Document of The World Bank Report No: ICR2969 IMPLEMENTATION COMPLETION AND RESULTS REPORT (Loan No. IBRD-80910) ON A LOAN IN THE AMOUNT of €59.1 MILLION (US$ 85 MILLION EQUIVALENT) TO MONTENEGRO FOR A FIRST PROGRAMMATIC FINANCIAL SECTOR DEVELOPMENT POLICY LOAN February 25, 2014 Finance and Private Sector Department South East Europe Country Unit Europe and Central Asia Region CURRENCY EQUIVALENTS (Exchange Rate Effective as of May 2, 2012) Currency Unit EUR US$1.00 €0.76 FISCAL YEAR (January 1 – December 31) ABBREVIATIONS AND ACRONYMS BCP Basic Core Principles GoM Government of Montenegro Capital Adequacy, Asset Quality, Management, International Bank for Reconstruction and IBRD CAMELS Earnings and Liquidity and Sensitivity to market risk Development CAR Capital Adequacy Ratio IFC International Finance Corporation CBCG Central Bank of Montenegro IFRS International Financial Reporting Standards European Banking Agency Common Regulatory COREP Reporting Standards IMF International Monetary Fund CPS Country Partnership Strategy KAP Kombinat Aluminijuma Podgorica Kreditanstalt für Wiederaufbau / German KfW DPF Deposit Protection Fund Development Bank DPL Development Policy Loan LOLR Lender of Last Resort EBA European Banking Authority LTD Loan-to-deposit ratio EBRD European Bank for Reconstruction and Development M&E Monitoring & Evaluation EC European Commission MoF Ministry of Finance ECA Europe and Central Asia NPL Nonperforming Loan EIB European Investment Bank PB Prva Banka ELA Emergency Liquidity Assistance PBG Policy Based Guarantee EPCG Elektroprivreda Crne Gore AD PD Program Document EU European Union PDO Project Development Objective FDI Foreign Direct Investment ROA Return on Assets First Programmatic Financial Sector Development FPFSDPL Policy Loan ROE Return on Equity FSA Financial Supervisory Authority RVP Regional Vice President FSAP Financial Sector Assessment Program SAP Supervisory Action Plan FSC Financial Stability Council SEC Securities and Exchange Commission GDP Gross Domestic Product Vice President: Laura Tuck Country Director: Ellen Goldstein Sector Director: Gerardo Corrochano Sector Manager: Lalit Raina Task Team Leader: Michael Edwards Montenegro FIRST PROGRAMMATIC FINANCIAL SECTOR DEVELOPMENT POLICY LOAN (P116787) CONTENTS B. Key Dates ....................................................................................................................................1  C. Ratings Summary ........................................................................................................................1  D. Sector and Theme Codes.............................................................................................................2  E. Bank Staff ....................................................................................................................................2  F. Results Framework Analysis .......................................................................................................2  G. Ratings of Program Performance in ISRs ...................................................................................6  H. Restructuring (if any) ..................................................................................................................6  1.  Program Context, Development Objectives and Design ..........................................................7  1.1  Context at Appraisal ............................................................................................................7  1.2  Original Program Development Objectives (PDO) and Key Indicators (as approved): ......9  1.3  Revised PDO (as approved by original approving authority) and Key Indicators, and reasons/justification: ......................................................................................................................10  1.4  Original Policy Areas Supported by the Program (as approved):......................................10  1.5  Revised Policy Areas (if applicable): ................................................................................12  1.6  Other significant changes (in design, scope and scale, implementation arrangements and schedule, and funding allocations):................................................................................................12  2.  Key Factors Affecting Implementation and Outcomes ..........................................................13  2.1  Program Performance: .......................................................................................................13  2.2  Major Factors Affecting Implementation: .........................................................................15  2.3  Monitoring and Evaluation (M&E) Design, Implementation and Utilization: ..................16  2.4  Expected Next Phase/Follow-up Operation (if any): .........................................................17  3.  Assessment of Outcomes ........................................................................................................17  3.1  Relevance of Objectives, Design and Implementation: .....................................................17  3.2  Achievement of Program Development Objectives ..........................................................18  3.3  Justification of Overall Outcome Rating (combining relevance, achievement of PDOs): 20  3.4  Overarching Themes, Other Outcomes and Impacts .........................................................21  3.5  Summary of Findings of Beneficiary Survey and/or Stakeholder Workshops (optional for Core ICR, required for ILI, details in annexes): ............................................................................22  4.  Assessment of Risk to Development Outcome ......................................................................22  5.  Assessment of Bank and Borrower Performance (relating to design, implementation and outcome issues) ..............................................................................................................................22  5.1  Bank Performance ..............................................................................................................22  5.2  Borrower Performance .......................................................................................................23  6.  Lessons Learned .....................................................................................................................24  7.  Comments on Issues Raised by Borrower/Implementing Agencies/Partners ........................25  ANNEXES .....................................................................................................................................26  A. Basic Information Programmatic Financial Country: Montenegro Program Name: Sector Development Policy Loan Program ID: P116787 L/C/TF Number(s): IBRD-80910 ICR Date: 02/25/2014 ICR Type: Core ICR Lending Instrument: DPL Borrower: MONTENEGRO Original Total USD 85.00M Disbursed Amount: USD 78.49M Commitment: Revised Amount: USD 85.00M Implementing Agencies: Ministry of Finance Central Bank of Montenegro Cofinanciers and Other External Partners: B. Key Dates Revised / Actual Process Date Process Original Date Date(s) Concept Review: 10/28/2009 Effectiveness: Appraisal: 05/23/2011 Restructuring(s): Approval: 09/01/2011 Mid-term Review: 09/30/2012 Closing: 01/31/2013 01/31/2013 C. Ratings Summary C.1 Performance Rating by ICR Outcomes: Satisfactory Risk to Development Outcome: Substantial Bank Performance: Satisfactory Borrower Performance: Satisfactory C.2 Detailed Ratings of Bank and Borrower Performance (by ICR) Bank Ratings Borrower Ratings Quality at Entry: Satisfactory Government: Satisfactory Implementing Quality of Supervision: Satisfactory Satisfactory Agency/Agencies: Overall Bank Overall Borrower Satisfactory Satisfactory Performance: Performance: 1 C.3 Quality at Entry and Implementation Performance Indicators Implementation QAG Assessments (if Indicators Rating: Performance any) Potential Problem Program Quality at Entry No None at any time (Yes/No): (QEA): Problem Program at any Quality of Supervision No None time (Yes/No): (QSA): DO rating before Moderately Closing/Inactive status: Satisfactory D. Sector and Theme Codes Original Actual Sector Code (as % of total Bank financing) Banking 100 100 Theme Code (as % of total Bank financing) Regulation and competition policy 100 100 E. Bank Staff Positions At ICR At Approval Vice President: Laura Tuck Philippe H. Le Houerou Country Director: Ellen A. Goldstein Jane Armitage Sector Manager: Lalit Raina Lalit Raina Program Team Leader: Michael Edwards Alexander Pankov ICR Team Leader: Alexander Pankov ICR Primary Author: Michael Edwards Paula Genis F. Results Framework Analysis Program Development Objectives (from Project Appraisal Document) The overarching objective of the operation is to strengthen the banking sector, which is a critical pre-condition for sustainable economic recovery and balanced private sector-led growth. Two operations were envisioned to support a comprehensive program of measures to strengthen the banking sector, with a view to mitigating the impact of the global financial crisis and increasing the resilience of the sector to possible future shocks. The specific reforms proposed to strengthen the banking sector were in the following areas: (i) maintaining market confidence; (ii) 2 strengthening the bank liquidity framework; (iii) assessing and addressing banking sector vulnerabilities; (iv) enhancing the regulatory framework; and (v) problem bank restructuring. These reforms are an integral part of Montenegro's EU accession strategy insofar as they aim to bring the supervisory and regulatory framework for the banking sector closer to EU practices. It should be noted that the envisaged second operation of the programmatic FSDPL laid out in the Program Document was changed into a Policy Based Guarantee (PBG) with some different policy areas and expected targets (Section 1.6). The first PFSDPL was converted into a single operation after it was decided to change the second operation to a guarantee so as to leverage or increase the World Bank's financing available to the Government of Montenegro through a PBG operation. OPCS has advised the team to prepare separate ICRs for the first FSDPL and PBG. This ICR assesses the key expected results and outcomes at the end of the program, as illustrated in the Program Document of the first operation. Since specific targets for the first operation were not provided given the original programmatic design, we are obliged to assess results based on the program end targets, which were also supported by the PBG (instead of the envisioned second operation). Revised Program Development Objectives (if any, as approved by original approving authority) N/A (a) PDO Indicator(s) Original Target Actual Value Formally Values (from Achieved at Indicator Baseline Value Revised approval Completion or Target Values documents) Target Years Indicator 1 : Annual deposit growth (%) Value Negative growth (-23 (quantitative or from September 2008 to Positive growth N/A Positive growth (9%) Qualitative) March 2011) Date achieved 03/31/2011 01/31/2013 01/31/2013 12/31/2012 Comments Positive annual growth in bank deposits beginning in 2011 through 2012 enabled (incl. % banks to reach the pre-crisis (September 2008) level of deposits (1.991 million euros) achievement) (100% achieved). Indicator 2 : Annual credit growth (%) Value Negative growth (-26 Negative growth (- (quantitative or from September 2008 to Positive growth N/A 5.00%) Qualitative) March 2011) Date achieved 03/31/2011 01/31/2013 01/31/2013 12/31/2012 Comments The decline of new lending has slowed, but it has not reached the targeted positive (incl. % growth owing to low demand and banks’ more conservative lending standards post- achievement) crisis (partially achieved). Indicator 3 : Enhanced ability of the central bank to provide emergency liquidity assistance Value Through enactment of the Enhanced ability of A new Emergency N/A (quantitative or Law on Central Bank of the CBCG to Liquidity Facility 3 Qualitative) Montenegro of July 30, provide emergency was adopted by the 2010 (Off. Gaz. 40/10, liquidity assistance Central Bank of 46/10), aligned the (ELA) Montenegro legislative framework for the CBCG with EU sound practices, incl., i.a., expanded powers and instruments for the CBCG's function as LoLR. Date achieved 12/31/2011 01/31/2013 01/31/2013 12/31/2012 The CBCG has strengthened the liquidity framework in country through formally Comments putting in place a mechanism to provide banks with emergency liquidity assistance (incl. % through a LoLR facility and a new by-law on banks' Required Reserves (100% achievement) achieved). Indicator 4 : Liquidity in the banking sector measured as ratio of liquid assets to liabilities 1.00 (in compliance with the CBCG requirement of Value minimum ratio of 1 (quantitative or 1.58 N/A 1.83 calculated as an Qualitative) average for all working days in a ten day period) Date achieved 12/31/2011 01/31/2013 01/31/2013 12/31/2012 Comments (incl. % (exceeded in 83%) achievement) Indicator 5 : Quality of banks loan portfolio – NPL ratio (%) Value (quantitative or 25.00 8.0 (below) N/A 17.65 Qualitative) Date achieved 06/30/2011 01/31/2013 01/31/2013 12/31/2012 Comments The quality of portfolio has improved, but the target was not met owing on the slow (incl. % economic growth combined with a weak capacity of lenders to restructure and/or achievement) execute on collateral and on banks’ sharply reduced lending volumes (40% achieved Indicator 6 : Capitalization of banks based on CAR minimum requirement (%) Value (quantitative or 11.90 12.00 (above) N/A 14.70 Qualitative) Date achieved 06/30/2009 01/31/2013 01/31/2014 12/31/2012 Comments (incl. % The overall CAR target was exceeded. (100% achieved). achievement) Indicator 7 : Effectiveness of supervision of banking system consistent with Basel Core Principles Effective No independent Value Two BCP ratings supervision of assessment available (quantitative or materially non-compliant, N/A banking system to evaluate the Qualitative) two not applicable. consistent with CBCG's progress on 4 Basel Core strengthening their Principles supervisory regime in line w/the BCPs-the FSAP not updated, as envisaged. Critical weaknesses: legal protection for supervisors and internal audit capacity at CBCG Date achieved 05/31/2007 01/31/2013 01/31/2013 01/15/2013 Comments The FSAP update is well overdue. The authorities have been asked to formally (incl. % request an Update (not provided). A BCP self-assessment undertaken by the CBCG, achievement) which cannot substitute for an independent, third-party assessment. (0 % achieved) Strengthening legal authority of CBCG for resolution of problem banks according to Indicator 8 : international and EU good practices Strengthened legal authority of CBCG for resolution of problem banks according to Bank resolution Enhanced legal Value international and EU framework not consistent provisions for bank (quantitative or N/A good practices with good international resolution and their Qualitative) through amendments practice implementation to the Law on Bankruptcy and Liquidation of Banks (Official Gazette No. 44/10) Date achieved 05/31/2007 01/31/2013 01/31/2013 09/30/2011 Comments The CBCG’s regulatory framework was enhanced by providing new powers through (incl. % amendments to both the Law on Banks and the Law on Bankruptcy and Liquidation achievement) of Banks (see Section 2.2) (100% achieved). Status of implementation of SAP and withdrawal of central government deposits from Indicator 9 : Prva Banka Value EUR 0.9 million (quantitative or EUR 25 million 100.00% N/A (90%) Qualitative) Date achieved 04/30/2011 06/30/2012 01/31/2013 04/30/2013 After the successful implementation of the SAP and withdrawal of eligible Comments government deposits, the bank no longer poses a systemic risk. With a substantially (incl. % market based financing structure, it operates in a more safe financial condition (90 % achievement) achieved). 5 (b) Intermediate Outcome Indicator(s) Original Target Actual Value Formally Values (from Achieved at Indicator Baseline Value Revised Target approval Completion or Values documents) Target Years G. Ratings of Program Performance in ISRs Date ISR Actual Disbursements No. DO IP Archived (USD millions) 1 01/05/2012 Satisfactory Moderately Satisfactory 0.00 2 01/29/2013 Moderately Satisfactory Moderately Satisfactory 78.30 H. Restructuring (if any) Not Applicable 6 1. Program Context, Development Objectives and Design 1.1 Context at Appraisal Montenegro was hit hard by the global financial crisis beginning in late 2008 onwards. The First Programmatic Financial Sector Development Policy Loan (FPFSDPL) launched the financial sector reform program in 2010 through preparation of the Development Policy Loan (DPL) series1. In addition, the FPFSDPL builds on an earlier operation which supported the development of Montenegro’s financial and enterprise sector. The Montenegrin financial system is composed almost entirely of the banking sector, with assets accounting for about 89 percent of GDP. The banking sector is dominated by foreign banks. The sector consists of eleven banks, five of which are wholly owned subsidiaries of (non-Greek) Eurozone banks and together occupy about 72 percent of the market share at end-2012. Montenegro has no state banks and none of the banks are subsidiaries of a Greek parent bank. However, two of the five foreign banks (Hypo and NLB Montenegrobank) have been intervened by their home governments and their restructuring plans are currently being discussed with the European Commission. The five EU banks have traditionally accounted for about 72 percent of total banking sector assets. However, since the beginning of the global financial crisis in 2008, the share of the domestic banks, as measured by asset size, has decreased from 16 to 10% at end-2012, as Prva banka (or Prva Bank) (formerly the second largest bank in the system) has been aggressively downsized as part of its restructuring program. Prva, now the sixth largest bank by asset size, is no longer considered to be a systemically important bank. Liquidity buffers have been rebuilt since the massive withdrawal of deposits undermined the banking system's liquidity in late 2008. Between September 2008 and 2011, the banking sector lost more than 19 percent of its total deposits. Since then, system wide liquidity has improved to its current level of 40 percent; however, Prva banka continues to be the least liquid bank within the system reporting liquid assets to short term liabilities at 11.0 percent (compared to 40 percent system wide) and liquid assets to total assets of 8.6 percent (compared to 24 percent system wide). As the real estate and credit bubble burst, domestic credit flow and liquidity suddenly stopped and the Montenegrin economy went into recession in 2009. Growth plummeted, from almost 7 percent in 2008 to -5.7 percent in 2009, one of the sharpest growth declines among European and Central Asian economies. External demand (in particular for aluminum and steel) dropped, while liquidity problems in the financial and corporate sectors escalated. Total employment declined by almost 7 percent from the second half of 2009 to end-2010, despite a gradual moderation of wages and shortened working hours. The absolute poverty rate doubled to close to 7 percent in 2010. 1 This ICR assesses the results based on the end of program targets included in the Program Document of the FPFSDPL, as no separate end-results were defined for each operation. It should be noted however that the envisaged second operation of the programmatic FSDPL, as laid out in the Program Document of the first operation, was changed into a Policy Based Guarantee (PBG). See Sections 1.6. 7 In response, the Government implemented emergency financial, fiscal and social measures to stem the impact on the economy while continuing EU-accession related structural reforms. An announcement of a bank deposit guarantee in October 2008 stopped the run on deposits. The Central Bank responded with a menu of measures aimed at easing the liquidity crisis while strengthening inspection and supervision. On the fiscal front, the Government implemented cuts in nominal wages and increased spending on active labor market programs targeting the youth and new job entrants. It also began preparing the ground for a significant further tightening of the budget in the considerably changed external environment. With a sharp drop in economic activity, domestic demand and imports, a significant external adjustment took place from 2009 onwards. Montenegrin exports (in particular for aluminum and steel) declined by double digits, which coupled with domestic problems in the financial and corporate sectors, led to an abrupt economic slowdown. A double-digit fall of manufacturing, construction and transport in 2009 was only partially compensated by growth in energy production and agriculture, leading to an estimated economic decline of around 5.7 percent in 2009. The massive drop in production in the heavily indebted and overstaffed Aluminum Company (KAP) alone, the country’s largest exporter and industrial producer, accounted for about 1¼ percent decline in GDP. The economic downturn reduced previous gains made in living standards. Total employment declined by almost seven percent from the second half of 2009 to end-2010, despite of the moderation of wages and shortened working hours. The number of unemployed between December 2008 and 2010 rose by 13.2 percent. A recent poverty analysis confirmed that the poverty rate increased to 6.8 percent in 2009, after having declined from 11.3 percent in 2006 to below five percent in 2008. Almost a quarter of employees were affected by deteriorating labor market conditions during the crisis, including 10 percent that experienced wage arrears and another 10 percent that suffered salary reductions. About 30 percent of crisis-impacted households increased labor supply, either by having a non-working member seek work or having working members seek additional work. Owing to an abrupt decline in capital inflows and a large fall in external and domestic demand, significant external adjustment took place. The current account deficit was reduced by half between 2008 and 2010 as imports contracted. However, it remained high at about 23 percent of GDP in 2010, as exports and tourism hardly recovered. During 2006–2010, net FDI financed on average about 63 percent of the current account deficit, excluding one-off inflows from the recapitalization and partial privatization of Montenegro’s power utility in 2009. Access to capital was retained through foreign banks’ increased financial support to their Montenegrin subsidiaries, which contributed to a rise in external debt to 94 percent of GDP in 2009. The rapid expansion of the Montenegrin banking system came to a halt in late 2008 due to the impact of the global financial crisis on the overheated domestic economy. The system’s rapid growth was driven by the entry of foreign banks, along with increased domestic demand coming in particular from the real estate sector6. Total assets of the banking system increased by more than 100 percent on average in 2006 and 2007, growing from 67 percent of GDP to 111 percent of GDP. Asset growth slowed substantially since 2008 due to the impact of the global financial crisis, with assets growing by only 11 percent in 2008 (owing to credit controls applied by the 8 CBCG and the impact of the crisis), and then contracting by 8.6 percent in 2009, and a further 2.7 percent in 2010. A massive withdrawal of deposits severely undermined the liquidity of the system in late 2008, although the situation has improved since then. The system’s liquid assets to short term liabilities ratio declined from 32 percent in 2007 to 21 percent in 2008. Since then, system wide liquidity has markedly improved to 40.1 percent at end-2012. The liquidity situation was helped by large cash inflows into the banking system as a result of partial privatization of electricity production and distribution, and by substantial capital injections from the foreign parents of Montenegrin banks. The credit crunch reached its peak in 2009 with a 14.3 percent decline in credit year on year, due to banks’ rising asset quality problems and a decline in demand for loans from a corporate sector affected by the weakening economy. The availability of parent bank credit declined and Montenegro’s banks were forced to adjust their liquidity risk exposures. Borrowings from parent banks as a share of total liabilities dropped from 25.1 percent (26.9 percent of GDP) in 2008 to 17.5 percent (15.2 percent of GDP) in 2011. Consequently, the system’s loan-to-deposit ratio decreased from 155 percent in April 2009 to 104 percent by September 2011. Further, as banks have focused on cleaning up their balance sheets in 2010 and 2011, credit continued to decline through end-2012. As the crisis began to unfold in 2008, NPLs increased rapidly reaching a peak of 25 percent of loans during the second quarter of 2011. Thereafter, they declined to 15.5 percent by end-March 2012 as two leading banks began to transfer large amounts of NPLs to their sister companies. However, by end- 2012 banks’ overall NPLs increased again to 17.6 percent. The bulk of NPLs are centered in the trade, tourism, and construction. NPL ratios within the banks vary greatly ranging from 2.5 percent to a high of 36 percent. Between September 2008 and 2011, the banking sector lost more than 17 percent of its total deposits. As a consequence of rapidly increasing NPLs, nine out of 11 banks had to be recapitalized by their shareholders, as bank profitability turned strongly negative (ROE at -6.9 percent) at the same time, reaching its nadir of -27.3 percent ROE in September 2010 before improving to -18.3 percent in 2012. Parent banks supported their Montenegrin subsidiaries with necessary liquidity support and substantial capital injections. This helped partially offset declining domestic deposits and capital erosion. Importantly, the parent banks provided about EUR230 million in new capital from end- 2008 to March 2011. The bank liquidity situation was also helped by large cash inflows from partial privatization of electricity production and distribution. 1.2 Original Program Development Objectives (PDO) and Key Indicators (as approved): The overarching objective of the first PFSDPL operation is to strengthen the banking sector, which is a critical pre-condition for sustainable economic recovery and balanced private sector- led growth. 9 Two operations were envisioned to support a comprehensive program of measures to strengthen the banking sector, with a view to mitigating the impact of the global financial crisis and increasing the resilience of the sector to possible future shocks. The specific reforms proposed to strengthen the banking sector were in the following areas: (i) maintaining market confidence; (ii) strengthening the bank liquidity framework; (iii) assessing and addressing banking sector vulnerabilities; (iv) enhancing the regulatory framework; and (v) problem bank restructuring. These reforms are an integral part of Montenegro’s EU accession strategy insofar as they aim to bring the supervisory and regulatory framework for the banking sector closer to EU practices. The program indicators, as shown in the Policy Matrix of the Program Document (PD) of the first operation, included:  Annual deposit growth (%)  Annual credit growth (%)  Enhanced ability of the central bank to provide emergency liquidity assistance  Liquidity in the banking sector measured as ratio of liquid assets to liabilities  Quality of banks loan portfolio – NPL ratio (%)  Capitalization of banks based on CAR minimum requirement (%)  Effectiveness of supervision of banking system consistent with Basel Core Principles  Strengthening legal authority of CBCG for resolution of problem banks according to international and EU good practices  Status of implementation of Supervisory Action Plan (SAP) and withdrawal of central government deposits from Prva Banka It should be noted that the envisaged second operation of the programmatic FSDPL laid out in the Program Document was changed into a Policy Based Guarantee (PBG) with some different policy areas and expected targets (Section 1.6). The first PFSDPL was converted into a single operation after it was decided to change the second operation to a guarantee so as to leverage or increase the World Bank’s financing available to the Government of Montenegro through a PBG operation. OPCS has advised the team to prepare separate ICRs for the first FSDPL and PBG. This ICR assesses the key expected results and outcomes at the end of the program, as illustrated in the Program Document of the first operation. Since specific targets for the first operation were not provided given the original programmatic design, we are obliged to assess results based on the program end targets, which were also supported by the PBG (instead of the envisioned second operation). 1.3 Revised PDO (as approved by original approving authority) and Key Indicators, and reasons/justification: None. 1.4 Original Policy Areas Supported by the Program (as approved): The objective of the first PFSDPL operation is to support the authorities’ reform program for strengthening the banking sector. Since the beginning of the global financial crisis in the autumn 10 of 2008, the authorities worked diligently to formulate and deliver a coherent policy response aimed at restoring long-term macroeconomic and financial sector stability, and encouraging a sustainable economic recovery. In the fiscal area, to respond to the crisis and contain the widening fiscal deficit, the Government undertook politically difficult expenditure cuts to consolidate Government and expenditure growth, including by privatizing selected state assets and concessions. In the financial sector, the authorities gave priority to restoring depositor confidence and stepping up the supervisory effort, including restructuring of problem banks. In parallel, the authorities pursued a longer term effort towards strengthening the entire regulatory framework for the banking sector in order to bring it in line with international practices and EU directives, and thus make the sector and regulatory bodies better prepared for possible future shocks. These reforms are consistent with the Economic and Fiscal Program for the three-year period that the Government was obliged to prepare as part of the EU accession, starting from 2007. The need for a stronger regulatory and institutional framework for the banking sector was also highlighted by the European Commission (EC). The negative impact of the crisis on Montenegro’s economy provides a strong rationale for the first PFSDPL operation, which was designed to provide a coherent policy response to systemic risks in banking sector. It also lays the foundation for healthy future growth by advancing the regulatory reform agenda in financial sector. The operation supports strengthening the banking sector and increasing its resilience to future shocks, by undertaking reforms in the following five key areas: The policy areas included into the Program Document of the first PFSDPL were the following: Maintaining market confidence. The banking sector went into an abrupt tail-spin beginning in late 2008 owing to the global financial crisis, which sharply impacted parent bank funding and undermined depositors’ confidence, thus negatively affecting local banks’ liquidity (as most banks were funded from abroad). The ensuing economic slowdown in Montenegro yielded a dramatic rise in non-performing loans (NPLs), which caused banks to report negative earnings and to effectively stop lending. The policy measures adopted through the first PFSDPL encouraged depositors to return funds to Montenegrin banks over time, and similarly, to begin to lend again. Strengthening the liquidity framework. Bank liquidity was sharply eroded owing to the parallel withdraw of deposits by citizens and the effects of the global financial crisis on parent bank access to international capital markets. The CBCG did not have a functioning Lender of Last Resort (LoLR) facility in place to provide liquidity support to solvent banks facing liquidity pressures. The first PFSDPL policy measures adopted addressed this weakness, providing the CBCG with a key liquidity tool to utilize in the event needed. Moreover, in time banks’ liquidity improved; in part owing to depositors’ returning funds, changing the reserve requirements and inadvertently, through their cessation of lending. 11 Assessing and addressing banking sector vulnerabilities. As the project was being prepared it became apparent that the CBCG did not have a means to quickly grasp solvency, regulatory and potential other threats affecting its designated systemically important banks. To mitigate these risks, the project team agreed with the CBCG to develop Supervisory Action Plans (SAPs) based upon on-site examinations at those banks deemed to be of special concern. This enabled the supervisor to better understand the risk profile of designated banks, its ability to improve the quality of its loan book and oversee the bank’s recapitalization against a more full understanding of bank specific risks. Enhancing the regulatory framework. In a bid to align the CBCG’s regulatory framework to emerging EU guidance on strengthening bank supervisory powers, the CBCG’s enforcement authorities were expanded to take pre-emptive measures and strengthen its bank resolution legal framework in a number of critical areas. Restructuring of problem banks. This set of supervisory measures was directed to a single domestically owned bank. As the on-site examination prepared ahead of the SAP determined the bank’s solvency was threatened, the CBCG ordered the bank to reduce its size; as a part of which the Ministry of Finance (MoF) began to remove public deposits held on account at the bank. 1.5 Revised Policy Areas (if applicable): The original policy areas included into the PD of the first PFSDPL were not revised, but the envisioned second operation was converted to a guarantee. The guarantee operation had the same objective but somewhat different policy areas for the reasons explained in Section 1.6. 1.6 Other significant changes (in design, scope and scale, implementation arrangements and schedule, and funding allocations): The envisaged second operation of the PFSDPL laid out in the first PFSDPL Program Document was changed into a Policy Based Guarantee (PBG) owing largely to two separate but related sets of challenges. Firstly, the Eurozone crisis exacted a tremendous economic and social cost on Montenegro, as well laid out in the Financial Sector Policy Based Guarantee (FSPBG; P130157) Program Document. The prolongation and depth of the crisis in the Montenegrin banking system obliged two small sets of changes to the second operation, as briefly described in the next section. Secondly, given the steep economic decline Montenegro experienced, its fiscal condition sharply worsened in 2011, which required additional financing. The FSPBG operation, designed in lieu of the second programmatic DPL instead, became a Euro 60 million PBG which enabled Montenegro to leverage its borrowing considerably through a World Bank guarantee provided a private lender. The financial sector reform program remained largely intact through the PBG, though two policy areas were not carried forward in the PBG for the reasons outlined below: The first policy area “maintaining market confidence” was not carried forward as bank depositors began to return their monies to banks in late-2011, indicating that public confidence in 12 the financial system had begun to improve. The envisaged Deposit Protection Fund (DPF) regulatory changes were included in the second operation. The second policy area supporting “strengthening liquidity framework” was not deemed necessary as banks’ liquidity improved beginning in late-2011 owing to the return of deposits and parent bank recapitalization, obviating the need for additional liquidity enhancement measures. Additionally, the CBCG’s LoLR policy adopted was deemed by the team as sufficiently robust as to not require further changes: instead, the PBG operation introduced measures to strengthen systemic risk monitoring and the crisis preparedness framework. Each of the indicative triggers from the first PFSDPL for the second DPL operation (re-cast as the FSPBG) are featured in Annex 2 of the FSPBG Program Document (see Section 2.1). The rationale for the above changes were discussed extensively with the Country Director and RVP, and of course the FY12 PBG approved by the Board. 2. Key Factors Affecting Implementation and Outcomes 2.1 Program Performance: The project was initiated as a programmatic financial sector DPL consisting of two operations. For the reasons explained in Section 1.6, the second DPL operation was changed into a Financial Sector Policy Based Guarantee (FSPBG; P130157) and its policy actions were substantially carried forward. This table presents the policy actions and their status under both operations. Prior policy actions of PFSDPL 1 Prior action from Program Document for DPL 1 Status The Borrower has, through enactment of the Law on Protection of Deposits of August Completed 7, 2010 (Official Gazette 44/10), introduced a mechanism for ensuring a smooth transition from the blanket deposit guarantee by (i) increasing the ceiling for limited deposit insurance coverage; (ii) enhancing the financial resources of the Deposit Protection Fund by allowing additional funding sources in case of emergency; and (iii) shortening the mandatory payout period. The Borrower has, through enactment of the Law on Central Bank of Montenegro of Completed July 30, 2010 (Official Gazette 40/10 and 46/10), aligned the legislative framework for the Central Bank of Montenegro (CBCG)with European Union sound practices, including, inter alia, expanded powers and instruments for the CBCG’s function as lender of last resort. The CBCG has (i) completed onsite examinations and stress-testing of systemic banks Completed to determine the current and projected level of capital adequacy of such banks; and (ii) approved, and made progress in implementation of, supervisory action plans for banks of special concern, in each case applying a satisfactory methodology. The Borrower has, through enactment of the Law on Amendments to the Law on Banks Completed of August 7, 2010 (Official Gazette 44/10), enhanced the regulatory framework for the banking sector, including, inter alia,(i) strengthening “fit and proper” criteria for bank management and shareholders; (ii) improving the definition of “related parties”; (iii) clarifying the CBCG’s powers for remedial action; (iv) strengthening the interim administration process for problem banks; and (v) improving the statutory protection of CBCG employees The Borrower has, through enactment of the Law on Amendments to the Law on 13 Bankruptcy and Liquidation of Banks of August 7, 2010 (Official Gazette 44/10), provided CBCG with improved instruments for resolution of problem and insolvent banks in a timely and least costly manner. The CBCG has approved the time-bound Prva Banka Supervisory Action Plan (PB Completed Supervisory Action Plan) on the basis of an on-site inspection, and has confirmed that Prva Banka is in full compliance with minimum regulatory requirements and provisions of the approved PB Supervisory Action Plan. The Borrower has (a) withdrawn twenty five (25) per cent of central government deposits from Prva Banka by April 30, 2011, and (b) adopted, through its Ministry of Partially completed Finance, a decision on the complete withdrawal of central government deposits from Prva Banka by June 30, 2012. The CBCG has adopted the decision on Minimum Standards for Credit Risk Completed Management in Banks, Official Gazette 22/12, April 12, 2012, implementing IFRS 39 for the banking system as of January 1, 2013. The Government has by its decision dated March 29, 2012 approved the Law Completed on Financial Collateral, and thus improved the legislative framework for financial collateral and facilitated enhanced liquidity management at financial institutions. Indicative triggers for FSDPL2 (transformed into FSPBG) Prior action from Program Document for DPL 1 Status Adoption of the following regulations by the DPF: (i) regulation on Completed informing depositors on DI scheme in line with the EU directive; (ii) regulation on guarantee deposit payout procedure; and (iii) guidelines for DPF's employees during the payout process. Adoption of the following regulations by the CBCG: (i) by-law on the Completed (i) and (ii) but not supported Lender of Last Resort function of CBCG; and, (ii) new Policy for by the PBG; rather, systemic risk Reserve Requirements. monitoring and crisis preparedness were included, respectively. CBCG updates and implements SAPs for banks of special concern, as Completed evidenced by recapitalization of banks within the prescribed timetable. Adoption of the following regulations by CBCG: (i) capital adequacy; Completed (i) and (iii) but (ii) not (ii) COREP (European Banking Agency common regulatory reporting supported by the PBG; rather, a standards) regulation on large exposures and implementation; and, (iii) credit risk management. information disclosure were included instead Adoption of CBCG decision on the timetable for harmonization of Completed regulations with IFRS and associated bank supervision capacity building plan. Implementation of PB Supervisory Action Plan, including maintenance Completed of CAR above 12 percent, and compliance with regulatory liquidity ratio. Timely implementation of the MoF decision on withdrawal of central Included and partially completed, as a government deposits from Prva Banka, aiming to reduce the value of small remaining balance of eligible deposits from the same source by (i) further forty (40) percent by public deposits remain on account at December 31, 2011; and (ii) further thirty five (35) percent by June 30, Prva Bank. 2012. Implementation of a policy requiring all state and state controlled Completed, but not supported by the institutions to conduct price and quality based selection process for PBG banking services. 14 2.2 Major Factors Affecting Implementation: Adequacy of government's commitment, stakeholder involvement, and/or participatory processes: The design of the Government’s reform program and this operation benefited from consultations with relevant stakeholders. The authorities have pro-actively communicated with the public on the objectives of the DPL financial sector reform program. The MoF and the CBCG representatives made frequent appearances on TV and in printed media, regularly issued press releases (published on MoF and CBCG websites in both Montenegrin and English) and organized roundtables to explain the measures taken by the authorities to boost market confidence and restore healthy financial intermediation. The changes in legislation were extensively discussed with industry stakeholders, and went through an extensive inter-ministerial harmonization process before their submission for the Parliament’s consideration. The Bank team has also consulted widely with stakeholders, including banking sector representatives, academic and representatives of other key development partners, including the IMF and the EC Delegation. Soundness of the background analysis supporting the operation(s), lessons learned incorporated, and the rationale for the Bank’s intervention: The project team had unprecedented access to the authorities and banking records alike throughout the protracted project preparation period. As such, the detailed sectoral analysis featured in Annex 2 of the Program Document demonstrates the depth of understanding the challenges the financial sector faced, as agreed with the authorities. As well, the Bank and the IMF jointly reviewed and provided technical assistance to the authorities on the legal amendments to the draft Law on Banks and the Bank Bankruptcy and Liquidation Law. The IMF has taken the lead on reviewing the draft law on the Central Bank, while the Bank has played the same role for the Deposit Protection Law. The first PFSDPL incorporated lessons from Bank’s experience in 2008-2009 crises, as well as in previous economic and financial crises. A recent comprehensive review of the Bank’s responses to financial crises underscored the following lessons:  Early response. The key lesson from the Bank’s responses to previous crises is the importance of an early response. In this case, the Bank fielded an identification mission within a few weeks from receiving the request for budget support, even though the Country Partnership Strategy (CPS) did not foresee a need for a DPL instrument at that time.  Need for focus. During crises, it is crucial that operations focus on selected key areas for good outcomes. The proposed operation incorporates this lesson by focusing on a main challenge recognized by the Government, namely, addressing vulnerabilities in the banking sector and making the banking sector more resilient to cope with possible future shocks.  Government ownership. The proposed reforms need to support the authorities’ priorities and an extensive dialogue is essential to develop ownership of the technically complex, politicall y sensitive reforms in the banking sector. This operation was prepared in direct collaboration with the top leadership of the MoF and the CBCG. 15  Communication strategy. Through a carefully planned and implemented communication strategy by the Government and the Bank undertaken in support of this operation, public understandings of key financial stability measures adopted were substantially improved. The staff of the World Bank Field Office in Podgorica played a critical role in this regard by ensuring consistent and timely communication with key stakeholders. The Bank also kept civil society and the general public informed of its position on critical issues through interviews to national media and press releases.  Coordination among development partners. Coordination proved critical as such a coordinated approach yields better understood results. This operation incorporates this lesson by working closely with the IMF, EC, and EBRD. The negative impact of the crisis on Montenegro’s economy provided a strong rationale for the operation, designed to provide a coherent policy response to systemic risks in banking sector. It also laid the foundation for more healthy future growth by advancing the regulatory reform agenda in financial sector. Assessment of the operation’s design: The Law on Central Bank of Montenegro was amended (Official Gazette 40/10 and 46/10) to further align the CBCG legislative framework with sound European Union practices, including, inter alia, expanded powers and instruments for the CBCG’s function as lender of last resort. Relevance of the risks identified at appraisal and effectiveness of mitigation measures: The first PFSDPL was a high-risk operation, developed in the depths of the Eurozone sovereign debt crises, wherein external uncertainties were protracted and heightened. Key risks were identified in four major areas: (i) economic risks; (ii) financial instability; (iii) governance) and (iv) implementation related risks. Having identified these sets of risks through the prolonged preparation phase, the team was able to mitigate against worse outcomes owing to the deep commitment of the authorities to avoid the potential threat of financial instability in Montenegro. Given that the politically sensitive and technically complex financial sector reforms undertaken could be stalled, or subject to backtracking following the mid-2011 approval of the first PFSDPL, the team designed a uniquely robust set of the prior actions (i.e., enactment of new legislation as opposed to submission to the Parliament, implementation of supervision action plans by banks as opposed to approval of SAPs by the CBCG, recapitalization of Prva Banka) which would prove difficult to reverse. Furthermore, the financial sector reforms supported under this operation were largely continued and deepened under the second operation, converted from a DPL to a PBG. Finally, Article IV of the Loan Agreement included (as a remedy of last resort) a clause allowing the Bank to accelerate repayment in the event the agreed Program goes off track after disbursement. 2.3 Monitoring and Evaluation (M&E) Design, Implementation and Utilization: At the Government level, the MoF was responsible for the overall implementation of the operation and for the reporting process; their efforts were closely aligned with the CBCG, 16 who drafted the key regulations and in close collaboration with the MoF undertook the needed supervisory and reforms steps. Design: There were nine indicators to monitor the outcomes, for which targets were established for each indicator to capture the results achieved. The baselines and outcome indicators were objective and cumulatively formed a clear result chain demonstrating both the regulator’s and financial sector’s performance. Having said that, PDO Indicator No. 7 proved less helpful to assess the regulator’s performance given the internal and external environment. Implementation: The M&E and implementation arrangements were continuous throughout the preparation phase and contributed to the implementation of key reforms and the achievement of development objectives.  Utilization: Given that the program was designed in the middle of the global financial sector crisis as a programmatic operation over a period of two years, systematic efforts were made with the authorities to define mostly quantitative indicators to facilitate monitoring. 2.4 Expected Next Phase/Follow-up Operation (if any): The Government of Montenegro remains committed to completing the substantial financial sector reform program implemented through the first PFSDPL operation. And whilst considerable progress has been made, the key follow-on reforms were tackled in the subsequent PBG operation. The Bank continues its high-level policy dialogue with key implementing institutions, namely the CBCG and MoF. 3. Assessment of Outcomes 3.1 Relevance of Objectives, Design and Implementation: Relevance of Objectives The objectives of the first PFSDPL are consistent with key priorities and expected outcomes supported under the current Country Partnership Strategy (CPS). The FY11-FY14 CPS for Montenegro, endorsed by the Board in January 2011, envisages a series of two programmatic financial sector DPLs. The second operation, delivered in FY12 substantially as first envisaged, was converted from a programmatic DPL into a PBG to enable Montenegro to better meet its 2012 fiscal shortfall needs (Section 1.6). These two operations constitute over half of the CPS lending envelope and fall under the first of the two main CPS priority areas, namely ―support EU accession through strengthening institutions and competitiveness. The CPS clearly states that one of the key outcomes of the CPS is expected to be a stronger banking system governed by a modern regulatory framework and central institutions, which is more resilient to future shocks. The authorities gave priority to restoring depositor confidence and strengthening their supervisory and regulatory framework for the banking sector in order to bring it in line with international practices and EU directives, and thus make the sector better prepared for possible future shocks. These reforms are consistent with the Economic and Fiscal Program 17 for the three-year period that the Government was obliged to prepare as part of the EU accession, starting from 2007. The need for a stronger regulatory and institutional framework for the banking sector was also highlighted by the EC in its 2010 opinion on Montenegro’s Application for Membership of the EU. Relevance of Design and Implementation The set of financial sector related reforms undertaken through the first PFSDPL and follow- on PBG proved highly relevant to the authorities’ efforts to mitigate vulnerabilities in the financial sector, and are in line with the Government of Montenegro’s aspirations to join the EU. Given the complexities of the reform measures adopted through both operations to mitigate key financial sector vulnerabilities at a time of tremendous uncertainty within Europe, the PDO remained relevant to the achievement of the outcomes. Since the beginning of the crisis in the second half of 2008, the authorities have formulated and delivered on a broadly coherent policy response aimed at restoring long-term macroeconomic and financial sector stability, and encouraging a sustainable economic recovery. The policy areas of the first DPL supported the mitigation of risk, which was considerably heightened in the Eurozone during the project preparation phrase. Subsequent adjustments to the PBG prior actions were rather few, and reflected the dynamic state of the sector’s performance. In the fiscal area, to respond to the crisis and contain the widening fiscal deficit, the Government undertook politically difficult expenditure cuts to expenditures, including by privatizing selected state assets and concessions. 3.2 Achievement of Program Development Objectives This ICR assesses the key expected results and outcomes at the end of the program, as shown in the Program Document of the first operation, since there were no separate targets for each operation and since they were in the end converted into single operations. As explained in Section 2.1, most of the actions of the envisioned second operation were completed through the PBG and thus they contributed to achieving the program targets although technically PBG was a separate operation. Accordingly, the PBG will be assessed through a separate ICR. The key expected results and outcomes at the end of the program were to: (i) increased confidence in the banking sector; (ii) enhanced ability of the CBCG to provide emergency liquidity assistance; (iii) effective supervision of the banking system consistent with Basel Core Principles; (iv) strengthened legal authority of the CBCG for resolution of problem banks according to international and EU good practices; and (v) Prva Banka no longer poses a systemic and fiscal risk. In sum, all the Prior Actions precedent to Board approval were approved, and moreover, substantially all of the expected key outcomes were achieved against the backdrop of unprecedented financial uncertainties arising from the Eurozone and sharply declining economic growth in Montenegro. Moreover, through this operation the authorities enacted a set of key legal and prudential reforms, as laid out below, essential to the restoration of the depositors’ confidence, the sine 18 qua non of financial stability, resulting in a sharp increase in deposits and to a lesser degree, lending. The first PFSDPL strengthened the banking sector, a critical pre-condition for sustainable economic recovery and balanced private sector-led growth to a substantial extent, as demonstrated by the achievement of virtually all of the expected outcomes, as summarized below. 1. Maintaining Market Confidence. Increase confidence in the banking sector is reflected in the stabilization of bank deposits and the resumption of lending.  Increased confidence in the banking sector leading to (targeted) positive annual growth in bank deposits in 2011 and 2012 of 1.5 percent and 9 percent, respectively, to gradually reach the pre-crisis (September 2008) level of deposits. The total decline in deposits from September 2008 to March 2011 reached -23.3 percent).  The decline of new lending has slowed, but it has not reached the targeted positive growth owing to the prolonged Eurozone financial crises and subdued Montenegro economic growth, which negatively impacted loan demand. The year-on year credit growth went from -8% in 2010 and 2011 to -5% in 2012 as healthier mid and small size banks have begun growing their loan books with new lending concentrated in consumer lending and SMEs as banks try to diversify their loan portfolios away from large enterprises. 2. Strengthening the Liquidity Framework. through enhancing the ability of the central bank to provide emergency liquidity assistance and critically, enabling banks to maintain adequate liquidity during a period of prolonged stress.  Between September 2008 and 2011, the banking sector lost almost 20 percent of its total deposits. The liquidity framework was strengthened and adequate liquidity maintained through passage of the Emergency Liquidity Assistance (ELA) reforms and banks’ improved liquidity position evidenced through the CBCG’s financial reporting. The system's liquid assets to due liabilities ratio went from a low 1.58 at the end of 2011 to 1.83 by the end of 2012. 3. Assessing and Addressing Banking Sector Vulnerabilities through adoption of new, more proactive prudential measures supported by the operation to improve the quality of banks’ loan books and their capitalization levels.  The quality of banks loan books varied considerably owing to their respective risk appetites and implementation of loan underwriting standards. Banks’ overall NPLs rose to 21.0% at end-2010 before declining to 15.5% at end- 2011 owing to the off-loading of NPLs by two leading banks. After which NPLs began to rise again to 17.6% at end-2012 with the prolonged economic slump of Montenegro, above the target of less than 8%.  Banks’ overall capitalization remained above the targeted 12%, at 15% from 19 2008 until end-2012, when the overall ratio fell to 14.7%, during which time most banks were recapitalized by their parent groups. 4. Enhancing the Regulatory Framework for the Banking Sector through strengthening the CBCG’s legal authority to resolve problem banks in accord with EU good practice, a key deterrent or consequence was established, though the BCP was not undertaken as part of the envisaged FSAP.  The CBCG’s legal authority to resolve problem banks was markedly enhanced through passage of the amendments featured in the prior actions, by inter alia, (i) clarifying the CBCG’s powers for remedial action; (ii) strengthening the interim administration process for problem banks; and (iii) providing the CBCG with improved instruments for resolution of problem and insolvent banks in a timely and least cost manner (100% achieved)..  While a number of key regulatory reforms were adopted (see Section 2.2) an independent Basel Core Principles (BCP) assessment was not undertaken as envisaged to determine benchmark nearly 30 banking supervision and regulation principles to internationally accepted norms. Thus, with no source for a benchmarking, this narrowly defined outcome was not achieved. 5. Restructuring of Problem Banks through the implementation of the Supervisory Action Plan (SAP) at Prva Bank and the concurrent gradual withdrawal of central government deposits, Prva Bank no longer poses a systemic risk. This is a material positive outcome from the operation.  The Ministry of Finance removed substantially all (eligible) deposits from Prva Bank by end-June 2012, with only about 1.5 million euro (or about 5%) remaining on account. Subsequently such deposits increased slightly by end- 2012 and thereafter were reduced to about 900,000 euro (about 3%) by end- April 2013 (the target was 0%). Moreover, Prva Bank’s size was reduced as part of its mandated restructuring, rendering the bank no longer systemically important. 3.3 Justification of Overall Outcome Rating (combining relevance, achievement of PDOs): Rating: Satisfactory The first PFSDPL was a high-risk complex operation, developed in the midst of the Eurozone sovereign debt crises. The project substantially delivered on the PDO, strengthening the banking sector (through prudential and related means). The results achieved were highly relevant, as owing to the close collaboration between the authorities and project team throughout the preparation phase, Montenegro was successfully able to avoid financial instability. This key outcome could not have been assured as the project was prepared during a period of substantial external uncertainties. The relevance of the first PFSDPL was high for both the CPS and government strategies and the achievement of the objectives was substantial, as it strengthened the capacity of the 20 supervisory authority to react in the event of a worse scenario and improved the resilience of the financial systems. The overall outcome is rated as satisfactory. 3.4 Overarching Themes, Other Outcomes and Impacts (a) Poverty Impacts, Gender Aspects, and Social Development There were no measured poverty impacts specifically related to this operation. Nevertheless, the reforms proposed under this operation are expected to have overall positive poverty and social impact. The deteriorating conditions in the economy, manifested in the banking sector instability and the near collapse of the aluminum industry, are very likely to have adverse effects on growth, employment, and poverty. This operation would help mitigate the negative effects of the crisis on poverty as it aims to: (i) increase the capacity of the financial authorities to anticipate and address risks in the banking sector, thus avoiding a systemic crisis that could be very costly to depositors; (ii) enhance the capacity of the financial authorities to deal with troubled banks and thus help preserve taxpayers’ money; and (iii) facilitate the resumption in credit activities as economic growth returns. (b) Institutional Change/Strengthening (particularly with reference to impacts on longer- term capacity and institutional development): The CBCG adopted a proactive posture with the onset of the Eurozone crisis, having recognized the potential implications. In a bid to tackle one of the most pernicious effects of the crisis, the CBCG has taken the initiative to develop a comprehensive, integrated approach to NPL reduction, which is complex, resource intensive and time consuming. Loosely based on the 1991 London Rules, the approach is designed to create an incentive based, voluntary framework to support real (operational as well as financial) restructuring to return distressed borrowers to financial health. However, it is not envisioned to come into full force before 2014. As well, the CBCG continued to systematically work on harmonizing its bank regulatory framework with relevant EU Directives and practices. This broad aim is crystallized through the far-reaching set of Indicative Triggers agreed, which have been nearly all realized, including the 2013 introduction of IFRS financial reporting and accounting standards. (c) Other Unintended Outcomes and Impacts (positive and negative): In 2012, the newly established Financial Stability Council (FSC) adopted a comprehensive new confidential national crisis management framework. This framework develops crisis contingency plans at the level of each of the three financial sector supervisors (CBCG, SEC and FSA), the MoF and the Embedded in the framework is the PFSDPL prior action of a lex specialis (or the draft Financial Stability Law) to replace the emergency anti-crisis Law on Measures for Protection of the Banking System which expired at end-2009. The FSC considered the enactment of a permanent law to replace the expired emergency anti-crisis law, but felt that given the existing state of the banking sector, enacting a permanent law could wrongly be interpreted by some to signal a lack of confidence in the system. 21 Instead, they opted to prepare a lex specialis -- but not submit it to Parliament until such time as they declared a financial crisis. If enacted, the lex specialis would grant the authorities additional powers to intervene in the financial system by providing liquidity and capital support. As a further positive impact from the FPFSDPL operation and follow on PBG, the CBCG has recently requested World Bank assistance to enhance their crisis management capacity through conducting a crisis simulation exercise in the second semester of 2013, which may yield more understandings of the efficacy of this arrangement. 3.5 Summary of Findings of Beneficiary Survey and/or Stakeholder Workshops (optional for Core ICR, required for ILI, details in annexes): Not applicable. 4. Assessment of Risk to Development Outcome Rating: Substantial Overall macroeconomic risks remain substantial given Montenegro’s high external vulnerability owing to the prolonged eurozone economic slump and regional environment in which the country operates. Slower than expected growth in Southeast Europe and the EU in 2012 and year to date 2013 may dampen Montenegro’s recovery, which would further strain the fiscal stance. Slower recovery would affect the corporate sector performance and consequently the financial sector. Montenegro’s heavy reliance on tourism revenues and exports to Europe makes it vulnerable to prolonged deterioration in regional stability or slowdown of growth in the EU. Furthermore, the country’s euroization, high level of external debt and large debt service requirements over the medium term render the Montenegrin financial sector vulnerable to a slowdown in capital inflows and call for a continued prudent fiscal policy. Finally, given the size of the country, even a small shock may have a sizeable impact on the economy. Finally, thought there is no IMF program in Montenegro, the implementation of the ongoing acquis communitaire chapter negotiations with the EU will serve as a policy anchor in regards key economic, legal and financial reforms, similar to that of EU countries. The Government’s structural reform program that aims to increase competitiveness, will contribute to improved investor confidence in the medium-term. 5. Assessment of Bank and Borrower Performance (relating to design, implementation and outcome issues) 5.1 Bank Performance (a) Bank Performance in Ensuring Quality at Entry (i.e., performance through lending phase): Rating: Satisfactory 22 The comprehensive design of this operation, developed over nearly two years, reflects a robust, well thought out set of prior actions and key expected outcomes. The project design benefited from frequent new guidance disseminated from the global financial crisis, e.g., from the’s new focus on macro-prudential oversight, defining a global liquidity standard and identification of key attributes of a bank resolution regime, new EBA reporting standards and capital requirements, EU draft Directives circulated for comment, etc. It is noted that while a number of the Indicators chosen were of a high level (deposit growth, credit growth, liquidity, capitalization, etc.) each represents a key dimension of public and investor confidence in the financial sector. As such, this set of indicators served as a reasonable proxy for continuing financial stability, essential to the ability of the banking sector to fulfil its intermediation role. Considering both the large body of knowledge promulgated in the midst of the crisis and the banking sector’s sharply deteriorating financial performance during the project preparation phase, the quality at entry of the Bank is assessed as Satisfactory. (b) Quality of Supervision (including M&E arrangements): Rating: Satisfactory The Bank devised an effective approach to work with counterparts in the development of the financial sector reform program. The Bank cooperated effectively with the Ministry of Finance, which was the coordinator of activities on the Borrower’s side and maintained very close cooperation with the CBCG. The Bank assisted through a number of challenging reforms with persistence and delivering high level support in all policy areas. By all indications, the counterparts in the Government of Montenegro were very satisfied with the technical support and systematic approach to reforms provided by the Bank Team. Moreover, the task team monitored the country’s overall economic performance and the timely adoption and effective implementation of the agreed program conditions. They also validated the Borrower’s monitoring and evaluation findings on the progress and results of program implementation. Further, the task team regulatory consulted and coordinated with the IMF in carrying out its supervision work. Therefore, the quality of supervision has been assessed as Highly Satisfactory. (c) Justification of Rating for Overall Bank Performance: Rating: Satisfactory The overall performance is rated Satisfactory since the Bank performance in both Ensuring Quality at Entry and in Quality of Supervision were rated Satisfactory. 5.2 Borrower Performance X Check here if the Government and the Implementation Agency is the same or indistinguishable 23 (a) Government Performance: Rating: Satisfactory The Government developed the institutional and regulatory framework to improve financial sector stability, strengthen the regulatory and supervisory regimes and public sector funds management. A significant number of major regulations and law amendments were introduced as a result of this operation. Cooperation with the Bank by the MoF and CBCG was very strong, with often difficult discussions as to specific reform measures. The authorities completed all PFSDPL prior actions, readily shared information with the Bank team and continue to implement reforms in a very difficult regional and domestic environment. The Government showed strong commitment to the consultation process, i.e., through consultation with stakeholders on important legislative amendments and regulatory reforms alike. The EU accession agenda and the unfolding Eurozone crisis together played a critical role in driving the pace of the reforms. In implementing agreed upon measures, the professionalism and dedication of the Government Team and CBCG counterparts proved to be determinant factors. (b) Justification of Rating for Overall Borrower Performance: Rating: Satisfactory The performance of the Government and implementing agency, the CBCG, was deemed satisfactory as all the prior actions and key outcome indicators have been achieved on a timely basis. 6. Lessons Learned It is important to maintain sufficient flexibility, particularly in the case of programmatic policy development loans, to adapt and respond to client needs and economic realities in the country. As the external environment was rather negative during the preparation phase, adding a strong sense of urgency to the need to adopt financial sector related reforms, the team worked hard to build sufficient ownership of the many policy and regulatory changes. The conversion of the second DPL to a PBG, which significantly leveraged the Bank’s lending, was a direct result of the Montenegrin 2012 financing gap, as the prior actions were not significantly different. As well, the regular coordination with other partners combined with providing necessary technical assistance on a timely basis positively impacted outcomes achieved. Cooperation among international agencies (i.e. World Bank Group, IMF, KfW, EBRD) and with the EU, proved essential given that extensive technical assistance was being provided and needed to be coordinated and aligned with the country’s priorities and strategic goals. 24 This cooperation was underscored by the central role played by the Government of Montenegro through the Ministry of Finance and CBCG. Further, the reforms in the financial sector in which the Bank had a comparative advantage, were designed in cooperation with the IMF. The financial sector reforms have been also indirectly aided by investments in undercapitalized banks by the EBRD and the IFC. 7. Comments on Issues Raised by Borrower/Implementing Agencies/Partners (a) Borrower/Implementing Agencies: The CBCG's comments, as appended in Annex 4 are well considered and accepted; the single specfic concern as to the ICR regarded the statement in Section 1.4, which was removed. (b) Cofinanciers: None. (c) Other partners and stakeholders (e.g. NGOs/private sector/civil society): None. 25 ANNEXES Annex 1. Bank Lending and Implementation Support/Supervision Processes (a) Task Team members Name Title Unit Responsibility/ Specialty Lending (from Task Team in Program Document) Alexander Pankov Country Sector Coordinator ECSPF Task Team Leader Martin Melecky Senior Financial Economist ECSF1 Senior Financial Economist Aquiles A. Almansi Lead Financial Sector Specialist FFSAB Lead Financial Sector Specialist Danijela Vukajlovic-Grba Consultant ECSF1 Economist Lalit Raina Sector Manager ECSF2 Sector Manager Julie Rieger Senior Counsel LEGLE Counsel Aleksandar Crnomarkovic Sr Financial Management ECSO3 Sr Financial Management Specialist Specialist Kenneth Simler Senior Economist ECSP3 Senior Economist Jan-Peter Olters Country Manager ECCKO Country Manager Ross Delston Consultant ECSPF Consultant Djurdjica Ognjenovic Consultant ECSPF Consultant Supervision (from Task Team Members in all archived ISRs) Michael Edwards Lead Financial Sector ECSPF Lead Financial Sector Specialist Specialist Aquiles A. Almansi Lead Financial Sector Specialist FFSAB Lead Financial Sector Specialist Kenneth Simler Senior Economist ECSP3 Senior Economist Angela Prigozhina Country Sector Coordinator ECSPF Senior Financial Specialist Alexander Pankov Country Sector Coordinator ECSPF Senior Private Sector Development Specialist Lalit Raina Sector Manager ECSF2 Service Line Manager Jan-Peter Olters Country Manager ECCKO Country Manager Andrew Lovegrove Consultant ECSF1 Consultant Sanja Madzarevic-Sujster Senior Country Economist ECSP2 Senior Country Economist Jose C. Janeiro Senior Finance Officer CTRLA Senior Finance Officer 26 Djurdjica Ognjenovic Consultant ECSF1 Consultant Aleksandar Crnomarkovic Sr Financial Management ECSO3 Sr Financial Management Specialist Specialist Julie Rieger Senior Counsel LEGLE Counsel Danijela Vukajlovic-Grba Consultant ECSF1 Economist (b) Staff Time and Cost (from SAP) Staff Time and Cost (Bank Budget Only) Stage No. of Staff Weeks US$ Thousands (including travel and consultant costs) Lending FY09 9.84 141.34 FY10 26.75 275.12 FY11 34.04 211.04 FY12 6.16 18.25 TOTAL: 76.79 645.75 Supervision/ICR FY12 0.00 0.02 FY13 0.00 0.73 FY14 0.25 0.87 TOTAL 0.25 1.62 27 Annex 2. Beneficiary Survey Results (if any) Not applicable. 28 Annex 3. Stakeholder Workshop Report and Results (if any) Not applicable. 29 Annex 4. Summary of Borrower’s ICR and/or Comments on Draft ICR 30 Annex 5. Comments of Cofinanciers and Other Partners/Stakeholders Not applicable. 31 Annex 6. List of Supporting Documents 1. Program Document, July 2011 2. Letter of Development Policy, June 2011 32 IBRD 34825R2 19°E M O N TE N E GRO CITIES AND TOWNS NATIONAL CAPITAL RIVERS a MAIN ROADS in Dr To RAILROADS BOSNIA AND Priboj Cehotin OPSTINA (MUNICIPALITY) BOUNDARIES HERZEGOVINA To a To Priboj Foca Gradac INTERNATIONAL BOUNDARIES Pljevlja Ljubisnja 20°E (2238 m) Du Bioc rm v (2396 m) ito r Žabjlak Zabljak ´ Durdevica SERBIA Tara San Rudinice Plužine dzak To Goransko Kom v Foca Tomasevo ari Ta Bijelo Polje Bajovo a Sin ra nc Polje jaj 43°N evi ˘ Savnik na Mojkovac To Vucitrn To Mostar Zeta v Rozaje Gvozd v Ivangrad Kapa Kolasin Velimlje Moracka Berane v ´ Petrovici ‘ Niksic (2227 m) v Matesevo Vilusi v Andrijevica Morakovo Medurijecje To Komovi To Dubrovnik (2656 m) Dakovica Grahovo Lijeva Rijeka Murino ca Ze M o ra ta Pelev Plav To Dubrovnik Crkvice Danilovgrad v Gusinje KOSOVO Risan Spuz v Perast Bioce Herceg- Novi Tivat Kotor PODGORICA CROATIA Radovi´ci ije vn a Cetinje Tuzi C Plavnica ALBANIA Sveti Budva Stefan Virpazar Petrovac Lake A dr ia tic Scutari Stari Bar Sea Bar Shkodër 42°N a un To -B Kukes a 0 5 10 15 20 Kilometers MONTENEGRO Bojan Ulcinj 0 5 10 15 20 Miles Sveti Nikola To Tirane This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information shown on this map do not imply, on the part of The World Bank GSDPM Map Design Unit Group, any judgment on the legal status of any territory, or any endorsement or acceptance of such boundaries. 19°E FEBRUARY 2014