Interview for Business Magazine: BH banks are immune to coronavirus

Over the last two years, since the world has been hit by the coronavirus pandemic, testing has been one of the most widespread global activities. While their customers were tested to COVID-19 disease, bankers were undergoing the so-called stress tests, in order to find out to what extent their operations are immune to the negative effect of coronavirus. Vesna Papić, Manager of Financial Stability Department of the Central Bank of Bosnia and Herzegovina explains for Business Magazine to what extent BH banking sector is immune to the consequences of the pandemic.

BM: What have the latest stress tests of the Central Bank have shown - how much is banking sector of BH stable and resilient to assumed shocks?

PAPIĆ: According to the actual data from the end of the third quarter of 2021, it can be concluded that banking sector is sound and that, despite deteriorated circumstances from macro-economic environment in previous periods, arising from the  COVID-19  pandemic, it has kept its stability. Moreover, capitalisation indicators continued to improve during the pandemic, while asset quality did not deteriorate, on the contrary, the share of non-performing loans in the total loans continued to decrease. Such trends were considerably contributed by the measures for curbing the effects of the pandemic, which were adopted by the competent Banking Agencies. Banking sector profitability, having declined sharply in 2020, recovered in 2021, reaching the record amount of net gain at the sector level for the relevant part of the year during the first nine months. Following absence of credit growth in 2020, resulting from decreased demand for loans, and stricter conditions for granting loans, lending, although still weak, was recovering gradually in 2021, with recovery being stronger in household sector than in the sector of private non-financial companies. In adverse scenarios of the latest conducted stress test, a lower number of banks had recapitalisation needs than in the stress tests conducted in the end of 2020 due to the existing sound capital base. At the system level, a satisfactory capitalisation level was kept, so, in case shocks assumed in a severely adverse scenario materialise, capital adequacy rate would stay at much higher level than the prescribed regulatory minimum of 12 per cent.

BM: Could you explain to us, in language understandable to the average reader, which adverse scenarios were applied in the latest stress tests and which percentage of banks appeared to be vulnerable to assumed shocks?

PAPIĆ: In the CBBH stress tests, two adverse scenarios were used, mainly based on current developments in the world related to COVID-19 pandemic, different by strength and duration of shocks, i.e. time period needed for the recovery of economic activity. The purpose of severely adverse scenario was to assess the resilience of banking sector and individual banks to exceptionally strong shocks in the period for which stress test was conducted, and it was assumed that shocks would last longer and have stronger effect on economic activity in the country than assumed in a milder adverse scenario. In severely adverse scenario, resilience of BH banking sector was tested to unpredicted negative events in restraining  COVID-19 pandemic which may be due to virus mutations, insufficient efficiency of vaccines in case of new virus variants, a new wave of contagion due to premature relaxation of measures and other unexpected negative events which would additionally weaken economy at the global level.

 This would affect the continued decline in external and domestic demand, and reduce the inflow of remittances from abroad and lead to a continued decline in economic activity in BH, and shocks from the real sector would gradually spill over into the financial sector, too. After a fall in real gross domestic product of 3.2 percent in 2020, a stronger extreme scenario for the next two years assumed a continued decline of economic activity, and only in the third year of stress testing is expected to have a slight economic recovery. In contrast to the stronger one, in the milder extreme scenario it is assumed that in the first year of stress testing, the same level of gross domestic product will be achieved as in 2020, and that in the next two years, there will be mild economic growth, which would still not be enough to return the economic activity at the pre-pandemic levels. In both extreme scenarios, banks' reactions and responses to assumed shocks are not projected, and their resilience is tested in case they do not have the capacity to recapitalize or take any other measures to protect themselves against shocks. In this regard, the results of both extreme scenarios should not be interpreted as predictions of future events, but as a test of resilience to unlikely strong shocks from the macroeconomic environment. In the case of materialization of such assumed extreme scenarios, in the last stress tests, the need for additional capital in the first year of stress testing was expressed by one bank, and in the period of three years of assumed adverse events by four banks in the milder, and by six banks in the stronger extreme scenario. These are smaller banks in BH banking sector, which in previous periods showed a lower level of risk resilience. The assets of four banks that show recapitalization needs in a milder extreme scenario make up 7.6 percent of total assets of the banking sector at the end of the third quarter of 2021, while the assets of all six banks show lacking capital amount to 13.7 percent of the banking sector total assets. Given that the goal of stress testing was to identify the least weaknesses in the banking sector, as well as, in each bank individually, in the event of extremely strong shocks in a stronger stress scenario, in case there would be no possibility to react to presumed extreme conditions, and to recapitalize in time over a three-year horizon, this number of banks with potentially lacking capital is to expect, and it can be assessed that the level of risk is not worrying for the overall financial stability in the country.

BM: Last summer's stress tests by the European Central Bank (ECB) showed a significant reduction in banks' capital, for which key drivers were credit risk, market risk and limited ability to generate income in adverse economic conditions - to what extent are those findings matching to those which the Central Bank has identified?

PAPIĆ: The specificity of the stress test conducted by the ECB and the EBA (European Banking Authority) in the summer of 2021 is, in the settings of the extreme scenario, characterized by the prolonged action of the COVID-19 scenario, which is reflected in a cumulative decline in economic activity of 3.6 percent in the European Union for a period of three years, assuming a cumulative decline in economic activity for each member state individually. Under the assumed extreme scenario, which is very hard, given the data from the end of 2020, the ECB concludes that the banking system is fully resilient and would maintain stability. Stress tests conducted in the CBBH on the data from the third quarter of 2021 are also based on similar assumptions, with a stronger extreme scenario assuming a decline in economic activity in the next two years, and only a slight recovery in the third period of stress testing (cumulative decline of three percent in three years compared to the end of 2020). The results showed that the banking sector would be able to maintain stability under the projected shocks in all three stress scenarios, and that it would remain adequately capitalized. However, in a stronger extreme scenario, the adequacy rate at the system level would decrease significantly from the initial 19.2 percent - according to data from the third quarter, to 16.4 percent by the end of 2023 (difference of 281 basis points), although it would still remain well above the regulatory minimum, thanks to a good capital base, according to data from the third quarter. If we compare this with the results of the ECB stress test, where in a stronger extreme scenario, the capital adequacy ratio fell by 485 basis points, from the initial 15 percent - according to data from the end of 2020, to 10.2 percent by the end of 2023, we can say that the assumed shocks had a somewhat stronger effect on the decline in the capitalization of banks in the EU, but that the results are in line with the findings of the stress test conducted in the CBBH. In conditions of economic stress, the reduction of regulatory capital, and consequently the reduction of capital adequacy, are mostly affected by the significant negative contribution from losses based on credit risk, i.e. the cost of provisions and net operating income. Losses based on credit risk also have the greatest negative impact on the reduction of capitalization of the EU banking sector, followed by losses based on market risk and a reduction in operating income.

BM: How is the impact of the extremely bad internal political situation treated in the CBBH stress tests, i.e., how much does the growing political instability affect the stability of the domestic banking sector?

PAPIĆ: The political situation in the country has a limited, mostly indirect impact on the banking sector, which spills over into the overall economic situation in the country, which affects all bank clients - both individuals and legal entities. The banking sector of BH has so far shown strong resilience to all types of shocks and risks, whether they come from the external or internal environment. Therefore, political instability, as an internal risk, has so far not had a significant direct impact on the performance of the banking sector. It can be said that banks, understanding and accepting all the specifics of political life in BH, have long incorporated time ago this type of risk and challenge into their strategic and business decisions. Moreover, regardless of the level of stability of the political environment in the country, the BH banking sector has extremely successful cooperation with system institutions at all levels of government, which is best seen in the volume of public sector lending, growing steadily from year to year.

BM: How reliable are stress tests in general, since they are conducted regularly, but nevertheless there are periodic "surprises" in the form of bank failures like the one that spilled over from the United States in 2008 to virtually the whole world? Specifically, in the case of BH, what are the experiences so far in terms of matching the results of stress tests and the real situation in the banking and financial sector in general?

PAPIĆ: The history of stress tests in the economic world dates back to the early 1990s, when they were mostly conducted by individual banks with the aim of internal risk management. At the time, the stress test as a stability exercise had small-scale, with limited data, and was used largely as a complement to existing statistical tools to assess banks' performance. The design and function of stress tests evolved significantly in the years that followed, only to be fully realized by monetary and supervisory authorities after the great financial crisis of 2008. Since then, stress tests have played an important role in supervisory tools, both in the EU and in the US, where stress tests are conducted on a regular annual basis, and whose reliability is best reflected in the fact that the financial sector has largely maintained stability at global level, after the world financial crisis and that the possibility of a repeat of the negative scenario at a 2008 scale is extremely low. In line with the task of contributing to the preservation of financial stability in the country, the Central Bank has also been conducting stress tests for the banking sector in BH for years. The first stress test was conducted by the CBBH in 2007, after which, the stress tests were regularly improved and redesigned in accordance with the needs and economic trends in order to provide the most adequate and reliable results. Looking back on the years behind us, we can freely say that stress tests are the really reliable indicators of vulnerability in the banking sector, bearing in mind that the results of tests conducted are largely compatible with the performance of the banking sector. Despite several recorded economic crises (recessions in 2012 and the last in 2020), the banking sector remained one of the most stable links in BH economy, successfully absorbing all the negative shocks to which he was exposed, which the stress tests had previously shown continuously.

BM: What are the expectations regarding the stability of BH banking sector in the coming short and medium term and what are the key challenges and risks that could threaten this stability?

PAPIĆ: Risks to the stability of the banking sector are related to risks from the macroeconomic environment. Factors that affect the stability of the banking sector at the global level in the current year are the continuation of the pandemic, slow economic activity, inflation and low interest rates. In the significantly worsened conditions from the macroeconomic environment, the BH banking sector managed to maintain significant liquidity, as well as capitalization, while the quality of assets was further improved. Risks to financial stability have been mitigated compared to expectations from the beginning of 2021, given that the credit risk to which the banking sector has been exposed, since the beginning of the crisis, caused by the coronavirus pandemic , has not materialized. During 2021, there was no increase in non-performing loans, while at the same time , the share of loans under some of the temporary measures of the regulator to mitigate the negative consequences of the pandemic was significantly reduced. Of course, in the future, a lot will depend on the lending activity of banks, which has only slightly recovered when it comes to lending to the private sector. In the first three quarters of 2021, banks also managed to achieve significant profitability, primarily due to the growth of operating income on the basis of collected commissions and fees. Liquidity is still high, although a further outflow of non-residents' deposits and a significant increase in deposits of domestic sectors, especially government and households, are noticeable.

What we see as a potential risk for the banking sector in the medium term is certainly the structure of deposits of domestic sectors, which are mostly short-term, and therefore considered an unstable source of funding. Inflation expectation are one of the key risks that could threaten stability in the coming period. The global trend of rising inflation has not yet spilled over into the financial markets, due to the commitment of the leading central banks to continue with the current monetary policies regardless of inflationary trends. The reaction of central banks to the increased inflation at the global level in the coming period will determine the behaviour of banks related to the issue of financing intensity, as well as interest rates.

BM: To what extent are the CBBH stress tests harmonized with European standards and what are the main improvements of the mechanism developed in 2019 compared to the previously applied ones?

PAPIĆ: The latest generation of stress tests was developed in 2019 and is fully in line with the new regulatory framework for banking operations in BH, which includes new regulations for maintaining capital adequacy, based on Basel III (EU CRR / CRD - Capital Requirements Regulation and Directive), as well as, an estimate of the provision for expected credit losses in accordance with International Financial Reporting Standard (IFRS 9). The framework for conducting the stress test is based on the 2018 EBA methodology. The new stress testing tool, with a three-year time horizon and explicit macroeconomic scenarios, includes satellite models for assessing the credit risk of the corporate and household sectors, and integrated modules for assessing the risk of interbank contagion and market risk assessment, which are the key improvements, compared to the previously applied framework.