LENDING BOOMS, FOREIGN BANK ENTRY AND COMPETITION:

THE CROATIAN CASE

Evan Kraft Ljubinko Jankov

Croatian National Bank*The views presented here are the authors’ alone and do not necessarily represent the views of the Croatian National Bank.

Outline

• Lending booms, banking and currency crises

• Foreign banks and lending booms

• The Croatian case– features of the lending boom – causes: competition, liberalization, stock

adjustment, capital inflows– consequences– policy measures

Consequences of lending booms: financial side

• Credit quality deterioration—looser underwriting standards (Gavin and Hausmann 1996), dilution of relationships (Niinimaka 2001)

• Financial accelerator followed by crisis

• Financial deepening, with positive long-term effects on growth (Wachtel 2001, Levine, Loayza and Beck 2000 )

Policy dilemmas

• Difficult to measure extent of bad asset problem in real time

• Where is the trade-off between preventing crisis by slowing down growth and slowing down beneficial financial deepening?– speed limits view– increased capital requirements view– wait and see view

Consequences of lending booms: macro side

• Investment and/or consumption boom

• Increased volatility of GDP, recession and currency crises

What causes lending booms?

• Real business cycle theory—positive technology or terms of trade shocks. Such booms would not be problematic at all.

• Financial liberalization

• Capital inflows

• Wealth shocks

Lending booms and banking crises: the evidence

• Caprio and Klingebiel (1996), Demirgüç-Kunt and Detragiache (1997), Honohan (1997) and Eichengreen and Arteta (2000) all find evidence that rapid lending growth increases the probability of banking problems

• However, Eichengreen and Rose (1998) do not find this, and Gourinchas, Valdes and Landerretche (2001) find that only Latin American lending booms are strongly correlated with crises.

Foreign banks and lending booms

• Foreign banks less dependent on domestic funding sources, above all deposits

• Foreign banks subject to strong push factors

• Competition strong among foreign players

• Evidence from Latin America and Central and Eastern Europe confirms these observations

• Effect on instability: foreign banks grow faster but are more sound—ambiguous effects

Croatia’s lending boom: phase 1, 1995-1998

• Liberalization of banking laws in early 1990’s

• Substantial entry by domestic banks

• Funding:– high deposit growth due to repatriation of deposits

held abroad after ending of hostilities– strong foreign borrowing after Croatia received an

investment grade credit rating in January 1997

Croatia’s lending boom: phase 2, 2000-present

• Large scale entrance of foreign banks, late 1999 and early 2000

• Recovery of household loans begins in second half of 2000

• Recovery of enterprise loans is slower, beginning slowly in the first half of 2001 and only reaching 15-20% growth rates– improved enterprise liquidity in 2000 may have slowed

loan demand, but also improved balance sheets

Credit growth: households

Graph 1: Lending to households (corrected), yoy growth

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100

Credit growth: enterprisesGraph 2: Lending to enterprises (corrected) yoy growth

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-5

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35

Causes of lending boom: demand side

• Stock adjustment under communism, economy was “financially repressed”– war and transition led to further write-offs and

credit contraction– but economy is relatively developed, and probably

the equilibrium level of credit/GDP is far above the actual

• Insider loans (in phase 1)• Capital inflows

Causes of lending boom: supply side

• Liberalization and competition – removal of restrictions on entry and interest rate controls

meant to stimulate supply– increasing competition also should increase supply

• Availability of funding– deposit growth (especially 1995-97 and 2002)– foreign borrowing (especially 1997, 2000 on)

• Foreign bank role– t-tests show that both privatized and de novo (greenfield)

foreign banks increased lending faster than domestic banks in 2000 and 2001

Deposit growth

Graph 3: Growth rate of total deposits, yoy, %

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06.9

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09.9

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12.9

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06.9

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09.9

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06.9

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09.9

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12.9

9.3)

03.2

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Evidence of increased competition

• Number of banks decreases after 1998, and Herfindahl index increases, but competition actually increases

• Narrowing spreads between lending and deposit interest rates

• Lower variation of market interest rates across banks• Increased number of banks actually covering the

whole territory of Croatia• Panzar-Rosse h test

Lending boom and banking crisis: what is the connection?

• Downgrade incidents: – definition: greater than 4 percentage point increase

in bad assets (B to E)– 37 of 43 banks undergoing downgrades in 1998-99

grew faster than 30% yoy in at least 1 quarter prior to downgrade

– 30 of 40 banks that grew rapidly experienced downgrades

Lending boom and failure

• Early Warning System (EWS) – best predictors of failure are deposit interest rates

and liquidity– loan growth a weaker predictor– but loan growth may be correlated with other

problems– cannot conclude that rapid growth leads to failure

Macro side of lending boom, phase 1

1995 1996 19971998

Inflation, retail prices, % 3,7 3,4 3,85,4

Real GDP growth, % 6,8 6,0 6,6 2,5

Current Account, % GDP -7,7 -5,5 -11,6 -7,1

Sources: Croatian National Bank and Central Statistical Office.

Macro side of lending boom, phase 2

1999 2000 20012002

Inflation, retail prices, % 4,4 7,4 2,62,3

Real GDP growth, % -0,4 2,9 3,8 5,2

Current Account, % GDP -6,9 -2,3 -3,8 -7,1

Sources: Croatian National Bank and Central Statistical Office.

Policy measures: phase 1

• Tighter monetary policy introduced in mid-1997

• Chilean-style capital controls introduced in April 1998

• Not clear whether capital controls or bank failures and the Russian crisis slowed down banks’ foreign borrowing and lending boom

Policy measures, phase 2

• “16% rule”—banks must buy low-interest rate Croatian National Bank paper if growth of risk assets exceeds 4% in a given quarter.

• “35% rule”—banks must hold liquid foreign exchange assets equal to at least 35% of their total foreign exchange liabilities

• These measures are mainly aimed at slowing growth, not at preventing asset quality problems per se

Why not just raise interest rates?

• Transmission mechanism based on fx market

• CNB bills rate would be most likely instrument

• Raising rates could trigger more capital inflows

• Rates would have to be raised very substantially

• Implications for public finance

Prudential measures

• Banks that grow faster than 20% will be required to form special reserves (0.10% of risk assets)

• Like a temporary increase in capital requirements• Banks will be exempt if they meet higher capital

standards (15% for growth between 20% and 30%, 20% for growth between 30% and 40% etc)

• Exceptions for new banks (first 3 years).• Mergers: growth based on sum of merged entities.