Document of The World Bank Report No: ICR83598 IMPLEMENTATION COMPLETION AND RESULTS REPORT (Loan No. IBRD G2130) ON A LOAN IN THE AMOUNT of 60 MILLION EURO (US$ 79.2 MILLION EQUIVALENT) TO MONTENEGRO FOR A FINANCIAL SECTOR POLICY BASED GUARANTEE May 8, 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 CAR Capital Adequacy Ratio GoM Government of Montenegro International Bank for CBCG Central Bank of Montenegro IBRD Reconstruction and Development CPS Country Partnership Strategy IFC International Finance Corporation International Financial Reporting DPF Deposit Protection Fund IFRS Standards DPL Development Policy Loan IMF International Monetary Fund European Bank for Reconstruction and EBRD KAP Kombinat Aluminijuma Podgorica Development Kreditanstalt für Wiederaufbau / EU European Union KfW German Development Bank FDI Foreign Direct Investment MoF Ministry of Finance FSAP Financial Sector Assessment Program NPL Nonperforming Loan FSC Financial Stability Council SAC Structural Adjustment Credit Financial Sector Development Policy FSDPL SAP Supervisory Action Plan Loan FSL Financial Stability Law TA Technical Assistance Financial Sector Policy Based FSPBG WB World Bank Guarantee 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 Financial Sector Policy Based Guarantee (P130157) TABLE OF CONTENTS 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): .. 8  1.3  Revised PDO (as approved by original approving authority) and Key Indicators, and reasons/justification: ................................................................................................................... 9  1.4  Original Policy Areas Supported by the Operation:......................................................... 9  1.5  Revised Policy Areas (if applicable): ............................................................................. 10  1.6  Other significant changes (in design, scope and scale, implementation arrangements and schedule, and funding allocations):........................................................................................... 10  2.  Key Factors Affecting Implementation and Outcomes ........................................................ 10  2.1  Performance: .................................................................................................................. 10  2.2  Major Factors Affecting Implementation:...................................................................... 12  2.3  Monitoring and Evaluation (M&E) Design, Implementation and Utilization: .............. 13  2.4  Expected Next Phase/Follow-up Operation (if any): ..................................................... 13  3.  Assessment of Outcomes ...................................................................................................... 13  3.1  Relevance of Objectives, Design and Implementation: ................................................. 13  3.2  Achievement of Program Development Objectives: ...................................................... 14  3.3  Justification of Overall Outcome Rating (combining relevance and achievement of PDOs):....................................................................................................................................... 16  3.4  Overarching Themes, Other Outcomes and Impacts: .................................................... 16  3.5  Summary of Findings of Beneficiary Survey and/or Stakeholder Workshops: ............. 17  4.  Assessment of Risk to Development Outcome ..................................................................... 17  5.  Bank and Borrower Performance.......................................................................................... 18  5.1  Bank Performance: ......................................................................................................... 18  5.2  Borrower Performance: .................................................................................................. 19  6.  Lessons Learned.................................................................................................................... 20  7.  Comments on Issues Raised by Borrower/Implementing Agencies/Partners....................... 21  8.  ANNEXES ............................................................................................................................ 22  8.1  Annex 1. Bank Lending and Implementation Support/Supervision Processes ............. 22  8.2  Annex 2. Beneficiary Survey Results (if any)............................................................... 23  8.3  Annex 3. Stakeholder Workshop Report and Results (if any) ...................................... 24  8.4  Annex 4. Summary of Borrower’s ICR and/or Comments on Draft ICR ..................... 25  8.5  Annex 5. Comments of Cofinanciers and Other Partners/Stakeholders ....................... 28  8.6  Annex 6. List of Supporting Documents ........................................................................ 29  A. Basic Information Country: Montenegro Program Name: Financial Sector Policy Based Guarantee Program ID: P130157 L/C/TF Number(s): IBRD G2130 ICR Date: May 2, 2014 ICR Type: Core ICR Lending Instrument: Guarantee Borrower: Montenegro Original Total Commitment: Up to Euro 60 Disbursed Amount: N/A million Implementing Agencies: The Ministry of Finance of Montenegro is responsible for overall implementation of the proposed operation. The Central Bank of Montenegro (CBCG) is closely involved in the work on most prior actions. Cofinanciers and Other External Partners: N/A B. Key Dates Process Date Process Original Date Revised/Actual Date(s) Concept Review: January 5, 2012 Effectiveness: July 27, 2012 Appraisal: May 18, 2012 Restructuring(s): N/A N/A Approval: June 28, 2012 Mid-term Review: N/A N/A Closing: July 27, 2013 July 27, 2013 C. Ratings Summary C.1 Performance Rating by ICR Outcome: 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 Quality of Satisfactory Implementation Satisfactory Supervision: Agency/Agencies: Overall Bank Satisfactory Overall Borrower Satisfactory Performance: Performance: 1 C.3 Quality at Entry and Implementation Performance Indicators Implementation Performance Indicators QAG Assessments (if any) Rating Potential Prob. Program at any time No Quality at Entry (QEA): None (Yes/No): Problem Program at any time(Yes/No): No Quality of Supervision (QSA): None DO rating before Closing/Inactive status: None D. Sector and Theme Codes Original Actual Sector Code (as % of total Bank financing) 1. Banking 50 100 Theme Code (Primary/Secondary) 1. Regulation and competition policy 50 70 2. Other Financial Sector Development 30 30 Financial Consumer protection and financial literacy 20 0 E. Bank Staff Positions At ICR At Approval Vice President: Laura Tuck Philippe H. Le Houérou Country Director: Ellen Goldstein Jane Armitage Sector Manager: Lalit Raina Lalit Raina TTL: Martin Melecky Alex Pankov ICR Team Leader: Michael Edwards ICR Primary Author: Michael Edwards ICR Primary Co-Author: Paula Genis 2 F. Results Framework Analysis Development Objective: 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. The operation supports strengthening of the systemic risk monitoring and crisis preparedness frameworks, the banking sector soundness and transparency, and depositors and market confidence, thus increasing Montenegro’s financial sector resilience to possible future adverse shocks. More specifically, this operation’s support derives from reforms in the following areas: (i) systemic risk monitoring and crisis preparedness; (ii) resolution of problem banks; (iii) restructuring of Prva Banka; (iv) depositor protection; and (v) the regulatory framework for banks. It should be noted that the FSPBG came about as a result of converting the envisaged second operation under the (initial) Programmatic Financial Sector Development Policy Loan (PFSDPL, or P116787) into a single guarantee operation so as to leverage or increase the World Bank's financing available to the Government of Montenegro. The FSPBG has some different policy areas and expected targets than the envisaged second operation of the PFSDPL laid out in the Program Document of the PFSDPL (see Section 1.4 for an explanation of differences). OPCS has advised the team to prepare separate ICRs for the first FSDPL and FSPBG since they were converted to separate operations. This ICR assesses the key expected results and outcomes at the end of the FSPBG, as laid out in its Program Document. Revised Program Development Objective None. (a) PDO Indicator(s) ─ from Annex 1 Policy Matrix in the Program Document Baseline Value Original Target Formally Revised Actual Values (from approval Values Target Values Achieved documents) (from approval at Completion or documents) Target Years PDO Indicator 1: Enhanced macro-prudential oversight and crisis management framework in line with international good practice as appraised by next Financial Stability Assessment Program (FSAP) update. Value No (based on the Yes (based on FSAP N/A Yes. Though the (quantitative or 2007 FSAP expected in 2013- FSAP update was qualitative) findings) 2014) not undertaken, the authorities have demonstrated their deep commitment to advancing macro-prudential oversight through numerous FSC meetings. 3 Date achieved 12/31/2007 12/31/2013 N/A 06/30/2013 Comments The authorities’ commitment to advancing macro-prudential oversight is demonstrated (incl. % through the following examples. The authorities by law established in 2010 the Financial achievement) Stability Council (FSC) which includes the MoF, CBCG Governor and the heads of the Insurance Supervision Agency and Securities and Exchange Commission. The FSC is mandated to meet quarterly to monitor systemic risk necessary to take make macro prudential policy recommendations to be implemented by the appropriate regulator. In a bid to fulfil its mandate and contain financial sector risks, in 2013 the FSC met seven times. With regards the FSAP, it is well overdue and the authorities signaled in early 2014 their interest to undergo an FSAP update, though the assessment is not yet scheduled. (Partially achieved). PDO Indicator 2: Improved quality of banks’ loan portfolios (system’s NPL ratio) Value (quantitative or 19.7% < 12 % N/A 18.82% Qualitative) Date achieved 9/30/2011 7/27/2013 N/A 6/30/2013 Comments Banks’ NPLs rose to 21.0% at end-2010 before declining owing to the off-loading of NPLs (incl. % by two leading banks. After which NPLs began to rise again with the prolonged economic achievement) slump of Montenegro (Partially Achieved). PDO Indicator 3 : Well capitalized banks (based on average CAR of the banking system) Value (quantitative or 16% >15 percent N/A 15.50 percent Qualitative) Date achieved 12/30/2009 7/27/2013 N/A 6/30/2013 Comments Banks’ overall capitalization remained above 15% from 2008 until 2012, during which time (incl. % most banks were recapitalized by their parent groups. (100 % achieved). achievement) Prva Banka has a market based financing structure, and operates in sound and safe financial PDO Indicator 4 : condition while meeting all prudential norms (measured in terms of amount of Government deposits) Value (quantitative or EUR18.2 million EUR 0 N/A EUR 0.684 million Qualitative) Date achieved 12/31/2011 6/30/2012 N/A 7/28/2013 The Ministry of Finance substantially removed (eligible) deposits from Prva Bank to about Comments 700,000 euro by end-June 2013. The bank no longer poses a systemic risk, with a (incl. % substantially market based financing structure in place, it operates in a more safe financial achievement) condition (90 % achieved). Increased confidence in the banking sector leading to positive annual growth in bank deposits PDO Indicator 5: over 2012-2013 to gradually reach the pre-crisis level of deposit. Value (quantitative or EUR 1.8 billion EUR 1.991 million N/A EUR 2.075 billion Qualitative) Date achieved 12/31/2009 7/28/2013 N/A 6/30/2013 Comments Deposits have increased since 2008, reflecting the return of overall confidence in the banking (incl. % system as deposits exceeded the end-2009 level by end-June 2013. (100% achieved) achievement) 4 PDO Indicator 6: Effective supervision of banking system consistent with Basel Core Principles (no materially non-compliant ratings on BCP assessment in next FSAP update). No (the first FSAP No. As the FSAP has BCP assessment not been updated, yielded 2 Materially there is no available Value Non-Compliant independent (quantitative or ratings, Nos. 1.5 and Yes N/A assessment of the Qualitative) 14: legal protection for CBCG's progress on supervisors and strengthening their internal audit capacity supervisory regime in at CBCG) line with the BCPs. Date achieved 12/31/2009 6/30/2012 N/A 7/28/2013 Comments The FSAP update is overdue and the authorities have recently signaled their interest to (incl. % undergo an FSAP Update, but to date a formal request letter has not been received. (0 % achievement) achieved) All banks produce financial statements in international accounting standards (IFRS) as of PDO Indicator 7: 2014 Yes. The CBCG regulation requiring Value banks report on the (quantitative or No Yes N/A basis of IFRS was Qualitative) adopted effective January 1, 2013. Date achieved 12/31/2009 7/27/2013 6/30/2013 Comments Banks report on the basis of IFRS, subject to the CBCG’s mandated ‘prudential filter’ for (incl. % loan loss provisions. (100 % achieved). achievement) PDO Indicator 8: Adequate liquidity in the banking sector. Value (quantitative or Yes (25.8%) Yes N/A Yes (23.5 %) Qualitative) Date achieved 12/31/2009 7/28/2013 N/A 06/30/2013 Comments A massive withdrawal of deposits undermined the banking system's liquidity in late 2008, (incl. % reaching a low of 21 percent liquid assets to short-term liabilities in 2008. Since then, system achievement) wide liquidity has improved to its current level of 23.5 percent1. (100 % achieved). 1 The CBCG Decision on Minimum Standards for Liquidity Risk Management in Banks of 09/2008 mandates that the ratio must exceed 1:1 on a ten day average basis. Thus, the regulation is determined on the basis of a ratio, and the PDO indicator is determined on the basis of a percentage. Thus, the 23.5 percent represents 1.23:1, or 23.5 percent excess liquidity over the minimum standard of 1:1. 5 G. Ratings of Program Performance in ISRs No. Date ISR Archived DO IP Actual Disbursements (US$mil.) N/A H. Restructuring (if any) Restructurin Board ISR Ratings at Amount Disbursed Reason for Restructuring & g Date(s) Approved Restructuring at Restructuring Key Changes Made PDO in US$mil. Change DO IP N/A 6 1. Program Context, Development Objectives and Design 1.1 Context at Appraisal: Montenegro was hit hard by the global financial crisis in late 2008. External demand for 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 sharp fall of manufacturing, construction, transport and tourism in 2009 was only partially compensated by growth in energy production and agriculture, leading to an economic decline of about 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. Unemployment increased to 13 percent, two percentage points up from its low in 2008. 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 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 sector. 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 improved to 26 percent in 2009 and to 33 percent in 2010 and in the first three months of 2011. 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. Prva Banka, the largest domestically owned bank, experienced the most significant deposit outflows early in the crisis, and thus was the only bank to receive emergency support from the 7 State. Following which, the bank started to experience severe liquidity problems, potentially undermining confidence in the entire banking system. The bank’s liquidity improved over time through the deliberate shrinkage of its balance sheet in 2010-2012. Montenegro's banking sector continued in 2012 to strengthen its capitalization and liquidity positions and to work to accelerate the resolution of NPLs. Banking system profitability returned in 2012, albeit modestly, as the sector remained under pressure from the Eurozone crisis and slowing domestic growth. Thus, restoring financial soundness to banks remains a priority in order to resume new lending to creditworthy borrowers. In this regard, through the recently strengthened legal framework, the CBCG is adequately empowered to foster financial stability, and the authorities began working on contingency plans to be able to cope with any future external shocks. 1.2 Original Program Development Objectives (PDO) and Key Indicators (as approved): 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. The operation supported strengthening of the systemic risk monitoring and crisis preparedness frameworks, the banking sector soundness and transparency, and depositors and market confidence, thus increasing Montenegro’s financial sector resilience to possible future adverse shocks. More specifically, this operation’s support derives from reforms in the following areas: (i) systemic risk monitoring and crisis preparedness; (ii) resolution of problem banks; (iii) restructuring of Prva Banka; (iv) depositor protection; and (v) the regulatory framework for banks. The key indicators, as shown in the Policy Matrix of the Program Document (PD), included:  Enhanced macro-prudential oversight and crisis management framework in line with international good practice as appraised by next Financial Stability Assessment Program (FSAP) update.  Improved quality of banks’ loan portfolios below 12% (system’s NPL ratio)  Well capitalized banks with average CAR of the banking system to remain above 15%  Prva Banka has a market based financing structure, and operates in sound and safe financial condition while meeting all prudential norms (measured in terms of amount of Government deposits)  Increased confidence in the banking sector leading to positive annual growth in bank deposits over 2012-2013 to gradually reach the pre-crisis level of deposit.  Effective supervision of banking system consistent with Basel Core Principles (in terms of absence of materially non-compliant ratings on BCP assessment in next FSAP update)  All banks produce financial statements in international accounting standards (IFRS) as of 2014  Adequate liquidity in the banking sector. It should be noted that the FSPBG came about as a result of converting the envisaged second operation under the original Programmatic Financial Sector Development Policy Loan (PFSDPL, or P116787) into a single guarantee operation, 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 FSPBG Program Document. The prolongation and depth of 8 the crisis in the Montenegrin banking system obliged two small sets of changes to the second operation, as briefly described in Section 1.4. 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. OPCS has advised the team to prepare separate ICRs for the first FSDPL and FSPBG, since each was converted into a single operation. This ICR assesses the key expected results and outcomes at the end of the FSPBG as laid out in its Program Document. 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 Operation: The Government has been pursuing a program of financial sector reforms whilst facing the spillover of the global financial crisis, the authorities responded with significant measures and managed to contain the financial turmoil in the banking sector through a serious of measures adopted under the first WB supported FSDPL approved in September 2011. This follow-on PBG operation supported the adoption of a set of further measures to strengthen the banking sector, with a view to address key vulnerabilities of the Montenegrin banking sector and increase its resilience to possible future shocks. The five policy areas supported by the FSPBG are as follows:  Strengthening systemic risk monitoring and the crisis management framework;  Addressing banking sector vulnerabilities;  Completing the restructuring of Prva Bank;  Enhancing the depositor protection scheme;  Further improving the regulatory framework for banks. As originally conceived, the second operation of the PFSDPL was designed to include two different policy areas, which were not carried forward in the FSPBG:  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 the financial system had begun to improve. Moreover, deposit insurance protection regulations were issued as prior actions for the FSPBG. 9  The second policy area supporting “strengthening liquidity framework” was not deemed necessary to include as banks’ liquidity improved beginning in late-2011, owing to the return of deposits and parent banks’ recapitalization, obviating the need for additional liquidity enhancement measures. 1.5 Revised Policy Areas (if applicable): There were no significant changes in the policy areas as laid out in the Program Document of the FSPBG. 1.6 Other significant changes (in design, scope and scale, implementation arrangements and schedule, and funding allocations): None. 2. Key Factors Affecting Implementation and Outcomes 2.1 Performance: This operation is a Policy Based Guarantee from the IBRD, which provided a partial credit guarantee on a 100 million Euro borrowing. The guarantee provided a World Bank 60 million Euro guarantee of the principal amount of a commercial bank borrowing, with a seven year bullet maturity on a non-accelerable basis. The balance of the Montengrin borrowing, or 40 million Euro, was provided without a guarantee in a second tranche with a five year maturity. The loan proceeds were made available to the Borrower upon the effectiveness of the Loan Agreement with Credit Suisse, by ratification by the Parliament of Montenegro. There were no changes to the terms of the loan from what was described in the Program Document. The Montenegrin financial system is composed almost entirely of the banking sector, with assets accounting for 85 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 Eurozone banks and together occupy 72 percent of the market share at end-June, 2013. 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) have been intervened by their home governments and their restructuring and/or sale can reasonably be expected in the near to medium term. Since the beginning of the global financial crisis in 2008, the share of the domestic banks, as measured by asset size, has decreased from 17 to 10% at end-June, 2013, as Prva (formerly the second largest bank in the system) has been aggressively downsized as part of its restructuring program. Prva is now no longer considered to be a systemically important bank. Liquidity buffers have been slowly 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 21 percent of its total deposits. Since then, system wide liquidity has improved to 23.5 percent at end-June 2013. 10 POLICY ACTIONS AND THEIR STATUS UNDER THE FSPBG Prior actions from the Program Document of the FSPBG Status FSC has: (i) carried out periodic systemic risk monitoring and taken appropriate macro-prudential decisions as evidenced by written minutes of meetings and the assessment methodology used; Completed (ii) adopted the national contingency plan including a draft lex specialis [the draft Financial Stability Law] granting extraordinary powers to CBCG and the Government to provide emergency liquidity and capital, if necessary, on declaration by the FSC of a financial crisis. The CBCG has: (i) updated and approved supervisory action plans (SAPs) for 2012 for banks of special concern, Completed based on completed on-site examinations, off-site monitoring and stress-test results as of December 2011 and made satisfactory progress in such SAPs implementation. The Borrower and the CBCG have presented evidence showing that: (i) Prva Banka has made satisfactory progress in the implementation of all actions required by the 2012 SAP, maintains a CAR above 12 percent pursuant to the order issued by CBCG, and complies with all other regulatory requirements; and Completed (ii) The Borrower has withdrawn central government deposits from Prva Banka in accordance with the agreed withdrawal schedule between the MoF and Prva Banka to ensure Prva Banka 's future financing on market terms. The Borrower has enacted: (i) Regulation on Informing Depositors and Potential Depositors about Deposit Protection Scheme (Official Gazette 16/12, March 19th 2012), to bring public communication protocols vis-a-vis insured depositors in line with EU Directive on Deposit Guarantee Schemes 94/19/EC and 2009/19/EC; Completed (ii) Decision on Detailed Conditions, Manner and Procedure of the Guaranteed Deposit Payout (Official Gazette 16/12, March 19th 2012), to improve the efficiency and transparency of guaranteed deposit payouts. The CBCG has, in order to implement the Standardized Basel II Approach, adopted the following regulations: (i) Capital Adequacy Decision, Official Gazette 38/11, July 1, 2011 on capital adequacy; (ii) Decision on the manner of calculating banks' exposures, Official Gazette 15/12, March 5, Completed 2012on large exposures; and, (iii) Decision on Public Disclosure of Information and Data by Banks, Official Gazette 2/12, December 29, 2011 on banks transparency and information disclosure under Pillar 3 of Basel II. The CBCG has adopted the decision on Minimum Standards for Credit Risk 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 on Financial Collateral, and thus improved the legislative framework for financial collateral and facilitated enhanced liquidity management at financial institutions. Importantly, the CBCG continues to make good progress in harmonizing the regulatory framework for banks with relevant EU Directives and practices through, inter alia, requiring the full implementation of IFRS as of January 2013. The CBCG employs a full range of supervisory techniques to identify vulnerabilities in the banking sector and requires bank management and owners to undertake prompt corrective actions as necessary. Nevertheless, like many of its 11 regional neighbors, it has provided regulatory forbearance with respect to the calculation of loan loss provisions. Banking sector profitability remained negative in 2013 with the sector posting aggregate losses. Operating results of the banking sector continued to reflect declining income, increased provisions for loan losses and high overhead expenses. Banks’ net interest spread decreased from 4.39 in 2012 to 4.05 in 2013, reflecting very low credit growth and a declining net interest income in 2013 on the back of rising NPLs. Recognizing the financial sector’s tepid performance and rising NPLs, the CBCG has taken an important initiative to develop a comprehensive, integrated approach to NPL reduction through TA provided by the World Bank’s Vienna FinSAC office. 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. The CBCG has expanded powers to act as lender of last resort and has the full range of instruments and authority for dealing with a problem bank. The Deposit Insurance Fund insures the deposits of both individuals and legal entities. As of end-2013, it had a total coverage ratio of about 8 percent (including an EBRD back-stop facility), which is amongst the highest in the region. The CBCG’s has recently received TA from the World Bank to conduct a crisis simulation exercise.  Overall, banks’ capital adequacy remains above prudential requirements. At end-June 2013 the banking system reported overall regulatory capital to risk-weighted assets was 15.5 percent, well above the required 10% minimum for all banks. 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 pro-actively communicated with the public on the objectives of the DPL financial sector reform program. The MoF and the CBCG representatives made numerous TV appearances and 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 borrower, through the CBCG, agreed to adopt a substantial set of key financial sector policy actions under the FSPBG program, as laid out in the Policy Matrix. This robust set of policy actions were negotiated and substantially fulfilled against the backdrop of the European sovereign debt crisis, which impacted Montenegro’s ability to significantly reduce the level of NPLs and precluded the complete removal of all eligible public deposits from Prva Bank by 27 July 2013. Soundness of the background analysis supporting the operation(s): The project team had unprecedented access to the authorities and banking records alike throughout the protracted project preparation process for the predecessor DPL and the FSPBG alike. As such, the detailed sectoral analysis featured in Annex 3 of the Program Document demonstrated the depth of understanding the challenges the financial sector faced, as agreed with the authorities. The Bank 12 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 negative impact of the crisis on Montenegro’s economy provided a strong rationale for this second operation, designed to continue 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. Furthermore, the financial sector reforms supported under this operation were largely continued and deepened from the prior DPL. 2.3 Monitoring and Evaluation (M&E) Design, Implementation and Utilization: The PFSDPL team liaised regularly with the MoF as the main policy counterpart for the program and to a substantial degree with the CBCG, which put forward the legal and regulatory amendments for adoption on many of the agreed policy actions. 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, who drafted the key regulations and in close collaboration with the MoF undertook the needed supervisory and reforms steps. Periodic updates on MoF deposits in banks were provided, from which it was determined in the mid-2013 that eligible deposits at Prva bank have almost been reduced to zero, as committed to by the authorities. Design: There were five key outcome indicators to monitor, for which eight expected results were established to reflect the outcomes 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. 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 initially as a programmatic operation in the middle of the global financial sector crisis, 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): None. 3. Assessment of Outcomes 3.1 Relevance of Objectives, Design and Implementation: Relevance of Objectives The objectives of the FSPBG operation are highly correlated with the key priorities and expected outcomes supported under the FY11-FY14 Country Partnership Strategy (CPS). The CPS for Montenegro, endorsed by the Board in January 2011, envisaged a series of two programmatic financial sector DPLs. These operations constitute over half the CPS lending envelope and fall 13 under the first of the two main 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.” Since the beginning of the crisis in the second half of 2008, the authorities have formulated 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 cuts to expenditures, including by privatizing selected state assets and concessions. In the financial sector, the authorities gave priority to restoring depositor confidence and stepping up 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 for the three-year period that the Government was obliged to prepare as part of the on-going EU accession process. 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 FSPBG 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 to mitigate key financial sector vulnerabilities at a time of tremendous uncertainty within Europe, the PDO remained relevant to the achievement of the outcomes. 3.2 Achievement of Program Development Objectives: Key outcome indicators supported by the FSPBG included: (i) enhanced macro-prudential oversight and the legal authority of the CBCG and the MoF to rapidly and transparently resolve any future crisis situations; (ii) enhance stability and soundness of the banking system; (iii) Prva Banka operates under sound and safe financial condition and a market based financing structure; (iv) confidence in the banking system is restored and total bank deposits steadily increase to pre- crisis levels, and (v) supervision of the banking system is conducted consistent with Basel Core Principles and based on best international accounting standards and regulatory reporting. In sum, all five of the expected key outcome indicators were substantially achieved against the backdrop of unprecedented financial uncertainties arising from the Eurozone and sharply declining economic growth in Montenegro. The PFPGB further strengthened the banking sector, as demonstrated by the achievement of virtually all of the expected key outcomes of the FSPBG operation, as summarized below.  Enhanced macro-prudential oversight and the legal authority of the CBCG and the MoF to rapidly and transparently resolve any future crisis situations. Macro-prudential oversight and crisis management capacity has been increased through two key means: 14 o The periodic meeting of the Financial Stability Council (FSC) to consider banks’ prudential reports and market trends to identify emerging risks represents escalated macro-prudential oversight. According to which, the FSC members would take decisions within their respective authorities to stem or mitigate such risks. o The authorities’ prepared a lex specialis to submit to Parliament only at such time as they declared a financial crisis. As a national contingency plan, the lex specialis provides the CBCG and MoF with extraordinary powers to provide liquidity or otherwise take resolution related decisions in the event of a financial crisis.  Enhance stability and soundness of the banking system. The CBCG undertook a systematic exercise to prepare and execute on supervisory action plans (SAPs) for banks of special concern in a bid to reduce risks in said banks through supervisory and/or enforcement means. This exercise was continued for 2013 in selected banks. o Banks’ NPLs however have not declined to 12% as foreseen, rather have increased in 1H13 to 18.8%. This rise in NPL stock is broadly in line with regional comparators over the same period, though troubling nonetheless; the mitigation of NPLs is the subject of on-going FinSAC technical assistance. o Overall bank capitalization on the other hand rose to 15.5% at end-June 2013, well above the 10% risk weighted CAR prudential norm.  Prva Banka operates under sound and safe financial condition and a market based financing structure. The CBCG conducts an annual on-site examination of this bank, as it continues to represent a potential threat to banking system stability owing to its large bank network and participation in the payment system. o The Ministry of Finance has substantially removed all (eligible) public deposits from Prva Bank by end-June 2013, with only about 0.7 million euro (less than 5% of the original 18.2 million euro) remaining on account. Moreover, Prva Bank’s size has been reduced as part of its mandated restructuring, rendering the bank no longer systemically important. o Prva Bank met all the operational business parameters as regulated by law and is under the permanent supervision of the CBCG.  Confidence in the banking system is restored and total bank deposits steadily increase to pre-crisis levels. The Deposit Protection Fund (DPF) has improved its standards of communication, insured coverage limits and payout capacities through issuance of new regulations. The DPF board has taken many such steps to modernize its processes to better comply with the International Association of Deposit Insurers (IADI) standards or core principles. o Deposits have increased since the 2008 low to near pre-crisis levels of about 2.1 billion euro at end-June 2013, reflecting the return of overall confidence in the banking system. 15 Banks’ liquidity (defined by regulation2 as the ratio of the sum of liquid assets to the sum of due liabilities) remained broadly flat from the baseline of 25.8 percent to 23.5 percent at end-June 2013, though it subsequently improved to 32.2 percent at end- 2013.  Supervision of the banking system is conducted consistent with Basel Core Principles and based on best international accounting standards and regulatory reporting. Though the authorities have not formally sought an FSAP update to objectively assess the depth and breadth of regulatory and supervisory reforms through a BCP asessment, it is clear that key prudential measures on capital, publication of financial results, credit risk management and liquidity tools were adopted by the CBCG to further improve the regulatory framework for banks. o The FSAP update has not formally been requested to date. o That all banks now produce and publish financial reports in compliance with IFRS standards, notwithstanding the permitted use of a “prudential filter” for loan loss provisioning3, is a material (and visible) outcome, fully aligned with international best practice. 3.3 Justification of Overall Outcome Rating (combining relevance and achievement of PDOs): Rating: Satisfactory The GoM and the CBCG adopted a rigorous set of financial sector reforms during a time a great uncertainty in the Eurozone, which proved highly relevant to mitigating risks in the banking sector. The FSPBG 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 relevance of the FSPBG was high for both the CPS and government strategies and the achievement of the objectives was substantial, as it strengthened the capacity of the 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 bankruptcy of the aluminum industry are very likely to have adverse effects on growth, employment, and poverty. 2 The CBCG Decision on Minimum Standards for Liquidity Risk Management in Banks of 09/2008 mandates that the ratio must exceed 1:1 on a ten day average basis. The liquidity regulation is determined on the basis of a ratio, and the PDO indicator is determined on the basis of a percentage. Thus, the 23.5 percent represents 1.23:1, or 23.5 percent excess liquidity over the minimum standard of 1:1. 3 In accordance with the risk weights assigned in the Regulation on Credit Risk Management. 16 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 both complex, resource intensive and time consuming. Loosely based on the 1991 London Rules, the FinSAC supported 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 mid-2014. As well, the CBCG continues 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 Prior Actions adopted and more recently, the introduction of IFRS accounting standards as of January 2013. (c) Other Unintended Outcomes and Impacts (positive and negative): In 2012, the recently established Financial Stability Council adopted a new national crisis management framework. This framework develops crisis contingency plans at the level of the three financial sector supervisors (CBCG, SEC and FSA), the MoF and the FSC. A lex specialis (or draft Financial Stability Law) was developed 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 may signal a lack of confidence in the system. 3.5 Summary of Findings of Beneficiary Survey and/or Stakeholder Workshops: Not applicable. 4. Assessment of Risk to Development Outcome Rating: Substantial Overall macroeconomic risks are 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 2013 dampened Montenegro’s recovery, which further strained its fiscal position. 17 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 combined with its large debt service requirements render the Montenegrin financial sector vulnerable to a slowdown in capital inflows and augur 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. Although 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. Bank and Borrower Performance 5.1 Bank Performance: (a) Bank Performance in Ensuring Quality at Entry: Rating: Satisfactory The comprehensive design of this operation, building upon the earlier FSDPL, reflects a well thought through set of prior actions and key expected outcomes. The project design benefited from frequent (new) guidance issued by the European Union, Basel Committee for Bank Supervisors, Financial Stability Board, European Banking Authority, etc. resulting from the global financial crisis. It is noted that while a number of the indicators chosen were of a high level (deposit growth, reduction of NPLs, liquidity, capitalization, etc.) each represented a key dimension of public and investor confidence in the financial sector. As such, these 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 FSPBG 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 second 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 delivered 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. 18 (c) 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 regularly consulted and coordinated with the IMF in carrying out its supervision work. Therefore, the quality of supervision has been assessed as Satisfactory. (d) Justification of Rating for Overall Bank Performance: (e) 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: NOTE: When the government and implementing agency are indistinguishable, provide rating and justification only for Overall Borrower Performance. X Check here if the Government and the Implementation Agency is the same or indistinguishable (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. Cooperation with the Bank Team by the MoF and CBCG was very strong, with often difficult discussions as to specific reform measures. The authorities completed all prior actions and five of the eight expected results (see below ‘b’ section) and 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 satisfactory and would be have been rated Highly Satisfactory had the PDO Indicators (reducing NPLs below 12%, removing all eligible deposits from Prva Bank and undergoing an FSAP update) been achieved on a timely basis. 19 6. Lessons Learned It is important to maintain sufficient flexibility, particularly in the case of the envisaged programmatic policy development loans, so as to adapt and respond to client needs and economic realities in the country. As the external environment was rather negative during the FSPBG preparation phase, adding a strong sense of urgency to the need to adopt financial sector related reforms, the team built 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. In sum, the FSPBG operation incorporated lessons from Bank’s experience in 2008-2009 crises, as follows:  Need for focus. During the Eurozone financial crises, it proved crucial that this operation narrowly focused on 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 reforms adopted supported the authorities’ priorities and represented technically complex, politically sensitive reforms in the banking sector. This operation was prepared in direct collaboration with the top leadership of the MoF and the CBCG.  Communication strategy. Public understandings of key financial stability measures adopted were substantially improved through a carefully planned and implemented communication strategy by the Government and the Bank. The staff of the World Bank Country Office in Podgorica played a crucial 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. 20 7. Comments on Issues Raised by Borrower/Implementing Agencies/Partners (a) Borrower/Implementing Agencies: None. (b) Cofinanciers: None. (c) Other partners and stakeholders (e.g. NGOs/private sector/civil society): None. 21 8. ANNEXES 8.1 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) Lalit Raina Sector Manager ECSF3 Martin Melecky Sr. Financial Sector Specialist DECWD Task Team Leader Zeljko Bogetic Lead Economist ECSP2 Gianfranco Bertozzi Senior Financial Officer FABBK Supervision (from Task Team Members in all archived ISRs) Michael Edwards Lead Financial Sector ECSPF3 Task Team Leader Specialist Lalit Raina Sector Manager ECSF3 (b) Staff Time and Cost Staff Time and Cost (Bank Budget Only) Stage No. of Staff Weeks US$ Thousands (including travel and consultant costs) Lending FY12 37.02 260. 26 TOTAL: 37.02 260. 26 Supervision/ICR FY13 2.59 8.89 TOTAL 2.59 8.89 22 8.2 Annex 2. Beneficiary Survey Results (if any) Not applicable. 23 8.3 Annex 3. Stakeholder Workshop Report and Results (if any) Not applicable. 24 8.4 Annex 4. Summary of Borrower’s ICR and/or Comments on Draft ICR 25 cocc Mr. Michael Edwards Lead Financial Sector Speclallst WORLD BANK Podgorica. June 4, 2014 No 11-324512 Subject CBCG Comments on Draft FSOPL1 ICR Report The Cen1ral Bank of Montenegro Is pleased to nole thal the the overall performance or the programme has been raled by the World Bank os .satisfactory· We also appreciate the recognition of positive outcomes end effort• made by CBCG In laking necessary policy aCllOns and steps tn achieving key progrem outcomes Within the agreed PBG program reforms. the CBCG, as an implementing agency, had undertaken all necessary measures lo meet program objeclives and targets ie. lo strengthen the banking sector In Montenegro and maintain financial stability. As recognized In the draft FSO repon. the CBCG worked llltensi\'ely on lur1her Improvement of the regula1ory and superviscxy framewoi1c, macroprudentlal ovetS19ht end crisis management and confidence In lhe banking sector Namely, during 2012 and 2013 the CBCG adopted several regulations that tackle Credit Risk In banks, cepitahzabon end regulatory reporting In accordance with bes1 EU and lnlemational practices In addition, the CBCG implemented Basel II standan:l1zed epproatn whereby special emphasis has been placed on capital adequacy with an aim of strengthening bank capltallzailon In stress situations, large bank exposures and data transparency based on Basel II-Pillar 3. The CBCG successfully lmplemen1ed IFRS and IAS 39 standards m bank reporting dunng 2013 with an aim to 1nerease banl