DETERMINANTS OF LOAN PRICING FOR CROATIAN BANKS
IVAN ŠVERKO
HYPO ALPE –ADRIA-BANK, CROATIA
IVICA PRGA
GRADUATE SCHOOL OF ECONOMICS & BUSINESS, CROATIA
ZORAN MARTINOVSKI
IFC, MACEDONIA
Key words:
Croatian banks, loan pricing, obligatory reserve, net interest margin, credit risk
E-mail address:
Telephone number:
ivan.sverko@hypo-alpe-adria.hr
++385-1-6032-949, Fax:++385-1-6067-949
E-mail address:
Telephone number:
ivica.prga@hibo.hr
++385-1-4551-291, Fax: ++385-1-4551-290
E-mail address:
Telephone number:
Zmartinovski@ifc.org
++389-70-360-094, Fax:++389-2-3704-208
1. INTRODUCTION
In recent years, there are many discussions on high interest rates for loans in Croatia. Most of
these comments say that these rates are one of the burdens for potential GDP growth in the
Republic of Croatia.
In times of economic crisis usually different sectors and business segments expect from
banks to provide more reliable (or cheaper) financing of their activities and projects with the
aim of restarting the economic cycle (again). The same is true in Croatia. One of the
very common questions of the public is - why Croatian banks currently do not offer lower
interest rates for loan portfolio and in that sense help the recuperation of the national
economy?
There are few determinates of loan pricings in every country: (1) liabilities` pricing, (2)
regulatory costs, (3) credit risk costs, and (54 net interest margin.
The aim of this work is to try to analyze determinants of loan pricing for the Croatian
banks and to audit the reliability of these prices. This analysis will help us making
conclusions on the persistence of the public expectations for lower interest rates.
2. THE BASICS OF LOAN PRICING
Pricing the loan initially requires determining the renegotiation outcomes as a function of the state
of the borrower. This is complicated by the result that renegotiated interest rates are not
monotonic in borrower type. A related complication is that the bank is not always successful in
preventing the borrower from taking on additional risks. The bank allows some loans to continue
even though the borrower chooses to add risk to the project. This makes pricing bank loans quite
distinct from the standard view of pricing corporate securities.1
According to Hasan and Zazzara,2 an appropriate pricing formula for a credit exposure has to
consider two main parts:
 Counterparty credit characteristics - various risk factors, such as the counterparty’s
Probability of Default, the Recovery Rate related to the granted facility (mortgage,
loan and loan commitment, etc…), the maturity, the Exposure in the event of Default
and the amount of Regulatory Capital requested by the supervisory authorities.
 Bank internal factors - includes commissions, operational costs, and other
subjectively allocated costs.
Speaking on credit characteristics, one can distinguish expected and unexpected loss.
According to Curcio and Gianfrancesco3, expected loss (EL) depends on the borrower’s
probability of default (PD) and the loss given default (LGD). Assuming the independence
between PD and LGD, the expected loss rate (ELR) for a single loan/borrower j is simply
1
Gary Gorton, James Kahn: THE DESIGN OF BANK LAN CONTRACTS, COLLATERAL, AND
RENEGOTIATION, NBER Working Paper Series, February 1993, pg. 4.
2
Itekhar Hasan, Cristiano Zazzara: PRICING RISKY BANK LOANS IN THE NEW BASEL II
ENVIRONMENT, Bank of Finland Research, Discussion Papers, 3-2006, pg. 8.
3
Domenico Curcio, Igor Gianfrancesco: BANK LOAN PRICING AND BASEL II: A MULTI-PERIOD RISKADJUSTED METHODOLOGY UNDER THE NEW REGULATORY CONSTRAINT, Banks and Bank
System, Issue 4, 2009, pg. 66.
given by the following product: PDj×LGDj, whereas, for a whole credit portfolio, it is the
sum of each loan’s ELR. Since they are expected, these losses must be hedged by adequate
accounting loan-loss provisions and represent a physiological cost of bank lending activity.
Unexpected loss (UL) is function of the PD variability and the correlation between the
portfolio assets and must be covered by an appropriate amount of economic capital. Ex post,
UL equals the difference between the actual loss and EL. Ex ante, the unexpected loss can be
measured through a portfolio model based on a Value-at-Risk (VaR) methodology. Within the
new regulatory framework, banks have to set aside an amount of regulatory capital to face the
risk of unexpected losses, deviating these resources from their lending activity and suffering
from the consequent opportunity cost.
Graph 1 Expected and unexpected loss
Source: Author
A consistent pricing methodology avoids numerous questionable practices in loan pricing by
lenders. One questionable practice is demonstrated by lenders who typically do not include
any costs associated with the risk of the loan in their pricing. This omission encourages bad
credits to borrow at the same price that are being used to entice better credits. Another such
practice is evident in lenders within the same organization who make a wide variety of
assumptions about what it costs the bank to originate and maintain borrowers. Lenders
typically don't have good personal knowledge about what it costs to run the commercial
banking organization. They may be estimating something, pulling a number out of the air, or
using the rules of thumb used at a previous bank - probably just as ill-founded. A third
questionable practice occurs when lenders associate too large an earnings credit with
corresponding balances. They don't take into account all factors associated with deposit
profitability. They know less about deposit profitability than loan profitability.4
3. DETERMINANTS OF CROATIAN BANKS LOANS` PRICINGS
As stated before, there are few determinates of loan pricings in every country. In the line
with Hasan and Zazzara, the most important and deterministic factors of laon pricing in the
Republic of Croatia are as follows: (1) liabilities` pricing, (2) regulatory costs, (3) credit
risk costs, and (4) net interest margin.
a.d.1. Liabilities` pricing is one on the most important part determining the loan prices.
4
Thomas A. Hannagan: LOAN AND RELATIONSHIP PRICING, RMA Journal, December 2004, pg. 19.
Speaking of Croatian banks` deposits one should mention high euroization of total banking
system. This euroization is the specific of banking sectors in all ex Yugoslavia countries.
The structure of Croatian banking sector liabilities is as follows:
Graph 2 The structure of Croatian banking liabilities
Source: Financijska stabilnost, Croatian National Bank, July 2010, pg. 35.
As seen above roughly 45% of total banking liabilities consists of residents FX deposits
(either in form of pure FX or foreign currency linked deposits).
Speaking only on deposits the picture is a bit different:
Graph 3 Currency structure of deposits
Source: web page of Croatian National Bank
As seen above, roughly 80% of Croatian banks deposits are nominated in foreign currencies.
Finally, one should consider the pricing habbits of Croatian banks (and to compare it with
deposits` prices of other countries). In gerenal, Croatian banks overpay their deposits in
comparison with other countries. This can be seen the following graph:
Graph 4 Deposits` pricing levels of Croatian banks
Source: web page of the Croatian National Bank
It can be seen from the above graph that in last two to three years Croatian banks have been
paying roughly 4% on FX time deposits. Current levels are around 3,5%. While, banks from
EU countries pay around market prices (EURIBOR rates) Croatian banks currently overpay
deposits by roughly 2,5%. This can be seen by comparing the above graph with the following
one (showing the development of 3M EURIBOR).
Graph 5 Development of 3M EURIBOR
Source: Bloomberg
There are many reasons of such overpayment of deposits. The most important ones are as
follows:
 The first one is the fact that the Republic of Croatia Credit Default Swap (as a proxy
of market price of credit risk) was always substainable factor in pricing foreign loans
(as a alternative source of funding for banks).
 Most of deposits (especially retail ones) are with the administrative interest rates.
These are the changable interest rates which can be changed by banks. Before the new
Banking Act (or before March 31st 2010) banks had an option to change interest rates
without stating and proving reasons to their customers. However, with the above
mentioned law, banks are now obliged to prove to their clients reasons of changing
interest rates (these reasons can be for example changing of referential interest rates,
changing of regulatory costs, etc.). The pricing pattern of administered deposits is
different then the ones linked to referential interest rates (eg. EURIBOR) used in EU
countries.
All and all, Croatian banks (due to many reasons) in comparison with EU countries
substantially overpay their deposits. Therefore, their input price is substantially higher than
the one in EU countries.
a.d.2. Furthermore, regulatory costs in Croatian banking system are very high. These costs
mainly come from the fact that big parts of funds are imobilisated in some forms of reserves.
Currently, Croatian banking system is under very developed and strict regulation. All of these
measures resulted in regulation costs substantially higher then in other accession countries.
The banking system is regulated with the few acts. The most important one is Banking Law 5.
Banking Law has conducted in 2010. This Law regulates conditions for the establishment and
operation of a bank, as well as for the supervision of bank operation.
Besides the Banking Law, very important parts of banking regulation in Croatia are different
decisions of the Croatian National Bank. The most important ones are as follows:
 Decision on the capital adequacy of banks,
 Decision on the classification of placements and contingent liabilities of banks,
 Decision on reserve requirements,
 Decision on the marginal reserve requirement,
 Decision on the limitation of banks` exposure to foreign exchange risk, and
 Decision on the minimum required short-term FX assets.
Out of the mentioned decisions the ones having the biggest impact on regulatory costs are as
follows:
 Decision on reserve requirements6 defines obligatory reserve of banks. It is currently
at the level of 13%7, and is different for foreign exchange (FX) and for Kuna sources.
For FX sources obligatory reserve is kept partially in kuna and partially in foreign
exchange. For Kuna sources obligatory reserve is kept in kuna. Remuneration rate for
HRK obligatory reserve is 0,75% and for FX funds 50% of market rate.
 Decision on the minimum required short-term FX assets8 regulates the ratio of shortterm foreign exchange assets (up to three months) and total foreign exchange
liabilities. It is currently setup at the level of 20%. As some other decisions it went
through many changes in last few years. Up until 2006 it was valid only for pure
foreign exchange items, but after the last change it is valid for foreign exchange and
for currency clause items.
5
Official gazette 117/2008, 74/2009, 153/2009
Official gazette 133/2010
7
Here it should be mentioned that obligatory reserve in most of EU countries is at the level of 2%. In some
countries is more conservative, but it is not higher than 5% in any of the respective countries.
8
Official gazette 59/2008, 17/2009, 23/2009
6
Taking into account all above-mentioned decisions one can assume that regulatory costs in
Croatian banking system are very high. These costs mainly come from the fact that big parts
of funds are imobilisated in some forms of reserves. This can be seen from the following
example - let’s assume that the bank takes a EUR 100 deposit from the domestic retail
customer. The percentage of funds that can be used for placements is as follows:
Table 1 Retail deposit as a source of funds
Deposit amount
100
Obligatory reserve (17%)
13
- HRK obligatory reserve
6,5
- FX obligatory reserve
6,5
32%
13,50
Left for placing to customers
73,50
Source: Author
As it can be seen in this example, only 73,50% of the funds from this deposit can be used for
loan placements.
All together, above-mentioned reserves have substantial effects on total costs of borrowings.
The company Arhivanalitika has done calculation of the average regulatory costs (for the
Croatian Banking Association) in June 20059. It shows that the total average regulatory cost
for the whole Croatian banking system was at that time 1,48%. Moreover, the same study has
noted the constant growth of total banking regulatory costs in the Republic of Croatia. If one
adds this 1,48% to the cost of deposits of roughly 3,5%, the minimum interest rate (covering
only costs of deposits and regulatory costs) is roughly 5%.
Furthermore, the comparison of of emerging countries regulatory costs is shown on the
following graph:
Graph 6 Comparison of banking regulatory costs
Source: Financijska stabilnost, Croatian National Bank, July 2010, pg. 49.
a.d.3. As in other countries, credit risk exposure is the most important and the most relevant
risk exposure of the banking sector in the Republic of Croatia. This is especially true in the
times of financial crises – which Croatian economy is now facing.
Istraživanje za Hrvatsku udrugu banaka – Pokazatelji regulacijskog opterećenja banaka u šest zemalja srednje
Europe i Hrvatskoj, Arhivanalitika, Zagreb, June 2005., www.arhivanalitika.hr/IRO_glavna.pdf
9
The quality of the portfolio exposed to credit risk can be seen through different parameters.
The most important one is the level of non-performing loans (NPL) in the total exposure.
The development of B and C placements (or NPLs) can be seen on the following graph:
Graph 7 The development of the NPL in the banking sector
Source: web page of the Croatian National Bank
As one can see, the level of NPLs in the total credit risk exposed investments is currently at
the level of 6,9%. However, the development of this ratio is even more relevant. It can be seen
that the ratio was constantly decreasing, while starting from 2008 it began to increase (mainly
due to the effects of financial crises).
Besides the NPL ratio, second main indicator of credit risk problems is definitely the coverage
of problematic loan portfolio or coverage of the total loan portfolio. Croatian national bank
calculates two different coverages. Their development is shown as follows:
Graph 8 The development of provisions` coverage
80%
70%
Coverage 1
60%
Coverage 2
50%
40%
30%
20%
10%
Q2/10
2009
2008
2007
2006
2005
2004
2003
2002
2001
0%
Source: web page of the Croatian National Bank
Coverage 1 shows the ratio between loan loss provisions and total placements and contingent
liabilities. It is currently at the level of 3,7%. Its development line is very much similar to the
line of NPLs. It was constantly decreasing, but it becomes increasing starting from 2008.
Coverage 2 shows the ratio between loan loss provisions and B and C placements and
contingent liabilities (or NPLs). The ratio is currently at the level of 40,9%. Its curve looks
different than the one of NPLs or the one of coverage 1. It basically constantly decreases.
Taking all above mentioned into account, one can conclude that a substantial part of portfolio
(6,9%) is non-interest bearing and represents additional cost factor in the total loan pricing
formula.
a.d.4. Finally, required net interest margin is very important in every decision on loan
pricing. Besides the public opinion of having very expensve products, one addtional myth
about Craoatian banking sector is that it is highly profitable. However, comparison of ROE
(as one of the major profitability ratio) is as follows:
Graph 9 Development of banking sectors ROE
Source: PROFITABILNOST BANAKA I KREDITI: KAKO SU BANKE UBLAŽILE KRIZU 2008-2010, HUB
Analize, Croatian Banking Association, # 25-26, September 2010, pg. 6.
As one can notice, Croatian banking sector is not more profitable than the other peer group
sectors. The truth is even different – one can notice many other countries with more profitable
banking sectors (compared to Croatian one).
4. INSTEAD OF CONCLUSION
As stated at the beginning, in recent years, there are many discussions on high interest rates for
loans in Croatia. Most of these comments say that these rates are one of the burdens for potential
GDP growth in the Republic of Croatia. Therefore, there is more and more pressure on Croatian
banks to revise these rates.
However, this analysis shows that higher loans` interest rates in Croatia are quite reasonable
phenomena. The major reason is definitely high deposits rates Croatian banks currently pay.
Furthermore, high regulatory costs are additional burden resulting in higher loans` interest rates.
When one add additionally costs of credit risks as well as required net interest income, the total
(relatively high) loans` interest rates are quite reasonable and expected.
Second question raised is – can we expect lowering of loans interest rates? The answer lies in the
analyzed costs structure. If it will be positive one it should definitely be accompanied with lower
interest rates on liability side and definitely with lower regulatory costs.
REFERENCES
1. Domenico Curcio, Igor Gianfrancesco: BANK LOAN PRICING AND BASEL II: A MULTI-PERIOD
RISK-ADJUSTED METHODOLOGY UNDER THE NEW REGULATORY CONSTRAINT, Banks
and Bank System, Issue 4, 2009
2. Gary Gorton, James Kahn: THE DESIGN OF BANK LAN CONTRACTS, COLLATERAL, AND
RENEGOTIATION, NBER Working Paper Series, February 1993
3. Itekhar Hasan, Cristiano Zazzara: PRICING RISKY BANK LOANS IN THE NEW BASEL II
ENVIRONMENT, Bank of Finland Research, Discussion Papers, 3-2006
4. Thomas A. Hannagan: LOAN AND RELATIONSHIP PRICING, RMA Journal, December 2004
5. PROFITABILNOST BANAKA I KREDITI: KAKO SU BANKE UBLAŽILE KRIZU 2008-2010,
HUB Analize, Croatian Banking Association, # 25-26, September 2010
6. FINANCIJSKA STABILNOST, Croatian National Bank, July 2010
7. Bloomberg
8. Web page of the Croatian National Bank