Introductory remarks

The macroprudential diagnostic process consists of assessing any macroeconomic and financial relations and developments that might result in the disruption of financial stability. In the process, individual signals indicating an increased level of risk are detected based on calibrations using statistical methods, regulatory standards or expert estimates. They are then synthesised in a risk map indicating the level and dynamics of vulnerability, thus facilitating the identification of systemic risk, which includes the definition of its nature (structural or cyclical), location (segment of the system in which it is developing) and source (for instance, identifying whether the risk reflects disruptions on the demand or on the supply side). With regard to such diagnostics, instruments are optimised and the intensity of measures is calibrated in order to address the risks as efficiently as possible, reduce regulatory risk, including that of inaction bias, and minimise potential negative spillovers to other sectors as well as unexpected cross-border effects. What is more, market participants are thus informed of identified vulnerabilities and risks that might materialise and jeopardise financial stability.

1. Identification of systemic risks

Total systemic risk exposure has remained moderately high (Figure 1). Structural weaknesses of the financial and non-financial sectors are unchanged from the previous assessment (Macroprudential Diagnostics No. 8), with favourable developments continuing in the financial sector due to an improvement in asset quality, increase in solvency and lower dependency on external financing.

Figure 1 Risk map, second quarter of 2019

Note: The arrows indicate changes from the risk map in the first quarter of 2019 published in Macroprudential Diagnostic No. 8 (July 2019).
Source: CNB.

Continued economic growth and favourable financing conditions have alleviated the structural vulnerabilities of domestic non-financial sectors. Despite the economic slowdown in the second quarter of 2019 caused by decreases in goods exports and capital investments, real economic activity growth is expected to accelerate in the remaining part of the year, which will have a favourable effect on debt indicators. General government and private sector debt to GDP ratios could thus continue declining. The still high level of debt is a major structural risk, even more so as it includes high shares of external debt and foreign currency-indexed debt. Household sector debt increased slightly to 33.4% of GDP at mid-year, but has remained lower than the EU average. However, non-financial corporate debt, although reduced, has remained quite high (81.9% of GDP, on an unconsolidated basis). Along with economic growth, the currently favourable international market conditions have also contributed to improved debt sustainability. Still, the economy’s exposure to changes in financing conditions will remain high as long as the debt level is high.

Structural weaknesses in the financial sector are still assessed as moderately high. Despite the favourable impact of a continuing decrease in the share of non-performing loans and the increase of their coverage on the financial sector’s stability, Croatia has remained among the EU countries with the highest share of non-performing loans in total bank loans. In addition, the long-standing growth trend in the share of kuna and fixed interest rate household financing has had a positive impact on currency and interest rate induced credit risk, with the stability and solvency of banks (measured by the Z-index) underpinned by the high level of capitalisation and an increase in current earnings. The banking sector’s continuing consolidation increases market concentration, which could limit the degree of competition in the system, accelerating and stimulating the spillover of any difficulties experienced by one bank to the whole banking system. However, the sector’s resilience has been strengthened by the gradual exit of banks with poorer asset quality and performance indicators from the market. In addition, a higher sectoral concentration can help enhance the cost effectiveness of banks through economies of scale. Also, bank balance sheet concentration in terms of exposure to groups of connected clients and the government sector continues to be high. However, the sector's structural vulnerabilities have been mitigated by the increasing diversification of financing, i.e., a greater reliance on domestic, diffused sources and a lower reliance on foreign owners.

The cyclical vulnerabilities of the financial sector are assessed as low. Value adjustment expenses measured in relation to bank assets are at their lowest level since the pre-crisis period, a typical characteristic of the late stage of the credit cycle. High bank liquidity levels and declining interest rates have boosted transaction account deposits. With the maturity of liabilities shortened as a result and an increase in general-purpose and housing loans with increasingly longer initial maturities, the assets and liabilities maturity gap has grown. The factors alleviating the impact of a decrease in the net interest margin on bank profitability in the last two years have included lower value adjustment expenses and unit administrative costs, with the latter due to continuing market consolidation and the digitalisation of business operations.

Short-term risk continues to be assessed as very low. The financial stress index, showing current developments in the Croatian financial market, has increased slightly from the previous report. However, this can be attributed solely to the shallowness of the money and bond markets, where new government bond issues and short-term interbank financing led to a rise in the indicators of interest rate differentials, i.e., increased the measure of volatility (Figure 2). The country’s risk perception is reduced, with CDS spreads on Croatian government bonds standing at all-time lows, and August saw government borrowing through issuing foreign currency-indexed kuna T-bills at a negative interest rate.

Figure 2 Croatian index of financial stress and the contributions of individual markets

Source: CNB.

The currently favourable financing conditions facilitate household debt servicing, but a prolonged period of low interest rates could result in an increase in vulnerabilities.

The negative consequences of such trends include a further increase in financial and real assets prices, which raises the risk of a sudden and steep fall in prices. The debt of the household sector has been on the increase, driven mainly by the growth of general-purpose cash loans, most of which are non-collateralised loans maturing in five or more years. A number of banks continue to grant such loans applying more lenient criteria than when granting housing loans, thus not acting in compliance with the CNB Recommendation. The increase in general-purpose lending could partly be linked with real estate investments, as may be concluded from the extension of the initial maturities of loans, whose individual amounts are relatively high. This, and the growth of real estate prices cause the accumulation of credit risk, which can materialise in the case of a contraction of economic activity and growth in the unemployment rate. Especially vulnerable are households with below average incomes and no savings, as, despite lower interest rates, their debt servicing burden is not alleviated due to the increasingly high amounts of loans granted. Box 1, Components and distribution of net household assets in Croatia, gives an overview of the household distribution of income, savings and all other components of real and financial assets.

The non-financial corporations sector has recorded positive trends due to a lower debt burden and capital growth. The growth of capital and gross operating surplus has been reducing debt burden and corporate debt indicators. Specifically, a continuing decrease in interest rates and good business results have reduced the solvency and liquidity risks of the corporate sector. However, there are still uncertainties looming over the future business results of the Fortenova Group (former Agrokor) and legal issues related to the settlement reached. In addition, adverse demographic and migration trends weigh down on the future business performance of corporations, already faced with a qualitative and quantitative labour shortage and increased labour costs.

2. Potential risk materialisation triggers

The main potential triggers for risk materialisation in Croatia lie in external developments. The escalation of protectionism, that is, the so-called trade war between China and the USA, has increased geopolitical uncertainties. Risks in the EU are further aggravated by the continuing uncertainty surrounding Brexit and fiscal sustainability in some large member states (Italy, France, Spain). The German economic slowdown, so far evident in manufacturing, poses another risk to the European and Croatian economies, which could spill over through trade channels as well as through investments, tourism and EU funds.

Given the start of monetary easing in the EU and USA, interest rates could remain low. As anticipated, euro area economic growth has decelerated, and is expected to stand at 1.5% in the medium term, with significant negative risks and an inflation rate remaining below the target of 2%. Under such circumstances, the ECB continues pursuing an expansionary monetary policy, introducing a two-tier system to penalise excess liquidity in order to lessen the consequences of low or negative interest rates threatening bank profitability. As regards the USA, the yield spread between the ten-year and two-year bond almost disappeared by the end of August, and such a yield-curve flattening trend indicates uncertainty regarding future trends, i.e., an increased risk of recession, which may also be triggered by a stronger Chinese economic slowdown.

Domestic factors are at the moment less likely to trigger a contraction of the domestic economy and unemployment growth capable of leading to credit risk materialisation. However, despite positive macroeconomic projections, there are still uncertainties regarding future economic growth, which will increasingly depend on the possibilities of increasing the labour participation rate. The favourable condition of public finances, reflected in the currently low country risk premium, could be deteriorated by the accumulation of additional arrears in the health sector, a sharp increase in expenditures on wages and various transfers in the pre-election period, legal actions and international arbitrations (e.g. the legal action taken by banks regarding the conversion of Swiss franc-denominated loans, the MOL legal action and the trade unions’ legal action about the implementation of collective agreements) and, in the long term, the anticipated changes to be introduced to the pension system following the Government's announcement renouncing the key elements of the last year's reform. As regards the financial sector, some banks are exposed to an additional risk stemming from the indefinite amount of total costs of anticipated consumer legal actions related to the pronouncement of the contracted variable interest rate and the currency clause for loans granted in Swiss francs null and void.

3. Recent macroprudential activities

3.1. Continued application of the countercyclical capital buffer rate for the Republic of Croatia for the fourth quarter of 2020

On the basis of a new quarterly analytical assessment of the development of cyclical systemic risks, the CNB has announced that the countercyclical capital buffer rate of 0% will continue to be applied in the fourth quarter of 2020. Specifically, the economic slowdown in the second quarter of 2019 was accompanied by a slightly decelerated growth in placements to the private sector, measured by both stocks and transactions. This led to a further decrease in the standardised relative debt indicator (the ratio of total placements to nominal annual GDP), which remained below its long-term trend, with the result that the credit gap calculated on the basis of this ratio has remained negative. The specific relative debt indicator, i.e. the ratio of domestic credit institutions’ loans to the non-financial sector to seasonally adjusted quarterly GDP, continued to decrease in the second quarter, and the credit gap calculated on the basis of this indicator is also negative. As other important indicators, such as credit growth dynamics, real estate price developments or current account balance trends also do not point to risks of excessive credit growth, corrective interventions on the part of the Croatian National Bank are still not necessary.

3.2. Continued application of the structural systemic risk buffer

At mid-2019, the CNB carried out a regular biennial review of the requirement to maintain the structural systemic risk buffer, confirming the need for the continued application of the structural systemic risk buffer at the previously set rates for two types of credit institutions. Credit institutions that have their head office in the Republic of Croatia are required to maintain the structural systemic risk buffer rate of 1.5% and 3% of their total risk exposure amount (as defined in Article 3 of the Decision on the application of the structural systemic risk buffer, Official Gazette 78/2017).

An analysis of the structural elements of financial stability and systemic risk in the economy shows that structural vulnerabilities and systemic risk exposure have remained at a moderately high level (see chapter 1 Identification of systemic risks). Despite the alleviation of structural imbalances, brought about by the continued economic growth, both public and private sector debt as well as external imbalances have remained substantial, exceeding those in other CEE countries, which makes the domestic economy vulnerable to possible changes in financing conditions in international markets. In addition, adverse demographic and migration trends have a negative effect on the Croatian economy’s growth potential and the sustainability of debt of all sectors. Despite having been in decline for several years due to economic growth and the mentioned migration trends, Croatia has continued to have a noticeably higher unemployment rate than other CEE countries. In the financial sector, which is stable and well-capitalised, the continued consolidation of credit institutions has led to an increase in the already high concentration, which significantly exceeds the EU average, making the system sensitive to potential vulnerabilities of individual banks.

3.3. Recommendations of the European Systemic Risk Board (ESRB)

3.3.1. Recommendation of the European Systemic Risk Board amending Recommendation ESRB/2016/14 on closing real estate data gaps (ESRB/2019/3)

In August 2019, the ESRB published the Recommendation amending Recommendation on closing real estate data gaps, adopted in late 2016, in order to harmonise data required for the assessment and monitoring of risks to financial stability associated with real estate markets. The amendments, aimed at facilitating the establishment of a harmonised data collection system at the EU level, were adopted because soon after the adoption of Recommendation ESRB/2016/14 it became obvious that most EU countries would find harmonisation difficult due to a large number of missing data and their various definitions. Some of the important amendments include a recommendation to the European Commission to establish a common minimum framework for EU statistics on the physical commercial real estate market (such as the price index, rental index, vacancy rates, etc.), to amend certain definitions and indicators for the monitoring of the residential and commercial real estate markets for the purpose of harmonisation with definitions from existing EU regulations (AnaCredit, CRD/CRR), and to extend initial deadlines for the delivery to the ESRB and the Council of interim reports on the information already available or expected to be available (from end-2018 to end-2019) and for the delivery of final reports (from end-2020 to end-2021 for financial indicators for the commercial real estate market and to 2025 for some countries’ physical market indicators; the deadline for the residential real estate market remained end-2020).

The Recommendation and amendments thereto were discussed at the sessions of the Financial Stability Council and at the meetings of the representatives of Croatian institutions engaged in data collection (the Croatian National Bank, the Ministry of Finance, the Croatian Financial Services Supervisory Agency and the Croatian Bureau of Statistics). The conclusion was that more effort should be put into the collection of missing data on the real estate market. With this aim in view, the CNB is setting up a new system for the collection of granular data on consumer lending conditions, which will enable the monitoring of risks associated with the residential real estate market in line with the requirements set forth in the Recommendation. The activities on the collection of data on the commercial real estate market are planned to be linked with future data collection pursuant to the requirements of the European Reporting System (Finrep, AnaCredit, Eurostat).

3.3.2. Implementation of Recommendation ESRB/2012/2 on funding of credit institutions

The CNB carried out a regular assessment of the funding plans of credit institutions for the end of 2018, delivered by significant credit institutions in Croatia pursuant to the Decision on the reporting of funding plans (Official Gazette 76/2015). The monitoring and assessment of the feasibility of funding plans are in compliance with the Recommendation on funding of credit institutions (ESRB/2012/2) and take into account the Guidelines of the European Banking Authority in order to improve the risk assessment of funding and liquidity sources as well as the impact of the implementation of these financing plans on the flow of credit to the real economy (for more details, see Macroprudential Diagnostics No. 1, chapter 3.4.4).

The assessment shows that at present there are no risks related to the unsustainability of the funding or liquidity structures or an adverse impact on credit to the real economy. Banks are planning to continue meeting their funding needs primarily by relying on their clients’ deposits, with most of household deposits to remain covered by the deposit insurance system. They are also planning to partly fund the flow of credit to the private sector by the existing excess liquidity. This, and the continued growth of private sector deposits, will enable banks to continue deleveraging against parent banks and further reduce (deposit and lending) interest rates. Although such bank strategies tend to lead to a decrease in short-term liquidity indicators, they are expected to remain above the prescribed minimum because of the currently high liquidity levels. Banks’ reliance on public sector sources is mostly accounted for by CBRD credit support to the real sector. Their share in total liabilities is therefore not significant, and, what is more, banks do not rely on innovative financial instruments. Given the above, banks do not see any objective impediments on the supply side precluding the planned credit flow and expect lending to the private sector to continue to rise.

Macroprudential policy implementation in other European Economic Area countries

Due to their strong credit growth having continued for some time, coupled with real estate price growth, an increasing number of EEA countries have embarked on macroprudential policy measures aimed at alleviating related systemic risks, and the countries already using these measures have additionally tightened them. The most actively applied measure, i.e. the non-zero countercyclical capital buffer rate, was in September 2019 applied by ten countries (ranging from 0.25% in France to 2% in Norway and Sweden). They were in October joined by Bulgaria, which applied the rate of 0.5%, having already announced that it would raise it to 1% in 2020, and three more countries will apply the non-zero rate in the first half of the following year: Luxembourg (0.25%), Belgium (0.5%) and Germany (0.25%). In addition, Sweden and Norway will increase the countercyclical buffer rate to the already announced 2.5% by the end of 2019, while Denmark, the Czech Republic and Slovakia announced in the summer that they would raise it to 1.5% and 2% respectively as of mid-2020.

The structural systemic risk buffer was in September applied by 16 EEA counties, with the rates ranging from 0.5% to 3% (Figure 3). The United Kingdom activated the structural systemic risk buffer for the first time in late July, applying it to ring-fenced bodies^[1] and large housing savings banks whose assets exceeded GBP 175bn. The prescribed rate ranges from 1% do 3%, depending on the amount of assets of a particular institution, and is currently applied to the five largest banking groups and one housing savings bank. The measure was introduced to contain systemic risk to the financial sector and the real economy that could arise owing to the operational problems of these large institutions and to mitigate a potential contraction in credit to households and non-financial corporations. In Hungary, the requirement to maintain the structural systemic risk buffer was, after a new review, revoked for a bank that had been required to maintain it in the previous period. The amount of the prescribed and annually reviewed buffer rate depends on the level of the so-called problematic exposures^[2] secured by real estate pursuant to Pillar 1 capital requirement, with the exception of credit institutions having exposures of such kind lower than HUF 5bn.

Figure 3 Distribution of the application of the systemic risk buffer and rates applied in EEA countries

Source: ESRB.

With a view to increasing banks’ resilience to systemic risks associated with the real estate market, Estonia and Finland have announced the implementation of macroprudential measures pursuant to Article 458 of Regulation (EU) No 575/2013 (hereinafter: Regulation) related to an average risk weight floor for real estate-secured exposures for credit institutions using internal rating based approaches for the calculation of own funds. As macroprudential measures under Article 458 of the Regulation cover a period of two years, which can be extended, Finland, due to the continued increased level of systemic risk stemming from the fast growth of housing loans to already debt-burdened households, announced that it would extend for one year the application of the 15% average risk weight floor for residential real estate-secured exposures, applied since the beginning of 2018 and due to expire at the end of this year. Estonia, on the other hand, due to strong cyclical pressures and a surge in housing loans to households, introduced an average risk weight floor (also amounting to 15%) for the first time for precautionary reasons, for retail real estate-secured exposures to Estonian residents.

Table 1 Overview of macroprudential measures by EU member states, Iceland and Norway

Notes: The measures listed are in line with Regulation (EU) No 575/2013 on prudential requirements for credit institutions and investment firms (CRR) and Directive 2013/36/EU on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms (CRD IV). The definitions of abbreviations are provided in the List of Abbreviations at the end of the publication. Green indicates measures that have been added since the last version of the table. For CCB, green marks the rates applied or announced after 1 July 2019.
Disclaimer: of which the CNB is aware.
Sources: CNB, ESRB and notifications from central banks and websites of central banks as at 26 September 2019.
For more detailed data, see: https://www.esrb.europa.eu/national_policy/html/index.en.html.

Table 2 Implementation of macroprudential policy and overview of macroprudential measures in Croatia

Note: The definitions of abbreviations are provided in the List of abbreviations at the end of the publication.
Source: CNB.

Glossary

Financial stability is characterised by the smooth and efficient functioning of the entire financial system with regard to the financial resource allocation process, risk assessment and management, payments execution, resilience of the financial system to sudden shocks and its contribution to sustainable long-term economic growth.

Systemic risk is defined as the risk of an event that might, through various channels, disrupt the provision of financial services or result in a surge in their prices, as well as jeopardise the smooth functioning of a larger part of the financial system, thus negatively affecting real economic activity.

Vulnerability, in the context of financial stability, refers to structural characteristics or weaknesses of the domestic economy that may either make it less resilient to possible shocks or intensify the negative consequences of such shocks. This publication analyses risks related to events or developments that, if materialised, may result in the disruption of financial stability. For instance, due to the high ratios of public and external debt to GDP and the consequentially high demand for debt (re) financing, Croatia is very vulnerable to possible changes in financial conditions and is exposed to interest rate and exchange rate change risks.

Macroprudential policy measures imply the use of economic policy instruments that, depending on the specific features of risk and the characteristics of its materialisation, may be standard macroprudential policy measures. In addition, monetary, microprudential, fiscal and other policy measures may also be used for macroprudential purposes, if necessary. Because the evolution of systemic risk and its consequences, despite certain regularities, may be difficult to predict in all of their manifestations, the successful safeguarding of financial stability requires not only cross-institutional cooperation within the field of their coordination but also the development of additional measures and approaches, when needed.

1. On 1 January 2019, structural reform requirements came into effect in the United Kingdom for banks with more than GBP 25bn of retail deposits. These banks were required to separate, in terms of financing, operation and organisation, the provision of core retail services (deposit-taking, payment operations and financing households and small businesses) from other banking activities (investment banking and international financial market trading) in order to reduce risks and increase the retail banking’s resilience to shocks originating in other areas of operation or in global financial markets. Banks’ core retail activities that have been separated in this way are known as ring-fenced bodies. ↑

2. The Central Bank of Hungary defines these problematic exposures as the sum of non-performing and restructured gross loans secured by commercial real estate and the gross value of domestic commercial real estate held for sale on credit institutions' balance sheets. ↑

3. The Box shows the preliminary results of a working paper by M. Kunovac: What affects the net wealth of households in Croatia? ↑

4. The Household Financial and Consumption Survey was conducted in coordination with the European Central Bank. The European Central Bank had already coordinated two HFCS waves in some EU member states, the first one in the period from 2008 to 2010 and the second one in 2013. As Croatia joined the EU in July 2013, the Croatian National Bank (CNB) joined the third wave of the survey, in 2017, when data on net household assets for 2016 were collected. The survey was carried out in cooperation with Ipsos agency and the Croatian Bureau of Statistics (CBS) on a gross sample of 4 070 households. The realised sample comprised 1 357 households, which means that the response rate was 33%. Jemrić, I., and I. Vrbanc (CNB working material) provide a detailed sampling procedure, a description of the survey, a summary overview of the main results and their comparison with the results of the previous waves of the survey. ↑

5. For more details, see Nestić, D. (2005), Rubil, I. (2013), Rubil, I., P. Stubbs, and S. Zrinščak (2018), based on the Household Budget Survey of the CBS. ↑

6. An interesting example is provided by Austria, where inequality in the distribution of financial assets is lower than inequality in the distribution of real assets, as shown by the low share of main residence ownership (45%). For more details, see Fessler P., P. Lindner, and M. Schurz (2019). ↑

7. The survey probably overestimates inequality in the distribution of income as its sample comprises 7% of households that responded that they had no income of any kind and that their annual gross income is zero. EU-SILC 2016 data suggest a slightly lower income inequality distribution among Croatian households (EU SILC has a Gini income coefficient of 0.3 and the HFCS 0.5). ↑