Bosnia and Herzegovina (BiH) has been an independent country for almost 20 years. During that time its banking system has been through a complete transformation and faced the impacts of one of the world’s most serious financial crises. It has gone through these two significant financial events successfully without having any Lender of Last Resort (LoLR) facility to support the process. This article looks at whether the absence of a LoLR was a problem in these two instances and whether the Central Bank of Bosnia and Herzegovina (CBBH) should establish a LoLR facility now.
When the Central Bank of Bosnia and was established in 1997, it was structured as a strict Currency Board. This required it to have full foreign-exchange backing for all its domestic currency (KM) liabilities and prohibited it from lending to anyone, including the government and banks. The main reason for this was so that the CBBH could provide an element of stability in an environment that had been through extreme instability: hyper-inflation, war, bank failures and political breakup.
When Bosnia and Herzegovina was established as an independent state, it inherited a banking system that was a mix of state-owned banks from former Yugoslavia and newly-created local privately-owned banks. During the war that preceded independence, the banking system had split into three quite distinct regional systems.
When the CBBH was established in 1997 as the sole Central Bank in BiH and I went there as its governor, there were 76 registered banks operating in BiH, a country of around 4 million people. None of those 76 banks operated over the whole country and most were very small.
Aggregate deposits in the 76 banks were only around 500 million euros. Though there were a lot of banks, the banking system played little economic role as the citizens preferred to keep their savings under the mattress rather than in banks, and the banks therefore had limited funds to lend.
Over the following 20 years, the BiH banking system has been transformed into a system of 27 banks that is dominated by four foreign-owned banks that operate over the whole country. Total bank deposits have risen to over KM15 billion (Euro 7.5 billion) and the banking system now plays a major economic role in the country.
This transformation came about in the following ways:
- Some major foreign banks entered the market by purchasing the better of the locally-owned banks. In some cases, they purchased more than one local bank and merged their operations. The two biggest banks in BiH today were both established in this way;
- Most of the state-owned banks were sold or closed;
- The other small, local, privately-owned banks were also either merged or closed.
In all, the two BiH Banking Agencies (there is one in each BiH Entity), with a coordinating role from the CBBH, closed around 30 local banks during this transformation phase. Some depositors’ money was lost during the transformation. The amounts were not large, mainly because the citizens did not hold much of their savings in these early BiH banks. Also, not all the deposits that were lost were those of Bosnians. Some international embassies and IFIs also lost deposits in the process.
This complete banking sector transformation process was done without any LoLR to assist or smooth the process, and without public sector support being provided in any other way. So clearly, the absence of a LoLR was not a problem for the banking sector transformation process in BiH. But would the existence of a LoLR have helped the process? I doubt it.
If the CBBH had been able to provide LoLR support to save some banks or ease the transformation of others, it would then have had to decide which banks were solvent and which were not, which banks were systemically-important and which were not. (Though in truth, at the time few of the banks were systemically important.) I suspect the pressure on the CBBH to provide support both from local shareholders – many of whom had strong political connections – and from local and foreign depositors to save them or help them through the transformation process would have been considerable. Any support granted would have slowed the transformation process and probably opened the CBBH up to criticisms of favoritism and bias. I was very glad that the CBBH Law gave me a single and simple answer to all such pressure – the CBBH cannot help.
By the time the global financial crisis occurred, the banking system in BiH was in a much-improved condition. Most of the banks were well-capitalized and very liquid. Part of this was due to the nature of the banking environment in BiH and the decisions of the banks themselves.
But most of it was due to the strength and soundness of the banking sector’s regulatory framework in BiH. Most of the regulatory framework had been put in place in the late 1990s when the banking system was still very weak. The regulations imposed strict requirements on capital, liquidity, maturity mismatches etc. They had been eased a little as the banking sector became better governed and financially stronger but it was still a strict system. So the banks in BiH were not able to build up any of the extreme balance sheet positions or mismatches as banks in some of the world’s major financial markets were able to do.
The direct effects of the financial crisis on BiH were also limited because the banking system in BiH did not have extensive or strong interconnections with the international financial markets, despite the high level of foreign ownership. Their primary financing source was local retail deposits. For the most part, these remained stable during the financial crisis. The instances of deposit withdrawal that did occur were temporary and related to concerns about the parent bank rather than the BiH subsidiary. Some deposits were withdrawn from the foreign-owned banks and put into locally-owned banks – the reverse of the usual expectation.
The CBBH and the BiH Banking Agencies handled these temporary problems well (I was no longer the governor by this time). They did not have a need for a LoLR to handle the impacts of the global financial crisis on BiH banks. This was primarily because the regulatory framework in BiH had prevented BiH banks from establishing large balance-sheet mismatches; and the BiH banks were essentially Volcker-style retail banks.
Does BiH need a LoLR facility now?
The IMF played a major part in the design and establishment of the CBBH and in the decision to set it up without a LoLR facility. This was not an oversight. It was a key element of the CBBH design. In discussions I had with the IMF late in my term as governor (probably around 2002) the IMF was still strongly against giving the CBBH any LoLR powers for the following reasons:
- Problems of choice and potential moral hazard: These problems exist with LoLR facilities everywhere. It is not always easy to distinguish a bank which is solvent but temporarily illiquid from a bank that is illiquid because it is facing solvency problems. A decision to lend or not to lend usually has to be taken very quickly: in hours rather than days. Though they never explicitly said it to me, the IMF may have had doubts about the capacity to take these sorts of decisions in BiH, especially as responsibility for banking supervision was split between three agencies;
- Limited need for liquidity support: The banking system in BiH at the time was highly liquid and substantially foreign owned. The immediate need for a LoLR facility did not look like a high priority. What the IMF proposed as an alternative, and assisted with, was to help strengthen the existing sources of liquidity available to BiH banks through a so-called Vienna initiative, which focused on parent bank support and other mechanisms such as credit lines;
- Limited scope to provide LoLR because of the currency board requirements: Most LoLR facilities set strict conditions under which banks can access LoLR money from the Central Bank and then leave the amount of lending under the facility to the banks based on their needs. The currency board requirements of full foreign exchange backing for all the CBBH’s KM liabilities would not allow the CBBH to operate an open window. The amount the CBBH could lend via LoLR would be limited to its “excess foreign assets.” When the CBBH was first established, this number was zero. It is now positive and around KM500 million (250 million euros). If requests for LoLR loans exceeded this level the CBBH would have two options:
- Breach the currency board restriction. This would have required a change in the CBBH Law and nobody supported such a proposal. The Currency Board has delivered a high degree of financial stability to BiH in an otherwise very unstable environment;
- Refuse to lend once the limit was reached. This was the only feasible option but it undermines one of the basic tenants of LoLR schemes.
None of these positions or arguments have changed since 2002. The only thing that has changed since then is that the world’s financial markets have been through a major crisis, and liquidity problems and pressures were one of the crisis’ major manifestations. This seems to have caused the IMF to change its position on the absence of a LoLR in BiH as they are now proposing that a limited LoLR facility be established in the CBBH.
But BiH did not suffer any major direct effects from the last financial crisis. This wasn’t due to luck. It was due to the structural characteristics of the BiH banking system. These same structural conditions still exist today. So I still do not see a need for a LoLR facility in the CBBH.