## The address of the governor of the CNB Marko Škreb to the Croatian State Parliament

Published: 12/4/2000

Mr President, Honourable Members, Ladies and Gentlemen,

It is an honour for me, after a relatively long period of time, once again to have the opportunity to address the House of Representatives of the Croatian State Parliament, in connection with the Croatian National Bank materials that have been placed on the agenda for this session. In the Croatian National Bank’s Annual Report for 1998, provided to the Parliament in June last year, there is a very detailed statement of the indicators for monetary policy, economic trends and the situation in the banking sector for what is now the year before last. In accord with the Croatian National Bank Law, this House was also sent a report for the first six months of 1999. Accordingly, it has to be assumed that on this occasion there is no point wasting time retelling the figures and evaluations contained in these documents. Since about a year has passed from the time these reports were written until this debate in the Croatian State Parliament, I shall restrict myself to just some of the most important topics, referring the while to the most significant indicators and information.

As the members of this respected House know well, according to our Constitution and the Croatian National Bank Law, the central bank is charged with: preserving the stability of the national currency, which also then means with price stability in the country, with taking care of internal and external liquidity, including looking after the international reserves of the country, as well as with supervision of the banking system. Each one of these areas excites particular interest among the most general public, as witnessed by the numerous reports appearing every day in the press.

1. The Banking System

It is beyond dispute that banks have a central rôle in the financial system of the country. For this reason, in my address today, I would first of all like to say something a bit more about the banking system, while in the second part I would refer to monetary policy, thus covering the two most important tasks of the CNB.

The honourable House should be reminded, perhaps, that we are not the only country faced with high banking costs in the transition. Almost all the transitional countries have passed through two banking crises:

• the first was the crisis of the old banks with their heritage (dubious assets) from the previous economic system and
• the second crisis, occurring in banks founded after changes in the economic system that were not able to remain viable, because of either weak management and/or increased competition in the market as the transition period progressed.

The first banking crisis, the crisis of the old banks, as they were called, started with the beginning of the transition process (and even before it), and is even now ending with the sale of the rehabilitated state banks to foreign strategic investors. Among the costs of this crisis, brought about by the heritage of the past and, partially, as is too often forgotten, by the enormous consequences of the war, I would count:

• the issuing of the so-called big bonds in 1991, in the amount of about $990 million, • the 1992 conversion of foreign currency savings into a public debt, in the amount of$3,190 million and
• the rehabilitation of Slavonska Banka, Splitska Banka, Riječka Banka and Privredna Banka, during the period from 1995 to 1996, at a cost of $473 million. All told, the costs of the first banking crisis, as it is called, can be estimated at about$4,653 million.

The precise amount of the costs of the first banking crisis is hard to estimate because in the estimates one should not forget revenue, i.e., items that reduce the total costs, such as, for example, income from the privatisation of banks, salaries, profits and tax revenue that the rehabilitated banks would not have been able to make, or to pay, if they had collapsed. I would not like to burden the House with the technical details about how to express the costs in terms of current values or questions of the conversion rate for the calculations, but would like to illustrate the way in which these figures are suitable for providing an orientation only.

There is no doubt that these costs have been very high, placing Croatia among countries with the highest costs for the solution of the banking crisis in terms of proportion of GDP, which has been several times analysed and highlighted in CNB reports, as well as in public statements made by employees of the central bank. These high costs are typical of countries caught up in a war, like Kuwait and Israel in parts of their histories.

At the beginning of 1998 another, the second, banking crisis made its appearance in Croatia; the then government made a decision to rescue Dubrovačka Banka and Croatia Banka, the costs of which were estimated at $347 million, with the proviso, of course, that we can expect revenue from the, I hope, up and coming privatisation of these banks. The second feature of the crisis is the costs of the payment of insured savings deposits in banks in which bankruptcy proceedings have been started. These costs were a charge upon the Budget, because not enough premium income had been collected in the fund of the State Agency for Deposit Insurance and Bank Rehabilitation. I would recall that in 1998 and 1999, the Croatian National Bank required that bankruptcy proceedings be started in nine banks and four savings banks, while it withdrew the operating permit from one branch of a foreign bank, one bank and six savings banks. The cost of paying out insured savings in the case of banks and savings banks where bankruptcy proceedings have already started can be estimated as being in the region of$400 million. Once again, this is an estimate. If bankruptcies and liquidations that have been proposed should be initiated, this could increase the costs by some additional $50 million. Accordingly, the total costs of the second banking crisis could be estimated at about$800 million.

If we add together the costs of the first and the second crisis (with the renewed qualification that this is a matter of gross costs and outline amounts), we will arrive at the sum of about \$5.45 billion. Of this, about 85% is accounted for by the first crisis, and 15% by the second. The first crisis, then, was much larger, much more dangerous to the whole of the economic system than the 1998 crisis. Accordingly, I would like to emphasise the fact that the crisis is on the whole a thing of the past.

Here I shall not refer to the causes of the first crisis, because I believe that the socialist inheritance and the consequences of the war are well known to the public at large. I shall, however, have a little more to say about the causes of the second banking crisis.

What, in my estimation, were its main causes?

First, and most importantly, the roots of the second banking crisis go back much beyond 1998, even beyond the period when I was appointed Governor of the CNB. It started with the over-indulgent granting of operating licenses for banks in the first half of the nineties. There was not enough caution with respect to the number of banks, and not enough with respect to the people who were installed in managerial positions in the bank. However, it should be recalled that then the Law did not even seek the so-called prior agreement of the central bank for the appointment of managers, that is the Managements, of the banks, but only some non-binding opinion. At the time I was appointed Governor, in March 1996, 55 operating licenses had already been issued to banks. After that, only six new banking operating licenses were issued (Tršćanska Štedionica - Banka, Hypo Banka Croatia, Libertas Banka Dubrovnik – which was never opened – Bank Austria Croatia, Volksbank, BNP –Dresdner Bank Croatia, Société Générale – which is not working, but at no cost to the taxpayer - and Bayerische Hypo- und Vereinsbank).

The excessive number of banks and/or bad management and supervisory boards in those banks that deliberately flouted not only the regulations but all the principles of good banking practice in a few years brought some of the banks into a hopeless situation. What ought to be obvious but, it seems, needs constantly repeating, is the simple fact that for the poor performance of the banks that have collapsed it is primarily the people who were managing these banks that are responsible – their management and supervisory boards. It is not the CNB that made the bad business decisions, or lent money that could not be collected, but the managements of the banks. Supervision of the banks does not exist to stop bad lending practice, but to observe and penalise it.

May I be permitted to observe that it is in the very essence of the market economy that every individual player makes its own business decisions and, which is crucial, bears all the consequences of these decisions, including the possible institution of bankruptcy proceedings. The CNB cannot and may not manage the commercial banks, except when the situation has already become so serious that a provisional administrator has to be appointed to protect the creditors (including the depositors) of the bank, which was made possible only by the new Banking Law of the end of 1998. One has to be aware that there is no supervisory institution that can in advance keep a check on every single transaction in a commercial bank. There is risk inherent in the very concept of the market, and not every decision in business, however well meaning it might be, can always be successful.

Furthermore, as I have said frequently, there is hardly a country in the world that has not had to come to terms with a banking crisis within the last fifteen years, from the USA to Sweden, Finland to Japan, from Estonia and Latvia to the Czech Republic and Hungary.

Once again, I have to say in public that the procedures of some of the members of bank management and supervisory boards that denounce the CNB for the bad management of the banks that they managed or supervised are absurd. It is the same as if the manager of some company denounced the financial police, claiming that they were to blame for his having run his company badly or having embarked on some legally forbidden activity. Like a driver who has been stopped by the traffic police accusing the policeman for his having driven too fast. I have to say that it is actually quite amazing that such pieces of logical bravura can be sold to the public, day after day, case after case. I hold the calls of some politicians and business people that the Governor of the Croatian National Bank be dismissed as a result of such kinds of accusation to be the absolute height of absurdity.

Secondly, the CNB started building up most of its functions practically from zero when Croatia became independent. At the beginning of the nineties, there was no Supervision and Control Section capable of effective supervision of the banks in the contemporary sense. And when I took over the duty of governor in March 1996, this department, although already considerably better equipped, was quite clearly inadequately prepared to deal with the problems of the rapidly developing but already bloated transitional banking system, with its almost 60 banks and some twenty savings banks. It is well known that there is no way of creating at short order a highly qualified and effective supervision and control system. For this, years of training, work and experience are required. What has, however, been achieved in the meantime in the CNB in the area of bank supervision will be addressed later.

Thirdly, one objective barrier in the way of a more effective system of bank supervision was the then Banks and Savings Banks Law, which did not sufficiently allow the CNB to take an active part. It was only the new Law of the end of 1998 that allowed us to make a rapid and effective impact on the banks. Accordingly, it was only then that we could take effective measures vis-a-vis banks in which we had earlier spotted problems. It was actually thanks to the urging of the CNB that the last government proposed the kind of law that gave us the necessary authority.

Fourthly, something that certainly did not help the central bank to supervise banking institutions, at least from the time I have been at the head of it, was the political climate in which the banking system developed, a political climate, throwbacks to which have been visible in the last few days, in which there were attempts to get the CNB to act at variance with the law through political pressure. The general public is probably not aware that in most developed countries, the major part of the supervisory work of the central bank is done through what is called moral persuasion. This does not use the directly repressive measures that are allowed by the existent laws, but depend during talks with the management of a bank on the authority of the central bank that derives from its independence and from the measures foreseen by the law that it can employ if necessary. In the great majority of cases, this is enough for a bank to change its manner of behaving. In this country, unfortunately, this was not the case, partly because some bank managements deliberately flouted regulations for their own benefit, and partly because a climate had been created in which some banks were politically protected, and thus did not believe that it was necessary to take the corrective measures enjoined by the CNB.

The rôle of politics in banking is always exceptionally harmful and costly. I have to remind members that I warned of this in my address to this House on June 4, 1998. Then I said: "I advocate the elimination of any kind of political influence on the banks, which should lend their money only on the basis of professional banking decisions. The banks may not be charitable institutions or local development funds; they are business outfits. For this reason, let us leave the management of banks to bankers, because this is a complex and highly professional business. In the same way, let us not all fall into the trap of the politicking creation of distrust in the banks, because there is no reason for it. Only in this way can the banks look after the money entrusted to them and only thus can the stability of the overall financial system be maintained, and this is the basis for economic progress”. Two years later, I can do nothing but repeat this same call.

The four reasons just stated were the main causes of what is called in Croatia today the second banking crisis. Could the CNB have stopped the second banking crisis? No. The most that could have been done, perhaps, was that some of the banks that went under could have been closed a little earlier. I am sure, however, that in this case the attacks on the CNB, both political and from the public, would have been still stronger, including statements that it was the CNB that was destroying banks that were really quite healthy. We have been exposed to violent attacks for two and a half years. The extent to which more rapid closures might have been possible is the only thing that we can discuss at a technical level as the CNB’s possible share in the responsibility.

Those who think that the crisis of part of the banking system could have been totally avoided in the situation in which I was appointed to this post are not right, I am afraid. I have never avoided my responsibilities for the consolidation of the banking system, and I will not avoid them today. Someone had to carry out the elimination of bad banks from the market, because the problems existed. Problems in the banks cannot be wiped out or eliminated at a simple stroke of the pen. What was the main aim in this work has been achieved: we have avoided a systemic crisis in Croatian banking, which might have been, had it not been avoided, much more expensive than the 800 million dollars that the second banking crisis has so far cost. Certainly, there have been things along the way that we might have done better, as can be seen today much more easily with hindsight. But I am equally convinced that the bill for the second banking crisis would have been much bigger if we had conducted ourselves according to the advice and procedures recommended by the critics of the policy that, for all the constraints I mentioned earlier, we did actually run with respect to the banking sector. I repeat, and this is not the evaluation of the CNB alone, but that of independent foreign analysts as well, the CNB did carry out its main assignment: it stopped the crisis taking on systemic dimensions, and thus creating considerably greater costs.

Today, standing before this House, I can say with all due responsibility that the business of settling the situation in the Croatian banking system is going on successfully, and that we are beginning to harvest the first fruits of the on-going consolidation process.

The situation in Croatian banking is much better than in the last two years, and particularly than it was five or ten years ago. Let us not forget that ten years ago the Croatian banking system as a whole was insolvent. The improvement can be seen in the banks’ performance and in the gradual fall in interest rates in the banking market that occurred before any measures of monetary policy. Today the interest rates are half of what they were when I came into office. This is a sign that the restructuring of the banking sector has at last given rise to increased efficiency. I have to say that we in the CNB are extremely pleased with this and see a good outlook for the whole of the banking system in the years to come; we see a continued increase in efficiency, a fall in interest rates, the reduction of loan risk and, as a consequence, a much more stable banking system.

I would hope that after the rapid privatisation of Riječka Banka and Splitska Banka foreign strategic investors will be more in evidence in the Croatian banking market than in Hungary, the banking market of which is considered the most efficient in the transitional countries of Central and Eastern Europe. This is a guarantee of the stability of the domestic banking system in the future and something that can have a soothing effect on savers, after the consolidation problems that our banking system has had to go through in the last two years.

At the end of 1998 this House voted in a new Banking Law, which made it possible for the CNB to act much faster and more efficiently, and to reduce the costs of future banking difficulties.

The Supervision and Control Section, which is still in the process of being created, is today at more or less the same level as those in other advanced transitional countries with which we should compare ourselves. It is capable of coping with the current situation in the banking system. I repeat that I am proud of the advances that have been made in this part in the last few years. Here are a few figures in support of my claims. During 1999 and the first few months of 2000, thanks to changes and progress in the undertaking of the supervisory function, and also to the new Law, a total of 87 inspections have been carried, ten provisional administrators and three commissioners have been appointed. Unfortunately, in the period between 1998 and 2000 it was necessary to look for bankruptcy proceedings in 12 banks and four savings banks, while two banks and six savings banks had their operating licenses withdrawn. Furthermore, in 1999 and 2000, 63 different rulings were made, related to the establishment of insolvency, or for the sake of improving the state of affairs and obviating illegalities and irregularities, 43 complaints were made, and more are in preparation. It should also be stated that in the case of ten banks and two savings banks the criminal police were called in, the financial police and the state attorney. In addition, during 1999 a great number of byelaws were passed and regulations drawn up.

All of this, honourable Members, was done in institutional and economic conditions that were far from easy, with the status quo that I described at the beginning and in an atmosphere of constant pressures from interest groups that directed, and still do direct, the attention of the public against the CNB, in order to conceal their own objective responsibility for the situation in given banks and savings banks.

I would particularly lay stress upon the fact that those who consider the Croatian National Bank alone could in its work make up for the years of accumulated financial indiscipline, that it could have stopped corruption and business crimes, that it could have corrected the mistakes made in privatisation, that it could have made up for the non-existence of a special institution dealing with financial frauds of the most complex kind, that it could have made up for the ineffective work of the supervisory boards in the banks, and finally, for the work of those who made the decisions about where to lend money, the banks’ managements, are living in an illusion. We have drawn public attention to this for years.

I do not wish here to evade my own share of the responsibility. I would only like there to be a just weighing of the roles of all the institutions in Croatia in the recent construction of financial discipline and a state ruled by law and order. Please be objective; demand a great deal from the Croatian National Bank and its Governor, but do not expect the impossible. What I cannot accept is that, without good reasons and objective professional evaluations about what supervision of the banks can and cannot achieve, there should be attempts to conceal the real reasons for the problems and difficulties in our banking sector and indeed in the whole of the economy. Bear this in mind: does this kind of viewpoint, this kind of debate, make any contribution to the detection and solution of the real causes of the difficulties?

2. Monetary policy

I would like to devote the second, much shorter, part of this address to the implementation of monetary policy. Its basic objective is price and exchange rate stability. During recent years we have had exceptionally good results in the maintenance of price and exchange rate stability. The mean rate of inflation in the last medium term period was lower in Croatia than in any other transition country. We can be proud of that.

I have to stress that this was achieved in a situation in which we did not peg the exchange rate, but let it adjust to the changes in the economic fundamentals, in such a way that stability was not threatened and without allowing the stability of the entire banking system to be put in jeopardy because of excessive oscillations in the exchange rate and the currency risk in the banks’ balance sheets and in the balance sheets of domestic companies and households. Currency substitution, that is the replacement of the domestic by a foreign currency, is very great in Croatia, which places a limit on the effectiveness of monetary policy. In the situation we are in, any sudden change in the exchange rate would threaten all those who have obligations denominated in a foreign currency or indexed to one, but whose income is in kuna. If a great number of firms lost the ability to meet their obligations because they were suddenly increased in this way, the stability of the whole financial system might be called into question. For this reason, among other things, the Croatian National Bank has for years resisted the idea that devaluation is a solution to the problems of the economy.

Alongside the idea of devaluation, in recent times the idea of Euroisation has appeared, that is, the total replacement of the kuna by the Euro, as the only legal means of payment in Croatia. Without going here into a detailed discussion about the reasons for and against Euroisation, one ought say quite clearly that there is no exchange rate regime that can make up for or replace structural changes. With or without the Euro, we will have to work more, better and more efficiently. In the economy, there are no short cuts.

In these circumstances I would like to say a few words about the way we in the CNB see monetary policy this year. The right macroeconomic policy combination does not mean – as has been the case in a large number of transition countries, and in Croatia, a combination of a restrictive monetary and an expansive fiscal policy, but a balanced combination of these two levers of macroeconomic policy. Otherwise, after some time, a country will usually find itself in danger of high inflation and exchange rate instability.

This year’s budget is on the way towards what we in the CNB have been advocating over the last few years, that is, constraints on the growth of public expenditure, and bringing order into the state’s finances, that is, of meeting the financial obligations of the government on time, when they become due. This has given the CNB more manoeuvring space in which to run its monetary policy. To the extent to which the requirement to fulfil the fundamental objectives of the CNB will permit, the central bank will use measures of monetary policy, and not only of the consolidation of the banking sector, to bring about the further reduction of interest rates and the growth of lending in the healthy part of the economy.

I would like, however, once again to stress the point that monetary policy is not the main determining factor in the amount of the interest rate on the Croatian market. The interest rates, as we have repeated year after year, are the product of numerous structural factors such as: the microeconomic efficiency of the banks, i.e., their restructuring and cost cutting, the structure of the banking market, which is segmented, the ability of the judiciary to protect creditors, and so on. As in many other cases, there are no easy solutions to bring the rates down; instead, a relatively wide range of measures of economic policy has to be implemented.

Interest rates are high in Croatia today, particularly as compared with those in developed countries. However, it is worth recalling that in March 1996 the overnight market interest rate was about 30 per cent, that the lending interest rates of the commercial banks were about 25 per cent, and that today the overnight rates are practically in single figures, and lending bank rates are exactly a half of what they were four years ago. This, then, is a long-term trend towards the lowering of interest, and it is certain to continue.

Keeping up with the many articles written about the economic problems, I have noticed something that gives me concern in recent times, and that is the offering of quick-fix solutions for the profound and complex problems of the Croatian economy. Mainly this is a matter of offering "as a panacea for all the ills in our economy” changes in monetary policy in the direction of much greater expansiveness. The logic behind such thinking is that a greater money supply will reduce interest, solve the problem of "lack of liquidity” (which is in essence the problem of insolvency and lack of financial discipline), increase investment, increase growth, reduce the value of the "over-valued kuna” and thus stimulate exports, and thanks to all this the problem of very great unemployment will also be solved and of course provide the standard of living that all the citizens of this country have the right to want. One gets the impression that in most of our economic woes, it is monetary policy that is the primary problem. The acceptance of quick-fix solutions, and above all monetary expansion, would be a highly retrograde step and would get in the way of our being rapidly integrated into Europe. But it would not solve our key problems of stagnant exports, insolvency and unemployment.

Ladies and gentlemen, what a fine thing for me personally and for the whole of the Croatian National Bank it would be if solutions were so simple. If problems in the real sphere, in the functioning of law and order, in the structure of our exports, in high unemployment and so on could be solved by the mere printing of money, why then, I put the question in public, would we worry our heads about reducing costs, efficiency, the competitive struggle and so on? Why does that Europe we so often refer to and to which we aspire not employ such solutions, but is on the contrary hard at work on the new economy of the 21st century, on increasing knowledge, expansion via the Internet, on the new technologies and restructuring?

Monetary policy is a powerful instrument, especially in the maintenance of price stability. And so let us not set it tasks that it is incapable of performing satisfactorily. The abuse of monetary policy will just lead to inflation, which is, I repeat, nothing but theft, theft from the poorest. I have always stood out against inflation, and shall continue to do so.

3. In Conclusion

There are, I repeat, no quick and easy solutions. This is what has to be done. Firstly, maintain price and exchange rate stability. Secondly, go on with structural changes in the banking sector by concluding the privatisation of the rehabilitated state banks and the consolidation of the rest of the sector. Thirdly, go on with the stepping up of the supervision of the banks. Fourthly, in the conditions created by the new fiscal policy, attempt to reduce the proportion of the mandatory reserves, to the extent allowed by the achievement of the primary objectives. Fifthly, improve the regulatory framework, including the law about the central bank, which needs updating in line with European standards. Sixthly, go on with and complete the changes in the payments clearing system. Seventhly, maintain and reinforce the international reserves, which have in the last few years played the important rôle of guarantor of stability.

It is particularly important to step up the payment of insured savings, which is the responsibility of the government, and will have an effect on confidence in the Croatian financial system.

The independence of the Croatian National Bank in future, which we all believe in, must not however mean its isolation. It can completely achieve its aims only in cooperation with others. The implementation of the objectives of the CNB depends, that is, among other things, on: firstly, institutional conditions, such as the functioning of the judicial system; secondly, on the existence of an at least outline consensus on the optimum combination of monetary and fiscal policies; thirdly, on a reinforcement of all the institutions that are essential to provide equal market competition, with a special emphasis being placed on the strengthening of financial discipline and the application of institutional sanctions to corruption; fourthly, attracting foreign direct investment, and entry into various trade and economic associations (WTO, CEFTA, OECD, EU); and fifthly, a stable political environment and still greater openness to the world, for there is simply no alternative to this route.

The implementation of these objectives also depends a great deal on the degree of public support that the policy of the CNB either has or does not have. For without clear and unambiguous backing from the public at large for the healthy policies and tasks that I have mentioned, they will be for a certainty impossible to implement. I would particularly like to ask you, ladies and gentlemen, members of this House, let us use together this most important platform in Croatia to send a message to Croatian savers and the Croatian public that Croatian banking is more stable than it was two years ago, and much more stable than it was five years ago.

The difficulties we are now in, and those that we will certainly come up against, must not be a reason for us to give up on the objective. On the contrary, they have to be an additional spur to us to persevere, for our own sakes, for the sakes of our children and their children.

Ladies and gentlemen, members of this House, I invite you to take part in a calm, professional and reasoned discussion about the situation in the banking system and the work of the central bank, in this place where this debate should be held, in this House. Monetary policy and the stability of the banking system are too serious things for judgements about them to be made without such a debate.

Let us try to rise above the artificially created atmosphere in which the central bank and its governor are, on the one hand, accused of having helped to create the so-called tycoons and, on the other, put in dock by those same tycoons for having brought about their downfall. Let us be above the sweeping judgements that would, on the one hand, suggest that it was a firm monetary policy that brought down the last government, while, on the other, they hint that the same policy was simply servile to that government. One the one hand they accuse us of having let the managements of the problematic banks alone for too long, and on the other they say that we are taking precipitate measures without letting them find their own way out of their difficulties. And as for the recent avalanche of attacks because we have put a provisional administrator into Istarska Banka, let it once and for all be said whether there was anything in this against the current laws of this country, and whether we behaved towards this bank in any way differently than to other banks in the same situation.

Let us respond today to the question: what really is the nature of this policy? The public has the right to a serious answer to this question. Behind the Croatian central bank, during the four years I have held the office of governor, there are four years of price and exchange rate stability; international reserves have been at a historic high, contributing to the investment rating of Croatia with the most important world agencies; there has been the achievement of difficult consolidation of the banking system in which a systemic crisis was avoided, and which has led to interest rates that are half what they were at the beginning of my period of office. For this reason, I cannot offer my resignation until the public, the Council of the Croatian National Bank, its employees, and I personally have been told what there was in our work that outweighed all this. For this kind of debate about the reports of the Croatian National Bank, I am at your service today.