Financial Crisis and their affects on the Financial System

& Real Sector in B&H

Damir Njuhović, PhD Candidate at SSST/Buckingham University

International Burch University, Sarajevo date: 17.04.2012

Three broad topics

1. History of Financial system in B&H2. How did 2007/2008 Crisis start / spill over to

B&H / result in new Crisis 2011/20123. The consequence on B&H economy (banks and

real sector) Practical examples & possible way forward

B&H financial system prior to crisis

System before 1992- a socialist regime (pre 1992) Centralized system with one bank at the Republic level Huge industrial systems with “Leading companies” Functioning of system, approval process, coordination

between republics System following 1996 until 2000 (1996-2000) New emerging banks Small accumulation of deposits – low trust Restricted foreign credit lines Introduction of currency board

Financial system from 2000 onwards

Entrance of Foreign banks 2001 onwards Standards for loan approval (market aggressive behavior) HVB retail and Hypo Corporate Price setting behavior but no Bond market until 2009 Competition prices went from 25% to 7-8% in 2008 Also improvement in supporting institutions, court,

financial reports etc. Opening of stock market 2002/2003

Situation as it is before crisis

Uncoordinated privatization practice: - unconnected companies within large industry

system - many SME’s (riskier) and lost market especially

foreign penetration Many new Banks at country level - no umbrella bank / uncoordinated practice by

banks commercially based - different strategies (retail, treasury, large, foreign

companies etc…)

Finances available through

Bank credit (by far most common form) Leasing (financial / operational) + R/E recently Factoring (only “Prvi Factor” present part of NLB Group)

since 2007 - some current banks plan to organize factoring Micro Financial Institutions (MFI’s) Private equity & Capital markets - IPO (Initial Public Offering very low activity, restricted

exit for potential equity investors) - Corporate bond market underdeveloped with few issues

How does Financial support approval process function Request, source Treasury if LT, internal meetings,

risk consultation, layer consultation collateral wise, short credit analysis, indicative offer,

Client meeting, Law department, credit analysis (financial, quantitative),

Risk, overall application, risk Credit Committee final decision, law department.

Beginning of crisis 2008 What is the trigger of the crisis? - Asset securitization (what is it and how it has occurred?) What is it? - Bundling and transfer of cash generating assets on capital

market - Assets legally separated from originator and rated as such - Originator withholds first loss peace and slices portfolio

to get better rating Government sponsored agencies stimulated AS Interest rates versus mortgage prices USA Bank loans amount to 10% GDP while bonds /

securities to 150% GDP

Basel I all loans in same basket irrespective of risk up to 2005

AS enabled huge leverage and asset increase while RWA was controlled

Basel II (2005-2008) - allowed IRA in each bank to access risk - properly secured mortgage loans low risk - industry loans higher risk But was late as RWA / asset gaming continued until

2007/2008 (see graph)

Spill over effect from USA real estate market to the rest of world

Huge liquidity squeeze in combination with the run on deposits end of 2008 Consequential loan reduction to withhold Bank solvency in B&H

Highly restricted credit lines from abroad Lost trust between Banks Overall 2008 crisis is Liquidity crisis

Beginning of “new” crisis 2011/2012

Fiscal stimulus to real sector and banks resulted in over indebtedness

Over indebted countries largely on a periphery of EU (less industry/competitiveness)

Especially dangerous countries using EUR as a monetary mean

Unequal competitiveness in Europe - those that adopted EUR as official currency and - those over indebted in foreign currency loans – small

devaluation possibility What about USA and their indebtedness – is it coming?

Question and answer session

New Basel III regulation (see table)

TCE / RWA = min. 7% roughly 7 times increase in tangible capital to

Basel II TCE counts as only loss absorbent part of equity shortened period to adapt until 01.jan.2013 in EU 9% tangible capital adequacy ratio

introduced (until 30.06.2012) huge competition for capital – lack of capital Banks required to withhold 30 day system wide

liquidity shock

RWA - Risk Weighted assets before crisis much slower growth in respect to

total assets after crisis quick growth (i.e. performance

guarantee which counts 20% RWA in good times counts 100% in bad times)

growth of RWA / assets on graph still not observed – suspicion for RWA gaming

European banks started to look seriously undercapitalized

Low correlation in crisis and non crisis periods RWA:

Basel III impact largely on SME’s in B&H

adequate capitalization of NWB’s in respect to rising NPL

limited help from parent expected therefore very strict approval criteria undercapitalized parent banks – limited operations

in SEE especially towards riskier businesses new capital everybody competing for new liquidity requirements – limits long term

loans / restructuring

The consequences for B&H How did crisis spill to B&H? - export reduction (heavy industry affected most)- lack of new credit lines in combination with deposit withdrawal Results in rising illiquidity in domestic market Vienna Initiative – build up of cash position in CBBH

(lack of good projects) Reorientation of commercial banks on retail sector – it is

short sighted vision! Lost relationship with SME’s (98% of companies in B&H) Hard to regain relationship – un transparent information

from SME’s

Low credit growth / stagnation Loan price increase / however limited to cover as

competition is high Deteriorating fiscal position Lack of collateral – value revised in combination with

illiquidity Over indebted companies lacking market for their products

(uncompetitive in foreign markets) RWA gaming in B&H (table) Limited collateral disposal in highly illiquid environment - assets more relevant as measure of RWA

Practical examples (see paper)

Examples of how companies from different sectors of the economy were affected & dealt with crisis:

IT Sector (retail, wholesale & software programming) Wood industry Supermarket retail chains (food, hardware – expand or be

acquired) Pharmaceutical industry (expand or be acquired) Real estate (liquidity squeeze) & Cement industry (fall in sales, secured receivables)

Practical examples continued

Auto industry (VW, Cimos, Alloy Weal) Heavy metal, coal and coke industry

(ArcelorMittal, GIKIL, Coal mines) Food industry (Mims group, organic food – not

organized etc…) To big to fail companies Foreign versus domestic companies: - parent help expected - coordinated restructuring action at parent level

Possible way forward

Organization of industrial development bank Coordination at country level and reunification of

broken supplier / buyer chains FDI but distinction between market and export

orientated Liquid capital markets (bond / equity) Factoring as in Mexico (reliance on credible big

buyer)

Limitations Source of cheap funding in illiquid environment Lack of potential investors (country rating, lost

trust, pension reform, - life insurance as alternative institutional investor

– needs time for people to adopt to new system) Destroyed supplier / buyer chain many

companies already sold, - lost market, need to regain reputation again, - experienced workers getting older and older……

Fixed exchange rate to EUR (CB) – one of greatest limitations

- productivity growth should follow growth of productivity in exporting countries otherwise unemployment rise / wage cuts to boost competitiveness……

Solution to re orientate to less advanced countries in Africa / Asia

or seek cheaper funds from EU & top edge technology…….

CBBiH – Central Bank role Only one mean to affect monetary politic through obligatory

reserve relaxation on short term and long term deposits No effect from S/T deposits relaxation: - current crisis is not Bank liquidity crisis - to overcome illiquidity in real-sector structural reform needed

(improve receivable collection method / factoring) or as some suggest:

- relaxation of CB terms and conditions and printing money based on FX reserves which are currently 1:1 to domestic currency in oscillation – possible source of instability in future

Lender of last resort function done by Foreign banks and credit lines – compensate for Trade imbalance

Question and answer session

Conclusion Destroyed industrial systems – 98% SME’s (lost adequate

supply chain) Various different banks with different strategies Restricted L/T financing Restricted overall financing Basel III on SME’s Liquidity not problem but ratio Capital / RWA Proportional reduction in RWA (danger relationship will

be lost) Fixed exchange rate not competitive on international

market FDI predominantly market orientated