Balkanalysis.com

By Borko Handziski

The following article is an abridged version of an in-depth study on the Macedonian banking sector, originally published in the Monthly Bulletin of the Ministry of Finance of the Republic of Macedonia. We are making both the abridged version and the original text (.PDF), which contains several charts and tables, available for the first time in English.

The author, Borko Handziski, is the Economic Affairs Officer for the Delegation of the European Commission in Skopje.

The Macedonian banking sector has grown rapidly over the past few years. However, its current stage of development, measured by the level of financial intermediation, is still lower compared to the other transition countries (of Central and Eastern Europe) and the EU member states.

Introduction: Some Vital Statistics

The banking sector in Macedonia comprises 21 bank and 15 saving houses and has a dominant share in the overall financial sector. The banks have the majority assets of the banking sector, whereas the saving houses manage only 1.3% of the total assets. The banking sector is largely concentrated, with 2 banks having 55.5% of the total assets and 55.9% of total bank activities. By the end of the first half of 2004, 95.1% of banking capital had been privatized, and foreign capital was present in 15 banks (foreign capital has a 45.7% share in total banking capital). Out of the 15 banks, 8 banks (with 47.5% share in total assets) have foreign investors as majority shareholders.

Comparative analysis with the other transition countries shows that the Macedonian banking sector is lagging behind in the bank consolidation process. In the group of 16 transition countries, Macedonia (after Slovenia) has the highest number of banks per population. Despite the large number of banks, a high concentration of assets is present, with the two largest banks having 55.9% of total assets and the 12 smallest banks accounting for only 13.9% of total assets. This structure results in lack of competition among banks, thus hurting their efficiency. On the other hand, Macedonia ranks 14th for the foreign banks to total banks ratio, so the banking sector needs to further attract foreign investors. The entry of foreign capital is particularly important for strengthening competition and achieving higher efficiency. The advantages of foreign banks operating in Macedonia are multiple: transfer of know-how, investment in IT, using modern risk management methods, additional capital etc.

Factors Determining Low Efficiency

The banking sector is rather specific in terms of the factors that determine bank performance, and bank operations are strongly influenced by exogenous developments. Bank liabilities (taken deposits) are mainly determined by the sustainable economic stability and future expectations of the economic and political environment in the country and the region. The assets side is also influenced by macroeconomic developments in the country and the region, as well as by the monetary and fiscal policy. The inefficiency of the banking system is mainly determined by: legislature, macroeconomic environment and the bank management.

Legislature

The legal acts related to the functioning of the financial system are a key factor that determines the overall performance of the banks. This particularly relates to the legal acts regarding the collection of collateral assets. The efficiency of court procedures is an essential requirement for good bank performance, as it allows banks to pursue a more efficient (and more expansive) credit policy. If the judicial system does not allow for timely, efficient and simple resolution of court disputes, the banks’ credit portfolio will have high share of non-performing loans and investments in securities, something which is exactly the case in the Macedonian banking system.

On the other hand, such a credit portfolio implies higher lending rates and reduced possibility for crediting (having only few investment projects that can earn such a high return to be able to cover to high interest costs). The inability to provide more credit to clients would then result in risk free investments (such as CB-bills or government bills), even keeping cash on its own account. The above mentioned scenario captures completely the current situation in the Macedonian banking system. The weakness in the judicial system has resulted in a large share of uncollected loan repayments (NPLs), even though there is a positive trend in declining NPLs (13.8% in 2004). As a result, banks operate with high interest margins (lending rates), meaning they are unable to invest all of their assets as loans. This is reflected through the excess liquidity banks have on their accounts at the central bank. In 2003, the average excess liquidity of banks was around 28 percent.

In 2003 the EBRD introduced a new method for measuring reform progress in the legislature (related to the banking sector) in the transition countries, as an addition to the existing regional survey for the reforms in the legislature related to secured transactions. The results of the survey on secured transactions (which began in 1999) show that Macedonia falls in the group of countries with low progress in reforms. The aim of the new survey is to assess “the laws in action,” meaning how the legislature on secured transactions is applied in the court practice in these countries. The survey measures the level of reforms through the following indicators: (1) time needed to recover the assets, (2) amount expected to be recovered (as % of total value) and (3) simplicity of the process. According to this indicators, Macedonia ranks in the middle of the 15 SEE and CEE countries, lagging behind the advanced transition countries, and the least developed countries such as Serbia and Montenegro, Bosnia and Herzegovina, Albania, Moldavia (and Romania) at the bottom of the list.

Macroeconomic environment

The performance of the economy has a significant impact on the development of the banking sector. The level of economic development as well as the current economic trends strongly influences both the asset and liability side of the banks’ balance sheets. The frozen deposits, collapse of the pyramid schemes and bankruptcy of several small banks during the 1990′s had a substantial negative impact on the confidence in the banking system. As a result, Macedonian banks operated with a very limited deposit base, with most savings being stored “under the matrices” (and in foreign currency).

In November 2001, NBRM conducted a survey to estimate the size of foreign currency savings outside the banking system. The results of this survey showed there were between 1-1.5 billion deutschmarks of savings circulating outside the banking system. The improved economic environment, strengthened banking supervision and the creation of the Fund for insurance of deposits resulted in a return of confidence in the banking system. However, a key milestone in the transfer of savings back to the banking sector was the introduction of the euro and the need for conversion of the 12 national currencies into euro, which began on January 1, 2002. The banks offered conversion with no commission if funds are deposited in a savings account for a minimum of 15 days. So, in the last quarter of 2001, households’ deposits had an enormous increase, ending 3.6 times higher (or 27.7 billion denars) on year-to-year basis. During the first quarter of 2002 there was withdrawal of deposits, but between 60 and 70 percent of the new deposits remained in the banking system.

The poor economic performance and the developments in the region also had a negative impact on banks’ credit activity. In an environment of economic and political instability, low level of foreign investments and high interest rates, banks had a difficult time finding suitable investment projects to invest in. The low usage of foreign credit lines (only 45.7%) which are available with low interest rates is a further proof of the limited opportunities for investing. Thus, it is not surprising that investments in other banks (of which 80% are in foreign banks) are higher than loans to clients. The high level of funds deposited in foreign banks, which are low risk but also low yield, has adversely affected banks’ profitability.

Management

The skills and capacity of the top management is also an important aspect that determines the performance of any company. The managers of the Macedonian banks play a significant role in the performance of the banking sector. The role of the management can be analyzed from two aspects: the skills of the top managers and the functioning of the system of corporate governance. In addition to the previously mentioned factors, the management in Macedonian banks further contributes to the present poor performance of the banking sector. This can be measured through the low level of investments in IT (which has been one of the main contributors for increased efficiency in the past decade), little use of latest risk management methods, poor customer orientation etc.

This situation is clearly observed through many examples and anecdotal evidence. For example, whereas Estonia has 93% of transactions conducted online, (only few) Macedonian banks have only recently introduced online banking. Customer orientation has been the main company focused for decades in the developed countries, but Macedonian banks (again only some) only recently have introduced a “yellow line” to protect the privacy of the customer (an investment of less than 10 euros). Significant progress has been made in the past few years in developing new risk management methods and models (for reducing credit, foreign exchange, market, liquidity risk etc.), however the implementation of these new findings lacks in most Macedonian banks.

One of the reasons is that only a fraction of top managers have participated in trainings on these topics. My conclusions are supported by the bankers themselves. I tried to conduct a survey among bank mangers in which (among other things) I asked top managers to provide their opinion on the impact of the management on the bank performance.

Although I did not receive the critical amount of feedback to publish the results, I received enough answers on this particular question, and the results was the bank CEO’s agree that the skills of bank managers in Macedonia represent a significant constraint on banks’ profitability.

The second aspect of the role of the management’s role is the corporate governance in the banking sector. Corporate governance depicts the relationship between the company and the interest parties such as shareholders, managers, creditors, employees, clients etc. The lack of an adequate corporate governance is not only present in banks, but in the overall corporate sector, having detrimental impact on the quality of the decision-making process in the companies. Lack of transparency and unclear relationships between shareholders, managers and the clients (which are very often the same) are particularly present within smaller banks, and seriously jeopardize effective corporate governance.

Conclusions

Historical analysis and comparative approach with the other transition countries point to an insufficient level of development and poor performance of the Macedonian banking sector. Measured by the share of total assets to GDP, the Macedonian banks are lagging well behind the more advanced transition countries. The structure of the Macedonian banking system shows high concentration, while at the same time a large number of small banks. Macedonia has the second largest number of banks per population, whereas over a half of bank assets are owned by the two largest banks.

The result of this inadequate structure is lack of competitiveness in the banking sector, which seriously undermines the banks’ efficiency. The DuPont analysis of the banks’ financial results shows high level of non-interest revenues (from fees and commissions) and lesser interest revenues, meaning that earnings from non-core activities (rather than the core business of financial intermediation) are the main determinant of the banks’ profitability.

Bearing this in mind, the fact that Macedonian banks are the least profitable among the transition countries comes as no surprise. The high level of non-performing loans and high interest margins also point out to the poor performance of the banking system, and trying to reduce this two will have further negative impact on rates of return. The EBRD index on reforms (in the banking sector and non-banking financial institutions) is an additional indicator for the insufficient level of reforms compared to the other transition countries.

The reasons for the poor performance of the banking sector are both endogenous and exogenous. The most significant exogenous factors are the legislature and the macroeconomic environment. These two factors have had adverse impact on the banking system in the past. However, the latest reforms in the judicial sector (and banking sector related legislature) as well as the improved economic environment are a positive signal for an enhanced performance in the future. The skills of bank managers and the inappropriate system of corporate governance present an additional obstacle for improved efficiency and profitability of the banks in Macedonia. The managers have not been following the latest trends in banking regarding risk management methods, customer orientation, investment in IT etc. Corporate governance also remains an issue for the overall corporate sector, and the problems with lack of transparency and mixed shareholders, managers and client relationships are particularly acute in small banks.

The banking system has an irreplaceable role in providing financial assistance to the private sector and promoting economic growth. Thus, the efficiency of the banking system allows for more efficient (cheaper) financing of private entities, resulting in increased investments for companies and higher consumption for households. In the current environment where Macedonian enterprises are facing undercapitalization and low inflow of FDI, the banks’ role as a source of financing is even more important for promoting investments and economic growth. The results of the 2002 BEEPS survey show that half of companies in Macedonia finance only up to 20% of the working capital with bank credits.

There have been some positive trends moving the banking sector closer to the standards of the advanced transition countries (now EU member countries). The most significant trend is the reduction of the lending rates, which resulted in increased lending and narrowing of the interest margin. On the other hand, the reduction of deposit rates has not decreased the positive trend of deposits growth, implying a strengthening of confidence in Macedonian banks and return of financial assets of households in the banking system. The expansion of the banks’ credit portfolio and introduction of the latest bank products and services (such as online banking) in some banks has resulted in improved performance.

This positive trend needs to have a broader acceptance within the banking sector and to continue with more intensive pace, in order for Macedonian banks to achieve the level of development of the advanced transition economies.