assistance and training will be needed to introduce IAS for accounting along with ISA for the audit profession.

• Internal Audit/MIS/Risk Management. The importance of timely and accurate financial information for managerial purposes is a starting point for modern strategic planning in banking. Basle Committee guidelines on the importance of autonomous internal audit functions in banks will need to be introduced. They should be accompanied by comprehensive MIS for bank management to map out strategies for funds mobilization, asset management, and the level of risk to be assumed in portfolios and operations. The best method for introducing modern risk management practices is to have prime-rated institutions invest in the local market and expose their balance sheets to risk. More often than not, this represents a two-staged process in the Balkans. First, prime-rated institutions establish operations but focus on fee-oriented services with little risk involved. This is then followed by lending and other risk-taking activities when they feel comfortable with companies and the market. In the case of Kosovo, it is expected to be some time before any prime-rated institutions invest and take risk. Thus, technical assistance and training will be needed to shore up these practices, with particular emphasis on coordination with regulatory authorities to contain any potential for systemic risk.

• Overall Governance/Management. As banking in Kosovo moves toward a more commercial orientation, governance and management requirements will change. The new banking regulations and rules have mapped out key requirements for board members, major shareholders and bank managers to enable those banks to obtain a license to operate. In particular, there will be strong focus on internal audit, credit management, and asset-liability management. In the absence of direct investment from prime-rated institutions, technical assistance and training may be needed to strengthen the ability of bank boards and managers to exercise "fit and proper" standards of governance and management that are consistent with internationally recognized "best practices." Internal controls and crosschecks will be needed as well. For the foreseeable future, pressure will be on BPK to monitor developments in these areas through the use of full-scope and targeted inspections, in addition to ongoing off-site surveillance.

There are numerous risks to establishing the kind of environment and framework required for stable banking and sufficient levels of financial intermediation in Kosovo. Key among them are political risks and the potential market size. Others relate to lack of public confidence in formal banking institutions, and the amount of time required to build a new and comprehensive incentive structure for competitive market-based finance. These and other issues are highlighted below:

• Political Risk. Political risk represents one of the major impediments to financial intermediation. Internally, problems persist in reconciling the various communities. These problems are not expected to abate until outstanding issues are resolved. Such disputes are rooted in political and legal issues that touch on property claims, presumed rights to compensation, and even national sovereignty. Meaningful levels of formal private investment are not likely to materialize at least until some of these obstacles are removed. Political risk guarantees may facilitate larger investments, and a gradual restoration of confidence may lead to smaller investments. However, until the political risk rating of Kosovo improves, political risk will be an impediment to overall stability. This, in turn, will reduce direct investment from local and foreign sources. Prospects for financial intermediation may not be strong until the investment climate improves. This will require an improvement in the political landscape.

• Market Size. The size of the Kosovo market remains relatively small. The population is less than two million, and per capita income has traditionally been lower in Kosovo than virtually everywhere else in Europe. While remittances, informal savings, and strong family ties translate into more financial protection than indicated by economic statistics alone, the market is still small. This will cause investment prospects to appear less attractive and weaken prospects for financial intermediation.

• Public Confidence. Restoring confidence in civil institutions is a slow process, particularly after a long period of alienation. During the last decade informal parallel structures emerged. While these meet many immediate needs--and in some ways are more responsive on a personal and community level--in the long run, they do not meet the needs of a modern economy. At a minimum, these structures are clearly insufficient for banking and financial intermediation. For public confidence to be restored, prime-rated foreign investment will be needed. Here, political risk and market size are paramount. With no resolution of political risk and no signs of market growth - in the form of rising incomes, more purchasing power, and greater investment flows - it is unlikely that prime-rated banks from OECD countries will have any incentive to invest in Kosovo soon. Even with investment, it is doubtful that banks would expose themselves to risk for some time. Instead, they would probably rely on guarantees for balance sheet exposure, and focus on fee income-generating services in the form of transfers and remittances, trade finance, investment counseling, and foreign exchange trading for others’ accounts. This would do little for intermediation, as there would be little commitment, if any, to building retail deposit franchise.

• Ability of Banks to Mobilize Funds. Funding for and from banks is expected to be minimal for the foreseeable future. First, funding sources would be limited because of the unwillingness of banks to establish a retail-banking network needed for deposit mobilization in Kosovo. This would involve high cost and be risky, given the general distrust of banks and consequent unwillingness to deposit funds for safekeeping. Second, there are no bond markets or secondary financing markets. Third, there is understandable concern on the part of BPK about licensing banks if they cannot meet regulatory requirements.¹⁴ Thus, it is conceivable that investment groups with capital resources - and possibly the greatest interest in opening up banks - may not qualify for a bank license because of concerns about how those groups may have generated their capital. Fourth, prime-rated foreign banks to date have shown little interest in investing in the banking market in Kosovo.

• Willingness of Banks to Take Risk. Banks in general are unlikely to lend in any great volume soon for several reasons. First, their funding base will be limited. Second, the regulatory regime will be stricter in terms of the management and quality of assets than during the Yugoslav period. Third, judicial weakness in the commercial framework undermines the use of collateral for secured lending. Fourth, profit opportunities may abound for banks able to render needed services without the banks themselves subjecting their balance sheets to undue risk. Without donor assistance, this scenario is unlikely to change until there is competition. And competition probably will not materialize until political conditions have stabilized, risks have abated, some measure of public confidence is restored, and at least two or three professionally managed banks are licensed and operating in common segments, such as consumer banking, small business lending, and the like.

• Time Required to Build New Incentive Structures. The restoration of financial intermediation to support sustainable long-term economic growth will require a transformation of incentives and institutions. Even with the adoption of new regulations, it will take time for these changes to be implemented. Much training will be required, new principles and guidelines tested and adapted, and new standards of information dissemination introduced. Also, an appeals process will need to be institutionalized throughout the judicial and political system. In the banking sector, personnel need training in market-based commercial principles; regulations must be understandable, information systems should be used for strategic planning and monitoring; new standards of accountability and disclosure must be established; and management and governance practices need to be completely revamped to conform to emerging global standards.

• Donor Coordination. There are a number of potential issues that could weaken prospects for the development of sustainable financial intermediation. First, in an environment where human tragedy has occurred, there is a tendency to provide soft loans and grants for humanitarian purposes. This is almost always justifiable and sometimes appropriate. However, in other cases, this has led to aid features that distort market development through subsidized pricing, free loans, and agency arrangements instead of risk-assuming principal positions for institutions. While immediate relief can be provided, such features ultimately can undermine the foundation for sustainable medium-term finance and institutional development. Second, there is the risk of donor as well as recipient fatigue: aid recipients become frustrated with slow progress or donors’ reluctance to release funds without any accountability requirements on the part of the recipients. Donors may become frustrated with political division, corruption, or simply slow progress with the reform and implementation process. If this happens, there is a risk that donor coordination issues could undermine efforts to help Kosovo build a viable banking sector with adequate intermediation capacity.

Several medium-term challenges will persist based on the needs and risks identified in this chapter. The success or failure of efforts to introduce lasting reforms hinges on the effectiveness of donor coordination, efficiency of resource use, and ability to attract private direct investment into the banking and enterprise sectors. Progress also depends on an interrelated program for development of responsive civil institutions. Key medium-term challenges in banking sector development include the following:

• Expanding Institutional Capacity for Effective Implementation of Reforms. Progress has been achieved with new banking regulations and rules. Commercial reform is also underway in support of an improved environment for contract enforcement, recognition of property rights, secured transactions and other features that will provide some comfort to lenders to take risk. The challenge now will be to develop institutional capacity in the judicial system, in banking supervision, among accounting and audit professionals, and among the bankers themselves.

• Unifying the Payments System. The traditional payments system in Yugoslavia was organized outside the banking system to provide fiscal authorities with greater control over money flows. This undermines implementation of monetary policy, slows movement toward a viable inter-bank market to meet overnight and short-term liquidity needs, and reduces bank deposits. Kosovo is in the process of creating a payments system that will run through the banks. A critical concern of BPK is monitoring progress in this area. Meanwhile, bankers in Kosovo ultimately will need to adjust to new sources of funding, liquidity management techniques, and reporting requirements.

• Creating a Virtuous Circle to Restore Public Confidence. Observance by bankers of the new prudential regulatory framework and sound governance and management practices will be needed to restore confidence and financial intermediation. Deviation from global standards may lead banks in Kosovo down the same path found in many other neighboring economies: poor asset management that undermines solvency and liquidity, triggering doubts about deposit safety. This, in turn, undermines the funding base, limits access to credit, and raises its cost through fees and higher interest rates. Sound management should reverse this process in which sound returns, which strengthen capital and liquidity, lead to a more stable funding foundation based on rising levels of depositor, shareholder, inter-bank, and regulatory confidence.

• Utilizing Changing Incentives for Management Purposes. There is a tendency on the part of older bankers in Kosovo, whose activity was curtailed in the 1990s, to return to practices of the 1980s, when enterprises owned the banks. This spawned a non-commercial orientation of the banking system, which relied on connected lending, excess concentration, distorted classifications, and a passive role whereby banks merely disbursed credits to their enterprise owners. Elsewhere in the former Yugoslavia, this lowered the quality of bank loan portfolios and technical insolvency of the banks themselves. The new owners and managers of banks in Kosovo should ensure the new incentive structure works profitably for them. At a minimum, this will require more and better information for strategic planning, and the ability to monitor developments in a timely manner to ensure risks are adequately understood and controlled. In an open and competitive environment, these challenges will be far more demanding than previously experienced in the former Yugoslavia.

• Strengthening Credit and Overall Asset Management. In the former Yugoslavia, banks were traditionally passive institutions lending to their borrower shareholders without evaluating project or market risk. When principal payments fell due they were commonly rolled over. When interest payments came due they were frequently capitalized and rolled back into principal. Loan classification standards were not measured based on performance, and/or loan loss provisioning was insufficient to cover non-performing loans. The result was an overstated balance sheet and assets that were of lower quality than reflected in available financial information. Further, the subordinated role of banks in this relationship meant that there was little follow-up on loans. Bankers will need to adapt to new practices to better manage credit and overall asset-based risk. This should include a better understanding of underlying credit risk (including off-balance sheet exposures), as well as maturity, interest rate, exchange rate, and other risks attached to assets, where imprudent exposures can lead to massive and destabilizing losses.

• Developing Modern Asset-Liability Management Capacity. A sustainable commercial banking system means that banks will need to develop their asset-liability management systems for underlying financial sector stability. Over time, bankers will have to learn to structure and manage diversified portfolios (loans, securities, properties, etc.) under market conditions, and to ensure that these assets are matched with liabilities to ensure prudent management of risk exposures. As market conditions may lead to frequent changes in these values, banks will have to employ adequate systems and controls to be certain that they are monitoring these risks and exposures in a way that does not jeopardize their financial status. For major banks (when they emerge), these issues will be of greater importance in light of systemic issues and the risks of mismanagement after public confidence is restored.

• Clarifying the Role of Non-Bank Financial Institutions. Apart from the issue of micro-finance institutions, there is currently no strategy for non-bank financial institutions in Kosovo. At some juncture, a framework must be developed for insurance, leasing, factoring, venture capital, capital markets and other "non-bank" activities. With the growing influence of universal banking around the globe, establishing a stable banking system should be a high priority. At the same time, if adequate protective structures are in place, part of the attraction of banks in markets is the ability to diversify into these "non-bank" activities. Developing non-bank financial institutions will require an open environment for capital investment, regardless of origin. Medium-term objectives should include establishing a regulatory framework for private insurance, pension funds, and institutional investors, and building up the institutional infrastructure needed for information disclosure and market analysis. However, these efforts should be partly delayed until there is evidence that a stable monetary and banking system is evolving. Alternatively, if there is movement in the non-bank sector, such efforts should be introduced cautiously to prevent undue financial risk from slowing down progress in banking sector development.

E. Reform of the Payments System ¹⁵

Since the inception of UNMIK, the work of re-establishing a functioning payment system has passed through several stages. Of particular importance has been the establishment of BPK. As earlier noted, the BPK’s main purpose is to foster the development of efficient and sound banking and payments in Kosovo. More specifically, the BPK is responsible for providing: (i) an appropriate inventory of clean DM banknotes in the needed denominations; (ii) clearing and settlement services to banks in DM; and (iii) a full range of banking and payment services to the government. On a temporary and emergency basis, the BPK was also authorized to provide deposit and payment services to enterprises and to the general public until banks were able to do so.

At its inauguration in May 1999, the BPK was able to provide the following services: (i) teller window exchange of DM banknotes for clean notes and coins of desired denomination; (ii) universal teller window cash payments of UNMIK stipends and wages; (iii) receipt and deposit (at vault or teller window) of taxes and other payments to UNMIK; (iv) opening and maintaining of deposit accounts for banks and official entities and the acceptance of deposits and withdrawals from those accounts of DM; (v) receipt of payment orders (for non-cash payments) from authorized agents of depositors and their execution (clearing and settlement);¹⁶ and (vi) receipt of sealed bags or chests from enterprises for safekeeping.

As the government’s banker, the BPK can accept deposits from the CFA and other UNMIK agencies; it also makes payments from these accounts in accordance with the instructions of the CFA and other depositors. During the initial stage, all deposits with the BPK have been in cash since it is not yet prepared to accept non-cash deposits. The largest amount of payments from the UNMIK accounts has been for stipend and wage payments. Until the BPK has fully organized the transportation of cash from its Pristina vaults to its branches and sub-branches, it will not completely assume the responsibility for these payments, which have been made directly by UNMIK using BPK staff and facilities.

The BPK is also the bankers’ bank, and as such is responsible for clearing interbank payments in DM and settling them using bank deposits with the BPK. New PC-based computer equipment and banking software are now in place and provide a modern basis for the universal teller window services and for the subsequent interface with the interbank clearing and settlement system. Furthermore, a contract has been accepted for the provision of cash transportation services both within Kosovo and between Pristina and a foreign bank. The first bank was licensed in January 2000 and started operations in April. However, other commercial banks are not expected to be in operation in 2000. Due to these delays, the timetable for developing clearing and settlement rules and facilities as well as for adopting a liquidity requirement for banks to hold balances with the BPK is being moved down. By late 2000, the banking system still remains in an early stage of development, requiring considerable further attention in the future.

The institutional development of the BPK and of its payment services has been delayed by several factors. Admittedly, the original timetable was deliberately ambitious. The key management positions that were to be filled at end-1999 took place only at the beginning of April 2000. Furthermore, the out-of-date SDK computers and software could not be used as initially planned and having to work with the inherited staff of the SDK and the NBK slowed the development of new skills and procedures.

The delay in developing the BPK’s ability to offer deposit and payment services and the faster than expected establishment of banks with the ability to offer such services, necessitates a re-evaluation of the BPK’s plans to use the temporary authority given to it in UNMIK Regulation No. 1999/20 to accept deposits from enterprises. The IMF, which has provided advice to BPK, recommended that BPK offices should not provide services that compete with banks. Accordingly, the BPK should not open any deposit accounts for enterprises, which in the relatively near future will have two or three banks to choose from for the provision of deposit and payment services. A possible exception could be made for the state-owned utility companies if the BPK determines, on a case-by-case basis, that such a service would be useful for the public.

A further implication of these developments is that the teller window services for government wage and salary payments and tax collections can be moved to banks more quickly than was originally envisaged. The exact timing and geographical spread of bank branches capable of providing these teller window services remains, however, somewhat uncertain and, thus, the BPK will need to be able to provide their services in some locations for a number of months, possibly for as long as a year.

Moreover, it is recommended that the BPK should take the initiative of entering into agency agreements with its core customers - the CFA and other UNMIK agencies. These should include service contracts, formalizing responsibilities and expectations, as well as determining the financial compensation.

The BPK should also complete arrangements for shipping and processing coins and for the repatriation and replacement of old and damaged banknotes. Each of these services must be priced and its fee schedule properly posted. In addition, discussions with the Bundesbank for banknote maintenance and certain other cash-handling services are in the process of being concluded.

With an increasing number of banks being licensed, the need to develop interbank clearing and settlement becomes more urgent. Since the payment system infrastructure is only in the embryonic stage of development, it has been recommended that their design from the beginning, should be based upon electronic media deposited directly with the BPK, and settled on a gross basis to ensure safe and reliable service to customers. The infrastructure for this Electronic Interbank Transfer System would require secure leased telecommunication lines to allow banks to have reliable connectivity with the BPK.

Finally, it is recommended that an UNMIK regulation on payment transactions in foreign currencies be adopted in the near future. The objective of such legislation is to provide for a modern law establishing a firm foundation for an advanced market economy payment system to operate in Kosovo. It covers domestic payments in foreign currency - it does not apply to payments in the Yugoslav dinar, which are governed by existing FRY legislation and the National Bank of Yugoslavia - and covers large-value payments processed individually as well as payments processed in bulk. Above all, such a regulation provides for payment transaction participants’ rights and remedies, in case of both in-house and interbank payment transactions.

On balance, considering the difficult initial conditions, the outlook for reform of the Kosovo payment system is bright, although the development of the internal capabilities of the BPK (i.e., modernization of its hardware, software, and selection and training of staff) has been delayed and the licensing of banks has not proceeded as rapidly as was hoped. When a few more institutions have been licensed as banks and when bank services come on stream, the BPK will need to sharply refocus attention on its primary mission to serve banks and the Central Fiscal Agency.