mandate 16. 7. 2007−16. 7. 2013
My time in charge of Banka Slovenije
I took the helm of Banka Slovenije in July 2007 as its third governor. Slovenia had been a member of the EU for three years at that point, and had joined the euro on 1 January 2007 as the first new member. The government had not accepted the reappointment of the previous governor, which resulted in the post being vacant from the spring, which was most likely a factor in the rapid credit growth seen that year. Following several failed attempts and lengthy consultations, President Drnovšek finally came to a decision and proposed me as candidate for governor to the National Assembly. After “hearings” with party groupings, the National Assembly elected me at the end of June with 74 votes (of the 77 deputies present).
My taking office coincided with a time that came to be seen as the end of the period of financial optimism. The prevailing paradigm in international finance in the last third of the 20th century was the liberalisation of financial flows, the creation of financial derivatives, and globalisation. From simple intermediaries between savers and borrowers, banks and other financial intermediaries evolved into active creators of new financial products, which often had no connection with the real sector. New products such as asset-backed securities, and new business models such as originate-to-distribute were supposed to allow investors to find the optimum balance between risk and return. Bank balance sheets no longer reflected merely maturity transformation of short-term funding into long-term assets, but had become profit centres that aimed to actively manage individual products, and to evolve them into new, derivative products, to trade them, and to generate profit. In 2006, one year before the largest financial crisis of the last eighty years, the IMF optimistically said that these financial innovations were helping to increase the stability of the international financial system.
The Slovenian banking system was less involved in the liberalisation and globalisation process. But the banks’ optimism at that time reflected the optimism of the global financial industry, and was further encouraged by EU membership, by falling inflation and interest rates, and by the adoption of the euro. The Slovenian banking system had been operating in an atmosphere of fast, overheating credit growth for the preceding two or three years. Slovenia had joined the EU in May 2004, which for the international financial markets signified reduced country risk, as a result of which they were ready to lend capital to domestic banks and firms under more favourable terms. Around EUR 16 billion flowed from highly liquid international financial markets into the banking system. The domestic banks saw their debt to foreign banks increase by more than 80% in 2005, and then by a further 30% and 40% over the next two years. The borrowing was primarily short-term, based on trust between banks, without any commitment to rollover, which was not sustainable in the long term. Banka Slovenije itself injected additional liquidity, when it redeemed its own treasury bills at maturity. The domestic banks were quick to place the proceeds with domestic borrowers. Lending to non-financial corporations increased at annual rates of more than 25%, and by almost 40% in 2007 alone. The balance sheet total of the Slovenian banking system increased from EUR 24 billion in December 2004 to more than EUR 50 billion in December 2008, equivalent to around 130% of GDP. There was high demand for loans for all purposes: for housing loans and construction, for current financing, for various projects and, to a considerable extent, for financing M&A activity and privatisation. The SBI share index hit a record high of 2,674 points in August 2007, and reflected the optimistic mood of speculators and investors. In 2007 the banks reported record profits of EUR 514 million (double that in 2005), which is a reliable indicator of excessive credit growth. We were dealing with a typical speculative credit and stock market bubble, of the type that had long been warned against by Hyman Minsky, but the economics profession was ignoring it. I cite these events in detail because they are important in any objective assessment of the resolution of the financial and macroeconomic imbalances that came after 2007.
Loan financing is dominant in Slovenia’s financial system, and the capital market and stock market have never had a prominent role in financing projects or firms. This can have its advantages, but it is a weakness in a time of credit euphoria. While shifting stock values warn investors daily of the risk inherent in their investments, there are practically no fluctuations in the value of loans. Banks therefore underestimate the risks, and expect loans to be repaid at nominal value, with interest, when they fall due. During good times and amid high liquidity this creates the illusion that loans are a lower risk than they actually are, and gives rise to a credit cycle, which was fully evident in the period of 2005 to 2008. The optimism of loan financing can turn to pessimism merely on the basis of bad news, and lending then comes to a sudden stop. The reduced liquidity caused by foreign loans maturing, and the sudden stop were the main drivers, alongside the deteriorating credit portfolio, of the reduction in lending over the next few years at Slovenian banks.
Outbreak of the crisis
Broadly speaking, the macroeconomic picture at the start of my term of office can be defined by several imbalances:
- high, unsustainable credit growth, particularly in construction and housing
- uncritical, poorly secured lending for speculative management buyouts
- the high external indebtedness of banks, with unstable funding
- a large current account deficit
- a large structural budget deficit
- high growth in unit labour costs and inflationary pressures
The international financial crisis broke out in August 2007, one month after I took office. At first Slovenia did not feel the effects of the crisis, although the banks found that their ability to refinance foreign loans was declining, while firms noticed some reticence in their orders from abroad. Credit growth did slow, but remained positive, while the banks were disclosing a relatively low share (around 2%) of non-performing loans (rated C, D or E). In the first half of 2008 uncertainty prevailed as to how the crisis would develop, while the banks were having increasing problems in securing funding and with loan repayments from debtors, and then in September 2008 the international financial crisis broke out in full force with the collapse of Lehman Brothers, which brought the financial markets virtually to a halt. Most countries,, Slovenia included, announced a 100% guarantee on all bank deposits for a limited period. The country thus found itself in a crisis, with all the imbalances that had been developing for years before 2007. The financial crisis soon became an economic crisis, and a typical balance sheet recession occurred, when even good firms were unable or unwilling to borrow. Metaphorically speaking, the banking system was like the Titanic, sailing towards the iceberg. The SBI ended the year down 66%, credit growth was non-existent or negative, and the NPL ratio increased each year. Write-offs and provisioning for bad loans ate into bank profits, and the banking system recorded a net loss of EUR 770 million in 2012, which in the end necessitated the recovery and resolution process, which was carried out in autumn 2013, on the scale that we know very well. Between the time I came to office in July 2007 and the end of my term in July 2013, Banka Slovenije mainly had to deal with these inherited imbalances.
Dealing with imbalances
Banka Slovenije had to act in several areas simultaneously: to ensure the stability and liquidity of the financial system, to strengthen capital adequacy and banking supervision, to draw up an appropriate legislative framework for acting quickly, and to lay the groundwork for the recovery and resolution carried out in autumn 2013.
Banking supervision was organised on similar lines to other central banks, based on the standards of the Basel Committee on Banking Supervision (Basel 2). The banking supervision department conducted controls at the banks by inspecting their credit files and other documentation, and by analysing the data submitted regularly by them. At that time Banka Slovenije did not have any macroprudential instruments to restrict lending; these were only introduced much later at EU level. Banka Slovenije also had no power to assess the suitability of supervisory board members or of candidates for appointment to emergency administrations; this only became possible with the new Banking Act in late 2012. The Governing Board made frequent remarks on late reporting of supervision (several months after inspection), on the formalistic and static valuation of collateral and risks, and on the lack of rigorous action in the event of irregularities being identified at banks (recommendations, not orders, were issued most often). Supervisors were also not active enough in following up with the critical banks, which the banks took advantage of to delay complying with our requests. Certain banks concealed their credit exposure to non-performing customers by approving loans indirectly, e.g. via leasing companies, which did not fall under Banka Slovenije supervision. In the case of loans for M&A activity (holding companies), mostly it was impossible to conduct an in-depth risk assessment owing to the lack of transparency in the relations, which meant that the risks to banks were underestimated. Analysis of loan agreements was neglected, and there was no insistence on covenants, which are of singular importance in securing loans.
In 2011 and 2012 Banka Slovenije worked with the banks to save the most important firms in Slovenia by organising a number of meetings between banks and debtor firms, and encouraging them to find common solutions in the sense of restructuring past-due loans (the London approach), thereby keeping viable firms alive and, in the end, allowing loans to be repaid. Bank management boards had a rather passive attitude to outstanding loans, and were mainly waiting for defaults to be resolved by their legal departments. The government then passed a resolution (the Lahovnik measure) preventing banks from further extending loans to firms, which triggered the collapse of many debtors that might otherwise have survived.
The second half of my term of office saw frequent criticism of banking supervision by politicians and the media. I was forced to defend Banka Slovenije policy on several parliamentary committees, and to explain that it is the banks themselves, their owners and their supervisory boards that are primarily responsible for assessing the risk of bank loans before approval. It is clear that the criticisms were most often the result of misunderstanding exactly what banking supervision is. When the crisis caused loan repayments to begin to fall into arrears and collateral to deteriorate, and the banks restricted lending, Banka Slovenije was deluged with criticisms of why it had failed to prevent the approval of non-performing loans. Supervision merely allows the supervisor (Banka Slovenije) to determine after the fact the degree to which the stability of a bank is threatened by non-performing loans, and to prescribe appropriate measures. Were Banka Slovenije to prevent loans from being made before their approval by the relevant bodies at the bank, it would be usurping functions that belong to the owners and the bodies in question. It proved to be the case that advocates of nationalised banks in particular failed to see the difference between supervision and management, and showed a profound inclination for arbitrary decisions, preferably for a subjective assessment of whom to approve a loan for, and whom not to. This might also explain the insistence on government ownership of the largest banks, and the public demands to replace management boards and supervisory boards. Sadly this situation was not without consequence for bank performance, and the crisis showed clearly that it was these very banks that had the most non-performing loans.
Working with the government and the parliament: Between 2007 and 2013 Banka Slovenije worked with four different governments in Slovenia. No pressure came from politicians with regard to what actions to take, other than the “advice” from Prime Minister Pahor that Banka Slovenije should not set excessive requirements for recapitalisations. Without a doubt it was hardest to work with the government in office between November 2008 and February 2012, i.e. when there was a rapid deterioration in bank balance sheets, and a decline in capital adequacy. The public criticisms by certain ministers of the work of government-owned banks and the demands to replace their management boards and supervisory boards were a negative signal for foreign lenders. In confidential letters we warned the government against this harmful conduct, and called on them to appoint capable managers and supervisors as responsible bank owners. We appealed to the prime minister, saying that as the owner of the banks, the government should recapitalise them as any diligent owner would, or seek other owners who would be willing to do so. The government did not receive these letters very favourably. One particularly complex issue was the strategy in connection with the largest bank (NLB), its capital adequacy and its ownership. The second-largest owner, Belgium’s KBC Bank, was willing to recapitalise NLB on the condition that it would thereby become the majority owner, and thus be able to make changes to its development strategy. The Slovenian side did not accept this, and sought more “neutral” investors (interest from the Middle East was mentioned) who would merely recapitalise the bank with fresh money and leave all decision-making to the Slovenians. Of course nothing came of these wishes. KBC then withdrew from NLB, so that the entire cost of the recovery of the bank in 2013 was borne by the Slovenian government.
The Bank of Slovenia Act provides for a process of mutual information exchange between the bank, the government and the parliament. The finance minister and the president of the National Assembly’s monetary policy and financial system committee have a standing invitation to meetings of the Governing Board, where they can be briefed on any measures envisaged. Unfortunately we found that they did not attend as a rule, although they would have been able to obtain all the requisite information first hand. Banka Slovenije regularly submitted its annual report to parliament, as required by law; we nevertheless received a request for the report several months after it had already been submitted.
Cooperation in the legislative field: Banka Slovenije does not have the right to directly submit legislative proposals into parliamentary procedure. Working with the government (ministries) was often a tense and lengthy process. The following major legal changes should at least be mentioned: the introduction of the 100% guarantee for all deposits at the outbreak of the crisis; the drafting of a special law on bank bankruptcies allowing rapid action to be taken, which was not allowed under the previous law; the amendment of the Banking Act, which gave Banka Slovenije greater powers in the appointment of supervisory board members; and the drafting of the law on a bad bank and on the company for managing non-performing bank assets. The ministries required a good deal of convincing: they were unable to see the need for a special law on bankruptcies, or that the bad bank law would primarily have to define the modus operandi of an institution of this type, and not just give a formal definition of its make-up and management bodies. For unknown reasons the finance ministry left the draft bad bank law untouched on the desk for several months, thus wasting time when fast action was needed.
Banka Slovenije’s performance after joining the euro area: I come to this aspect of our work at the end, even though it is of the greatest visibility in terms of monetary policy. There arose a belief among the public and the media at that time that joining the euro and transferring responsibility for monetary policy to the ECB would allow Banka Slovenije to cut staff. In reality the volume of work increased significantly, as the national central banks have to participate in all of the ECB’s working bodies, to monitor all legislative proposals, and to draw up extensive statistics. Major internal organisational changes were also necessary. I believe that Banka Slovenije coped with these challenges well, both in terms of the number of staff, and in cost terms. Between 2007 and 2012 labour costs declined by 7.5% in real terms, while total costs were reduced by about 20%.