Republic of Croatia
Financial System Stability Assessment: Update

The 2002 Financial Stability Assessment Program (FSAP) found that the Croatian financial system was resilient, but vulnerabilities remain. The authorities have been proactive in addressing macroeconomic and financial vulnerabilities associated with rapid credit growth and have also taken prudential measures on contingency planning with supervisory authorities of foreign banks coupled with efforts to enhance risk awareness and strengthen home-host coordination. The Croatian National Bank (CNB) has put in place an effective bank supervision framework. The assessment reflected a legal and regulatory framework together with banking supervision practices of the Croatian authorities.


The 2002 Financial Stability Assessment Program (FSAP) found that the Croatian financial system was resilient, but vulnerabilities remain. The authorities have been proactive in addressing macroeconomic and financial vulnerabilities associated with rapid credit growth and have also taken prudential measures on contingency planning with supervisory authorities of foreign banks coupled with efforts to enhance risk awareness and strengthen home-host coordination. The Croatian National Bank (CNB) has put in place an effective bank supervision framework. The assessment reflected a legal and regulatory framework together with banking supervision practices of the Croatian authorities.

I. Background

1. The 2002 FSAP found that the Croatian financial system was resilient, but identified vulnerabilities in a number of areas. Large banks were found to be well-capitalized, and banking supervision was assessed as strong, though further improvements were needed in a few areas. The nonbank financial sector was relatively less developed and did not pose major systemic risks, but considerable weaknesses were identified in its supervisory and regulatory frameworks.

2. Since the 2002 FSAP, rapid progress has been made in strengthening the financial system, but new risks for financial stability have emerged. The regulatory and supervisory frameworks have improved, and most issues identified by the 2002 FSAP have since been addressed (Appendix II). However, both the banking and nonbank sectors have grown significantly and become more complex (Appendix III). In addition, many regulatory changes are being introduced in the context of EU accession and Basel II.

II. Sources of Potential Risk to Financial Stability

A. Macro-Financial Setting

3. Despite the solid macroeconomic performance of recent years, significant vulnerabilities have emerged. While GDP growth has been strong and inflation contained until recently, rapid (though slowing) growth of bank credit to the private sector has added to macroeconomic risks (see the accompanying staff report for more details).1 Credit growth has accompanied rising asset prices, a widening current account deficit, and external debt to levels that may not be sustainable from a macroeconomic perspective (Figure 2).2 Inflation also picked up, to above 6 percent year-on-year in early 2008. Moreover, a sudden correction of real estate and equity prices—with the latter already weakened from their October peaks—would adversely affect household and corporate balance sheets and could trigger an economic slowdown with potential second round effects on the banking sector.3

Figure 1.
Figure 1.

Central and Southern Eastern Europe: Indicators of Credit Growth

Bank credit to the private sector to GDP

Citation: IMF Staff Country Reports 2008, 160; 10.5089/9781451817485.002.A001

Source: IFS, ECB, National authorities, staff calculations, and WEO.
Figure 2.
Figure 2.

Croatia: Macroeconomic Risks Associated with Credit Growth

Rising External Imbalances

Citation: IMF Staff Country Reports 2008, 160; 10.5089/9781451817485.002.A001

Sources: CNB and ZSE.

4. croatia has been relatively unscathed by the global financial market turbulence, but some spillovers have been observed. Croatia has no direct exposures to the subprime market developments, and parent banks do not appear to have changed their willingness to fund Croatian subsidiaries. However, the spread on Croatian sovereign bonds relative to the Emerging Market Bond Index (EMBI) sharply rose from historical lows in mid-2007, and remained high compared with other emerging European countries (Figure 3). The widening of Croatia’s credit default swap (CDS) spreads may also suggest concerns with its external vulnerabilities. The stock market also experienced further falls in March 2008, in part due to liquidity disturbances from the renewed tensions in the global financial markets.

Figure 3.
Figure 3.

Croatia: Selected Financial Market Indicators

Citation: IMF Staff Country Reports 2008, 160; 10.5089/9781451817485.002.A001

Source: Bloomberg, and J.P. Morgan

5. The already high ratio of Croatian household debt to GDP continues to grow, raising macroeconomic concerns. As of end-September 2007, household debt stood at over 40 percent of GDP—one of the highest among the central and eastern European countries and comparable to the household debt levels in some core EU economies. The share of bank lending to households rose significantly from around 33 percent of total loans in 1998 to 55 percent in 2005, and subsequently stabilized around this level, with about 40 percent of households loans for housing.

6. The rising household debt ratio also increases the vulnerability of banks to a deterioration in debt servicing capacity. Of particular concern is the high, albeit declining, share of the FX-linked loans (i.e., denominated in or indexed to foreign currencies, Figure 4), to mostly unhedged customers,4 exposing banks to an indirect FX risk. Another source of concern is that the majority of loans, even mortgage loans with average maturity of around 20 years, are issued at floating rates linked to local or euro-area interbank market rates (less than 20 percent of all outstanding loans are at fixed rates), and are re-calculated quarterly, subjecting banks to credit risk through customers’ interest rate exposure.

Figure 4.
Figure 4.

Croatia: Prudential Risks Associated with Credit Growth

Citation: IMF Staff Country Reports 2008, 160; 10.5089/9781451817485.002.A001

Sources: CNB.

7. The debt burden of the non-financial corporations is also growing rapidly. The debt burden totaled 59 percent of GDP in end-2006. Debt owed to banks dominates the non-financial corporate debt structure, at around 57 percent of the total debt in 2006, and 54 percent of the loans are FX-linked. Current corporate financial performance indicators are broadly satisfactory, with return on equity steadily increasing in the last few years (from 1.8 percent in 2003 to 5.1 percent in 2006), and the ratio of nonperforming loans (NPLs) to total corporate loans steadily falling. The latter, however, has largely reflected the overall growth in corporate loans, with the amount of NPLs remaining relatively stable. While bank loans to the corporate sector are sufficiently diversified, the loan share of manufacturing or other productive capacity-generating and export-enhancing sectors is relatively small.

8. A further concern is that deregulation and strong competition resulted in banks’ lowering their underwriting standards.5 This weakening was indicated by the rapid expansion of FX-linked loans (particularly to the Swiss franc) to unhedged borrowers in 2005-06, the lengthening of mortgage maturities, and by a more general relaxation of requirements to qualify for various types of loans. While higher income households are still viewed to be the main borrowers, a growing share of bank lending is now channeled to low-and middle-income households. There are recent signs of tighter lending standards by some banks (e.g., through higher lending rates and tighter loan granting conditions), in part in response to the CNB measures, but lending practices need to remain under close watch.

9. With a significant share of foreign banks in the banking system, Croatian banks are exposed to external developments and contagion risks through their increased reliance on foreign funding. The strong growth of banks’ deposit base have supported the growth of credit to the private sector in recent years, but banks became increasingly dependent on foreign borrowing (including from their parent banks) until mid-2006.6 The reliance on foreign funding has in turn increased vulnerability to contagion risks, with the exposure highly concentrated (mainly to Austria, Italy, and France—Figure 5). Problems in a parent bank could be transmitted to local banks, given the high concentration of exposures to only a few countries.7 While reputational risks may render it unlikely that parent banks would not support their subsidiaries, the level and degree of their support would depend on general market conditions and cannot be assumed.8

Figure 5.
Figure 5.

Croatia’s Exposure to the Main Home Countries of Parent Banks1

Citation: IMF Staff Country Reports 2008, 160; 10.5089/9781451817485.002.A001

1 Share of Croatia in a given country’s total exposure to emerging Europe is 13 percent for Austria, 6 percent for Italy, 7 percent for France, and 2 percent for Germany.2Includes Belgium, UK, Netherlands, Switzerland, and Portugal.

III. Stability Assessment of the Financial System

A. Banking Sector

10. Financial soundness indicators (FSIs) suggest a reasonably healthy banking sector, including by regional standards (Table 2 and Figure 6). As of end-2007, the capital adequacy ratio (CAR) recovered to 16 percent, after dropping to 13.6 percent in 2006, reflecting, in part, the preference of foreign parent banks to inject additional capital to their subsidiaries rather than lend, given the high marginal reserve and foreign currency liquid asset requirements. The NPL ratio is on a declining trend, although this indicator tends to lag the cycle. Though still high, profitability has been falling in recent years, reflecting the narrowing interest margins under growing competition for market shares, and the effect of higher reserve requirements.

Table 2.

Croatia: Financial Soundness Indicators, 2002-07

(In percent, unless otherwise indicated)

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Source: CNB.

September 2007.

Figure 6.
Figure 6.

Selected Emerging European Countries: Financial Soundness Indicators

Citation: IMF Staff Country Reports 2008, 160; 10.5089/9781451817485.002.A001

Source: GFSR1/ September 2007 data for all countries, except for Albania and Slovenia (December 2006), Hungary (March 2007), Serbia, Montenegro, Russia, and Slovak Republic (June 2007).2/ September 2007 data for all countries, except for Albania and Slovenia (December 2006), Hungary (March 2007), Serbia, Montenegro, Poland, Russia, and Slovak Republic (June 2007).

11. Stress tests carried out jointly by the FSAP team and the CNB staff analyzed the extent of the vulnerabilities discussed in Section II and sensitivity of banks’ condition to a number of shocks. The tests included single factor sensitivity tests and macro scenarios agreed with the authorities. The former considered both direct and indirect credit risk induced by FX and interest rate exposure, and exchange rate, liquidity, and interest rate risks.9 Taking into account historical experience, the tests simulated very large but plausible shocks: a slowdown or a reversal in capital inflows, an economic slowdown in the euro area with a spillover to Croatia, and higher global interest rates, all resulting in a significant rise in domestic interest rates, sharp kuna depreciation, and a corresponding rise in NPLs given exposures to interest and exchange rate risks. Appendix IV provides the tests and the detailed results.

12. While the banking system capitalization is currently sufficient to withstand a range of shocks, banks are vulnerable to liquidity, contagion, interest rate- and foreign currency-induced credit risks. Under a capital inflow reversal scenario that results in a significant depreciation of the kuna and higher interest rates, the CAR would fall below the 10 percent regulatory minimum for 21 of 33 banks with a total of 55 percent of system assets (Table 3), and five banks would become insolvent. A slowdown in the euro area and higher global interest rates would significantly reduce banks’ capital, but leave the aggregate CAR above 10 percent, with no insolvencies.10 An outflow of 20 percent of bank liabilities with maturity up to three months would push the liquid asset ratios of the banking system down from 16 percent to 11 percent. Contagion from a parent bank or a reassessment of risk facing a Croatian subsidiary by its parent bank could also have a substantial impact on liquidity due to the dependence on parents for funding.

Table 3.

Summary Results of the Stress Tests Under Alternative Scenarios

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The minimum regulatory CAR is 10 percent.

Sub-groups by size are large banks (L) with share in total assets above 5 percent, medium sized banks (M) with share in total assets between 1 and 5 percent, and small banks (S) with share in assets below 1 percent.

Sub groups by ownership are foreign owned banks (FO), domestic privately owned banks (DO), and state owned banks (SO).

Assumes a depreciation of the kuna by 10 percent, an increase of kuna rates by 200bp, a decrease of euro interest rates by 50 bp, an additional increase of NPLs by 30 percent and an implied overall increase of NPLR by 118 percent.

Assumes a depreciation of the kuna by 30 percent, an increase of kuna interest rates by 300 bp and an implied overall increase of NPLR by 251 percent.

Assumes an increase of kuna interest rates by 200 bp, an increase of euro interest rates by 200 bp, an additional increase of NPLR by 10 percent and implied overall increase of NPLR by 146 percent.

13. There is a high degree of heterogeneity in the impact of the shocks among various banks and subgroups of banks (Table 3). In particular, smaller banks and state-owned banks exhibit greater vulnerability to direct and indirect credit risks, while foreign-owned banks, including some systemically important ones, exhibit greater vulnerability to liquidity and contagion risks, given their significant dependence on funding from parent banks and wholesale foreign deposits. State-owned banks also seem particularly vulnerable to liquidity shocks, reflecting mainly a large maturity mismatch between the liquid assets and the liabilities in one of the banks.

14. The stress tests suggest that higher capital buffers may be needed, particularly for the most vulnerable banks, to protect against worst-case but plausible scenarios. They also suggest that to assess bank resilience, backward-looking FSIs should be combined with regular forward-looking analyses, in particular to: strengthen stress testing analyses at the CNB by integrating scenario analyses in the tests and establishing data sources to facilitate quantitative assessment of various exposures; encourage stress testing among banks as part of risk management practices (for credit, liquidity, and market risks); and monitor closely the more-easily-overlooked small banks that show vulnerabilities and bank practices that could potentially heighten risks. Including benchmarks to assess liquidity risks as part of supervisory oversight would also be useful. Since the FSAP update mission, the CNB has intensified work on forward-looking stress tests to explore their sensitivity to additional shocks and scenarios, and plans to produce a forward-looking financial stability report.

B. Nonbank Financial Sector and cross Sectoral Developments and Risks

15. While smaller than the banking sector, the systemic importance of the NBFIs has increased since the 2002 FSAP, warranting a closer examination of the risk exposures of these institutions. Some nonbank financial institutions are direct subsidiaries of foreign parent banks while others are owned by the local banks, and there are important intragroup linkages in terms of ownership and activity (e.g., mortgage loan borrowers are required to provide collateral in the form of life and hazard insurance, and banks insure their credit risks). The full scope of cross-ownership and cross-sector exposures, however, is not known. A consolidated mapping of ownership and exposure links would help identify the extent of risk exposures, providing information for necessary actions.

Capital markets

16. Croatia’s capital markets have experienced very rapid growth, but the market continues to lack depth and liquidity. Equities have been the key driver of the rapid capital market growth. While market capitalization has more than tripled since 2001 to 133 percent of GDP at end-September 2007, the overall turnover ratio averaged 8.1 percent of capitalization, one of the lowest in the region. The existence of a number of company stocks that trade with a very low free float (the estimated amount of shares not readily and freely available for resale) contributes to low market liquidity and to the possibility that large orders generate significant price volatility.

17. The very rapid growth of the stock market has raised valuation concerns and the risk of a correction. The limited supply of securities coupled with increasing demand had exerted substantial pressure on the prices, though significant price correction has indeed taken place since early 2008. The favorable tax regime applied to equities likely also contributes to the popularity of the market. Investor education of the risks in the system, which the authorities have started addressing after the FSAP update, is needed to temper over-enthusiasm and herd behavior.

18. Further deepening of the capital market should be supported by: (i) stronger enforcement of disclosure requirements; (ii) strengthening shareholder rights by revising provisions in the Companies Act regulating conflicts of interest; (iii) enhanced market surveillance and analysis; (iv) an adequate legal framework and de-mutualization of the stock exchange to enhance market integrity; and (v) addressing the legal framework for the finality of settlement (to be introduced with the Capital Market Act). Increased sale and privatization of public enterprise shares could add to market liquidity.

The pension sector

19. The new mandatory pension funds (the second pillar) introduced in 2002 have grown in importance, but face challenges. Total assets reached 7.7 percent of GDP by August 2007. However, the 5 percent contribution rate (of gross salary) is quite low for a privately funded pillar that still functions mainly as a supplement to the public system. The contribution rate needs to be raised significantly, taking into account fiscal implications.11 Investment policies of the funds face regulatory restrictions and supply constraints: the funds are required to invest at least 50 percent of assets in government bonds and cannot place more than 20 percent in foreign assets. These restrictions will be lifted on EU accession.

20. The voluntary pension system is small, and participation is modest. Voluntary funds are subject to fewer investment restrictions, although the limit on foreign securities remains restrictive. A small subsidy is provided in the form of a government co-contribution to individuals participating in voluntary funds, which needs to be removed, and foreign investment limits liberalized to provide broader client choice.

The insurance sector

21. The non-life insurance sector is reasonably well developed, but life insurance is lagging behind. The share of life premiums in total premiums grew between 2000 and 2006, stimulated by the growth of the unit-linked business. Market concentration is high, with foreign-controlled companies having grown in relative importance. The insurance business is generally free of overly restrictive regulations. Observed risk retention ratios are high and need to be monitored to ensure that risk transfer mechanisms are being used appropriately.

22. Mortgage loan providers in Croatia frequently require the borrower to purchase a life insurance policy as collateral. The intent is to ensure coverage of mortgage payments through the payable benefit. While this practice has been customary in other countries, especially where collateral recovery is slow, its use as an obligatory collateral requirement needs to be based on fair pricing, and not to promote the insurance business within financial groups, and the customer needs to be sufficiently informed and protected.

The leasing sector

23. Risks stemming from the leasing sector have diminished with the new Leasing Act, and the regulation and supervision of leasing companies by HANFA. The new Act prohibits direct credit extension by leasing companies, which had stimulated their growth in the previous years to claim 11 percent of the financial sector assets—second to the banking sector. The Act also requires more stringent capital thresholds, fit and proper requirements, management and supervisory board structures, and risk management rules.

24. Nonetheless, greater efforts are needed to fully assess the developments in the sector, including profit/loss dynamics, ownership structures, interest rate and funding risks through effective regulatory reporting and risk analysis. Capital adequacy of the firms needs better assessment to ensure it is commensurate with the size and risk of operations. Changes in ownership and funding structures that may generate risks need to be monitored in collaboration with home supervisors. Including leasing clients in the credit registry—subject to the change in legislation—would improve information on debtors.

IV. Mitigation of Risks: Regulatory and Supervisory Issues

A. Measures to Address Rapid Credit Growth and Risks

25. The authorities have been proactive in addressing the macroeconomic and financial vulnerabilities associated with rapid credit growth. Concerned with the pace of credit growth against a relatively high base, rising external imbalances, and their potential implications for financial stability, the authorities adopted prudential and supervisory measures to limit the macro-financial vulnerabilities, including higher capital requirements for market risk, higher risk weights for unhedged FX-loans, guidelines for managing risks related to household and FX loans, and a link between capital adequacy and credit growth (Table 4). The CNB also adopted administrative measures to curb credit and external debt, against the background of deteriorating macro imbalances, intermittent support from fiscal policy, and limited instruments under a tightly managed exchange rate and high levels of financial euroization. Also, leasing companies were prohibited from extending loans and a credit registry was set up to enhance debtor information.

Table 4.

Croatia: Measures to Address Credit Growth

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26. The measures overall have achieved some positive results. The administrative credit measures have contributed to a slowdown in bank credit, as intended, and total credit growth to the private sector from domestic and external sources also slowed, though more modestly (a fall of 3 percentage points in total credit vs. 7 percentage points in bank credit at end-2007 vis-à-vis end-2006). Together with rising interest rates in the euro area, the prudential measures have contributed to a fall in the share of FX-linked loans in total loans. Banks seem more aware of risks related to such loans, have reduced their foreign borrowing, and intensified efforts to attract deposits and capital. However, the administrative measures have negative side effects, with potential implications for financial stability, intermediation, and market development (Box 1).12

27. Looking ahead, developing a plan for the eventual elimination of administrative measures is an important task. Beside their negative side effects, Croatia’s accession to the EU, likely in 2010-11, and eventual euro adoption would require a change in the existing policy framework to the extent that some regulations are incompatible or difficult to sustain under the EU integration.13

The Effects of the CNB Measures to Deal with Rapid Credit Growth

The prudential and administrative measures adopted in recent years have achieved some favorable results in addressing the vulnerabilities associated with rapid credit growth. The administrative measures have contributed to slowing the growth of bank credit since the beginning of 2007. Together with higher interest rates in the euro area, the guidelines for risk management, higher risk weights on unhedged FX loans, and the broadening of the base for FX LAR pushed banks to reduce the share of FX-linked loans. Banks have intensified efforts to attract deposits to fund their activities. Capital adequacy has also increased, in part because foreign-owned banks now find it cheaper to raise capital from the parents rather than rely on foreign borrowing subject to the CNB measures. Banks’ awareness of risks improved, especially regarding unhedged FX lending.

At the same time, the measures have some consequences that may have potential implications for financial stability. In the presence of the effective credit limits, foreign banks help arrange direct cross-border borrowing for their clients, typically for the most creditworthy large corporates, leaving the Croatian banks mostly with customers with no other sources of financing. The banks’ attempts to raise additional funds in the form of capital, rather than foreign borrowing to avoid the reserve requirements make the link between capital and the risks that it is supposed to cover more complex. Banks’ seeking higher returns to make up for the impact of effective limits on expanding loan volumes also increase their risk appetite. The implementation of the measures also have administrative costs for banks and the CNB, as attempts to circumvent the regulations prompt successive adjustments in their scope.

Also, the administrative measures have potentially negative longer-term implications. They encourage financial disintermediation as the banks’ ability to meet client demand is constrained by the credit limits and the current market shares in the system are preserved. They would also undermine access to credit, particularly for small- and medium-sized enterprises, with banks directing loans within the prescribed limits to the retail sector—more profitable, though riskier, sector with no productivity enhancing potential. The subsequent tightening of the credit limits (by limiting the monthly growth and broadening the coverage to sister companies) also have the effect of hitting banks disproportionately and giving competitive advantage to stand-alone financial companies over those connected to a bank. While bond issuance by banks may have been used to circumvent the MRR, the SRR on bond issuance can hinder development of long-term instruments and liquidity and maturity management by banks.


Impact of the Measures on Bank Lending and Foreign Borrowing

Citation: IMF Staff Country Reports 2008, 160; 10.5089/9781451817485.002.A001

Source: CNB

28. The transition strategy should be carefully designed to avoid undermining financial stability. In particular, it needs to identify: which measures should be eliminated, considering their negative effects and compatibility with the EU and euro frame-works; the circumstances under which they could be eliminated; the timing and pace of their removal in light of the potential macroeconomic implications; and safeguards to limit the potential consequences. The latter would include supportive macroeconomic policies, a resilient banking system, and strong bank supervision. Tighter fiscal policies, in particular, would be crucial in reducing excess demand pressures as liquidity is reinjected to the system. Banks need to make prudent lending and borrowing decisions, and the CNB intensify its monitoring of bank lending, risk management, and loan granting standards. Further prudential measures could be considered to contain any emerging prudential risks. Efforts to increase risk awareness, effective home-host supervisory coordination, and deeper financial markets and instruments to facilitate risk management would also be important for the transition.

B. Bank Regulation and Supervision

29. The authorities have built the necessary expertise and put in place an effective framework for bank supervision. The overall assessment of the BCP conducted by the FSAP update was positive (Annex). Most significant weaknesses identified by the 2002 FSAP assessment have been addressed. The CNB has also established necessary remedial powers to deal with noncompliance with regulatory requirements, weaknesses in risk management and banks’ financial condition, although guidelines could be developed on when preemptive supervisory action might be undertaken and some pre-planning on actions in the event of a crisis. Significant progress has been made in the area of home-host supervisory coordination.14 Only a few areas of bank supervision require further attention.15

30. An area that needs close attention is the lack of clarity on the supervision of the banking groups that include nonbanking operations. In particular, when a banking group includes nonbank operations, the CNB and HANFA cooperate through information exchange in accordance with the Memorandum of Understanding (MoU) established between the two institutions.16 There is a need to enhance consideration of group risks within a banking group, which are likely to grow as nonbanking activity within banking groups further develops, to clarify the lead supervisor role and to ensure that group risks are systematically monitored. The cross-sector risk exposures and close ownership links between banks and nonbanks call for stronger coordination between the CNB and HANFA to enhance the understanding of the risks bank and nonbank operations pose to the institutions subject to their respective supervision.

31. Basel II preparations are on track to become effective in January 2009. Most foreign banks—shareholders of Croatian banks, plan implementing internal ratings based (IRB) and advanced measurement approach (AMA). Their Croatian subsidiaries are either developing their own models or adjusting models developed by their parents (Table 5). Smaller domestic banks plan to implement standardized approach (SA) given the lack of data and experience for developing sophisticated models. The CNB and major Croatian banks seem well-placed to cope with the implementation. Impact studies are being prepared, including to assess the effect on capital. While the framework for risk-focused supervision is still evolving, the current supervisory techniques and risk management processes do not appear to pose risks for successful implementation. The CNB and banks also draw on knowledge from home supervisory authorities and parents. As in other countries, small banks are less prepared for implementation. Further dialog on a number of areas (e.g., consultative papers on Pillars 2 and 3 and the secondary legislation) would be helpful.

Table 5.

Croatia: Approaches for Basel II Implementation

(Based on the data as of June 2007)

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C. Nonbank Financial System Regulation and Supervision

32. Regulation and supervision of the nonbank financial sector has continued to improve since the 2002 FSAP. Many weaknesses identified by the 2002 FSAP have been addressed (Appendix II). HANFA, the unified regulator for the nonbank financial sector, was established in 2006 by integrating the former Croatian Securities Commission, Agency for Supervision of Pensions and Insurance, and Directorate for the Supervision of Insurance companies, and also assumed responsibility for supervision of the previously unregulated leasing companies. The inclusion of leasing companies under HANFA’s oversight has helped in narrowing a supervisory gap and room for circumvention of credit measures on banks. Coordination efforts on information sharing have been stepped up with the CNB. Work is also under way for joint inspections of banking groups under the CNB’s lead supervision, and to map cross-sector risk exposures and ownership linkages between banks and nonbanks.

33. The framework for securities, insurance, and pension regulation and supervision is largely in line with international standards, though some weaknesses remain. A potential weakness is the inability of the HANFA to directly impose fines without the court system. Another is the enforcement of financial statement disclosure and accounting and auditing standards for nonfinancial companies, a job shared between HANFA and other state and private institutions.17 A system of risk-oriented supervision also needs to be developed across the securities, pension, and insurance sectors, to include monitoring of risks and identify supervisory measures to mitigate them. In addition to complying with the regulation, supervision should focus on the management of various market risks as well as credit risks, and corporate/financial governance risks in the nonbank sector.

V. Systemic Liquidity Management and Contingency Planning

A. Systemic Liquidity Management

34. Although the CNB has a broad range of instruments to manage systemic liquidity,18 banks’ day-to-day liquidity management is complicated by the underdeveloped and segmented interbank money market. Daily turnover in the interbank market is low, with transactions concentrated in the unsecured overnight maturities, and no yield curve exists beyond one month. The market is unable to recycle liquidity across banks, with large banks relying on funds from the CNB, parents, or other large banks through bilateral arrangements, while small banks are constrained to trade with large banks given the exposure limits and internal limits set by their risk management systems. Limited amount of eligible collateral (kept for dealings with the CNB) and frequent changes in regulations also limit banks’ willingness to recycle excess liquidity.19 20

35. These and other impediments to efficient bank liquidity management need to be addressed within the limits of a monetary framework that aims to keep the kuna stable and limit financial vulnerabilities. With efforts to curtail credit growth to safeguard macro-economic stability having resulted in a significant build up of liquidity at the CNB, banks had become dependent on the CNB’s weekly repo operations in the absence of a well-functioning interbank market. Addressing these challenges requires: greater flexibility in the repo rate to reflect liquidity conditions; expanding the set of appropriate eligible collateral to raise the volume of securitized lending (to include government bonds with appropriate hair-cuts for longer maturities and FX denomination); continued dialog with banks on frequent regulatory changes to reduce their reluctance to recycle liquidity in the market; and incorporating the information implied by interbank market volatility in daily liquidity forecasting and management operations.

36. The authorities have taken some steps in this direction following the FSAP update. Since late 2007, the CNB allowed greater flexibility in the repo rate and emphasized that repo auctions will mainly be used for managing liquidity, where needed. Increased communication with banks has contributed to a better understanding of CNB measures, which is important to align incentives of financial institutions with those of the CNB.

B. Contingency Planning

Lender-of-last resort facility

37. A broadly adequate framework for emergency liquidity provision exists. A LOLR facility provides emergency liquidity to solvent banks at penal interest rates, for a period of no more than six months (used only once since 2002), and is accompanied by supervisory monitoring and conditionality to contain risks to the CNB (e.g., banks provide a detailed list of actions and cash flow projections for the period of loan use).21 Liquidity support must be fully backed by eligible collateral. Exceptionally, collateral requirements can be extended to long-term government securities, sovereign bonds of euro member countries, or other normally accepted collateral, if the CNB assesses that the bank’s liquidity problems threaten financial system stability. The CNB provides emergency liquidity only in kuna, but banks can exchange with the CNB the kuna funds borrowed for foreign currency. The 32 percent FX LAR also provides a cushion in case of a run on FX deposits. Substantial amounts of liquidity frozen at the CNB for various other regulatory requirements can be released in the event of a liquidity squeeze.22

Bank resolution and deposit insurance

38. The legal framework for bank resolution, insolvency proceedings, and deposit insurance provides the CNB with a broad range of powers. These powers enable the CNB to deal with solvency problems of a bank and to limit potential adverse effects on depositors’ confidence in the event that a bank closure proved necessary. The powers include: supervisory actions for bank improvement, and restructuring/liquidation/bankruptcy actions.

39. The banking legal framework covers three modalities of bank resolution: bankruptcy, liquidation, and use of special administrators. For bankruptcy, used for fully insolvent institutions, depositors are paid off immediately, and the State recovers the funds by the sale of recoverable assets according to an established hierarchy of creditors. For liquidation, depositors are not paid off but only receive reimbursement once viable assets are sold and proceeds received. Special bank administrators reportedly have the option to sell off partial balance sheets (e.g., viable loans with matching deposits) to other acquiring banks as a first step in resolution, but the legal framework does not explicitly list this mechanism.

40. Some basic requirements for banking resolution are, hence, not fully captured in the current or proposed laws. Since the legal framework does not explicitly list a pre-bankruptcy mechanism under the resolution process (namely, the option of conducting partial balance sheet transfers to continue servicing depositors without interruption), the CNB could be legally challenged by creditors and depositors if such mechanisms were used. Such appeals can slow the resolution process, preventing prompt reimbursement to depositors, and contributing to a deterioration of bank assets. This definitional/legal gap could be improved by listing the explicit use of the partial asset/liability carve-out mechanism among the legally permissible instruments under special administration arrangements. The CNB should also be given adequate legal protection for supervisory action taken in good faith (Annex).

41. The current deposit insurance scheme will be subject to a number of changes in the context of harmonization with the EU. The current system covers HRK 100,000 (approximately €14,000) for the sum of deposits of a person’s accounts held in a given bank. The new draft deposit insurance law, drafted to meet the EU standards as part of the EU acquis, would raise the coverage to HRK 160,000, and would also cover small-medium enterprises (SMEs) as well as individuals, with the possibility of coinsurance; while details on this are pending, pros and cons of coinsurance need careful assessment.

42. Discussions at the time of the FSAP update suggested a lack of clarity on the role of various agencies in bank resolution (the CNB, the State Agency for Deposit Insurance and Bank Rehabilitation (DAB), Ministry of Finance (MoF), and the courts). The mission considered that: (i) the overall responsibility for rehabilitation programs for ailing institutions should be with the CNB supervisors, and there should not be competing agencies with this task; (ii) the responsibility for providing capital to a troubled bank should be within the MoF; and (iii) the provision of liquidity support and other safety net funds should be the responsibility of the CNB and the DAB, respectively.

43. With a view to strengthening the bank resolution framework, the FSAP update recommended to: (i) establish clarity as to the roles and responsibilities of all the parties involved in the bank resolution process, and formalize the existing “common understanding” of these roles to limit the risk of delays and uncoordinated actions in the event of a crisis; (ii) set out clearly who takes the first losses, with clear guidelines to limit CNB support to systemic risk cases; and (iii) establish provisions for quickly paying/servicing guaranteed depositors upon a bank’s failure—not only upon formal bankruptcy. The authorities recently stepped up efforts to clarify the roles of agencies involved in bank resolution.

Crisis preparedness

44. While the impact of ongoing turbulence in the global financial markets have so far been limited for Croatia, continued global financial market pressures underscore the need for contingency planning. Planning would include policy options, as well as practical issues, such as developing contingency plans on how to implement the options, in particular where the banking system is largely foreign-owned. Such planning could be documented in a manual that includes specification of principles for crisis management; establishment of analytical frameworks for assessing a crisis; preparation of the steps and procedures; key information needed for necessary analyses;23 and specific forms of coordination, information sharing, and communication between the authorities (both externally and internally).

45. At the time of the update, there were no formal arrangements for crisis management and burden sharing between the CNB and other relevant foreign authorities. The notion of the parent bank taking responsibility for its Croatian subsidiary was seen as a first line of defense, followed by the possibility of releasing the significant quantity of bank reserves held at the CNB. A liquidity crisis originating in Croatia or elsewhere could still cause difficulties in the banking system if parent bank support failed to materialize in the event of adverse developments or possible regional contagion.

46. The mission suggested the CNB establish formal communications with monetary and supervisory authorities of parent banks on issues of crisis management. In particular it would be beneficial if the MoUs set out formally how to discuss modalities for action and coordination among supervisors. It would be useful for home-host authorities to discuss “who is in charge,” as well as the options and guidelines for the use of liquidity facilities by foreign and domestic-owned banks in a crisis situation. Strengthening banks’ liquidity management capacity would also help reduce the burden on the CNB in stressful situations.

47. Some work has started in this area. The CNB has initiated formal communications with the foreign bank supervisory authorities, with a view to clarifying how parent banks would react in case of a problem in Croatia. The existing MoUs with the supervisory authorities of Austria, Bosnia, Hungary, and Italy are planned to be upgraded regarding crisis management arrangements and MoUs to be established with France and Germany. No responses to the formal communications have yet been received. On liquidity management, the CNB has been monitoring banks’ liquidity and risk management through onsite-offsite inspections.

48. The team also considered it useful for the authorities to participate in crisis simulation exercises or “war games,” both in a domestic and a cross-border context. Such exercises have become more common tools to help develop the coordinating procedures in crisis management, and could be very useful in testing the adequacy of internal and international processes, potential weaknesses in communication and coordination channels and procedures, the understanding of the responsibilities within and between the relevant institutions, and the nature of information and data needs.

C. Institutional and Legal Framework for Bank Intermediation

49. The institutional framework has been strengthened significantly since the last FSAP but further work is ongoing to finalize the needed changes. The majority of changes to the institutional framework of the financial market are related to harmonization of the financial system legislation with the EU acquis communautaire. A number of Acts have already been passed, several legislative work ongoing, including the Credit Institutions Act, and are planned to be implemented.

50. Slow resolution of claims still underlie the problem of slow recovery of collateral and calls for improvement in the legal system. Slow collateral recovery constrains the expansion of long-term corporate lending, with average recovery taking about three years. It also results in banks requiring somewhat unusual types of (multiple) collateral (including guarantors), as well as life and hazard insurance for particular types of loans, or in banks’ insuring credit risk through insurance companies. In general, Croatia compares unfavorably with other eastern European countries with respect to investor protection and enforcement of contracts (World Bank “Doing Business Report for 2008”).

51. Progress has been made since 2002 in the area of land registry and cadastral reform, but further work is needed. Land registry was subject to long delays, with practical difficulties in registration and enforcement of pledges over movable property. The delays encouraged banks to take on additional collateral, undermining the scope for financial intermediation and increasing its cost. Land records can now be accessed through the Internet. Nevertheless, the data in the cadastre book and land registry apparently continue to diverge in some cases. The completion of the project would help banks verify cadastre or land register data on the land and real estate and facilitate loan granting procedures.

Appendix I. Main Recommendations of the FSAP Update

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Appendix II. Progress in Implementation of the 2002 FSAP Recommendations

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Appendix III: The Croatian Financial System Structure

52. The Croatian financial system has grown rapidly in recent years, and became one of the largest in the region (Figure 7), but remains dominated by commercial banks (Table 6). As of end-2007, banking sector assets accounted for 125 percent of GDP or 74 percent of the total financial sector assets. The sector is over 90 percent foreign-owned (all subsidiaries), with a strong presence of large Austrian and Italian banking groups (Table 7). It is highly concentrated, with the five largest banks accounting for 72 percent of the total banking system’s assets as of mid-2007.

Figure 7.
Figure 7.

Europe: Comparative Sizes of the Banking Sector

Total assets in Banking Sector, end-2006 (Percent of GDP)

Citation: IMF Staff Country Reports 2008, 160; 10.5089/9781451817485.002.A001

Source: National Banks, ECB, Raiffeisen Centrobank
Table 6.

Croatia: Structure of the Financial Sector, 2003-07 1/

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Sources: CNB (banks and building societies), Ministry of Finance (savings/credit unions), Central Bureau of Statistics (GDP), and Croatian financial services supervisory agency (other data).

End-2007 data are preliminary.

Supervisory data (figures may slightly differ from the monetary statistics).

Preliminary Q3 2007 data.

Table 7.

Croatia: Ratings of the Largest Banks, 2007

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Source: CNB and Fitch.

53. Although NBFIs remain small relative to the banking sector, these institutions have grown rapidly since 2002. Total assets of NBFIs have increased by over 20 percentage points of GDP since 2003 to 44 percent of GDP in end-2007. Leasing companies comprise the second largest group of financial intermediaries, with their rapid growth partly reflecting tighter requirements imposed on banks in an attempt to contain rapid credit expansion. The insurance sector also grew rapidly, partly stimulated by strong bank credit, as banks require various forms of collateral, including life or hazard insurance, and banks insure part of the credit risk by transferring it to insurance companies. The private pension fund sector began operations in 2002 and is growing rapidly.

54. There are important interlinkages between banks and NBFIs. Some of the non-bank financial institutions are direct subsidiaries of foreign parent banks while others are owned by the local banks. The larger banks generally have cross-sector subsidiaries or affiliates, including brokerage firms, pension funds, leasing companies, and asset management companies. There are important intra-group linkages in terms of ownership and activity (e.g., with bank mortgage loan borrowers required to provide collateral in the form of life and hazard insurance, and banks insuring their credit risks). While the exposure of banks to NBFIs has grown at a phenomenal rate (Figure 8), the full scope of cross-ownership and links within the financial sector is not fully known.

Figure 8.
Figure 8.

Croatia: Exposure of Banks to NBFIs

Citation: IMF Staff Country Reports 2008, 160; 10.5089/9781451817485.002.A001

Source: CNB.

55. Financial markets are relatively undeveloped. The interbank money market is shallow and segmented, with the market unable to recycle liquidity efficiently across banks. Only 20 percent of all transactions take place in the market with the remaining bilaterally. The FX market is more active and less volatile. Daily turnover has increased more than fourfold since 2003 to an average of €500 million in 2007. Although spot transactions have traditionally represented the bulk of FX transactions, the volume of FX swaps has increased recently, with the share rising to 60 percent of total transactions in 2007. The weaknesses and absence of longer tenor quotations in the money market along with exchange rate stability, hinder the development of longer term hedging markets for managing interest and exchange rate risks. Capital markets have recently boomed, with market capitalization one of the highest in the region (133 percent of GDP). However, the market continues to lack depth and liquidity and is dominated by equities; the overall size of the bond market remains small (15 percent of GDP).

Appendix IV. Stress Tests: Overview of the Shocks and Results24

56. The FSAP team conducted a set of stress tests jointly with the CNB, to analyze the extent of the risks and the resilience of the banking sector to a range of shocks. The tests included single factor sensitivity tests and macro-scenarios. They were designed and performed at the aggregate, peer group, and individual bank levels. The scenarios simulated exceptional but plausible shocks, taking into account historical experience. The single factor shocks considered both direct and indirect credit risk induced by FX and interest rate exposure, and exchange rate, liquidity, and interest rate risks.25 Three scenarios were also considered, including a slowdown or a reversal in capital inflows that result in a fall in net inflows, an economic slowdown in the euro area with a spill over to Croatia, and higher global interest rates. The shocks were calibrated using a combination of econometric analysis and coefficients drawn from similar studies to make up for data limitations. In the absence of a macro-model to simulate feedback effects stress tests assumed immediate impact.

57. Although the results suggest that Croatia’s banking system is sufficiently capitalized to withstand a wide range of shocks, there are pockets of vulnerability. The most significant risk for banks is captured by the combined impact of a decline in capital inflows that results in a significant currency depreciation and high interest rates. Under this scenario, given the significant unhedged FX and interest rate exposure of borrowers, the aggregate CAR would fall below the 10 percent minimum, reflecting shortfalls of 21 banks with 55 percent market share for assets; five banks would become insolvent (Table 8). Both the slowdown in the euro area and an increase in global interest rates would have a big impact on the banking system in terms of reduction in capital, but the aggregated CAR in both cases remains above the 10 percent minimum, with no insolvencies.26 Liquidity risk also appears to be substantial: an outflow of 20 percent of liabilities with maturity up to 3 months would push the liquid asset ratios of the system from about 16 to 11 percent (Table 9).

Table 8.

Croatia: Multivariate Stress Testing

(In percent, unless noted otherwise)

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Sub-groups by size are large banks (L) with share in total assets above 5 percent, medium sized banks (M) with share in total assets between 1 and 5 percent, and small banks (S) with share in assets below 1 percent.

Sub groups by ownership are foreign owned banks (FO), domestic privately owned banks (DO), and state owned banks (SO).

In brackets the increase in the ratio of NPLS to total loans to households and corporates (NPLR) that is implied by the respective increase of the foreign exchange rate or the interest rate is indicated.

Assumes a depreciation of the Croatian Kuna by 10 percent, an increase of Kuna rates by 200 basis points, a decrease of Euro interest rates by 50 basis points, an additional increase of NPLs by 30 percent and an implied overall increase of NPLR by 118 percent.

Assumes a depreciation of the Croatian Kuna by 30 percent, an increase of kuna interest rates by 300 basis points and an implied overall increase of NPLR by 251 percent.

Assumes an increase of Kuna interest rates by 200 basis points, an increase of Euro interest rates by 200 basis points, an additional increase of NPLR by 10 percent and implied overall increase of NPLR by 146 percent.

Table 9.

Croatia: Results of Stress Tests for Liquidity Ratios

(In percent, unless noted otherwise)

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Sub-groups by size are large banks (L, 6 banks) with share in total assets above 5 percent, medium sized banks (M, 4 banks) with share in total assets between 1 and 5 percent, and small banks (S, 23 banks) with share in assets below 1 percent.

Sub groups by ownership are foreign owned banks (FO, 16 banks), domestic privately owned banks (DO, 15 banks), and state owned banks (SO, 2 banks).

58. stress tests conducted for contagion risk also suggest significant vulnerabilities. Contagion risk within the domestic banking system (i.e., the impact of a default by one bank on the other banks in the system) is negligible, given the very limited interbank exposures among the banks in the system. However, contagion from troubles of a parent bank or a reassessment of risk facing a Croatian subsidiary by its parent bank could have a more substantial impact on Croatia’s banking system due to the dependence on parent companies for deposits and capital, and to the systemic impact of the banks in the Croatian banking system. A withdrawal of 100 percent of deposits by parent banks would result in negative liquid-assets-to-liquid-liability ratios for four foreign-owned banks with a 25 percent share in total assets. When more long-term funding (including loans and hybrid instruments) are withdrawn, most large foreign-owned banks with over 50 percent market share would show negative liquid-assets-to-liquid-liability ratios.

59. The stress tests also indicate that the aggregate figures mask a high degree of heterogeneity in the impact of the shocks among various banks and sub-groups of banks. In particular, smaller banks and state-owned banks exhibit greater vulnerability to direct and indirect credit risk, while foreign-owned banks, including some of the systemically important ones, exhibit greater vulnerability to liquidity and contagion risk from the parents.

60. Going forward, there is need to:

  • Strengthen stress testing analyses at the CNB. This calls for (i) integration of scenario analyses in the CNB stress testing exercises; (ii) integration of cross-sector and cross-border analyses; (iii) compilation of data series to facilitate quantitative assessment of exposures, including bankruptcy rates and leverage ratios for households and corporates; and more detailed information on distribution of assets by repricing and remaining maturities to facilitate interest rate and liquidity risk analysis.

  • Make scenario analyses more macro-consistent. The core macroeconomic structural model the CNB is currently developing could be used to test the sensitivity of various financial and macroeconomic variables to alternative shocks (e.g., to the exchange rate, interest rates, output, capital inflows in the form of bank borrowing, policy instruments, etc.). The results of such experiments could provide input for the macro scenarios used in stress testing.

  • Encourage stress testing among commercial banks. The CNB should (i) encourage banks to integrate stress testing in their risk management practices, and (ii) request banks to undertake stress tests from time to time for risks that the CNB determines, and report to the CNB the results of their analysis. The results of such tests could then be compared with the CNB’s own analyses.

  • Monitor developments in the smaller banks that exhibit vulnerabilities. While small banks are of less material importance, they exhibit greater vulnerabilities that that could undermine confidence in the banking system, thereby need close attention.

  • Monitor a number of risks and bank practices. These include: (i) degree to which banks may be undertaking riskier investments in the face of limits on credit growth and competition-induced margin compression, (ii) the extent to which all-purpose loans are invested in the stock market; and (iii) the extent to which insurance collateral actually transfers risks out of the banking groups. The outcome of such monitoring should be incorporated into stress testing and risk analyses and followed up with close onsite inspections of the banks involved.

Annex I: Summary Assessment of Observance of the Basel Core Principles for Effective Banking Supervision

61. The assessment of observance of the Basel Core Principles for Effective Banking Supervision (BCP) was performed in accordance with the guidelines set out in the October 2006 Core Principles Methodology. The assessment was conducted in October/November 2007, in the context of the IMF-World Bank FSAP update. The assessment reflected the legal and regulatory framework together with the banking supervision practices of the Croatian authorities as of early November 2007. As requested by the Croatian authorities, the assessment covered observance of both the essential and the additional criteria. The assessment was undertaken by Joerg Genner (German Financial Supervisory Authority) and Peter Phelan (formerly Financial Services Authority of the UK).

Information and methodology used for assessment

62. The BCP assessment was based on: (i) review of laws, regulations, and other documentation on the supervisory framework and on the structure and development of the Croatian financial sector; and (ii) interviews with staff from the CNB and with the representatives of several individual banks and the banking association. The work of the mission was informed by a self-assessment conducted by the CNB in September 2007 in accordance with the 2006 Core Principle Methodology.

Institutional and macroeconomic setting and market structure—overview

63. The Croatian financial sector is dominated by commercial banks. At end June 2007, there were 33 banks and 5 housing savings banks, accounting for around 120 percent of GDP or 74 percent of the total financial sector assets. The 33 banks consist of 15 foreign owned, 16 domestic private banks and 2 state-owned banks. The banking system is highly concentrated, with the five largest banks accounting for 72 percent of the total banking system’s assets. The foreign owned banks make up over 90 percent of the banking system assets and consist largely of Austrian and Italian owned banks. Due to the predominance of banking groups that have cross sector operations, the CNB closely coordinates the supervision of banks with the HANFA, the regulator for the NBFS.

64. The CNB’s Prudential Regulation and Bank Supervision Area is responsible for licensing and supervising the banking institutions. This Area is further divided into five departments: (i) the Licensing and Market Competition Department, (ii) the Prudential Regulation and Banking System Analysis Department, (iii) the Off-site Supervision Department, (iv) the On-Site Risk Management Supervision Department and undertake the on-site examinations; and (v) the Specialized On-site Supervision.

65. Overall, the CNB has most of the powers needed to address the challenges arising from the structure of the financial system. The Banking Law (BL), introduced in 2002, strengthened the CNB’s supervisory powers and resources. Supervision of conglomerates and cross border supervision is bolstered by the introduction of consolidated supervision and the signing of MoUs with almost all the home supervisors of Croatia’s banks. The HANFA’s establishment and the inclusion of leasing companies under its purview would help reduce regulatory arbitrage. Nevertheless, the growing complexity of groups will require more focus on conglomerate supervision and associated risks. Conflicts of interest are a potentially serious problem in banks and other market intermediaries. The CNB is aware of the challenges but the extent to which group risks are systematically monitored by the CNB as the consolidated supervisor remains unclear.

Preconditions for effective banking supervision

66. The preconditions for effective banking supervision are broadly in place, but some gaps remain. Some elements of the macroeconomic environment add to the risks in the banking sector and there is a need to address a number of areas that affect the quality of banking supervision, including the information infrastructure (both accounting and auditing and credit registry); legal infrastructure; and corporate governance.

Main findings

67. The CNB has made substantial progress toward establishing its bank supervision system at the level of international best practice. The CNB operates a comprehensive and transparent system in exercising its exclusive right to grant banking licenses, to maintain observance of bank legislation and regulations, and to impose and enforce prudential rules. The supervisor has a comprehensive understanding of the market and the supervised institutions. Most issues raised in the previous BCP assessment in 2002 have been addressed.

Objectives, independence, powers, transparency, and cooperation, CP 1

68. The responsibilities of the CNB as the only banking supervisor are established in law. The laws also establish the CNB’s powers to license, supervise, take remedial action against and revoke licenses of banks, and there is a clear and transparent decision-making process for such matters. The Central Bank is responsible to Parliament for its actions, and some details of supervisory activity are published in its Annual Report. The CNB’s resources are sufficient for its responsibilities, and the Governor and other senior staff are appointed by Parliament for terms of six years, and can only be dismissed for cause. Arrangements are in place for exchanges of information with other supervisors, both at home and abroad, subject to the protection of confidentiality. Individual supervisors are protected from law suit when carrying out their work in good faith, but this does not extend to the CNB itself. Operational independence of the supervision department needs greater transparency (see CP 1.2, Table 10).

Table 10.

Summary Compliance with the Basel Core Principles—ROSCs

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