Interview of Governor Senad Softić published in „Business Magazine“

The interview was published on 1 May 2020.

We cannot run out of cash!

The ongoing COVID-19 pandemic, as any other disasters, takes not only human lives but also brings about large economic and financial damages. The main defence against the harmful impact of the coronavirus on Bosnia and Herzegovina financial system is certainly the Central Bank of Bosnia and Herzegovina, whose Governor Senad Softić in the interview published by the Business Magazine explains how hard that pillar of defence is, and if there are grounds for the intervention measures which are actually on daily basis suggested from various institutional and informal sources, including those related to the use of foreign exchange reserves for the strengthening of the liquidity of economic enterprises, which are potentially rather dangerous....

BM: Which is the current amount of BH foreign exchange reserves and what is their structure?

SOFTIĆ: On 10 April 2020, the foreign exchange reserves amounted to KM 12.49 billion. Out of that amount, debt securities accounted for 70.2 per cents, cash and deposits of central and commercial banks accounted for 27.5 per cents and gold accounted for 2.3 per cents. A negligible part of the foreign exchange reserve portfolio is in the form of special drawing rights with the IMF, which is an obligation of the country based on its membership in the IMF.

BM: As BH foreign exchange reserves are mainly related to the investments in debt securities, to what extent is that fact making the current situation caused by the pandemic more difficult or easy and why? Specifically, can that be a problem in respect of shortage of cash in case this emergency situation lasts longer?

SOFTIĆ: Disturbances in the supply of cash by the Central Bank are not expected even in case of a longer duration of the emergency caused by the pandemic.

The CBBH always, not only in crises, has contracts for the purchase of euro cash with central banks. High liquidity of our foreign exchange reserve portfolio (even among debt securities in our portfolio, those with residual maturities up to one year amount to KM1.91 billion), meaning that in the shortest period of time, we can change the structure of foreign exchange reserves in favour of euro cash.

Accordingly, the CBBH has no obstacles to import euro cash, if we estimate that commercial banks in BH could exchange KM for the peg currency in the amounts higher than those held in the vaults.

So far, it has never happened that we were unable to meet the requests of banks, not even in October 2008. It should be stressed that at that time, in the period of approximately two weeks, depositors’ flight to foreign currencies was recorded. By the end of that month, all the deposits withdrawn at that time were returned back into the banking system.

I point out that since the appearance of COVID-19 in BH, we have not observed an unusual increase of demand for euro cash or currency transformation of household and corporate deposits.

We have KM cash available as much as banks would like to purchase from us. The supply of cash is one of the core functions of the CBBH and the needs for cash are planned, as a rule, in medium term. In other words, the situation that a bank sends a request for the purchase of cash to the CBBH and that we are unable to meet the request within our regular procedures, cannot happen.

BM: In which circumstances, i.e. in which procedure, the CBBH can use the foreign exchange reserves for purpose of preserving the financial and economic stability of the country?

SOFTIĆ: TheCentral Bank cannot use the foreign exchange reserves under any circumstances! That is not the money of the CBBH! The foreign exchange reserves are the assets of the CBBH based on our liabilities. Our liabilities include the banks' reserve accounts with the CBBH, deposits of internal depositors (primarily the government) and cash in circulation. That is the currency board principle. We cannot put into circulation more than what is covered by euro.

If more KM cash is not demanded, commercial banks do not increase their reserve accounts with the CBBH and deposits of internal depositors, primarily the government (for which we provide fiscal agent services in international payments) do not increase with the CBBH. The change can only take place on the basis of yields from the investments of foreign exchange reserves.

Confidence in the local currency is based on the depositors’ trust that each banknote and coin in their ownership, at their request, will purchase the same quantity of euro, as in the past, and that such ratio will not be changed in the future. The same principle is in effect when commercial banks hold funds in reserve accounts with the CBBH or when the government, for example, holds deposits with the CBBH due to the servicing of foreign debt which is due for repayment. Maintaining the fixed foreign exchange rate against euro is the strongest contribution of the CBBH to the system stability. Any perception of potential disturbance of the currency board would have huge negative consequences for BH.

BM: Speaking of the currency board, i.e. “eternal” dilemma on the appropriateness and efficiency of the existing model of the functioning of the CBBH, has it proved adequate in the current crisis and can we speak of some alternative solution which would make possible a more efficient reply to the problems caused by the pandemic?

SOFTIĆ: Any action which would bring about the decrease of confidence in the currency board, including the use of the foreign exchange reserves for fiscal interventions, would result in automatic devalorisation of convertible mark. In such scenario, in addition to the expected crisis in real sector, we would also have a devalorised currency, hyper-inflation and an almost complete deletion of the value of the assets of all domestic sectors.

It does not mean that the country's monetary policy cannot be changed; there is a legal procedure to do so. However, as rule, it is not done during crises and if economy has not been through considerable structural changes.

The direction chosen by BH is the adjustment of its economy in order to be able to function within the European Union. The currency board is not an obstacle in such process, but just the opposite.

BM: Yet, from the beginning of the crisis in BH caused by the pandemic, the issue of banks’ excess holdings above the reserve requirement has been continuously raised from various sources, i.e. the need to make those funds “available” has been suggested, but mainly without a specific idea how it should be done – do such suggestions make sense in the existing situation as such money was in accounts also prior to the crisis, due to the non-existence of good quality projects for which it could be used?

SOFTIĆ: TheCBBH cannot make banks lend to economy.

Liquid assets in the form of excess holdings above the reserve requirement amounted to KM 2.48 billion in the first ten day period of April. The decrease of the required reserve rate makes sense only when excess holdings above the required reserve are used. Otherwise, banks would only become exposed to higher costs of remunerations paid to the CBBH. The decrease of the remuneration rate on excess reserves, i.e. deviating from the ECB benchmark rate is not an option. In that way, we would take over the costs for the investing of the funds which we do not require banks to hold with the CBBH, with the investment climate in international markets being quite unfavourable for years.

Excess reserves exist not only because banks lack good quality investment projects but also because of regulations, related firstly to the liquidity risk management. Regulations in this area prevent banks to accumulate considerable differences in maturities between their liabilities and assets. If sources of funding, primarily bank deposits, are rather short-term ones, such as transaction and sight deposits, those funds cannot be invested for a longer period of time. It would lead to unacceptably high risk of depositors being unable to obtain their funds at request, or at least without a significant cost for the bank itself. Without alternatives, banks have been holding short-term sources of funds mainly in accounts with the CBBH in the form of excess reserves.

BM: Which options for making those excess funds available exist and would it be a good solution to issue more entity and maybe government bonds (does the latter option include the engagement of the CBBH and which engagement?)

SOFTIĆ: Banks’ purchase of debt securities of our governments and the amounts of such purchases depend on liquidity positions of banks, their internal business policies and their risk profiles. As a rule, a higher credit rating of the issuer and active trading in debt securities even after the primary issue means a stronger inclination of banks to hold securities in their portfolios. However, we should take into account that commercial banks, compared to investment ones, generally have much lower share of securities in their assets. It is simply a different business model. In BH, there are no investment banks organised on the principles of their operating in Western Europe and other developed market economies.

BM: Which is the estimated maximum period in which the stability of the domestic financial sector can be maintained in the situation when the inflow of commercial banks’ income is actually „frozen“ and the withdrawal of deposits of legal entities and natural persons is becoming more intensive?

SOFTIĆ: In the CBBH, we have not observed a considerable decrease of domestic sources of banks' funding. So, at the system level, we currently do not see a considerable decrease of banks’ lending capacities. The interest rates on deposits are quite low, so we do not expect the growth of banks’ costs at that basis.  

It would not be serious to give any estimates at this moment on how long the „banking system can endure“ in such circumstances, whatever that might mean. We have still not received the banks' balance sheets for March, from which we would be able to see at least indications of possible future trends in banking sector.

Until the pandemic, the banking sector was adequately capitalised, liquid and without any significant systemic risks. The pandemic will certainly have negative effects on the financial system stability. However, without any indications of the expected duration of the pandemic globally, its impact on economic activity in the country (speaking of time dimension and intensity and efficiency of the government measures for mitigating the effects of the pandemic on real sector), any estimate would be a speculation which is not based on facts.

BM: Related to the previous question, what have the stress tests of domestic banking system showed?

SOFTIĆ: The stress tests will certainly show much more vulnerabilities compared to the previous periods, but that is their purpose. On the basis of them, among other, micro and macro prudential measures are passed to mitigate systemic risks. So, the calibration of the stress tests scenarios will be a particular challenge, because the aim is not to have all banks failed, but to have systemic vulnerabilities indicated. Current macroeconomic circumstances are dramatically changed compared to anything recorded so far, which means that the system is already in some kind of stress scenario.

I believe that our financial system is capable of enduring a shock for the real sector for several months, without significant problems in its functioning. If real sector does not start recovering by the end of the second quarter, we can certainly expect a strong growth of credit risk.

Consequently, some banks might have problems in their operations, but, as I have already said, everything is still in the area of speculation.