FINANCIAL SECTOR ASSESSMENT PROGRAM

BOSNIA AND HERZEGOVINA

FINANCIAL INCLUSION

TECHNICAL NOTE

JUNE 2015

This Technical Note was prepared in the context of a joint World Bank-IMF Financial Sector

Assessment Program mission in Bosnia and Herzegovina during October-November 2014 led

by Michael Edwards, World Bank, and Sonia Munoz, IMF, and overseen by the Finance and

Markets Global Practice, World Bank and the Monetary and Capital Markets Department,

IMF. The note contains technical analysis and detailed information underpinning the FSAP

assessment’s findings and recommendations. Further information on the FSAP program can

be found at www.worldbank.org/fsap.

THE WORLD BANK GROUP

FINANCE AND MARKETS GLOBAL PRACTICE

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Contents

Executive Summary ................................................................................................................................................. 1

I. Overview of the Real Economy and Financial Sector............................................................................ 6

A. Overview of the Real Economy ............................................................................................................. 6

B. Overview of the Financial Sector .......................................................................................................... 8

II. Status of Financial Inclusion ......................................................................................................................... 10

A. Households ............................................................................................................................................... 10

B. Firms ............................................................................................................................................................ 14

III. Market Players and Institutional Potential to Expand Financial Inclusion ................................. 15

A. Commercial Banks .................................................................................................................................. 15

B. Microcredit Organizations (MCOs) .................................................................................................. 17

C. Leasing ........................................................................................................................................................ 24

D. Factoring .................................................................................................................................................... 25

IV. Legal and Market Infrastructure ............................................................................................................... 26

A. Credit Reporting Systems .................................................................................................................... 26

B. Insolvency and Creditor Rights’ Framework ................................................................................. 27

V. Government Policies and Programs related to Financial Inclusion ............................................. 28

VI. Consumer Protection and Financial Literacy ........................................................................................ 30

ANNEX I ...................................................................................................................................................................... 34

Tables

Table 1. Number of firms by size ....................................................................................................................... 7

Table 2. Business statistics by size ..................................................................................................................... 7

Table 3. Structure of the financial system ...................................................................................................... 9

Table 4. Indicators for access to finance ...................................................................................................... 11

Table 5. Selected indicators for the MCO sector ...................................................................................... 18

Table 6. Weighted Effective Interest Rates (EIRs) for MCOs ................................................................. 18

ii

Figures

Figure 1. SMEs’ share in top three export sectors ....................................................................................... 8

Figure 2. Deposit growth by sectors ................................................................................................................ 9

Figure 3. NPL and capital adequacy ................................................................................................................. 9

Figure 4. Credit growth by sectors ................................................................................................................. 10

Figure 5. Income versus credit depth, country comparison ................................................................. 10

Figure 6. Gender gap: the percentage point difference between male and female accounts at

a formal financial institution ............................................................................................................................. 12

Figure 7. Female labor force participation in developing countries (as % of total labor force)

..................................................................................................................................................................................... 12

Figure 8. Automated teller machines (ATMs) (per 100,000 adults) ................................................... 12

Figure 9. Modes of withdrawal (% with an account, age 15+) ........................................................... 12

Figure 10. Mode of payments ........................................................................................................................ 13

Figure 11. Saved any money in the past year (% age 15+) .................................................................. 13

Figure 12. Users of accounts ............................................................................................................................ 14

Figure 13. Personal remittances received (% of GDP) ............................................................................ 14

Figure 14. Selected Enterprise Survey results by countries .................................................................. 15

Figure 15. Selected Enterprise Survey results of BiH firms, by size ................................................... 15

Figure 16. Credit growth, banks vs MCOs ................................................................................................... 17

Figure 17. Total assets of the MCO sector .................................................................................................. 17

Figure 18. Share of MCO market by entity ................................................................................................. 20

Figure 19. Loans of MCOs vs Banks – FBiH ................................................................................................. 21

Figure 20. Loans of MCOs vs Banks – RS ..................................................................................................... 21

Figure 21. Leasing volume................................................................................................................................. 24

Figure 22. Total assets of the leasing sector .............................................................................................. 24

Boxes

Box 1. Examples of banks with a specific focus on SMEs ...................................................................... 16

Box 2. Prizma .......................................................................................................................................................... 22

iii

GLOSSARY

ALB Albania

AML/CFT Anti-Money Laundering/Combatting the Financing of Terrorism

BAM Convertible Mark

BARS Banking Agency of the Republic of Srpska

BiH Bosnia and Herzegovina

CBBH Central Bank of Bosnia and Herzegovina

CCR Central Credit Registry

ECA Europe and Central Asia

EIR Effective Interest Rate

EU European Union

FBA Federation Banking Agency

FBiH Federation of Bosnia and Herzegovina

FDB Federation Development Bank

GDP Gross Domestic Product

HRV Croatia

IFRS International Financial Reporting Standards

ILO International Labor Organization

IMF International Monetary Fund

IRBRS Republic of Srpska Investment-Development Bank

ITA Indirect Tax Authority

MCC Microcredit Company

MCF Microcredit Foundation

MCO Microcredit Organization

MIX Microfinance Information Exchange

MKD Macedonia

MOF Ministry of Finance

MOJ Ministry of Justice

NPL Non-performing Loan

POS Point-of-sale

RS Republic of Srpska

SMEs Small and Medium Enterprises

UMC Upper Middle Income Countries

USD United States Dollar

VAT Value Added Tax

1

EXECUTIVE SUMMARY

1. Financial inclusion in Bosnia and Herzegovina (BiH) performs relatively well

compared to peers, but gaps remain for selected market segments. A total of 56.2 percent

of adults in BiH have an account at a formal financial institution and 31.9 percent of these

account holders use it with high frequency1, compared to the regional average of 44.9 percent

and 22.5 percent, respectively. Lending services have a high outreach compared to regional

peers, while the usage of saving services are low with only 13.5 percent of adults reporting

saving any money in the past year compared to the regional average of 20.4 percent. In

particular, for the bottom 40 percent, the ratio of adults reporting saving any money in the

past year is even lower at 9.8 percent.2 Moreover, BiH is facing one of the largest gender gaps

in the region, with the difference between male and female account holders at a formal

financial institution amounting to 19.5 percentage points.3

2. Financial sector development and access to finance for firms is constrained by

weak domestic demand, high collateral requirements and inadequate credit

enforcement mechanisms. Credit to the non-financial private sector expanded by only 0.9

percent year-on-year in the first nine months of 2014, and by 1.1 percent in 2013. A significant

portion of the loans were used to finance working capital rather than investments, mostly due

to unfavorable growth prospects. Reducing the stock and flow of NPLs remains a challenge, as

financial institutions and borrowers alike have been deeply affected by the economic

slowdown following the global financial crisis. The banking sector faces high NPL ratios of

around 15.5 percent at Q2 2014, with higher default rates in corporate loans. Weaknesses in

the corporate insolvency and creditors’ rights regimes also pose important obstacles to debt

resolution. Moreover, collateral requirements are high, with collateral-to-loan values at 216

percent for small firms in BiH.4 Overall, 14.1 percent of firms in BiH identify access to finance

as a major constraint in the Enterprise Survey 2013.

3. Banks are liquid, but are tightening lending standards and segmenting clients

more distinctly. In general, there is a situation of over-liquidity in banks as they are

cautious in extending credit. The large foreign banks tend to find SME lending too risky,

viewing this segment as lacking stable repayment capacity or adequate collateral. This

perception of financial vulnerability has been aggravated by the financial crisis. Nevertheless,

some of the locally-owned banks have aggressively expanded their SME portfolio, in part by

taking over some of the clients of foreign banks. Banks report a sharper segmentation of their

SME clients, and smaller enterprises with less complete or formal documentation and lacking

collateral tend to be excluded from the market. Regarding micro loans, banks are not

interested to serve this segment of the market as the opportunities for cross-selling of products

and services are limited.

1 Measured by withdrawals of three or more times in a typical month. 2 Findex, latest available data is 2011. 3 Usage statistics show that this gap arises mostly from the fact that women are using their accounts much

less than men for receiving wages and government payments. This is an expected result, as according to the

International Labor Organization (ILO) statistics, the female labor force participation is very low at 34.1 percent

in BiH in 2012. 4 Enterprise Survey 2013.

2

4. The microcredit organizations (MCO) sector in BiH is less than 3 percent of

financial system assets in 2013. The size of sector has been declining since the microcredit

crisis hit in late 2008. The crisis had followed a period of rapid expansion between 2006 and

2008, which was accompanied by weak MCO governance, imprudent lending and inadequate

monitoring. The weakening of the loan portfolio and over-indebtedness of borrowers was

aggravated by the global crisis in 2008. Although the Law on Microcredit Organizations (MCO

Law) was passed in 2006, it came into effect only in mid-2008, when supervision was also

introduced. The industry used the gap in between the adoption and full enforcement of the

law to continue their imprudent practices in advance of supervision controls.

5. The separate laws governing microcredit organizations (MCOs) in the two entities

are not aligned, which creates an uneven playing field in the sector. The market structure

is different in the two entities: in the Federation BiH (FBiH), there are 12 MCFs and one small

MCC; in the Republika Srpska (RS), the market is dominated by one large MCC and five smaller

players. 5 As MCOs licensed in one entity can operate in the other, differences in the legal and

regulatory frameworks are creating grounds for unfair competition. In the FBiH, it is

recommended that two actions be taken in parallel: i) strengthen the supervisory powers of

the Banking Agency, by expanding its enforcement toolkit and improving the framework of

appeals; and ii) ease the corporatization process for MCFs.

6. The Federation Banking Agency (FBA) lacks a sufficient range of enforcement tools

for the MCO sector and it is recommended that the Law on MCOs be amended to

strengthen the supervisory powers of the FBA, and improve the framework of appeals

against FBA’s supervisory actions. Currently, the FBA’s enforcement mechanism is limited to

issuing orders or the severe action of revoking licenses, with no intermediate tools available.

Providing the FBA with a broader menu of corrective actions will give it the authority to impose

the necessary sanctions on MCOs that commit offences, while providing the rest of the market

with a more conducive operating environment. The expanded range of explicit powers could

include appointing advisors, imposing temporary administrators, removing or replacing

management and board members, and other measures. This will also be in line with the powers

already possessed by the Banking Agency of Repubilka Srpska (BARS)6. Furthermore, the

framework of appeals against FBA’s supervisory actions should be improved to enhance the

effectiveness of FBA supervision and authority.

7. In parallel, the formal facilitation of corporatization is recommended. Easing the

transition from MCFs to MCCs in the FBiH would help to strengthen corporate governance.

Companies would then be subject to the application of the Company Law, which provides

better internal checks and balances. Corporatization can also bring about other benefits: i)

fairer competition by leveling the playing field between the entities, ii) higher lending limits to

be better able to meet the needs of clients, iii) clearer liquidation processes, and iv) allows for

the sustainable growth of MCOs through their assessing a broader range of funding options.

5 The microcredit sector in BiH is composed of non-profit organizations (microcredit foundations, MCFs) and

for-profit companies (microcredit companies, MCCs). Minimum capital requirement for MCFs and MCCs are

BAM 50,000 and BAM 500,000 respectively, while credit limits are BAM 10,000 for MCFs and BAM 50,000 for

MCCs. 6 The strengthening of BARS’ supervisory powers was enabled through the amendment to the RS Law on

MCOs in 2011.

3

Currently, the process of corporatization is impeded by the requirement for MCFs to continue

on-lending in parallel with the acquired MCC. There are also issues regarding the transfer of

assets of MCFs to MCCs, in particular of donated capital. It is recommended to i) amend Article

15 of the Law on MCOs, to ease the establishment of MCCs; and ii) to resolve the issue of

donated capital.

8. The leasing sector is facing significant challenges and its viability is at stake.

Leasing sector assets have continuously declined from more than 6 percent of financial sector

assets in 2008 to 2.4 percent in 2013. This trend is likely to persist due to the following three

sets of impediments: i) VAT is applied on the interest of financial leases, which makes it

disadvantaged compared to banking products; ii) repossession of assets in the event of default

is cumbersome and lengthy, and can lead to further depreciation of the value of the asset; iii)

supervision of operating leasing within leasing companies puts them at a disadvantage

compared to companies providing similar services outside the scope of Banking Agency

supervision. It is recommended to: i) exempt the VAT on interest for financial leases to make

leasing on the same level playing field as other types of credit; ii) update the by-laws of the

pledge registry and regulatory framework for enforcement to enable more effective

repossession of assets; iii) revise the legal framework to clarify the business activities of

operational leasing; and iv) streamline the tax and fees imposed on leasing to avoid

duplication.

9. The financial sector consumer protection framework was significantly enhanced in

recent years in BiH, but improvement is needed on the transparency and disclosure

regimes. Reforms adopted in the consumer protection area include: i) placing the

responsibility for the regulation and supervision of consumer protection in the banking, MCO

and leasing sectors to the respective Banking Agencies; ii) establishing the Ombudsman offices,

and iii) introducing consumer disclosure requirements in line with the EU Credit Directives.

Going forward, it is recommended that transparency and disclosure of information in the

banking and MCO sector should be further improved through standardized disclosure formats

and price comparison tools to foster competition and increase the comparability of financial

products and services.

Recommendations Responsibility Time7

Microcredit Sector

Strengthen the supervisory and enforcement powers by

Providing the Federation Banking Agency with a broader range of

enforcement tools.

Improve the framework for appeals against FBA’s supervisory actions.

FBiH MOF, FBA I

Ease transition from MCFs to MCCs by

Amending Article 15 of the Law on MCOs to ease the establishment

of MCCs.

Resolving the issue of donated capital.

FBiH MOF, FBA I/NT

7 “I-Immediate” is within one year; “NT-near-term” is 1–3 years; “MT-medium-term” is 3–5 years.

4

Review the identification requirements for simplified Customer Due

Diligence (CDD), particularly on proof of income.

Government NT

Alternative Financing Instruments

a. Leasing

Exempt the VAT on interest for financial leases to create a level playing

field with other types of credit.

Government, BiH

ITA

I

Revise the legal framework to clarify the business activities of operational

leasing.

FBiH MOF, MOJ,

FBA

NT

Streamline the taxation and fees imposed on leasing, e.g. the property

sales tax, and direct taxation and supervision fees in the two entities.

FBiH / RS MOF,

FBA, BARS

NT

b. Factoring

Regulating factoring should be decided upon only after consideration of

best international practices, particularly on ensuring a level playing field

for all market participants.

FBiH MOF NT

Market Infrastructure

Enhance the by-laws of the pledge registry and the regulatory framework

for enforcement to enable more effective repossession of assets.

BiH MOJ NT

Take measures to ensure the quality of credit information reported by

organizations not regulated by the Banking Agencies who are engaged

in the purchase of claims from financial institutions to the central credit

registry (CCR).

CCR NT

Government Policies

Develop and implement a financial inclusion strategy, including a

financial education strategy. The financial inclusion strategy can be

developed and implemented possibly as a component of a larger

financial sector development strategy, providing a framework for

stakeholder coordination, prioritization, and sequencing of reforms and

actions.

FBiH / RS MOF MT

Review international experience and best practices in the design and

implementation of credit guarantee funds.

FBiH / RS MOF NT

Consumer Protection

Improve the transparency and disclosure of information in the banking

and MCO sectors:

Align the Effective Interest Rate (EIR) calculation methodology

with EU standards.

Develop a standard Key Facts Statement.

Publish regular tariff comparison tables for standard products of

banks and MCOs.

Impose and improve disclosure requirements for banks’ and

MCOs’ code of conduct in all branches.

FBiH / RS MOF,

FBA, BARS

I

5

Expedite resolution of small claims by allowing for binding decisions on

financial institutions up to a fixed value of dispute.

FBiH / RS MOF NT

Conduct a review on the Law on Guarantors to assess its impact on access

to finance and guarantor protection.

FBiH MOF NT

Corporate and financial reporting

Implement simplified financial reporting frameworks for all SMEs based

on the IFRS for SME standards.

BiH / FBiH / RS

MOF

NT

Standardize the definitions of SMEs for the usage of the public and

financial sectors.

BiH / FBiH / RS NT

6

I. OVERVIEW OF THE REAL ECONOMY AND FINANCIAL SECTOR8

A. Overview of the Real Economy

10. Bosnia and Herzegovina (BiH) accomplished significant economic growth before

being adversely affected by the global financial crisis. GDP per capita nearly quadrupled

and poverty dropped from a level close to 20 percent to about 14 percent between 1998 and

2008. However, the financial crisis in 2009 caused the GDP to shrink by 2.9 percent and

economic growth remained subdued since then, averaging 0.4 percent per year till 2013. The

economy is domestic demand driven and remains dependent on capital inflows, especially

remittances from other parts of Europe to finance a large current account deficit. On the

production side, the manufacturing of automobile parts, energy and metals dominate. As of

end-2013, unemployment remains high around 27.5 percent and the deflation trend is

continuing on the back of subdued domestic demand. Going forward, BiH needs to boost

exports to increase potential growth sustainably.

11. The economy was slightly recovering prior to the recent floods, but is expected

to contract in 2014. The economy grew by 2.5 percent in 2013, following a recovery in exports.

The trend was projected to continue in 2014 prior to the floods, albeit with a slower pace at 2

percent due to weak domestic demand and an unfavorable external environment. However,

the recent floods have considerably deteriorated the economic outlook for 2014. Preliminary

estimations from the damages and losses associated with the floods put the costs of the floods

at the equivalent of nearly 15 percent of GDP in damages (9.3 percent of GDP) and losses (5.6

percent) in 2014. This amounts to around USD 1.8 billion of damages and USD 1.1 billion of

losses. The hardest hit economic sectors were agriculture, transport and productive activities.

As a result, the economy of BiH is now expected to contract by 0.7 percent in 2014. On poverty,

simulations suggest that as a result of the recent floods, the share of households below the

poverty line may have increased by between 0.4 and 1.8 percentage points – prior to the

disaster, it was around 19 percent.

12. SMEs dominate the real sector in BiH. As of end-2013, there are 31,409 active

enterprises registered in BiH Statistical Business Register, 31,108 of which are SMEs. There are

also 30,278 “inactive” enterprises that are not closed in the administrative registers, and which

have not submitted financial reports. 74 percent of active firms in BiH are classified as micro-

level while 19 percent and 6 percent are small and medium respectively (see Table 1 for

definitions of size segments and details by entity). The transition of enterprises within size

segments appears to be limited, and this is mostly due to the lack of corporatization and weak

economic growth prospects. Meanwhile, these numbers do not include the “craftsmen”,

owner-entrepreneurs who are registered in municipalities. The number of these craftsmen is

estimated to be considerable – although data is available, it is still not reliable enough for

publication, according to the BiH Agency of Statistics.

8 This Technical Note was prepared by Yen Nian Mooi (Financial Economist) and Cevdet Cagdas Unal

(Financial Economist), with guidance from Douglas Pearce (Lead Financial Sector Specialist), World Bank

Group.

7

Table 1. Number of firms by size

Source: Agency for Statistics , Units of Statistical Business Register end-2013, Authors' Calculations

13. SMEs play a very important role in the economy owing to their crucial role in

generating income and employment. SMEs are estimated to account for 67 percent of total

employment, 73 percent of total turnover and 61 percent of total valued added at factor cost

in BiH. They are also dominant in top export-oriented sectors including manufacturing,

electricity and, water supplies (see Table 2 and Figure 1).

Table 2. Business statistics by size

Source: Agency for Statistics , Structural Business Statistics 2012

BiH RS FBiH Brčko District

Micro (0-9 employees) 23,313 6,990 15,018 1,305

Small (10-49 employees) 5,891 1,878 3,875 138

Medium (50-249 employees) 1,904 638 1,238 28

Large (250 employees) 301 96 199 6

Total number of firms 31,409 9,603 20,329 1,477

Shares in total

Micro (0-9 employees) 74.2% 72.8% 73.9% 88.4%

Small (10-49 employees) 18.8% 19.6% 19.1% 9.3%

Medium (50-249 employees) 6.1% 6.6% 6.1% 1.9%

Large (250 employees) 1.0% 1.0% 1.0% 0.4%

Number of

employees

Turnover

(thousand

BAM)

Value added

at factor cost

(thousand

BAM)

Small (0-49 employees) 168,505 24,799,066 4,758,795

Medium (50-249 employees) 100,970 14,482,834 2,722,623

Large (250 employees) 135,438 14,922,859 4,865,097

Total 404,913 54,204,759 12,346,514

Shares in total

Small (0-49 employees) 41.6% 45.8% 38.5%

Medium (50-249 employees) 24.9% 26.7% 22.1%

Large (250 employees) 33.4% 27.5% 39.4%

8

Figure 1. SMEs’ share in top three export sectors

Source: Agency for Statistics, Authors' Calculations. Data for 2013.

B. Overview of the Financial Sector

14. BiH’s financial sector is heavily bank-dominated and moderately concentrated.

There are 27 banks in BiH accounting for 87.1 percent of financial system assets, which are

equivalent to 84 percent of GDP as of end-2013. The banking system comprises mostly foreign

subsidiaries—91 percent of the banking sector assets, while domestically-owned and state-

owned banks account for 7 and 2 percent respectively. There are 17 banks in FBiH and 10 in

RS, with a share of 70 and 30 percent of the banking system respectively. The five largest banks

represented about half of banking sector assets in 2013.

15. The rest of the non-banking financial system is small. There are 25 insurance

companies, 19 microcredit organizations (MCOs), 34 investment funds, 8 leasing companies

and 1 factoring company in Bosnia as of end-2013. The non-bank financial sector grew rapidly

thanks to the microcredit and leasing sectors, and its assets reached 22 percent of GDP in 2007.

However, with the financial crisis in 2009, all non-bank financial institutions except the

insurance sector started to shrink continuously; with the largest contraction in the leasing

sector followed by the microcredit sector (see Table 3). There is one stock exchange in each

Entity, but capital markets remain underdeveloped.

9

Table 3. Structure of the financial system

Source: Central Bank of Bosnia and Herzegovina (CBBH)

16. The banking system is well capitalized and liquid, yet the adverse impact of the

Eurozone crisis is still evident in the weak asset quality and low profitability. The banking

sector’s capital adequacy ratio (Tier 1) is high at 15.6 percent while liquid assets are 43.4

percent of total short-term liabilities as of Q2 2014. The loan-to-deposit ratio remains

reasonable at 116 percent thanks to the acceleration in deposit growth in 2014 (see Figure 2).

However, banks are struggling with non-performing loans (NPLs) which amounted to 15.5

percent in Q1 2014, compared to 3.1 percent before the global financial crisis (see Figure 3).

Furthermore, there are pockets of vulnerabilities among individual banks.

Figure 2. Deposit growth by sectors

Figure 3. NPL and capital adequacy

Source: CBBH Source: CBBH

17. The floods also affected the financial sector, prompting forbearance measures.

The authorities introduced provisions allowing the banks to apply for loan restructuring or

moratoriums, while exempting the loans from being classified as NPLs. However, only about 1

percent of total loans have been restructured as of September 2014 —suggesting a limited

2007 2008 2009 2010 2011 2012 2013

Number of instituions

Banks 32 30 30 29 29 28 27

of which: Foreign-majority owned 21 21 21 19 19 19 17

Insurance companies 26 26 27 26 26 25 25

Investment funds (asset management companies) 28 32 33 32 32 33 34

Leasing companies 8 9 9 9 9 9 8

Microcredit organizations 24 27 26 25 25 22 19

Total assets (millions of BAM)

Banks 19,570 20,813 20,608 20,416 20,995 21,186 22,023

of which: Foreign-majority owned 18,351 19,769 19,477 18,944 19,336 19,476 19,928

Insurance companies 853 889 933 936 1,080 1,174 1,232

Investment funds (asset management companies) 1,762 1,225 871 888 810 796 762

Leasing companies 1,378 1,607 1,416 744 767 716 597

Microcredit organizations 946 1,213 1,087 853 742 676 667

10

impact of the floods on borrowers—although more loans could be restructured going forward

as banks continue to file for NPL exemptions.

18. Overall, the level of financial intermediation is broadly in line with the country’s

income level. Private sector credit growth has significantly slowed down in recent years as the

deleveraging process in EU and high level of NPLs prompted financial institutions to be more

conservative (see Figure 4). Despite this deceleration in loans, domestic credit reached 67.8

percent of GDP in 2013 which is broadly in line with its income level (see Figure 5).

Figure 4. Credit growth by sectors

Figure 5. Income versus credit depth,

country comparison

Source: CBBH Source: World Development Indicators, 2013

II. STATUS OF FINANCIAL INCLUSION

A. Households

19. Financial inclusion in Bosnia and Herzegovina (BiH) performs relatively well

compared to peers, but over 40 percent of adults did not have an account at a formal

financial institution. The percent of adults who have accounts at a formal financial institution

stood at 56.2 percent in 20119, above the developing ECA10 average of 44.9 percent. While this

ratio is broadly in line with the upper middle income average of 57.2, countries with higher

incomes in the Western Balkans (Croatia and Macedonia) perform better than BiH (see Table

4), signaling room for improvement. Disaggregating this data into urban and rural populations

does not alter the picture as the gap between two is relatively low at 5 percent points. In terms

of income distribution, the same picture holds again with the access to an account ratio for

adults in the bottom 40 percent of the total income being 5.4 percent points higher than the

average of developing ECA countries. Nevertheless, gaps remain relative to higher-income

neighbors.

9 Data used in this section is from Findex Database 2011 unless otherwise indicated. 10 All the Europe and Central Asia (ECA) comparators refer to developing ECA only.

11

Table 4. Indicators for access to finance

Source: Findex Database 2011, Enterprise Survey 2013.

20. The gender gap in access to finance is the largest among comparators. On an

aggregate level, 47.7 percent of females have an account at a formal financial institution in BiH,

which is somewhat comparable with the income level and regional average. Yet, crucially, the

gap between female and male access is 19.5 percentage points, and is the third largest among

all ECA countries after Turkey and Kosovo (see Figure 6). Usage statistics show that this gap

arises mostly from the fact that women are using their accounts much less than men for

receiving wages and government payments. This is an expected result, as the female labor

force participation is very low at 34.1 percent in BiH in 2012, according to the International

Labor Organization (ILO) statistics (see Figure 7).

Bosnia &

Herzegovina

Albania Croatia Macedonia Europe &

Central Asia

(developing

only)

Upper

Middle

income

General Access Indicators

% Account at a formal financial institution (age 15+) 56.2 28.3 88.4 73.7 44.9 57.2

The Bottom 40% 41.9 18.2 82.1 72.2 36.5 42.2

Rural 54.7 24.2 88.0 72.6 39.4 54.0

Female 47.7 22.7 87.2 71.5 40.3 52.9

# Bank branches per 100,000 adults 30.6 22.3 35.5 24.8 20.6 16.3

# ATMs per 100,000 adults 40.0 33.1 111.7 49.9 46.0 43.6

Access to Credit and other Sources of Financing

% Firms with a loan or line of credit 66.3 28.2 53.4 45.4 36.5 -

% Firms identifying access to finance as a major

constraint

14.1 6.5 22.9 19.3 17.1 -

% Firms using banks to finance investments 38.0 11.2 27.1 20.9 24.2 -

% Firms using banks to finance working capital 46.7 23.1 38.0 38.4 31.1 -

% Value of collateral needed for a loan 190.1 255.2 194.0 275.5 205.6 -

12

Figure 6. Gender gap: the percentage

point difference between male and female

accounts at a formal financial institution

Figure 7. Female labor force participation

in developing countries (as % of total

labor force)

Source: Findex Database 2011 Source: International Labor Organization (ILO), 2012

21. The main delivery channel of the financial system is branches. There are 963 bank

branches and 359 MCO branches in BiH as of Q2 2014. The number of bank branches per

100,000 adults is significantly higher than most of the comparators. In contrast, the country

lags behind the region in ATMs per 100,000 adults mostly due to cultural and security reasons

rather than an infrastructural gap (see Figure 8). In line with these trends, the main mode of

both deposit and withdrawal is the bank teller in the country (see Figure 9). In terms of the

mode of payments from the accounts, BiH performs worse than most of its peers (see Figure

10) in the usage of both checks and electronic banking, although the latter has been improving,

as reported by banks. Meanwhile, the usage of point-of-sale (POS) systems has been increasing

in recent years with the number of POS terminals per 100,000 adults increasing from 459 in

2009 to 552 in 2013.

Figure 8. Automated teller machines

(ATMs) (per 100,000 adults)

Figure 9. Modes of withdrawal (% with an

account, age 15+)

Source: Findex Database 2011 Source: Findex Database 2011

13

Figure 10. Mode of payments

Figure 11. Saved any money in the past

year (% age 15+)

Source: Findex Database 2011 Source: Findex Database 2011

22. Lending activity is high while savings remain limited. Lending services have a high

outreach compared to regional peers, while savings are low with only 13.5 percent of adults

reporting saving any money in the past year compared to the regional average of 20.4 percent.

In particular, for the bottom 40 percent, the ratio of adults reporting saving any money in the

past year is even lower at 9.8 percent (see Figure 11). Accordingly, the domestic savings to

GDP11 ratio is -3 percent as of end-2013 while the deposits stood at 54 percent of GDP. This

picture is in line with the country’s large current account deficit.

23. Accounts are used mostly for receiving wages. In terms of the usage of accounts,

34 percent of adults in BiH used their accounts to receive wages, the highest ratio among

comparators (see Figure 12). The country performs better also on usage for receiving

remittances as remittances inflows are more than its peers at 10.6 percent of GDP11 (see Figure

13). On the contrary, BiH lags behind similar countries on the account usage for business

purposes which was only at 2.7 percent.

11 World Development Indicators, 2013.

14

Figure 12. Users of accounts

Figure 13. Personal remittances received

(% of GDP)

Source: World Development Indicators 2013 Source: Findex Database 2011

B. Firms

24. Firms’ access to credit in BiH performs better than benchmark countries, but

credit growth to the private sector has been muted since the Eurozone crisis. In BiH only

14.1 percent of firms identify access to finance as a major constraint to growth compared to

the ECA average of 17.1 percent. In addition, firms in BiH perform better than their regional

peers in terms of having a loan and using banks to finance investments and working capital

(see Figure 14). Despite this positive picture, credit to the non-financial private sector expanded

by only 0.9 percent year-on-year in the first nine months of 2014, and by 1.1 percent in 2013.

As a result, the share of the corporate sector in total loans fell to 44 percent in September

2014, the lowest since end-2010. These trends show that economic and institutional challenges

remain to be addressed in the short-term.

25. Low growth prospects diminish the investment appetite of firms while their lack

of repayment capacity makes banks more conservative on lending decisions. A significant

portion of the loans were used to finance working capital rather than investments, mostly due

to unfavorable growth prospects (see Figure 15). The NPL ratio for corporate clients is

significantly higher than that for retail clients, which indicates that the lack of repayment

capacity among firms is a crucial problem. This also prompts banks to be more conservative

and tighten lending standards for the corporate sector although banks are liquid. Meanwhile,

data on SME credit penetration is lacking as banks do not use a common definition for SMEs.

26. The lack of formal documentation is a challenge for banks to lend to smaller

enterprises. Banks report a segmentation of their SME clients, and smaller enterprises with

less complete or formal documentation. It is recommended that the authorities further

implement financial reporting frameworks based on the IFRS for SMEs standard. A simplified

framework reduces the burden on SMEs and improves the quality of SME financial statements.

This in turn would help SMEs in their efforts to access financing from potential lenders.

15

27. The value collateral is another constraint on firms’ access to credit. The value of

collateral needed for a loan remains considerably high at 216 percent for small firms in BiH12,

which is consistent with the levels reported by financial institutions. The main factors that keep

collateral requirements elevated are the higher perceived risk of the firms, and challenges in

collateral enforcement and liquidation processes. These factors prompt financial institutions

to discount the present value of collateralized assets (see Section IV: Legal and Market

Infrastructure).

Figure 14. Selected Enterprise Survey

results by countries

Figure 15. Selected Enterprise Survey

results of BiH firms, by size

Source: Enterprise Survey(2013) Source: Enterprise Survey(2013)

III. MARKET PLAYERS AND INSTITUTIONAL POTENTIAL TO EXPAND FINANCIAL

INCLUSION

A. Commercial Banks

28. The BiH financial sector is dominated by commercial banks, which comprise 87

percent of the sector’s assets. A large number of players are foreign-owned, with parent

banks from the Eurozone (in particular Austria and Italy). Ever since the global financial crisis

hit, many of the local subsidiaries of these parent banks have been deleveraging, and reducing

their credit to SMEs. The group-wide strategy of foreign banks also affects the strategy of the

local subsidiary to a large extent, particularly on the focus market segments and types of

products offered.

29. Banks are liquid, but are tightening lending standards and segmenting clients

more distinctly. In general, there is a situation of over-liquidity in banks as they are cautious

in extending credit. The large foreign banks tend to find SME lending too risky, viewing this

segment as lacking stable repayment capacity. This perception of financial vulnerability has

been aggravated by the financial crisis. Nevertheless, some of the locally-owned banks have

12 Enterprise Survey 2013, for details on methodology please visit

http://www.enterprisesurveys.org/methodology.

16

aggressively expanded their SME portfolio, in part by taking over some of the clients of the

foreign banks. A handful of small banks also have a targeted focus on SMEs (see Box 1). Banks

report a sharper segmentation of their SME clients, and smaller enterprises with less complete

or formal documentation (e.g. financial statements, business plans, etc), and have less collateral

tend to be excluded from the market. As for micro loans, banks are not interested to serve

this segment of the market, as it is riskier and costlier. Furthermore, the opportunities for

cross-selling of products and services to this segment are limited.

Box 1. Examples of banks with a specific focus on SMEs

MF Banka is a small local bank owned by Mikrofin, a microfinance company headquartered in

RS. MF Banka targets SMEs and has taken over the enterprise clients of Mikrofin, which is

focusing more on households and agricultural workers. MF Banka has a unique business model

– loan officers provide consulting services to the client by making field visits to assist them in

their loan applications, including by helping SMEs project their cash flows.

Procredit Bank focuses on the SME sector exclusively, after moving away from the

microenterpreneur sector. It is registered in the Federation. The bank prides itself on providing

good client advisory services and training its staff to understand and serve the needs of SME

clients. Procredit is also aiming to expand its electronic offerings through e-banking and other

services.

30. Collateral requirements are high, with real estate the preferred collateral. Banks

report a minimum of 150 percent collateral-to-loan value and generally prefer deposits and

real estate. While movable collateral is accepted, they are not extensively used as banks do not

consider such securities as being safe. Banks report of movable assets being sold even while

the execution process is ongoing. In general, the enforcement of collateral in the case of

default is lengthy and difficult (see section IV: Legal and Market Infrastructure).

31. Banks do not use standardized definitions for SMEs, making it difficult to track a

comparable portfolio. The definitions used by banks are based on annual turnover figures

or loan exposures, and tend to vary considerably. For loans classified as micro, some banks

define it by the type of activity of the borrower. It is recommended that a standardized

definition of SMEs is used, at least for statistical purposes. A good candidate could be the

definitions used in the 2009 Accounting and Auditing Laws, which set out thresholds for small,

medium and large enterprises based on number employees, revenues and asset sizes. Reliable

and comparable statistics that use common definitions will enable a better understanding of

the needs and gaps of the sector as a whole. 13

13 Ideally, these definitions are used consistently across the country, e.g. across different government

agencies and the financial sector.

17

B. Microcredit Organizations (MCOs)

32. The microcredit sector in BiH experienced rapid growth before peaking in 2008,

and crashed thereafter. The industry experienced two years of very rapid growth from 2006

to 2008, with a significant supply of funds by foreign investors. Data from the Microfinance

Information Exchange (MIX) showed that the gross loan portfolio doubled from 2006 to 2008.

Market growth was driven by expansion to new and existing markets, including through

increases in loan size14 and the introduction of new products. In 2008, the industry began to

show signs of stress, with sharp increases in portfolio at risk (PAR) values.

33. Structural factors were at the root of the crisis, and the impact was exacerbated

by the global economic recession. The microcredit crisis was chiefly caused by the saturation

of the market and imprudent lending; which led to over-indebtedness of borrowers. MCOs

competed aggressively in already concentrated markets, with market penetration reaching 15

percent in 2008. The competition for the same target groups enabled clients to engage in

multiple borrowing and to increase their total loan amounts. During the crisis, about 40

percent of active borrowers had loans from more than one microcredit organization (MCO),

and 16 percent of borrowers in BiH reported being close to exceeding their repayment

capacity. Staffing and internal controls did not keep up with the rapid growth of the industry,

which led to a decline in monitoring quality, and new products were introduced without sound

borrower assessment tools and proper staff training. The Law on Microcredit Organizations

was passed in 2006, but came into effect only in mid-2008, when supervision was also

introduced. In between the adoption of the law and its full enforcement, industry players

continued their imprudent practices in advance of supervision controls. Weakening loan

portfolios, due to highly indebted borrowers amid a global crisis, resulted in net losses for the

sector in 2009 and a contraction in the number of MCOs. The decrease in portfolio was

followed by more restrictive credit policies, and the access to credit for the most vulnerable

population of BiH was affected (see Figure 16).

Figure 16. Credit growth, banks vs MCOs

Figure 17. Total assets of the MCO sector

Source: CBBH Source: CBBH. Note: RHS refers to right hand side and LFS

refers to left hand side.

14 There were no limits on loan sizes then.

18

34. The assets of the MCO sector have been declining from almost 5 percent of

financial system assets in 2008 to 2.6 percent in 2013 (see Figure 17). The number of

institutions has also consolidated, from 27 in 2008 to 19 in 2013. Performance has generally

improved since the crisis, with the overall sector showing positive income over expenses and

lower portfolio-at-risk (30 day) values (see Table 5). In the Federation, the deterioration of a

large MCF had affected the recent results of the sector.

Table 5. Selected indicators for the MCO sector

Source: Authorities

35. In general, MCOs and banks serve different targeted market segments. MCOs are

not allowed to accept deposits, but only to grant credit as well as provide advisory services to

microcredit beneficiaries. Loan sizes are smaller, with the average around BAM 2,500. The

maturity of loans in the MCO sector are also shorter term in nature (around 2 years), and the

interest rates are higher than banks (see Table 6 for weighted average effective interest rates

of the MCO sector). MCOs require less documentation from their loan clients compared to

banks, and use a different credit analysis process where loan officers often make field visits to

assess the creditworthiness of a borrower using a broader approach. Most microcredits are

provided to individuals, although there is still some group-lending done through “solidarity

groups” in “village banks” (e.g. in Mikra). Two of the MCFs have a gender-focus, with Mi Bospo

targeting women entrepreneurs and Mikra having women-only clientele.

Table 6. Weighted Effective Interest Rates (EIRs)15 for MCOs

Source: Authorities

15 Effective interest rates are calculated using different methodologies in the Federation and RS. See Section

VI: Consumer Protection.

2008 2009 2010 2011 2012 2013 Q2 2014

FBiH

Gross loans/ total assets (%) 92.0 83.4 81.1 82.5 83.5 83.3 86.0

Portfolio at risk (30 days, %) 2.7 8.6 6.2 3.2 1.9 1.5 4.5

NPL ratio (90 days, %) 3.1 14.6 28.6 29.9 29.8 30.6 31.3

Return on Assets (%) 4.1 -5.1 -1.9 2.2 2.6 3.3 -2.0

Return on Equity (%) 19.1 -25.6 -7.6 7.4 8.0 8.8 -5.4

Operating expense/loan portfolio (%) 8.9 10.3 13.0 15.9 17.5 16.9 16.1

RS

Gross loans/ total assets (%) 92.3 84.5 82.7 75.7 78.1 79.2 74.5

Portfolio at risk (30 days, %) 1.1 4.6 5.2 5.1 3.0 1.7 2.9

NPL ratio (90 days, %) 0.4 1.7 1.8 2.1 1.2 0.7 0.8

Return on Assets (%) 3.0 -0.5 -0.5 1.0 2.4 2.6 1.5

Return on Equity (%) 15.2 -2.4 -2.5 4.8 8.3 7.6 4.3

Operating expense/loan portfolio (%) 6.8 6.2 6.8 7.1 7.4 8.3 8.0

2010 2011 2012 2013

FBiH 29.73 29.11 27.89 25.29

RS 21.68 20.87 20.04 21.05

19

36. Microcredit organizations (MCOs) can be categorized into non-profit

organizations (microcredit foundations, MCFs) and for-profit (microcredit companies,

MCCs). MCOs are governed by the Law on Microcredit Organizations of the respective

entities, and supervised by the respective Banking Agencies. MCFs have a minimum capital

requirement of BAM 50,000 and are restricted to granting credit of up to BAM 10,000 per

client. MCCs have a minimum capital requirement of BAM 500,000 and can offer loans of up

to BAM 50,000 per client (see Table 7). MCOs registered in one entity can perform operations

in the other entity, although the playing field is not even due to the lack of alignment between

the MCO laws governing the two entities. The share of the MCO market by entity is shown in

Figure 18. The market composition in the two entities is very different, reflecting to a large

extent the differences in the legal basis of each entity when the current law on MCOs was

adopted. In the RS, MCOs operating under the former law had a choice to be incorporated as

MCFs or corporatize into MCCs; while in the Federation, all MCOs were obligated to first be

incorporated as MCFs. 16

Table 7: Microcredit organizations in BiH

Source: Authorities

16 In BiH, the process of corporatization is known as “transformation”. Nevertheless, it is not “transformation”

as it is commonly known elsewhere – in BiH, it means the MCF’s investment in an MCC, and the MCF continues

to exist alongside the MCC. This Note uses the term “corporatization” to encapsulate a broader meaning, to

allow for the future possibility of complete transition from an MCF to an MCC (without the need for retaining

the MCF, if the institution so desires).

MCFs MCCs

Profit orientation Non-profit For-profit

Minimum capital requirements (BAM) 50,000 500,000

Maximum loan size (BAM) 10,000 50,000

Number (as of December 2014)

FBiH 12 1

RS 3 3

20

Figure 18. Share of MCO market by entity

Source: Authorities, as of Q12014

37. The Federation MCO market is comprised of 12 MCFs and one MCC.17 The MCO

sector in the Federation has more than 171,600 borrowers who received credit equivalent to 4

percent of total credit extended in the banking sector. There are 286 MCO branches compared

to 576 for banks. Average weighted effective interest rates were 25.68 percent as of end-June

2014 (end-2013: 25.29 percent). Provision of credit is dominated by the MCFs, which supply

almost all the credit in the sector. The sole MCC is very small and was purchased by another

MCF in 2013.

38. The RS market is dominated by one MCC, Mikrofin, which has 95 percent of the

assets of the sector in RS. The remaining players consist of two MCCs and three MCFs. In

total, there are more than 49,500 MCO borrowers (banks: 300,611) served across 73 branches

(banks: 387). Microcredit is 3 percent of total bank credit at the end of June 2014, and the bulk

of MCO loans are split almost evenly between micro loans (up to BAM 10,000), and loans

between BAM 10,000 and BAM 50,000. Almost all the loans are to individuals, including

craftsmen, with a large proportion going to the agriculture (43 percent) and services (10

percent) sectors, and non-purpose loans. Average weighted effective interest rates were 21.83

percent as at end-September 2014 (end-2013: 21.33 percent).

17 As of December 2014.

21

Figure 19. Loans of MCOs vs Banks – FBiH

Figure 20. Loans of MCOs vs Banks – RS

Source: Authorities Source: Authorities

39. The separate laws governing MCOs in the two entities are not aligned, which

creates an uneven playing field in the sector. As MCOs licensed in one entity can operate

in the other, differences in the legal and regulatory frameworks are creating grounds for unfair

competition. In the Federation, two parallel actions are recommended: i) strengthening the

supervisory powers of the Banking Agency, and ii) easing the process of corporatization for

MCFs. It is important that both actions be done concurrently, as both are needed to ensure a

balanced and prudent growth of the sector, as well as to protect vulnerable customers.

40. The Federation Banking Agency (FBA) lacks a sufficient range of enforcement

powers for the MCO sector and it is recommended that this be strengthened. Currently,

the FBA is limited to the enforcement tools of issuing orders, or the severe action of revoking

licenses, with no intermediate actions available. Providing the FBA with a broader menu of

corrective actions will thus give it the necessary authority to regulate the market more

effectively, and contribute to the strengthening of the sector. It is recommended that the Law

on MCOs in FBiH be amended to include, among others, explicit powers to appoint advisors,

impose temporary administration, and remove or replace management and board members.

In the RS, the Banking Agency has broader and more nuanced enforcement options. The RS

Law on MCOs was amended in 2011 to strengthen the supervisory powers of the Banking

Agency, allowing it to undertake intermediate corrective measures such as appointing advisors,

appointing external administrators and suspending board members in the event of any

violations.

41. An improved framework for appeals against FBA’s supervisory actions should be

considered. Past attempts of the FBA to impose remedial actions on MCOs have been at times

challenged with court cases through the Administrative Dispute process. After an appeal, the

Court can suspend the decision of the FBA. This adversely affects the effectiveness of FBA

supervision and undermines its authority. Suspension of the operation of the supervisory

actions can promote continuation and proliferation of unethical and unhealthy behavior by the

regulated entities (MCOs). Eventually, these could undermine the viability of the sector. The

provisions of appeals by MCOs should therefore be improved. The case of the MCF Prizma,

22

whose license was revoked in October 2014 and subsequently reinstated18, illustrates how the

gaps in the legal framework allowed it to continue operating its questionable practices (see

Box 2: Prizma).

Box 2. Prizma

The MCF Prizma had its license revoked in October 2014. As of end-June 2014, Prizma was the

third largest MCO in FBiH, with BAM 65 million in assets and a gross portfolio of BAM 63 million.

The FBA’s decision was challenged in court, which ruled in Prizma’s favor as at end-November

2014, and Prizma’s license was reinstated.

The litany of Prizma’s alleged misdoings was long: among others, it had failed to send audit

reports on time, had qualified audit reports for several years, and irregular financial statements.

Prizma had also failed to meet certain financial covenants such as write-off ratios and portfolio

at risk (PAR) ratios, and its transaction accounts were blocked due to the inability to meet its

obligations to creditors.

The problems in Prizma had been brewing for several years. Upon the discovery of certain

offences, the FBA had issued orders, but did not have any intermediate enforcement tools to

issue corrective actions such as changing the board or installing temporary administrators. The

orders on Prizma to stop the practices deemed unlawful were also challenged with court

proceedings filed through the Administrative Dispute process. At the same time, Prizma filed a

proposal to delay the execution of FBA’s orders, which was granted by the court. This effectively

allowed Prizma to continue with the disputed activities. As the administrative dispute process is

lengthy, the activities suspected to be fraudulent continued on for a few years. The gaps in the

legal framework that allowed this to happen demonstrated how the continuation of suspicious

activities could tarnish the reputation of the sector, and ultimately prove detrimental to

borrowers and creditors.

The revocation of Prizma’s license also revealed the lack of clarity regarding the liquidation

process for MCFs. The termination of an MCF is not governed by the Law on Business Companies,

as it is considered a foundation. The uncertainty regarding the return of creditors’ claims has in

turn created concerns over the future funding for the rest of the sector.

42. Providing the FBA with expanded enforcement powers could also prevent the

imposition of burdensome regulation on MCOs that are operating within the bounds of

the law. In their efforts to rein in the fraudulent activities of some MCOs, the FBA has relied

on heavy-handed regulation, e.g. the requirement of numerous borrower verifications, and

disallowing cash disbursements to borrowers. While these regulations are intended to prevent

fraud, they impose increased costs for the borrowers, and might reduce access for those who

cannot afford them or who live in areas where bank branches are not easily available.

Increasing the powers of the FBA to deal with the offending MCOs would thus release the rest

of the market to operate in a more conducive environment.

18 Prizma challenged the FBA’s decision in court. As at end-November, the courts had ruled in

Prizma’s favor and its license was reinstated. Subsequently, Prizma sued the FBA for damages.

23

43. In parallel, it is important to enable greater ease of corporatization for MCFs who

seek it.19 Easing the transition from MCFs to MCCs in the Federation would help to strengthen

corporate governance, as companies are subject to the application of the Company Law which

provides better internal checks and balances. It is recommended that authorities amend Article

15 of the Law on MCOs to ease the corporatization of MCFs for those who seek it, as well as

resolve the issue of donated equity.20

44. Besides stronger corporate governance of MCOs, corporatization could bring

about fairer competition, higher lending limits, clearer liquidation processes and a

broader range of funding. By leveling the playing field between entities, fairer competition

can be achieved. Furthermore, MCCs would be better able to serve the needs of clients

through higher lending limits. MCCs have clearer liquidation processes, as they are governed

under the Law on Business Companies. Corporatization will also enable MCOs to access a

broader range of funding, enabling expansion and growth.

45. An important measure to ease corporatization is to remove the requirement for

MCFs to continue lending in parallel with the MCC under its ownership, as well as resolve

donated equity issues. Currently, the law in FBiH (Article 15 of the Law on MCOs) is

interpreted in such a manner that MCFs are required to continue their direct lending activities

even after the establishment of an MCC. International experience shows that the founding

non-profit foundation and newly established company might ultimately compete against each

other, generating difficult governance issues and conflicts of interest.21 Finally, authorities

need to resolve the issue of donated equity, in consultation with stakeholders. Currently,

equity contributed by donors is considered separately from the rest of the equity raised by the

MCFs. There are ambiguities related to the treatment of this donated equity, with regards to

when an MCF corporatizes or faces termination. The treatment of donated equity is an

impediment towards corporatization and should be resolved appropriately, including by

looking at models used in other countries and lessons learnt from international experience.

46. Extensive identification requirements to fulfill the Anti-Money Laundering (AML)

Law risks excluding the poorest borrowers from the market. Based on the Law on

Prevention of Money Laundering and Financing of Terrorist Activities, the Banking Agencies

have issued guidance on risk assessments and the proportional Customer Due Diligence (CDD)

measures to be applied.22 The nature of the product, limits on thresholds, type of clients served

and lack of cross-border transactions would suggest low vulnerability to money laundering

and thus a simplified CDD for most of the clients in the MCO sector. Nevertheless, the

identification requirements for the simplified CDD still appear to be onerous, particularly the

requirement for proof of income. This could shut off access to the borrowers who do not have

a stable means of income, or sufficient records to prove ownership of assets, or sources of

19 Likely candidates who might be interested at present would be the two largest MCFs in the FBiH. 20 The path and model of corporatization as well as the resolution of the issue of donated equity is beyond

the scope of this Technical Note. 21 One example is of the Bolivian NGO PRODEM, which created the commercial bank BancoSol. The initial

arrangement of dividing the market resulted in a falling out between the two institutions. See Lauer (2008),

“Transforming NGO MFIs: Critical Ownership Issues to Consider”. 22 CDD is classified as simplified, standard, and enhanced, corresponding to the low, medium and

high risk categories of risk assessment respectively.

24

income (e.g. remittances received via informal channels, sales of excess agricultural produce

within the community, sub-letting of short- or long-term room or plots of land). It is

recommended that authorities review the identification requirements for the simplified CDD

to ensure that an appropriate balance is achieved, as overly hefty requirements could raise

costs and undermine financial inclusion.

47. In the RS, it is recommended to reconsider plans to impose interest rate

restrictions on the MCO sector. Interest rate restrictions could price out the least credit-

worthy from the formal market, and force them to turn to informal lenders which often lend at

much higher rates. Global evidence shows that attempts to control interest rates as a means

to lower spreads are almost always counter-productive. The best way to lower prices on

lending is through encouraging competition, better transparency and effective disclosure

regimes. These could be achieved for example through strengthening disclosure

requirements, and facilitating better comparison of products and services for consumers (see

Section VI: Consumer Protection).

C. Leasing

48. The leasing market in BiH is small and declining, and its viability is threatened.

As of November 2014, there are seven leasing companies in BiH (six headquartered in

Federation, one in RS), with many of the companies owned by the subsidiaries of foreign-

owned banks. Prior to the enactment of the Law on Leasing in 2008, the assets of leasing

companies had grown at a rapid clip, due to an expansion in activities that were akin to shadow

banking rather than “true” leasing (see Figure 21). While the regulation in the market was

necessary to prevent such activities, several factors discussed further below have stifled leasing

activity, threatening its long term viability. The assets of the leasing sector have continuously

declined from more than 6 percent of financial system assets in 2008 to 2.4 percent 2013 (see

Figure 22).

Figure 21. Leasing volume

Figure 22. Total assets of the leasing

sector

Source: Authorities Source: Authorities

25

49. The majority of leasing in BiH is for vehicles (both passenger and commercial),

with some equipment leasing and very little real estate leasing. This is in part due to the

prohibition of the financing of construction activities by leasing companies after the enactment

of the Law on Leasing. Also, real estate leasing is unattractive for the lessee because a property

sales tax has to be paid at the beginning of the lease (when the asset is purchased), and at the

end of the leasing period (when the ownership of the asset is transferred to the lessee). This

real estate tax varies by municipality, and is around 5 percent of the asset value.

50. The bulk of leasing is done through financial leasing. The supervision of operating

leasing within leasing companies puts them at a disadvantage compared to companies

providing similar services outside the scope of Banking Agency supervision. In recent years,

rental car companies have been renting out cars through longer term contracts (e.g. for 3 to 4

years, with insurance, gas, etc). The legal framework defining the business activities of

operational leasing needs to be revised to clarify the activities of operating leasing.

51. The VAT treatment on financial leases puts it at a disadvantage to loans by banks.

VAT on financial leasing is paid up-front, on both the asset and the implied interest of the

whole lease. This makes leasing less attractive compared to loans, as banking products are

exempt of VAT on the same product. It is recommended to exempt the VAT on interest for

financial leases to make leasing on the same level playing field as other types of credit, and

stimulate the growth of this sector.

52. The difficulty of repossessing leased assets is an additional, significant obstacle

hindering the growth of the market. If the lessee does not voluntarily return the asset in

the event of default, the lessor has to go through full court procedures. The efficiency of the

courts varies widely depending on the municipality, and courts face a high backlog of cases.

Furthermore, judges have little understanding about the sector. The execution process is

lengthy, and is further delayed if the lessee obstructs the process, e.g. by moving the asset to

different locations.

53. Leasing companies are subject to an inconsistency in the interpretation of laws,

as well as differing treatment between the entities. Leasing companies claim that the

Indirect Tax Authority (ITA) is inconsistent in their opinions in the span of different inspections,

causing uncertainty in business processes, and at times, penalties on actions deemed

acceptable in past inspection opinions. Leasing companies are also subject to double direct

taxation, as well as double supervision fees from the two entities.

D. Factoring

54. The factoring market is nascent in BiH. There is only one factoring company, Prvi

Faktor, which is foreign-owned. The bulk of the company’s clients are large corporates, and it

purchases receivables only with recourse. Very few banks have offered similar products, and

they are mostly loans secured by receivables. A draft law on factoring is being prepared in

FBiH, and it is recommended that the regulation of factoring should be decided upon only

after consideration of best international practices, particularly on ensuring a level playing field

for all market participants (see Box 3).

Box 3: Regulating factoring

26

One fundamental issue with factoring resides in recognizing the commercial status of the

industry, which in turn determines the oversight structure. In some countries, factoring is

recognized as a commercial activity and is, therefore, regulated by commercial law, but it is not

unusual in certain countries to see factoring companies undertake the functions of financial

intermediation without authorization.

The regulatory environment has an important effect on the factoring industry. In some countries,

factoring operates entirely outside the purview of any regulatory structure or authority, and in

others it is regulated along with other financial services such as banking and insurance. In most

countries, however, the level of regulation falls somewhere in between (Bakker, Klapper, and

Udell 2004). For countries where factoring is developing, a law setting out minimum standards

for the management of factoring companies and specifying the tools to be used to manage key

risks in factoring operations could be envisaged.

Some countries simply restrict market entry to formally registered financial institutions such as

banks or other specialized financial institutions. However, those restrictions could hinder

competition by excluding the emergence of independent factors.

Source: Financial Sector Assessment: A Handbook, Chapter 6 (IMF and World Bank, 2005)

IV. LEGAL AND MARKET INFRASTRUCTURE

A. Credit Reporting Systems

55. The Central Credit Registry (CCR) is a credit registry operated by the Central Bank

of BiH (CBBH). It is governed by the Decision on Central Registry of Credits of Legal Entities

and Physical Entities in Bosnia and Herzegovina. The registry for legal entities was operational

in May 2006, with the addition of physical persons in early 2007. The CRC is a structural division

of the Payment Systems department at the CBBH.

56. Reporting to the CCR is mandatory for financial institutions supervised by the

Banking Agencies. It is a state-level registry, and collects data from all the banks, MCOs and

leasing companies in the country. Insurance companies report their information on a voluntary

basis. MCOs and leasing companies were obligated to report to the CCR only after they came

under the supervision purview of the Banking Agencies. Prior to that, MCOs were not

mandated to report to the CCR but could do so on a voluntary basis. MCO mandatory

reporting to the CCR was part of the response to the problem of over-indebtedness, which

was caused by the multiple borrowing of individuals and the lax lending policies in the MCO

sector.

57. The CCR is deemed to fulfill its purpose well and is functioning effectively. Each

year, the CCR receives an average of two million queries. Data is updated on a daily basis, and

credit reports show current as well as historical information of up to five years. Both positive

and negative information is reported, with no minimum threshold for reporting. Borrower

identification is not an issue. Access to borrower information requires consent, and borrowers

27

have means to correct errors in information, although the process of dealing with disputes and

complaints is not sufficiently clear. In general, data coverage and quality is good. Nevertheless,

the quality of data reported by organizations purchasing claims from financial institutions (e.g.

the transfer of non-performing loans), but which are not regulated by the Banking Agency,

could be further enhanced.

58. There is a private credit bureau in operation, which focuses mainly on the credit

information of legal entities. The private credit bureau, LRC Credit Bureau (LRC) was set up

in 2000 as a limited liability company, and has voluntary membership. Aside from financial

institutions, it also collects information from non-financial creditors such as utility companies

and municipalities. The private credit bureau is required by law to seek the consent of

borrowers in the form of signed documents, and to keep these signed documents. Prior to

the introduction of this requirement, LRC had operated a credit database on physical persons.

The current operations are focused on the credit reporting of businesses, as well as credit-

scoring services, market analysis and debt collection.

B. Insolvency and Creditor Rights’ Framework

59. The basic rights governing creditor/debtor relationships and the procedures for

enforcing these rights enable parties to rely on contractual agreements, fostering

confidence that fuels investment, lending and commerce. An effective enabling

environment for debt recovery protects creditors’ rights and helps mitigate the risk of bank

exposure. This strengthens the credit environment and helps expand access to finance.

Conversely, uncertainty about the enforceability of contractual rights increases the cost of

credit to compensate for the increased risk of nonperformance or, in severe cases, leads to

credit tightening.

60. In BiH, the registration of collateral is not an issue, but collateral enforcement is

difficult and lengthy due to the ineffectiveness of execution procedures. The creation of

security rights over both immovable and movable assets is not problematic. Bank loans are

usually secured, with real estate as the preferred form of collateral for banks and mortgages

as the security mechanism. While the legal framework over pledges for movable assets is

modern and largely sound, movable assets are not extensively used because the recovery of

such assets is difficult. Execution processes can be prolonged by debtors raising objections

and appeals. Furthermore, the courts face a high case backload, and inefficient case

management likely also contributes to aggravating the slow resolution of cases. Market players

report that execution procedures take on average over 4 years (and even longer in some

jurisdictions). In the case of movable assets, the depreciation of collateral value is significant

over such an extended timeframe. It is recommended to update the by-laws of the pledge

and regulatory framework to enable more effective recovery of assets, streamlining execution

procedures, and enhancing the capacity of the judges and court system.

28

V. GOVERNMENT POLICIES AND PROGRAMS RELATED TO FINANCIAL INCLUSION

61. In general, BiH lacks a defined policy towards financial inclusion, with no strong

champion. Programs and policies for SMEs are mostly ad hoc and driven by different

ministries. Consideration should be given to develop and implement a financial inclusion

strategy, possibly as a component of a larger financial sector development strategy, providing

a framework for stakeholder coordination, prioritization, and sequencing of reforms and

actions.

Federation BiH

62. There are 13 programs for SMEs in the FBiH. These include assistance for startup

companies and specific subsidy programs. Most of these programs are carried out through

different line ministries, including the Ministry of Development, Entrepreneurship and Crafts,

as well as the Ministry of Energy and Industry. The Ministry of Development and Industry has

a credit line channeled to end beneficiaries through Union Bank, a state-owned bank.

63. The Federation Development Bank (FDB) has limited capacity and lacks a clear

strategy. The FDB was established in 2008 in accordance with the Law on Development Bank

of the Federation of Bosnia and Herzegovina, and has an asset size of BAM 284 million.23 The

current loan portfolio funded from its own sources is around BAM 210 million, offered through

nine credit lines. The FBH also places a similar amount of loans on behalf of the government

through three credit lines. Loans placed are for project financing, and offer maturities of up to

10 years. The FDB is supervised by the Banking Agency under a special decree, but the Banking

Agency has no sanctioning power over the institution. Due to its constrained balance sheet,

the FDB plays a very limited role in supporting access to finance.

64. The FBiH government has plans to establish a credit guarantee fund, though it is

hampered by capacity constraints. While the proposal has been in discussion for several

years, stronger interest has been rekindled recently due to the flood damage on the assets of

firms and households. There is also an export credit guarantee fund, the Investment Guarantee

Agency (IGA), which is facing problems in fulfilling its obligations. IGA suffered from a lack of

internal risk controls and management procedures, which led to large over-exposures of credit

risk.

65. The FBiH government has established a fund in response to the floods, but it is

smaller than expected and lacks clarity in the allocation criteria. At the end of June 2014,

the FBiH government adopted a law establishing a fund to support the areas affected by the

floods. The purpose of the fund is to collect and distribute funds to assist the affected areas,

and finance and support the preparation, implementation and development of programs,

project and other activities aimed at revitalizing the affected areas. The fund includes

contributions from the government, government-owned companies, the Federation

Development Bank, citizens (though not mandatory)24 as well as the diaspora population. The

contributions to the fund have been smaller than envisaged by the government, and as of end-

October the fund size is BAM 9.6 million. There is lack of clarity surrounding the criteria of

23 www.rbfbih.ba 24 There is the ability to opt out from contributing.

29

allocation of the funds – municipalities are responsible for the allocation as well as decisions

on targeted beneficiaries.

Republika Srpska

66. In the RS, the Ministry of Industry, Energy and Mining is the primary ministry

responsible for the development of SMEs and entrepreneurship. A new strategy has been

developed, which includes support to competitiveness, promotion of SMEs and strengthening

of the business environment; however the implementation is yet to take place. The Republic

Agency for the Development of Small and Medium Enterprises, as well as local development

agencies in the municipalities run several programs to provide non-financial technical support

to SMEs, including education and consulting services.

67. RS government financial support to SMEs is directed through the Republic of

Srpska Investment-Development Bank (IRBRS). The IRBRS is a major player in the financial

sector, with BAM 2.25 billion in assets.25 Aside from the government funding, the IRBRS also

channels credit lines from international financial institutions. IRBRS offers a range of credit

lines intermediated through the commercial banks, including those supporting SMEs,

microbusiness in agriculture, startup activities and war veterans. Some of these credit lines

offer beneficiaries capped interest rates at low levels. The IRBRS also places loans (of maximum

size BAM 5 million per loan) directly on behalf of the Ministry of Agriculture, Forestry and Water

Management. The list of potential beneficiaries of these loans is defined by the Ministry, and

the Government of RS makes the final decision after the credit analysis of the IRBRS and

opinion of the Ministry.

68. A credit guarantee fund has been established in RS but banks have shown little

interest in utilizing it. The guarantee fund started operations in 2011, and current active

guarantees total BAM 20 million.26 The coverage ratio is up to 50 percent of the loan, and the

guarantee fund proportionally shares the collateral with the banks. Commercial banks showed

disinterest in utilizing the credit guarantee fund, citing complicated procedures, the inability

to determine the terms of the loan, and uncertainty in the event of collateral enforcement.

Consideration should be given in improving the design of the credit guarantee scheme. Best

practices include building attractiveness while ensuring additionality through well designed

eligibility criteria, proper coverage ratio and fees, sound risk management, and efficient

operational procedures.27

69. The RS government has taken several measures related to the floods, including

establishing a Solidarity Fund, and allowing for certain tax and fee exemptions. The

Solidarity Fund includes funding from the government, as well as mandatory contributions

from the citizens collected for a year up to the end of May 2015. The fund size is expected to

be BAM 80 million and provides vouchers of up to BAM 5,000 for affected households. The

vouchers are given in the form of electronic payment cards, which can be used through POS

terminals with certain designated stores. The RS government is also postponing tax obligation

25 www.irbrs.org 26 www.garantnifondrs.org 27 One of the most successful PCG programs on credit market for SMEs is considered to be FOGAPE in Chile

(see Annex I).

30

payments of affected companies for up to five years without interest. Affected companies are

also exempted from certain fees (e.g. special fee for performing business activities, fee for use

of natural resources), as well as real estate tax in certain locales. The IRBRS has also extended

the repayment and grace periods for affected companies using its credit lines.

VI. CONSUMER PROTECTION AND FINANCIAL LITERACY

70. The Consumer Protection Act of 2005 covers the protection of all manners of

consumer products and services at the State level including those provided by the

financial sector. While the Act includes some aspects of the EU Directives on Consumer Credit

2008, it only broadly and unclearly defines the consumer credit giving room to the entities to

form their own legal frameworks on consumer protection in the financial sector. Under this

Act, the Consumer Protection Council and the State-level Ombudsman institution have been

established as key institutions at State level but both have limited institutional capacity to focus

on financial sector issues.

71. The financial sector consumer protection framework has been significantly

enhanced in recent years in BiH. The amendments to the Laws on Banking Agency in both

the RS and FBiH placed the responsibility for the regulation and supervision of consumer

protection in the banking, microfinance and leasing sectors to the respective Banking Agencies.

Even for the branches of financial institutions that do not have headquarters in their territories,

both Banking Agencies are authorized to initiate onsite inspections within the context of

consumer protection.

72. RS has adopted additional consumer protection regulations within the existing

framework of financial legislation in 2011. With the amendments to the Law on Banks28, RS

introduced mandatory disclosure elements for financial services provided to individuals

broadly in line with EU Consumer Credit Directive. Among these elements are: the effective

interest rate (EIR), references or indices used for variable interest rate calculations, fees, terms

and manner of early withdrawal/repayment, beneficiary’s rights to renouncement, and

protection procedures. The indexation of variable interest rates and the disclosure of its

calculation are particularly important as these were the main areas of complaints prior to the

amendments.

73. Along with disclosure requirements, the introduction of an independent banking

system ombudsman office29 yielded successful results in RS. An independent ombudsman

office has been established under the RS Banking Agency in 2011 in order to improve the out-

of-court dispute settlement mechanism between financial institutions and individuals. In 2012

and 2013, the ombudsman office received around 212 complaints30 and 93 of those were

solved in favor of the beneficiaries. Most of the complaints were related to disputes before the

28 In addition to the Law on Banks, the Law on Micro-Credit Organizations and the Law on Leasing has also

been improved in compliance with EU Directives. 29 This covers the microcredit and leasing sectors in addition to the banking sector. 30 Excluding the ill-founded complaints and well-founded complaints withdrawn after submission.

31

adoption of amendments to the Law on Banks on consumer protection, with 90 percent of

complaints on banks and 70 percent related to loan operations.

74. In the Federation, a Law on Protection of Users of Financial Services has been

enacted in November 2014 and is an important step towards improving the financial

consumer protection framework. The law includes most of the elements of the EU Consumer

Credit Directive, including providing information in the negotiations phase, the disclosure of

annual effective interest rates, uniform calculation methodologies for effective interest rates

and variable interest rates, and the introduction of a cooling off-period. Meanwhile, an

ombudsman department established in the FBiH by amendments to the Law on Banking

Agency of the Federation of Bosnia and Herzegovina in 2012 (“Official Gazette of the FBiH”,

No. 77/12) has started operating in April 2014. As of September 2014, the Ombudsman has

received over 100 complaints but most of them were ill-founded and none were taken to the

mediation stage. Variable interest rate calculations, fees and repayment obligations of

guarantors were among the areas receiving the most complaints. While the authorities are to

be commended for these steps, more time is needed for an in-depth assessment of their real

impact on financial consumer protection.

75. The Law on Protection of Guarantors was adopted in FBiH in November 2013. As

more and more borrowers have failed to repay their loans following the global financial crisis,

guarantors came under severe pressure. In response to this, the government of FBiH adopted

a new law that includes a subset of disclosure requirements in the Law on Protection of Users

of Financial Services as well as the passing of the Law on Protection of Guarantors introducing

stringent requirements such as the right to safety of the guarantor, in cases when the creditors

fail to undertake all legal measures to check the primary borrower. The response of the financial

sector to this regulatory change was to use co-debtors instead of guarantors, or to require

loan insurance from the borrowers. The impacts of these developments on consumer

protection and access to finance are yet to be seen. Thus, it is recommended to conduct an

assessment of the law within a year after its adoption.

76. Despite improvements in the financial sector consumer protection framework,

improvement is needed on the disclosure regimes and dispute settlement mechanism in

BiH. It is recommended that transparency and disclosure of information in the banking and

MCO sectors should be improved by

Aligning the Effective Interest Rate (EIR) calculation methodology with EU

standards to ensure comparability,

Developing a standard Key Facts Statement31 to help consumers understand

the essential conditions of their contracts,

31 “Key facts statement” summarizes in plain language on 1-2 pages the key terms and conditions

of the contract for any financial product or service. The key facts statement would neither replace

nor be a part of the terms and conditions for a financial product or service, but would be required

to be given to the consumer to help him or her understand every essential term and condition.

Such statement should clearly indicate all fees and charges related to a financial contract or

product, as well as the mechanisms for recourse available to the consumer in the event of a

32

Publishing a tariff comparison table for banks and MCOs on a public sector-

operated website e.g. website of the Banking Agencies or Banking

Ombudsmen (which could also lower the interest rates by increasing the

competitiveness in the market).32 The tariff comparisons would be based on

standardized products.

In addition, the dispute settlement mechanism could be strengthened further by enabling the

ombudsmen to give binding decisions for complaints on transactions below a certain small

amount.33

77. A greatly expanded code of conduct, or consumer protection code, could help to

improve the practices of commercial banks vis-à-vis their retail customers in both

entities. While a code of conduct has already been developed by the Banks’ Association and

AMFI, this code is not well-known, even to members of the associations. The value of any code

of conduct is its widespread distribution so that consumers know that in principle, financial

institutions commit themselves to provide minimum service standards and to respond to

individual consumer’s complaints and disputes. The code of conduct should be placed in all

bank and MCO branches, and on their respective websites. Consumers should be advised that

if a bank or MCO fails to comply with the code of conduct, a complaint can be submitted to

the institution, the relevant Association, and the Banking Agency.

78. In general, financial knowledge of BiH citizens is low and the number of financial

education initiatives is limited. The World Bank funded a Financial Literacy Survey in mid-

2011, based on a random, nation-wide sample of citizens of BiH aged 18 or older. The Survey

showed that the general financial knowledge of BiH citizens was low, as indicated by the

average score of about 5.5 correct answers out of 13. There are some isolated measures

undertaken by government agencies and consumer organizations, as well as certain financial

and private institutions. However, there is no coordination of activities or a national strategy

on financial education.

79. The development and implementation of a financial education strategy or

program is recommended. There is a significant need for a comprehensive, nationwide

financial education strategy taking into account the issues related to financial planning and

customer rights. It is recommended that a Task Force or Steering Committee be established,

potentially comprising the financial regulators, CBBH and other stakeholders in the financial

sector, to bring together various ongoing and planned initiatives into a coordinated program

that has resources, among others, to extend to women and bottom-40 income earners. Also,

complaint. Examples of key facts statements include the EU’s Standard European Consumer Credit

Information, the US’ Schumer Box for credit cards and Peru’s Hoja Resumen (Summary Sheet). 32 Such comparison tables exist on both privately-run and publicly-operated websites, yet they are not

updated frequently and not known by most of the population. Some examples can be found at:

http://responsiblefinance.worldbank.org/~/media/GIAWB/FL/Documents/Publications/Public-

SectorOperated-Price-Comparison-Websites.pdf 33 For further details please see

http://siteresources.worldbank.org/EXTFINANCIALSECTOR/Resources/Financial_Ombudsmen_Vol1_Fundame

ntals.pdf

33

a national survey of financial literacy should be conducted regularly to gauge the results of

policies.

34

ANNEX I

Partial Credit Guarantee Funds: the Case of FOGAPE

FOGAPE is a guarantee system in Chile that allows SMEs to overcome their lack of collateral

or require longer maturities. It is a public fund managed by Banco Estado (a government agency)

that provides partial credit guarantees to working capital loans or investment loans provided by

commercial banks to SMEs. Its design includes several features to reduce moral hazard problems:

partial credit guarantees that force banks to share part of the risk, a bidding process that determines

how risks are shared among FOGAPE and financial intermediaries, the exclusion of banks with high

default rates on guaranteed loans from future bidding processes, and limits on the guarantees that

each bank can obtain from FOGAPE.

Larraín and Quiroz (2006) investigated the impact of the fund. Their findings indicate that FOGAPE

achieved not only credit additionality but also economic additionality. It appears that customers of

FOGAPE are 14 percent more likely to get a loan than non-customers. The scheme appears to have

contributed to an increase in the volume of credit by 40 percent; turnover in the companies

benefiting from the fund increased by 6 percent. Nevertheless, it is important to note that the study

only looked at loans made in larger cities. There are still some questions about the impact of

FOGAPE in rural areas.

SME BANK

GuaranteeProgram

Loan Application

Loan Disbursement, Repayment

AllocatesGuarantees basedon lowest % covered (biddingprocess)

-Fee varies by FI, depending on loss (claim) rate-Loss rates (default) less than 2%-FIs keep responsibility for analysis and collection