The banking crisis and the evolution of the market

In the middle of the financial crisis in 1999, the decision of thirteen larger banks to establish a private banking association, having the purpose of organising a transparent financial market, represented a significant step in the evolution of the Croatian financial system. The members of the association agreed to reject financial trading with other legally registered Croatian banks (i.e. those who were not members), declaring that lending to them would be too risky. Until this decision, trading on the official money market was organised so that every day, all registered banks quoted their ask and bid prices (rates) for overnight loans and other short-term transactions (three days, one week, one month). Discriminatory contracting was not supposed to happen: every registered bank had access to every other, if it was attracted by the prices that they offered. Since the banks with liquidity problems borrowed money extensively, this pushed up the overall interest rates such that they exceeded 30 percent. As the problem of liquidity intensified, some banks failed to fulfil their duty (to return short-term credits). They were counting on terribly slow judicial procedures, while waiting at the same time for government support. The law stipulated that the Government had a right to estimate, following particular criteria, which bank should survive and be rehabilitated and which should be left to bankruptcy. The authorities were under pressure from the lobbies that were formed around some banks, usually concentrated in certain Croatian regions, or which specialised in business with particular industries (agriculture, tourism), to give support to banks regardless of their underlying strength. The Central Bank was under pressure to relax its policy

32 _{This recession occurred not only as a consequence of the banking crisis but also as a reflection of}

the financial crisis in Asia and Russia and because of NATO intervention in neighbouring Kosovo, which damaged Croatian tourism that year.

of sound money, by allowing the commercial banks to use their obligatory reserves in order to finance their daily transactions.33 _{Lobbyists in fact demanded the}

printing of money as a solution for their difficulties. The Central Bank withstood pressure, but it was also reluctant to exclude illiquid and insolvent banks from the market, waiting for the decision of the Government.

In these circumstances thirteen healthier banks, among them the biggest four, decided to establish the Croatian Banking Association and to form a closed financial market. It was a clear example of spontaneous, private regulation of the market. The criteria for membership were much stronger than the norms that were stipulated in the banking law for entering the official financial market.34

Most important for this research, was that the Association required “fair business competition” and higher transparency from businesses. Later on, the new banking legislation strengthened the technical norms for the banking business, obviously following criteria affirmed by the Association, and concluding that the banking crisis was the outcome of weak regulation and a weak regulator. Various interpretations of these occurrences are possible; for example the proponents of spontaneous order could emphasise that the market participants created their own norms of behaviour which were later accepted by an official regulatory body. I will now analyse this process within the framework of property rights theory and in the context of the political and social limits of property rights.

4.2.1 The same rights, different costs

At first glance, banking practice in both groups of banks looked very similar. The old and the new banks practiced debt equity swaps, cross shareholding (companies in the equity of which they invested also owned bank’s shares) and high investment in non-liquid assets. And indeed, the legal property rights were the same for both groups, but the costs of enforcement of rights and the costs of the use of resources were different. As already mentioned Lueck’s (1995) paper distinguishes the costs of first possession in the case of single claimant and in

33 _{Obligatory reserves are a common instrument in the banking industry, which the regulator}

uses to increase the security of banking and to strengthen confidence in the financial system. I would like to recall here the description of money management under socialism in chapter IV, when different accounts, i.e. different functions of money, were strongly separated. Because the regulatory body, at the beginning of socialism, wanted to control all transactions, not just the overall performance of a particular, therefore it requested separate accounts for wages, business transactions and investment. Later, the purpose of regulation became the security of the system; therefore the regulation was relaxed.

the case of a race for resources (chapter III).35 _{However, in the former case a single}

claimant might calculate and establish his rights at the moment when his costs are the lowest. Since the old banks had already established relationships with the companies of which they owned shares, they were less exposed to a competition for resources. The new banks tried to achieve control over resources as early as possible; therefore their costs of appropriation were high. Debt equity swaps, cross shareholding and high investment in non-liquid assets in the old banks were - to a degree - seen to be a consequence of a socialist legacy; this was presented as their destiny and debt equity swaps as a kind of sacrifice made by old banks. Political lobbying and enforcement of their rights were cheaper. When the new banks started to imitate the pattern of the old banks, public support for this kind of practice had already faded, because of the marginalisation of individual shareholders and employees. All of that increased the costs of property rights for the new banks.

4.2.2 Property rights and values

The battle between the old and the new banks showed that regulation includes the promotion of values. The old banks advocated the security of business practice, while the new banks promoted aggressive competition. It was obviously possible that their lobby groups - by advertising contrasting values like stability or competitiveness - in fact promoted market regulation that was favourable to their clients. The old banks advocated responsibility in financial management only after several expensive rehabilitations of the banking industry and after they had structured their portfolio on a non-transparent capital market (which was described above). At the same time, it was obvious that the banking crisis from the end of the 1990s forced the evolution of the property regime towards increased stability in the financial market. At the beginning of the transition, the leading idea was different: the goal was to relax the criteria for opening a bank in order to increase competitiveness. This was the argument of the new banks.

At the beginning of the 1990s the Government saved the financial industry, leaving the ownership structure untouched. In the middle of the decade, four of

35 _{Actually, Lueck distinguishes several types of race: homogenous claimants with incomplete}

information; heterogeneous claimants with incomplete information; heterogeneous claimants with common knowledge and calculates the costs of enforcement of property rights and of the use of a resource. Similarly, Lueck distinguishes the situation in which a single claimant is first-best and the situation in which a single claimant bears positive costs of exclusion. (Lueck, 1995)

the five biggest banks were rehabilitated, but their management was replaced. Foreign investors later acquired these banks. However, the new banks required similar support to that which the government had provided for the old banks throughout the 1990s. At the end of the 1990s, some (private) banks were left to become bankrupt. Although this partly undermined confidence in the system, this was presented as an affirmation of the principle that the market punishes inefficiency. Sometimes, it is impossible to distinguish whether changes in the property regime benefit the entire society or if they fit only the narrow interests of a particular group. (This is argued in chapter III, in the section that discusses the evolution of property regimes).

I would like to clarify here that my wish is not to advocate the formal governmental regulation of the financial industry, or of any other industry, as a solution for an inefficient allocation of resources. Regulation could be left to market participants as well. It was explained in chapter III that legal property rights in essence only enforce economic property rights (or prevent their evolution). Legal property rights can decrease the costliness of property but also increase it. Regulation in a wider sense includes all market institutions, from customs and informal norms to laws. My concern here was to look at how these norms evolved and how they affected the efficiency of the allocation of resources.