Comments on Tamarisa-Igan Evan Kraft, Advisor to the Governor, CNB *The views expressed in this commentary do not necessarily coincide with those of the Croatian National Bank

Loan growth vs. bad loans in Croatia,

How could rapid credit growth without increasing loan losses be possible?  Discrete improvement in the legal system allowing foreclosure of assets that previously could not be foreclosed  Erosion of stock of credit (due to high inflation or write-off of bad loans to socialist enterprises) but not of wealth (wealth held as real property whose value jumps back rapidly after initial transition fall, leading to financial accelerator  New loan techniques that better recognize repayment ability  related: actual income is significantly higher than reported  Rapid income growth justifying expectations of higher future income

The next recession will be the proof of the pudding  Banks’ challenge is to make sure that they allocate their assets well they have enough capital and provisions to handle possible shocks (stress testing and risk models)  Supervisor’s challenge is to second-guess the banks, and to either disseminate best practices or enforce binding procedures where banks’ assessments may be inadequate.  Basel II provides numerous tools, but also some dangers and uncertainties tools: better definition of a large number of risks (credit, market, operational, securitization, liquidity, dilution…), and a wide range of risk management techniques (three approaches to credit risk and three to operational risk) dangers: it seems that the Standardized Approach will lead to lower capital requirements, perhaps by a substantial amount. Potential for lending will increase, but funding will not initially. uncertainties: how well will supervisors be able to control the modeling process and how opportunistic will banks be? How well will the market discipline measures based on disclosure work?

The paper’s message  Credit growth per se has not led to increased risk (decreased distance to default or increased bad loans)  In CEEC’s, it seems that sounder banks have grown faster, so that supervisory concerns are muted  In the Baltics, there is some evidence of weaker banks growing faster, which could be a supervisory concern. Mildly suprising that greater retail exposure is associated with lower distance to default— retail loan losses tend to be lower than wholesale.  But there is a question as to whether one should look at the local bank’s soundness, or that of its parent (if it is foreign-owned). Clearly, to state that these are identical would be to assume that the parent would always help out the child, which we know is not true. But it might be nice to present regressions using parent financial strength.

Branch and subsidiary  An interesting question not studied here is whether there is any difference in the performance of branches or subsidiaries. This may be difficult to study empirically due to lack of data (only a few large branches exist), but it might be worth discussing.  On an abstract level, both branch and subsidiary are part of the parent bank and form part of its capital. Differences arise: because losses in a subsidiary are limited to capital invested if the parent walks away in a crisis because the behavior of managers of a branch may be subject to less scrutiny than that of managers in the home country—little or no supervisory board oversight because the supervisor is different—home country for a branch and host for a subsidiary. The home country supervisory may be more “advanced” but the host country supervisor has a greater stake.

Asymmetric risk:  A branch that is large in the host country but small relative to the parent bank presents special problems, because the home country supervisor may not want to invest significant supervisory resources in it  The current EU framework is home-supervisor biased, but has some flexibility Directive 48 (the “Capital Requirements Directive”) states that home and host countries license risk models jointly, but if a consensus cannot be reached, the home country decides (Boštjan Jazbec’s concerns…) Directive 48 also puts all the burden for assessment of risk management and capital requirements on the home supervisor (for a branch structure) However, the Directive allows delegation of supervision by mutual agreement  Two approaches: The subtle approach: develop good relations with the home country supervisor, and hope to increase your involvement via cooperation The legislative approach: amend the Directive to allow joint supervision or even host country supervision of branches above a certain size threshold (“systemically important branches”)

Capital flows, loan supply and loan demand  The authors results suggest that the demand side is key to loan growth  But they do not model macro developments in the host country. Lelyveld and de Haas (2005) find that home country developments, particularly movements in home country GDP, dominate host country developments. Which makes some sense considering the relative economic size of the home country banks and their host country operations.  Also, the question of deposit growth might be made more explicit, rather than going only through GDP growth  And the interest rate as a demand indicator is tricky, because it could affect capital flows. More importantly, by neglecting capital flows, the model’s relevance for macro issues is limited.  On the other hand (!), it could be argued that maturity, not interest gap, explains foreign borrowing (banks borrow abroad because they need long-term financing to match long-term lending)

Policy issues  Policies aimed at prudential aspects of rapid credit growth Supervision and analytics: need strong monitoring, bank-level stress tests and risk models Require higher capital for faster growth (Croatia does this by limiting dividend payouts) Need to impose higher risk weights for Foreign Currency Induced Credit Risk (FCICR), because of free-riding

Policy issues, continued  Policies aimed at macro aspects of rapid credit growth High reserve requirements, particularly on foreign funding (Croatia: marginal reserve requirement). Problem: capital controls not allowed once in EU Demand-side limitations: loan to value and loan to income ratios (Romania) Asset-side reserve requirements: Croatia’s lending limits (16% in 2003, 12% in 2007) Above all, fiscal policy should be tighter than it would be in the absence of rapid credit growth Nonetheless, rapid lending growth seems to be an almost global problem at the moment,and solutions are not easy to find.

Thank you for your attention!