Financial Crisis and their affects on the F inancial System & Real Sector in B&H

1. Financial Crisis and their affects on theFinancial System & Real Sector in B&H Damir Njuhović, PhD Candidate at SSST/Buckingham University International Burch University, Sarajevo date: 17.04.2012

2. Three broad topics • History of Financial system in B&H • How did 2007/2008 Crisis start / spill over to B&H / result in new Crisis 2011/2012 • The consequence on B&H economy (banks and real sector) • Practical examples & possible way forward

3. 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

4. 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

5. 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…)

6. 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

7. 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.

8. 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

9. 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)

10. 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

11. 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?

12. Question and answer session

13. 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

14. 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

15. Low correlation in crisis and non crisis periods RWA:

16. 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

17. 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

18. 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

19. Practical examples (see paper) Examples of how companies from different sectorsof 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)

20. 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

21. 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)

22. 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……

23. 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…….

24. 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

25. Question and answer session

26. 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