Conclusions from CBA Analysis no. 20 DEVELOPMENT OF BANKING IN CROATIA: YEARS OF MATURING THROUGH INTERNATIONAL INTEGRATION 1999 – 2009

During the recent decade, the Croatian banking system has been reformed and has become a propulsive and competitive sector with a very positive contribution to the social stability and economic development. Reforms in the banking sector have been the sole segment in market reforms in which Croatia found itself at the top of the list of countries in transition. Consolidation, privatisation, reform of payment transactions, and intensified supervision and control are only some of the specific measures that have created one of the pivotal sectors of the Croatian economy.

Changes in Croatia have been a top of the wave of internationalisation that swept over the entire Central and Eastern Europe in the same period. Entry of foreign banks, which for the most part led to majority internationalisation of the banking systems and fast credit growth have occurred everywhere. Private sector has had the major benefit from such changes. Receivables from government have grown slightly while receivables from the private sector have grown at fast rate throughout the observed period. Receivables from population have grown faster than those from corporations, which led to the conclusions in some of the observers that banks were crediting consumption instead of production.

This conclusion ignores the changes in the financial structure. Financial substitutes such as factoring, leasing, direct indebtedness abroad, issue of securities and commercial crediting have developed at fast rate in the recent ten years. When all financial channels are taken into account, corporate financing has remained much more significant than population financing. However, the role of new financial brokers, instruments and markets has pointed out to the new role of banks. Banks started to function as centres of complex financial groups, integrated vertically (on international level) and horizontally (including a number of various agents on various financial markets).

In such conditions, two possible views of the banks’ development role are possible. A narrow view is an emphasis of the link between credit activities and overall economic activities. This link has doubtlessly been established which means, that in addition to direct production of additional value, banks produce major supplemental benefits. These benefits are reflected in a significant fall of interest rates; in a part of the observed period, some of them have not only approached but fit into the interest intervals applicable in the Eurozone.

A wider view expands the development role of banks even more. The quality standpoint emphasizes their capacity to keep the financial stability, integrity of payment system, trust, as well as capacity for fixed-term transformation of funds. To be able to perform such functions, banks must unify the knowledge and capital, which they succeeded in the recent 10 years. Capital adequacy was continuously far above the prescribed minimum, and non-performing loans were also decreasing.

In that period, deep structural changes took place – the number of banks has been reduced, and the share of the four leading banks has increased. This did not weaken the competition. On the contrary, fall of interest margin and profitability ratios (ROA and ROE) in the context of continuous progress of cost efficacy support the thesis that in the entire observed period there was powerful competition of major stakeholders in the banking sector. This fact is quite visible through non-price competition ratios, such as growth of territorial spread of distribution channels and application of technological and production innovations.

It is extremely difficult to manage a monetary policy in a banking system integrated both vertically and horizontally and featuring many financial substitutes. A reasonable selection of the exchange rate as an anchor of financial stability has caused major oscillations in money mass and interest rates on the money market and practically made impossible the effects of the monetary policy on the offer of loans. Possibility of easy access by banks to relatively cheap international funds occurred at the moment when a strong rise of foreign currency deposits was completed at the moment of conversion of European currencies into euro. Credit expansion based on banks’ indebtedness abroad forced the central bank to introduce a number of measures focused on making foreign sources more expensive (e.g. margin reserve requirements since 2004) and direct restriction of the growth of lending (since 2007). To all appearances, CNB thereby did not succeed in prevention of indebtedness of non-financial sectors; it only stimulated banks to additional capital infusion. Even that effect is not easily proved and the effects of the measures used in this decade will for some time be controversial and subject to various analyses.

In any case, banks were ready for the crisis due to more than solid capitalisation which definitely may be attributed to prudential measures such as introduction of additional capital requirement for currency induced credit risks.

Effects of the world crisis on the European periphery from Island to Ukraine have been various. Countries with a lower share of foreign banks on domestic market were much more affected with the exception of Slovenia as a member of EMU. Own currency and flexible exchange rate appeared as a risk factor and not an advantage, as currency risks caused powerful capital outflows.    

While the developed world makes efforts to resolve the consequences of crisis with the new rules of determination of capital requirement in the banks and regulating the bonus for banks’ employees, European developing countries are facing different issues:

• How to speed up the integration processes and particularly how to eliminate or significantly reduce currency risk and thereby the constant risk of financial and currency crisis?
• How to ensure on long-term basis the appropriate effect of local supervisors if any of the subsidiaries of international groups falls into troubles?

These issues will be of major importance for the development of banking in the following ten years.