Industry Forecast - Banking Sector: Brighter Outlook On Accelerating Economic Activity - MAY 2017


BMI View: The short-term outlook for Bosnia ' s banking sector has improved as the country ' s economic recovery takes hold and both capital ratios and asset quality improves. Political risks remain at the forefront of the immediate threats to stability, particularly if they jeopardise the IMF arrangement that remains the key anchor for reform.

Bosnia-Herzegovina's banking sector continues to show signs of improved health on the back of a brighter economic backdrop. Real GDP growth reached 2.4% y-o-y in Q316 and high frequency data point to accelerating domestic demand in the final months of the year, supporting our view for an expansion of 3.0% in 2017 and 2.4% in 2018.

In this context of growing business and consumer confidence, latest data from the Central Bank of Bosnia-Herzegovina (CBBH) also show an uptick in credit growth towards the end of 2016. Client loans were up 3.5% y-o-y in December, the fastest annual clip in two years, while total assets increased at a rate of 4.6% y-o-y. We expect lending and assets to expand by 4.0% and 6.0%, respectively, by end-2017.

At the same time, the liquidity levels remain sound, supported by robust deposit growth. Customer deposits were up by 7.3% y-o-y in December and recorded average annual growth of 7.7% through 2016 and a whole. As a result, the loan-deposit ratio reached 92% at the close of 2016, down from a peak of 116% in 2012.

Other indicators also suggest the system is on an increasingly stable footing: the sector-wide Tier 1 capital adequacy ratio stood at 15.1% at end-Q316, the highest level since Q314, when catastrophic floods derailed the nascent economic recovery and rocked the financial sector. The sector's non-performing loan (NPL) ended the quarter at 12.1%, the lowest level since the beginning of 2012. In both cases the trend is positive and likely to remain this way in the coming quarters, though smaller domestic banks are likely to lag ever further behind larger local and foreign-owned rivals.

An Improving Picture
Bosnia Banking Sector - Financial Stability Indicators
Source: CBBH.

The Shadow Of Politics

As in the wider economy, the country's political problems represent the main risk to banking sector stability and growth potential. The failure of the Bosniak (Muslim)-Croat Federation (FBiH) to adopt a new banking law is one of several stalled reforms that have put the country's crucial financing arrangement with the IMF in jeopardy, delaying the release of badly-needed funds and endangering the most important anchor for fiscal policy and reform. Meanwhile, in Republika Srpska (RS), prosecutors recently indicted 16 people for the embezzlement of funds through now defunct Bobar Bank, a major financial scandal that risks damaging the reputation of local banks and supervisory authorities.

Our core view sees local authorities eventually making enough progress on reforms to maintain the IMF arrangement - albeit with delays - and this should continue to provide incentives to shore up banking sector stability and encouraging renewed credit growth. Moreover, in December 2016 banking agencies in both entities signed a Memorandum of Understanding (MoU) with the German Federal Financial Supervisory Authority (BaFin) in order to boost cooperation in banking supervision - another positive development for future development.

Banking Sector Structural Overview

Asset Quality: Although Bosnia's banking sector demonstrated considerable resilience during the global financial crisis, it has suffered from a high non-performing loan (NPL) ratio ever since. The NPL ratio rose from 3.0% at the close of 2007 to 16.1% in Q314, a record high which came after the country was struck by devastating floods. Asset quality has since improved considerably, with the NPL ratio coming in at 12.1% at end-Q316. We expect this to continue to move south in the coming quarters.

FX Exposure: As of end-H116, only 1.3% of the loan portfolio was denominated in foreign currencies, with the vast majority of these in euros. However, when adding loans issued in Bosnian marka (BAM) but indexed to a foreign currency, the ratio increases to 60.5%. This has fallen gradually from a high of 72.9% at end-2009. Again, the vast majority (98.3%) of these foreign-indexed loans are indexed to the euro, with the remainder denominated in Swiss francs (CHF).

CHF exposure has fallen sharply since end-2008, when nearly 16% of total foreign currency-indexed loans were indexed to the Swiss franc. This reduction helped mitigate the impact of sharp CHF appreciation early in 2015. Furthermore, in November 2015 the government approved a law to ban loans denominated in any foreign currency except the euro, effectively eliminating exchange rate risks due to the country's quasi peg with the euro, part of a currency board arrangement that we do not expect to be removed over the forecast period.

Funding Structure: At end-H116, the loan-to-deposit ratio stood at 0.96, implying limited reliance of international financing and a reduced risk to any external shock. The ratio has improved in recent years (the last time it dropped below 1.00 was in January 2008) as y-o-y client deposit growth has remained consistently above loan growth.

Housing deposits represent 59.6% of total deposits as of September 2016, unchanged since end-2015. Within this, half of household deposits were long-term, while short-term deposits declined over the same period, from 6.8% of the total to 5.5%. This demonstrates growing confidence in the banking sector among residents, especially given the country's large informal economy.

Ownership Structure: More than 80% of Bosnia's banking sector is foreign-owned, with Austrian and Italian banks the leading market players. Typically this is regarded as a positive for financial stability as these foreign banks have more sophisticated risk management and funding structures, and are therefore better able to weather economic and financial market downturns.

Capital Adequacy: Bosnia's banking sector remains relatively well capitalised, with an average capital adequacy ratio (CAR) and Tier 1 ratio of 16.1% and 15.1%, respectively, as of end-Q316 - comfortably above the regulatory minimum CAR of 12%. The overall adequacy ratio has remained in the 15%-18% range since 2008, a key factor in reducing risks to the banking sector. However, as the IMF's 2015 Financial System Stability Assessment noted, this headline figure masks considerably different figures among individual banks, with domestically owned banks generally far less capitalised than those with foreign-based parents. Efforts to improve banking sector supervision should ensure that banks' average capital ratios remain strong in the coming years.

Sovereign Support Capacity: Bosnia's government will remain heavily dependent on international funds to plug budget deficits in both autonomous entities in the coming years. This will limit the state's ability to support distressed banks, going forward. However, around four-fifths of total banking sector assets belong to foreign-owned banks that would likely receive support from their parent in the case of a crisis.

Regulatory Body Assessment: The Bosnian Federation banking sector is regulated by the Banking Agency of the FBiH (FBA), an independent body established in 1996. This agency is responsible for the issuing and revocation of banking licences. In recent years the FBA has been more active in regulating Bosnia's micro-finance industry. In late 2014, the FBA revoked the licence of PRIZMA, which was one of the country's largest micro-finance operators at the time. Given its strict regulation of this industry, we expect it would act accordingly to similar issues in the commercial banking industry.

In the RS, banks are regulated by the Banking Agency of the Republika Srpska (BARS), which has also recently clamped down on problematic banks, revoking the licence of Bobar Bank and, more recently, placing Banka Srpska in liquidation. Both banking agencies have signed an MoU with Germany's main banking regulator to help improve supervision.