Friday, 22 July 2016

Slovenia and the banks

I bet you've never heard of Slovenia. It's at the north end of the Balkans, squeezed between Austria, Italy and Croatia on the Adriatic coast. It's small, peaceful, and prosperous compared to the rest of the Balkans. It is also stunningly beautiful, in a mountains-and-lakes sort of way. It is in many ways rather like Austria.

But at the moment, Slovenia is famous not for its lovely scenery, or its important history, or its rich culture. No, it is famous for its banks. And not in a good way. Slovenia's banking crisis is a long-running sore.

Slovenia's story is an all too familiar one. When it joined the EU in 2004, it entered the Exchange Rate Mechanism (ERM II) as a precursor to joining the Euro. EU membership requires free movement of capital across borders, and under ERM II its exchange rate was soft-pegged to the Euro. So it effectively lost control of monetary policy. The result, of course, was a mammoth inflow of foreign funds, a huge credit bubble, an enormous spike in real estate prices, and a massive current account deficit. This chart from a paper by the Bank of Slovenia on the causes of the banking crisis shows the buildup of credit from 2004 onwards, and in particular the strong spike in lending after Slovenia joined the Euro at the beginning of 2007:

Interestingly, in Slovenia the credit bubble seems to have affected corporations far more than households. And like most countries in Europe, the credit bubble burst at the end of 2007, not 2008.

You would think the bursting of the credit bubble would cause the greatest damage. But in Slovenia's case, the most harmful effects came from another source - the balance of payments. When you are locked into a currency union, a large and rising current account deficit is dangerous. All it takes is a shock somewhere else in the world for investors to refuse to finance it - and because you cannot devalue and you have no control of monetary policy, investor flight forces a wrenching adjustment to the balance of payments, usually accompanied by widespread distress in the real economy and a rapid fall in GDP. This is what we call a "sudden stop". And this is what happened to Slovenia in 2008 when the financial crisis hit.

Here is the Bank of Slovenia's lovely chart of Slovenia's sectoral balances. You can see how the external deficit (blue-green bars) rose from 2002 onwards and rapidly from 2007-08. When the financial crisis hit (box outlined in red) it abruptly switched from deficit to near-balance. At the same time, corporations rapidly deleveraged as the credit bubble burst (dark red bars). And the fiscal deficit (pale blue bars) surged from a perfectly reasonable 1.7% in 2008 to 6% in 2009. As a result of this, Slovenia was put into the EU's Excessive Deficit Procedure in November 2009.

The sharp-eyed among you will note that there is an even larger reversal between 2012-13. I shall return to this shortly. But for now, let's stick with 2008.

This table shows just how large the swings in investment and trade were between 2008-9 (outlined in red):

Note that the balance of payments adjustment involved sharp falls in both imports AND exports, both goods and services. This fed through into a steep drop in GDP.

And this is what the investment reversal looked like, charted:


The association between excessive bank lending, funded by cross-border investment flows, and Slovenia's sudden stop could hardly be clearer. But just in case anyone doesn't get it, the Bank of Slovenia spells it out:
The result of the fast growth of lending based on foreign borrowing by domestic banks and thus the increasing of the net debt of the Slovenian economy was increased vulnerability to financial shocks in the rest of the world, which materialised after the fall of Lehman Brothers in 2008.
I want this statement to be framed and hung on the wall of every economics department, Treasury department and central bank in the world. Oh, and business schools, too, since tax-adjusted Modigliani-Miller has done more damage than almost any other theory, encouraging as it does high leverage and a preference for debt financing over equity. High debt levels increase economic fragility and vulnerability to shocks. That applies to corporations, households and governments alike.

Slovenia's problem was not public sector debt, which even after the crisis was low by EU standards at about 30% of GDP. It was private sector debt, particularly corporations and - later - banks. And the 2008 "sudden stop" clobbered its economy. The GDP fall of 7.9% in 2009 was one of the worst in the EU.

However, as the table shows, it bounced back quickly. The economy started to grow again in 2010 and exports recovered, although investment continued to decline due to the legacy of the financial crisis elsewhere in Europe. Balkan countries suddenly weren't attractive investment prospects any more.

Nevertheless, by 2012 Slovenia looked as if it was on the road to recovery. Yet within a year, it was back in recession and its banks were collapsing. What went wrong?

In fact, the recovery was an illusion. Slovenia's economy was in deep trouble: its banks were weak and under-capitalised, its corporations were suffering due to the slump in demand, and to crown it all it was being expected to impose a yearly fiscal tightening of 0.75% of GDP.  Non-performing loans rocketed between 2008-12 as the weak economy took its toll on highly-indebted businesses:

Slovenian banks were already poorly capitalised, even by European standards. The rising NPLs ate the little capital they had, making an eventual state recapitalisation inevitable.

And their funding situation was dire. They had been unable to fund themselves since the 2008 sudden stop when their foreign funding inflows dried up, and had became completely dependent on the sovereign for funding. It worked like this: the Slovenian government issued bonds, which were bought by its banks, who then pledged them to the Bank of Slovenia for Euro funding. It kept the banks alive, but the toxic embrace between the sovereign and the banks threatened the stability and solvency of both. The inevitable sovereign credit downgrades followed in 2012 and 2013.  

In December 2013, the ECB's stress test results revealed a total capital shortfall in the Slovenian banking sector of 4.8bn Euros (about 10% of GDP). The three largest banks failed the tests. On 18 December, the European Commission approved Slovenia's plan to inject 3.2bn Euros of new capital into its banks and transfer non-performing loans into a new "bad bank", the Bank Asset Management Company (BAMC), Junior bondholders were forced to take a haircut of an estimated 600m Euros, and shareholders were wiped.

The junior bondholders - and even the shareholders - fought this bail-in tooth and nail. The Slovenia Times reports that the Slovenia Constitutional Court "admitted several applications" by subordinated bondholders to have the bail-in overturned. The Constitutional Court referred the matter to the European Court of Justice. This week, the ECJ gave its judgment. And the judgment has resolved - well, absolutely nothing.

The case hung on the interpretation of a Communication from the European Commission in 2013 which established the ground rules for the granting of state aid for banks in the financial crisis. This is known as the Banking Communication. The ECJ decided that the Banking Communication "must be interpreted as meaning that it is not binding on the Member States."

Bondholder representatives were delighted:
We are very satisfied with the ruling," said Mr. Kristjan Verbic, President of VZMD. "VZMD and Better Finance - The European Federation of Investors and Financial Services Users consider this decision to be a victory for investors. The European Court of Justice ruled that 'expropriations of and encroachment upon shares and bonds of Slovenian banks were neither necessary nor unavoidable for the restructuring of the banking system and allocation of state aid.' VZMD has maintained this was the correct analysis since the very beginning."
No doubt they will now go back to the Slovenia Constitutional Court and petition for the bail-in to be overturned, with the backup of an appeal to the European Court of Human Rights if the Constitutional Courts slaps them down.

But I fear they are wrong. The Banking Communication does not impose a requirement on Slovenia to bail in subordinated creditors and shareholders, but it doesn't prevent it from doing so, provided that the bail-in doesn't exceed what is necessary to overcome the banks' capital shortfall and doesn't leave creditors in a worse position than they would have been in had the bank failed. Indeed, as the judgment goes out of its way to emphasise that the Banking Communication provides for shareholders and subordinated debt holders to share in the losses from a failing bank, it is hard to see any reason for the bondholders to rejoice. Unless they can show that bail-in was either unnecessary or discriminatory, they still have no case.

And Slovenia can't possibly afford the cost of overturning the bail-in, anyway. Three years on, Slovenia is still in a bit of a mess. The bank bailout raised the government deficit to 15% and public debt/GDP to 71%, and Slovenia additionally suffered a brutal recession: even now, registered unemployment remains above 11% (though the unemployment rate from labour force surveys is lower, currently 8.9% according to the Slovene Statistical Service). GDP growth returned in 2014, but is set to taper off somewhat in 2016. Fiscal consolidation under the Excessive Deficit Procedure has brought its fiscal deficit down below 3%, but at the end of 2015, Slovenia's debt/GDP was 83% of GDP.

The IMF has just completed its latest Article IV consultation, and the principal findings are worrying. It appears that, expensive though it was, the bank restructuring was insufficient to restore normal credit conditions. Non-performing loans remain high, and bank lending is still contracting despite falling interest rates and loosening credit conditions. Partly, this is due to low credit demand, especially among smaller companies, many of which are still highly indebted and struggling to meet their obligations. The truth is that Slovenia's supply side has taken a terrible hit, and recovery is proving very slow and painful.

So what lessons should we draw from this?

Firstly, that relinquishing control of monetary policy by opening the capital account and fixing the exchange rate carries a terrible price. The Bank of Slovenia lays the responsibility for the 2004-8 credit bubble primarily at the door of the ECB, whose interest rate policy was too loose for Slovenia at that time. But the ECB had to consider the Eurozone as a whole, and Germany at that time was in the doldrums. Interest rates were inevitably lower than the overheating Slovenia needed. Slovenia is by no means the only Eurozone country with this problem. It may be that in the future, movement of capital in the Eurozone will have to be moderated to prevent the large destabilising capital flows that have caused so much damage over the last decade.

And secondly, that banks MATTER. Unless fiscal finances are very stretched, as in Greece, repairing banks should be a far higher priority than repairing fiscal finances. Repairing the banks early reduces the damage to the economy that a wrecked banking sector causes, and the return of bank lending brings recovery, as Latvia's remarkable performance has shown. This can help restore fiscal finances without the need for years of painful consolidation.

When researching this piece, I was struck by how little attention was paid to the state of the banking sector until it was far too late. The Bank of Slovenia comments that the Slovenian government did not take action to recapitalise its banks in 2008-11 when it should have done. But the IMF conducted two Article IV reviews during that time. And Slovenia was in the Excessive Deficit Procedure throughout, under regular supervision from the European Commission. The primary focus of both the IMF and the EC was on fiscal finances, and the IMF additionally did a "special issues" report in May 2009 that focused on inflation - yes, inflation, in a country which was in deep recession. Throughout all of this, the looming implosion of the banks appears to have gone almost unnoticed. If these august institutions don't take any notice of banks and their crucial role in making or breaking an economy, why on earth should we expect governments to?

Related reading:

Property, inequality and financial crises
How do you say "dead cat" in Latvian?
A Finnish cautionary tale
Black Thursday

Image from


  1. This comment has been removed by the author.

  2. So why is everyone so determined to keep the Euro? It seems to cripple every country except Germany.

  3. "...peaceful (by Balkan standards)..."

    Stopped reading after that.

    1. Ranked 10 on the Global Peace Index, right after Japan.

  4. ...peaceful (by Balkan standards).

    Do you realize Slovenia is one of the safest countries in the world?

  5. You're painting a too bleak picture of Slovenia. GDP growth is steady around 3% since 2014, and not 1%. Current account surplus is 8,5%/GDP, higher than Germany's for example.

    Also the banks are now one of the most capitalized (overcapitalized even) in the EU.
    And this is the main issue the bondholders and shareholders have; that the banking rescue was excessive, the bank's assets were valued through undisclosed secret procedures, that completely sidestepped standard accounting practices. The hole in the banks was calculated exactly so that all subordinated debt holders were completely wiped out. This was done so that the fiscal burden on the budget would be minimal, since when the recapitalisation was done the yield on govt bonds was at unsustainable levels. So, the shareholders and bondholders point is that they were harmed with this "virtual" bankruptcy of most of the banking system, and they would have gotten more out of their shares and bonds if the banks went through a regular bankruptcy procedure.

  6. Dominik Gruskovnjak, your comment has been deleted because it violates the comments policy of this blog. You can find the policy on the About This Blog page.

  7. Anonymous,

    Fair point about GDP, I will correct. The year-on-year growth rate is currently 2.5% and has been hovering between 2-3% since 2014. However, it is forecast to fall below 2% this year. See the IMF Article IV 2016 link in the text.

    I do not regard a very large current account surplus as a positive feature.

    Regarding the banks:

    - while NPLs remain a problem, bank capital will remain at risk.

    - I'm aware of the issues around the approach to the bank recapitalisation, but it is not primarily the focus of this article.

  8. < And Slovenia can't possibly afford the cost of overturning the bail-in, anyway.

    Overturning the bail-in would cost "Slovenia" about 1% of Slovenian GDP (a glance might suggest more like 1.4%, but mind that a considerable portion of sub debt was held by the state and state-owned entities). Is that something a country "can't possibly afford"?

    But perhaps more importantly, did it escape the author's attention that regarding the BoS, the publications whereof are the almost exclusive source for her writing, the Slovenian National Bureau of Investigation and the Slovenian Public Prosecutor’s Office have two weeks ago stated that the evidence they gathered in the ongoing investigation provides substantiation for BoS’s purposeful tampering with the banks' balance sheets as to paint a picture bleak enough to warrant a full wipeout of all the subordinated bonds in all the Slovenian banks that had them, without any compensation, all in the single night of 18 Dec 2013?

    It is rather incompatible with the laws of probability that of the 19 banks, 6 had sub bonds, and BoS detected negative equity in all the latter 6 and in none of the other 13. Furthermore, the Slovenian press has published an e-mail exchange between lower EC officials and Slovenian financial decision-makers containing a rather bizarre langue de bois ("enhanced burden sharing", as a codeword for a wipeout without compensation and without the right to its legal challenge), strengthening further the impression that implementing "enhanced burden sharing" on all Slovenian banks' sub debt then in existence was rather a politically-, and not financially/economically-based decision.

    1. There is no way a country that is running a fiscal deficit of nearly 3% of GDP,has high unemployment and slowing GDP, is a Euro member and is still in the Excessive Deficit procedure can afford an additional 1% of GDP to overturn the bail-in.

      You seem to have wanted me to write a different post. I am not discussing the wrongs or rights of the bank bail-in. I am describing how we got to this point.

    2. I seek no quarrel, but for Slovenia:
      (1) the latest EC estimates/forecasts for the fiscal deficit are 2.4% for 2016 and 2.1% for 2017; spreading 1% of GDP over several years does not seem that utterly unaffordable;
      (2) the EC forecasts for GDP growth in 2014 and 2015 turned out to be strong underestimates (again, reportedly/purportedly due to the bleak predictions submitted by BoS), so forecast of "slowing" GDP growth of 1.7% for 2016 may well turn out the same, and moreover, the forecast is 2.3% for 2017;
      (3) ranked by the unemployment rate, using the same-for-all methodology of Eurostat ( ), Slovenia's 8.1% was in May 2016 better than the Eurozone's average as well as median, and better than Belgium's 8.4% and bit worse than Lithuania's 8.0% (yet mind the rapid and persistent emigration from the latter).

      And regarding the different post I seem to have wanted you to write :), I think there'll be plenty of opportunity for that. Slovenia is small, but the mess its central bank has made of its bail-in, with the abovementioned clandestinely extortive role of a member of the C-5 subunit of the C unit of the DG COMP of the EC, and "serendipitous" promotions of the most servile Slovenian officials involved to various sinecures in Brussels, Frankfurt, and London, may eventually be of interest in looking for explanations how, or why, the bail-in was so utterly misapplied in the initial overeager desire to "create templates", first in Cyprus in March 2013, and then in Slovenia in December 2013 ...

    3. Anonymous,

      Nonono. It wouldn't be "spread over several years". Overturning the bail-in would be an immediate hit to the fiscal finances, taking the fiscal deficit back over 3% again. These days the EC is completely unforgiving about deficits even slightly over 3% (just look at Finland). Slovenia would be back in the Excessive Deficit procedure again.

      As this would mean further fiscal tightening, we would expect unemployment to rise. I'm not going to play "my statistic is better than yours": in my book over 8% is too high and the focus of the government should be on bringing it down, not making good subordinated creditors of failed banks.

      I may indeed have a closer look at the conduct of the Slovenia bank rescue. But I would do that on Forbes, not this blog.

    4. Regarding spreading it over the years, and even relegating the repayments to our "bad bank" (DUTB), there is a law draft on that in the initial legislative procedure, so it seems doable.

      Regarding the unforgiving EC,
      (1) it may well forgive given its highly problematic involvement (one of the EC's lower official's replies to being told the equity is positive, hence a wipeout without compensation (pardon me, an "enhanced burden sharing") is legally impossible, he replied almost literally "So fudge it into negative!")
      (2) also, let's wait a few days and see how much Italy will be forgiven with Monte dei Paschi di Siena.

  9. Slovenia is no longer formally in the Excessive deficit procedure - . Current trends confirm this (6-month deficit points to an annual deficit slightly above 2%).

    This is not to say that all's well. However, the conditions are better than the numbers originally used in your post would suggest. After the glacial recognition of accumulated problems and the somewhat revolutionary methods employed in dealing with them, Slovenia is today much closer to being just another "boring" EU country than being a macroeconomic outlier.

    As to the future, yes, there absolutely are risks. Then again, it is possibly not a good idea to appeal to the authority of the IMF or any other of the venerable institutions on this topic - you've summed up the reason for this in the last paragraph of your text.

    Disclosure - I live in Slovenia (and am known to spend my time explaning to people how non-unique the local developments really are - it's just another cheap credit, bad hangover, Kubler-Ross stages of grief story).

    1. I knew Slovenia was hopeful about exiting the Excessive Deficit procedure. Must have missed that in the press release with all the excitement about Cyprus.

  10. Oh, and one more thing... (says inspector Colombo :) - As others have pointed out, calling Slovenia "peaceful by Balkans standards" is a really curious statement. But I see you've already changed it. Thanks for that.

  11. The ECB is busy reminding the Slovenian police that their officials and documentation are immune from investigation being only accountable to the European Court of Justice!

  12. Never heard of Slovenia? I'm not sure when I first heard of the place, but it can't have been any later than the 1980s. Certainly I'd heard of it some time before the break-up of federal Yugoslavia. We Eastern Europe-watchers used to think the Slovene reformers were clever & funny but a bit disengaged from the rest of the federation; if things turned nasty, it looked as if they were more likely to jump ship than stay and try to get it back on course. As indeed they did.

    On the other hand, I freely admit that I've skimmed this post - it would take about an hour to read it properly, what with all the terms I'd need to look up. I'm selectively ignorant, but I'm working on making it more selective.

  13. In economic news, initial claims for unemployment benefits in the US showed a modest rebound last week.

  14. Hi Frances, I am not clear as to how capital inflows leads to a massive Current Account Deficit - could you kindly help explain the link

    Refer ("The result, of course, was a mammoth inflow of foreign funds, a huge credit bubble, an enormous spike in real estate prices, and a massive current account deficit ")


    1. Karthik,

      The capital account is the mirror image of the current account. When there are inflows of funds, the capital account goes into surplus and the current account into deficit. Very large sudden inflows of funds (hot money flows) can therefore cause the current account deficit to balloon.

      Hope this answer your question.

    2. Sorry, I should of course say NET inflows of funds.