I will speak on the financial stability experience of Kosovo. Like Montenegro, we have also adopted the euro unilaterally. This makes a difference compared to other countries with unofficial, partial euroization. So, I will try to make a distinction between a central bank that has monetary policy and a central bank that does not have monetary policy, and focus on the extent to which this is relevant for financial stability purposes.
Coming from a central bank without monetary policy, it is not very easy to speak on monetary policy issues in front of people, who conduct the monetary policy in their central banks. Nonetheless, I will try to make some points summarized in Figure 1.
Financial stability has become an important objective for almost every central bank. Central banks can pursue financial stability objectives mainly through two policy tools, including the monetary policy, which acts primarily via short-term interest rates on loans to banks, and more recently the macro-prudential policies. Recently, especially after the crisis, monetary policy has been increasingly used for financial stability purposes in many countries, and several central banks have already incorporated financial stability into their key objectives. However, key questions remain on whether a central bank can pursue financial stability objectives through monetary policy instruments and on the modalities to do so. What about central banks (for example, in the case of Kosovo) that do not have monetary policy? Can they still be effective in maintaining stable financial sectors? In the following part of my presentation, I will try to address these questions and contextualize them in the case of Kosovo.
The most common way for the monetary policy to pursue financial stability objectives is to engage in countercyclical policies or to “lean against the wind” by setting policy interest rates that are higher than what would be required for stabilizing inflation or output. This is also in line with the previous discussions, in which many argued that low interest rates can induce higher risk taking. In this regard, setting high interest rates would, on the one hand, discourage households and firms from borrowing and, on the other hand, may encourage banks to reduce their leverage ratios. Therefore, higher interest rates are expected to reduce the level of risk.
Also, the central banks that have monetary policy can use monetary policy instruments to increase the money supply and exercise the lender of last resort (LOLR) function by injecting liquidity into distressed banks.
Therefore, monetary policy instruments can be used to enhance or restore the financial stability. However, are they always effective in the pursuit of financial stability? Let us elaborate on some issues that suggest that monetary policy may not necessarily be effective as a tool to safeguard the financial stability. By setting higher interest rates, the central bank can discourage borrowing and reduce leverage, but at the same time it can reduce the aggregate demand and weaken the general economic activity, hence possibly decreasing the capacity of borrowers to repay their loans. Also, when liabilities have variable rates and short-term maturities, the increase of interest rates may increase debt servicing costs. In this way, the policies that increase the interest rate may further weaken the capacity of borrowers to repay their loans. This shows that monetary policy, though an important policy tool, has its own limitations and may not serve as a readily available tool to pursue the financial stability objectives.
In addition, despite the enhanced role of financial stability in central banks’ mandates, the primary objective of most of the central banks remains price and output stability. In this regard, central banks may face trade-offs between pursuing financial stability objectives and their traditional objectives, which are price stability and output or employment stability. Therefore, engaging in countercyclical behavior, that is, leaning against the wind by increasing the interest rate, involves paying a short-term cost by having a negative impact on output or employment in exchange for a medium-term benefit in the form of lower expected costs from the financial crisis (IMF Staff Report, 2015). This trade-off between financial stability and price stability objectives may undermine central bank credibility, because the short-term costs in terms of lower output or employment are very easily observable by the public, whereas the medium-term benefits in terms of lower expected costs from the financial crisis may never occur and are not easily observable by the public. In other words, leaning against the wind entails bearing a certain cost, which is widely felt by economic agents, in exchange for a potential benefit that is not certain to appear and, even if it does, it is not easy for it to be noticed by the wider public. Thus, leaning against the wind may damage the credibility of the central bank, and this loss of credibility may undermine the effectiveness of monetary policy and may even de-anchor the inflation expectations.
Another issue regarding the effectiveness of monetary policy in pursuing financial stability objectives is related to the effectiveness of the monetary policy transmission mechanism, especially in countries that have a high scale of euroization.
Under such circumstances, even if you have discretion over the monetary policy, you will not necessarily be able to affect the stability of the financial sector. Furthermore, even though the central bank’s interest rate is important in driving the interest rates charged by banks, we know that there are also other interest rates that may be important and relevant in the market, meaning that the transmission of the central bank interest rate to the commercial bank interest rate may not be very strong (Billi and Vredin, 2014).
Another channel through which central banks can have an impact on the financial stability is the LOLR function. The countries that have their own currency can be more effective in exercising the LOLR function because they can extend unlimited amounts of funds in their own currency, in case of need. However, in countries that have a large share of foreign deposits, the central bank may not be very effective in using the LOLR function, because its ability to use this function will depend on the amount of the international reserves available or the ability to increase them by borrowing. Even if the central bank can use this function, the active use of it may induce moral hazard by reducing the incentives of banks to manage their liquidity in a prudent manner, to act responsibly in accordance with their risk-bearing capabilities and, in case of crisis, to recapitalize and restructure.
So, having looked at the ways in which monetary policy can be used to pursue financial stability objectives and its limitations to do so, let’s now turn to the case of Kosovo and see how it dealt with financial stability under the conditions of unilateral euroization, which means no or very limited monetary policy tools are available. Kosovo’s experience is summarized in Figure 2.
The use of euro in Kosovo has strengthened the macroeconomic stability leading to low and stable inflation, which has been in line with the inflation rates in the euro area – the region with which we have the strongest trading ties. The exchange rate risk has been minimized after the euroization. Over 95 percent of the balance sheet of the banking sector is denominated in euro. This has led to a stronger confidence of banks in the economy and also to a stronger confidence of depositors toward the banks. This is one of the reasons why the deposits on the banking system of Kosovo have been very stable. Even during the crisis time, the confidence of the depositors has never been dented.
Having the financial stability as the main objective of the Central Bank of the Republic of Kosovo (CBK) and not having any “headaches” with the exchange rate and price stability issues, the CBK has been able to focus on the development of functions that are more relevant to the financial stability. Even though the CBK is a relatively new central bank, it has been quite successful in developing these functions, including the bank supervision, regulation, licensing, and financial stability units.
I mentioned earlier the LOLR function. This is one of the limitations to the CBK brought by the unilateral euroization, but we have managed to offset it to some extent by introducing an emergency liquidity assistance scheme, which is jointly funded by the central bank capital and the Government of Kosovo. We have a fund intended to be used for injecting liquidity into solvent banks, which are experiencing short-term liquidity problems. In addition, 90 percent of the banking sector of Kosovo is foreign owned. Out of 10 banks, eight are foreign owned banks, which compose 90 percent of assets, which implies that, in case there are additional needs for liquidity, we can expect a flow from the parent banks. Another argument for this is that the foreign banks that operate in Kosovo are very important in terms of size for Kosovo, but are very small relative to their own groups. So, we expect that any liquidity need of foreign banks in Kosovo would be easily fulfilled by their parent banks, because it would be a very small amount compared to the size of the parent bank.
The limited space of the CBK to act through the LOLR function has led to more conservative behavior by the central bank in terms of banks’ supervision, and also to a more disciplined behavior by the banks themselves. Banks in Kosovo are very much aware that they cannot easily knock on the door of the central bank to get help. This has encouraged a very disciplined behavior from a banking system that has remained sound, as it could not rely on the central bank liquidity back stop.
In terms of recapitalization needs, should a bank need such intervention, it is rather an issue for the government than for the central bank. The lack of monetary policy instruments may not be highly relevant in this context. This issue is mainly related to the solvency of the government, rather than to the capacity of the central bank to support the commercial banks.
The CBK has developed recently a macro-prudential framework, which, to some extent, is expected to fill some of the potential gaps created due to the lack of monetary policy. We have developed this framework based on the guidelines of the European Systemic Risk Board (ESRB) and we have also established a macro-prudential Advisory Committee within the central bank, composed of the heads of the relevant departments within the central bank. So far, the role of this committee has been mainly to analyze financial stability developments and the identification of the build up of any potential risk, while no macro-prudential measures have been deemed necessary to be taken so far. The macro-prudential policy has the advantage of being capable to target the risks closer to their source, in contrast with the monetary policy, which may be less able to deal with specific risks occurring in the banking sector.
Given all this, now let’s see briefly how Kosovo is performing in terms of financial stability. We have had a robust growth of credit to the private sector as evidenced by Figure 3, which has been mostly financed by domestically-collected deposits. In fact, it is also a characteristic of the banking sector in Kosovo that we have a small degree of exposure toward the external sector, both in terms of loans and deposits. Domestically-collected deposits amount to around 80 percent of total liabilities, which means that our banks have not relied very much on the developments in the external financial markets.
Despite the quite sustainable increase of lending, still the loan-to-GDP ratio remains below the average of the region, as exhibited in Figure 4. This means that there is still space to deepen financial intermediation, but here we must acknowledge the fact that the Kosovo banking sector started to operate later than the rest of the region. The sustainable lending activity growth has enabled a gradual convergence toward the average financial intermediation ratio of the rest of the region.
The already good portfolio quality has further improved during recent years, as exhibited by Figure 5. At the end of 2016, the non-performing loans (NPL) ratio was 4.9 percent and it has further declined in March 2017 to 4.5 percent. As we can see, the NPL ratio has remained very low all the time and it has not experienced any recent sharp spike, as observed in some of our neighboring countries. It peaked in 2013, when it reached 8.7 percent, but it has never reached two-digit figures. The reasons for this are related quite a lot to that conservative behavior of the banking sector that I mentioned earlier, and also to the fact that we started a new banking system and we did not inherit problems that the other countries did with state-owned banks and other similar problems. The first bank to operate in Kosovo was a foreign-owned bank and then the following banks were also foreign. Although two domestically-owned banks eventually started operating, they mostly hired the personnel from the foreign-owned banks, which means that we started the banking sector by applying modern banking practices, and this is one of the reasons that the quality of loan portfolio did not experience any deterioration.
The dynamics of the amount of total loans and the amount of NPL as evidenced in Figure 6 show that while total loans have maintained an upward trend, the amount of nonperforming loans has declined during recent years. The recent decline in the amount of nonperforming loans is related also to the legal reforms that have been undertaken in Kosovo. One of the most important problems in Kosovo was related to the efficiency of courts in enforcing contracts, but now we have amended the enforcement procedure law, which makes it very easy for banks to enforce contracts. Now the enforcement authorities can very easily freeze the banking accounts of bad debtors and transfer the amounts to the relevant parties. We have also reduced the number of auctions required to execute the collateral. Another important development is the functionalization of the private enforcement agents, which are helping a lot the courts in enforcing the contracts. These developments enable banks to offload some bad debts held on their balance sheet for some time and also impact the future attitude of borrowers in terms of abiding by the terms of their loan contracts. These developments have contributed to containing and reducing credit risk. The lower credit risk has contributed to a substantial decline of loan interest rates, which, until recently, were considered still excessively high.
Nonperforming loans remain very well provisioned with loan-loss provisions. As we can see from Figure 7, this ratio never dropped below 100 percent, which means that banks are being very careful in maintaining the loan-loss provisions.
As evidenced by Figure 8, the capitalization ratio of the banking system remains satisfactory, well above the regulatory requirement of 12 percent.
The loan-to-deposit ratio, as evidenced by Figure 9, remains below 80 percent, suggesting that still there is space for lending expansion without causing liquidity concerns.
Also, the liquidity position, shown in Figure 10, remains strong, with liquid assets to short-term liability standing above 40 percent.
Liquidity well above regulatory requirement
Liquidity well above regulatory requirement
Liquidity well above regulatory requirement
The degree of profitability remains satisfactory, with the profitability rates standing at higher levels compared to the banking sectors of the other countries in the region. This was due to the high interest rates on loans, but is also to the good quality of the loan portfolio. We can see in Figure 11 that the profitability levels remain high, despite the substantial narrowing of the interest rate spread from 8.5 percent in 2013 to 6 percent in 2016 (see Figure 12).
Interest rate gap substantially narrowed
Interest rate gap substantially narrowed
Interest rate gap substantially narrowed
We can see from Figure 12 that banks have maintained the deposits, interest rates at a low level during the past years, but have continuously reduced the interest rates on loans. I have presented data from 2013, but just in 2011 or 2012 the interest rates averaged 14 percent, and we can see that within a short period of time, they have halved average interest rates on loans. This was one of the main obstacles for access to finance, and we can see that banks are easing the access to finance. In addition to the judicial reform, other important factors that have affected the decline of loan interest rates include the steadily low deposit interest rates and increased banking sector competition. Even though we did not have a rapid increase in the number of banks, we can see that banks have started to compete more, by expanding in volume after the decline of interest rates. Currently, the interest rate spread in the banking sector of Kosovo stands at the average level of the region.
Let me summarize by drawing some conclusions from this presentation. Monetary policy appears to be an important tool to pursue financial stability, but it may not be necessarily effective. Therefore, monetary policy discretion in unilaterally euroized economies is not necessarily “missed” with regard to the financial stability, meaning that financial stability can be maintained even without full autonomy over the monetary policy. Unilateral euroization in Kosovo has reduced the financial risks and has enabled a greater focus on financial stability issues. In addition, as we can see from the recent decline of the interest rates in Kosovo and the decline of NPLs, the enhancement of the financial intermediation efficiency and the reduction of banking sector risks in unilateral euroized economies are rather pursued through structural reforms, which may guarantee longer-term and healthier outcomes for the stability of the financial system and the economy in general.
The views expressed in this article are those of the author and do not necessarily represent the views of the Central Bank of the Republic of Kosovo.
