Rethinking the role of the state in the financial sector: The case of Serbia

There are few financial sector topics that have generated as much debate as whether state ownership in the financial sector contributes to or hinders financial development and stability. The case of Serbia shows that both can be true.

The World Bank’s Finance for Growth Report, published in 2001, maintained that state ownership tends to stunt financial sector development, a view that has been supported by many researchers since. State-owned financial institutions (SOFIs) are often associated with poor corporate governance, political interference, crowding out of private sector resources, higher non-performing loans (NPLs) and lower profitability than their privately owned peers. Recent contributions to this topic find that state-owned banks (SOBs) tend to acquire more sovereign debt than private banks during periods of high fiscal need and sovereign distress, leading to macroeconomic and financial sector risks.

However, the assumption that state ownership is ‘bad’ for development has also been challenged by new research, which finds little evidence of a systematic negative relationship between SOFIs, SOBs and adverse financial development, including financial crises. Instead, evidence suggests that SOBs’ contribution depends on how they are managed and operated. Development finance institutions (DFIs) in particular can address market failures and help create markets for the private sector. 

In Serbia, the economy and banking system were hit hard by the global financial crisis of 2007-2008. In 2009, Serbia’s economy went into recession. The fiscal deficit was high and capital inflows decelerated. In the banking sector, NPLs were on the rise, peaking at 23 percent in 2014. NPLs were largely concentrated in five SOBs, of which two were systemic. In addition, three small banks (all with state involvement) had failed in 2012 and 2013, depleting the domestic deposit insurance fund.

The global financial crisis brought to the fore the urgency of accelerating the incomplete transition of Serbia to a market-based economy and addressing the significant role of the state the financial sector. In Serbia, SOFIs with implicit state guarantees had traditionally been a significant contingent fiscal liability for the government and a source of soft budget support for poorly performing state-owned enterprises (SOEs). 

Recognizing the need for reform, the government developed a SOFI reform strategy with World Bank and IMF support. The strategy aimed to reduce the number of state-owned banks with direct state ownership to one; divest from the other four state-owned banks; reform two public DFIs to focus them on addressing market failures; and implement corporate governance reforms across SOFIs. The government also implemented a successful NPL resolution strategy, articulated over two-phases: the first focused on enhancing banks’ capacity to tackle NPLs, developing a market for NPLs, and strengthening debt restructuring and resolution practices; the second phase centered on resolving NPLs from failed banks and SOFIs. The National Bank of Serbia also played an important role in the implementation of the NPL resolution strategy in line with its financial stability mandate. 
 

Figure: Elements of Serbia’s SOFI reform strategy

As a result of this reform effort, Serbia achieved some remarkable results:

• SOFI strategy: The government’s fiscal contingent liabilities were significantly reduced. The number of SOBs was reduced from 6 to 2 and their share in financial system assets declined from 15 to 6 percent. The successful privatization of Jubmes Banka in 2019 and Komercijalna Banka in 2020 are particularly worth mentioning.  
• Banka Postanska Stedionica (BPS) reform. BPS, the state-owned postal savings bank, was transformed from an undercapitalized bank with severe asset quality issues into a well-capitalized, liquid, and highly profitable institution. The bank’s NPL ratio fell dramatically, from of 43.5 to 3.9 percent between end-2016 and 2021. This turnaround was achieved by implementing a new business plan from 2017 onward that strategically focused the bank on retail and small and medium enterprise (SME) lending while phasing out lending to large corporates. Especially the focus on SMEs was in response to the considerable access to finance challenges that these firms faced in Serbia.
• NPL resolution: State-owned NPLs were dramatically reduced from US$3.9bn to below US$1bn between 2016 and 2022. In addition, three successful state-owned NPL tenders were implemented, returning otherwise frozen assets back into the economy. Meanwhile, NPLs system-wide decreased to below 4 percent in 2022.
• DFI reform: Asset quality reviews were undertaken for public DFIs with subsequent implementation of reforms addressing corporate governance issues, risk management and NPLs. A public policy document on development finance, published in 2021, identifies inadequate access to finance for SMEs as a market failure and sets out to reduce this funding gap with the help of the two DFIs.

The case of Serbia illustrates both the virtues and failures of SOFIs. In Serbia, SOFIs were sources of systemic risks for the banking sector and financial stability, that became evident after the GFC. At the same time, the government saw value in retaining one strategic SOB and two DFIs in the economy, with a view to focusing them to address market failures. BPS, with its focus on SME and retail lending, is trying to fill an identified market gap while also serving a policy function for the government, by providing low-cost services to pensioners for instance. However, the verdict is still out on whether the two DFIs will be able to effectively address market failures after implementation of the development finance action plan. In the meantime, it is important to safeguard the important achievements made, keep the focus on good corporate governance, and reevaluate the effectiveness of the DFIs in a few years from now.