## _cr07182 — Republic of Slovenia: Selected Issues (May 2, 2007)

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---

### Introduction and overview
- Prepared by Anita Tuladhar, Rudolfs Bems (both EUR), and Jochen Andritzky (MCM); Approved by European Department; Date: May 2, 2007; Copies price: $18.00 a copy.
- Core objectives (four issues examined):
  - How efficient is the Slovene banking sector in the EU context and how contestable is the market?
  - To what extent has the rapid rise in cross-border financial flows increased vulnerabilities in Slovene banks?
  - What is the state of development of Slovene capital markets and how can the contribution of these markets to growth and financial stability be enhanced?
  - How could the fiscal institutional framework be strengthened to advance expenditure reform and preserve fiscal discipline?
- High-level assessment and recommended direction:
  - Slovenia performs well macroeconomically but faces challenges from EU financial integration, limited capital market development, and a rigid public spending structure.
  - Key recommendations: strengthen bank efficiency and contestability; monitor cross-border exposures; deepen capital markets via a hybrid strategy; consider an expenditure-based fiscal rule to preserve fiscal discipline.

### Banking sector efficiency — findings and quantitative assessment
- Sector structure and market position:
  - The Slovene banking sector is dominated by a few large, state-owned banks.
  - The three largest state-dominated banks constitute 60 percent of the Slovene banking sector by asset size.
- Cost and efficiency indicators:
  - Cost-to-income ratios in Slovenia have remained higher than in comparator NMS and EMU countries; the three largest state-dominated banks show especially high ratios.
  - Labor costs drive higher cost-to-income ratios:
    - The share of labor costs in total costs in the NMS is at 80 percent of EMU levels.
    - In Slovenia the labor cost share is "only 5 percent below the EMU average."
    - Personnel expenses per employee in Slovenia in 2005 were "about one third of those in the EMU" and broadly similar to those in the NMS—implying overstaffing relative to peers.
- Profitability and provisioning:
  - Pre-tax profits (share of total operating income) and ROAE were considerably lower in Slovenia than in the NMS and EMU in 2005 and showed no increase from previous years.
  - With IFRS harmonization, preliminary estimates show provisions in Slovene banks decreased from 13 to 8 percent of operating income during 2005–06.
  - Profitability in 2006 still remained below EMU and NMS levels.
- Net interest margins and competition:
  - Net interest margins in Slovenia declined by around 2 percentage points over the five years preceding 2005; by end-2006 margins had decreased further but remained about 1 percentage point above the EMU average (EMU average = 1.51 in the presented data).
  - Still-high interest margins suggest low market contestability; competition increased recently after EU accession in 2004 and in anticipation of euro adoption in 2007.
- Stochastic frontier (cost efficiency) results:
  - Slovene banks are on average less cost-efficient than banks in the EMU and NMS.
  - The three biggest Slovene banks have average efficiency below the Slovene banking sector average.
  - Mean efficiency (Assumed output: Earning Assets) = 0.826.
  - Mean efficiency (Assumed output: Loans, Deposits, Other Earning Assets) = 0.756.
  - sigmaU/sigmaV = 2.68 (first specification) and 2.23 (second specification).
  - sigma2 = 0.14 (0.02) and 0.26 (0.004).

### Market contestability — measurement and empirical rankings
- Methodology:
  - Panzar and Rosse (1987) H-statistic estimated from ln(interest income/earning assets) = βF ln Fp + βL ln Lp + βK ln Kp + Const + ε; H = βF + βL + βK.
  - H = 1 implies perfect competition; 0 < H < 1 implies monopolistic competition.
  - Sample: 16 countries, period 1995–2005, total 579 banks; 16 alternative specifications tested.
- Benchmark competitiveness index (selected country H-statistics):
  - AUT: 0.65
  - BEL: 0.70
  - CZE: 0.15
  - EST: 0.61
  - ESP: 0.47
  - FIN: 0.59
  - GRC: 0.30
  - HUN: 0.31
  - IRL: 0.48
  - LTU: 0.31
  - LVA: 0.45
  - NLD: 0.64
  - POL: 0.53
  - PRT: 0.47
  - SVN: 0.30
  - SVK: 0.32
- Selected regression indicators (Table 2 baseline sample):
  - SVN βF = 0.58 | No. of obs. = 124 | R2 = 0.76
  - IRL βF = 0.76 | No. of obs. = 110 | R2 = 0.86
  - NLD βF = 0.74 | No. of obs. = 171 | R2 = 0.86
- Robustness and time variation:
  - Results robust to alternative specifications and to shortening the sample to 1999-2005.
  - Subperiod estimates (1995-99, 2000-02, 2003-05) show no statistically significant trend in H-statistic.
  - For Slovenia, existence of a long-run equilibrium was not rejected.
- Correlations and institutional determinants:
  - Contestability index vs. net interest margin: correlation = -0.74.
  - Contestability index vs. cost efficiency: correlation = 0.61.
  - Government direct ownership of the largest bank = 35 percent.
  - Government indirect ownership through state-owned funds and nonbank corporations = 16 percent.
  - One large state-controlled bank accounts for 40 percent of total assets.
  - Herfindahl index for 2005 ranks Slovenia as the 6th most concentrated among 16 sample countries (ECB, 2006).

### Market contestability — policy implications
- Potential efficiency gains from further privatization and enhanced local competition.
- Specific measures where the state retains dominant ownership:
  - Raise corporate governance standards to EU levels for board members.
  - Define longer-term growth strategy for state-dominant banks.
  - List these banks on the stock exchange to increase management accountability and transparency.
  - Maintain strong bank supervision to monitor bank performance and risks.
- Recommendation: policymakers should prioritize improving contestability to mitigate profitability pressure as integration deepens.

### Cross-border flows, foreign expansion, and vulnerabilities
- Extent of cross-border lending and borrowing (key statistics):
  - Loans to non-residents increased from 6 percent in 2004 to about 8 percent of banks’ balance sheets in 2006.
  - Exposure to the rest of former Yugoslavia reached 3.3 percent of banks’ balance sheets in 2006.
  - Foreign loan exposure of Slovenian banks grew from 2 to 12 percent of GDP between 2002-05.
  - Liabilities to foreign banks account for 30 percent of total liabilities.
  - Annual GDP (Billions of SIT) 2001–2005: 4,800; 5,355; 5,814; 6,272; 6,620.
  - Total bank assets (percent of GDP) 2001–2005: 83; 80; 82; 85; 100.
  - Selected y-on-y changes (2001–2005) in percentage points of GDP: Private sector credit 2.3; 0.5; 2.4; 4.7; 7.6. Foreign liabilities 0.9; 2.3; 3.4; 4.0; 12.4.
- Bank of Slovenia soundness indicators, 2003-05 (end of period, percent):
  - Regulatory capital to risk-weighted assets: 11.5; 11.8; 10.6.
  - Net interest margin to average interest bearing assets: 3.2; 2.8; 2.5.
  - Return on average assets (before tax): 1.0; 1.1; 1.0.
  - Average short-term assets to average short-term liabilities: 93.2; 88.4; 84.8.
  - Variable rate contracts (share of new loans of largest 8 banks): 30.1; 38.5; 54.5.
- Foreign expansion case: Nova Ljubljanska Banka (NLB):
  - NLB accounts for 40 percent of total Slovene banking sector assets and is majority owned directly and indirectly by the state.
  - Foreign asset exposure through subsidiaries in South-Eastern Europe and Switzerland grew from 3 percent in 2000 to 8 percent of total in 2005.
  - Contribution of the four countries (Macedonia, Serbia, Bosnia and Herzegovina, Switzerland) to group profits grew from 1 percent to 19 percent over 2000–2005.
- Summary risks from cross-border expansion:
  - Increased exposure to interest rate and funding risks; credit and currency risks when lending in riskier countries.
  - Stress tests do not point to high vulnerabilities given the still small share of foreign assets, but information on foreign credit exposure could be improved and future developments closely monitored.

### Stress tests — interest rate, credit, currency, and liquidity risk
- Interest rate risk:
  - Shock: two standard deviation increase of 2.4 percentage points raises effective interest rates by less than 2 percentage points in tests.
  - A 0.5 percentage point reduction of net interest margin (corresponding to a rise in foreign funding costs by about 2 percentage points) is absorbed through lower profits with CAR broadly unaffected under no balance-sheet-effect assumption.
  - Conclusion: the system can absorb moderate interest rate and margin shocks, but larger or combined shocks could reveal greater vulnerabilities.
- Credit and currency risk (selected figures, September 2006):
  - Foreign claims (percent of total assets): Loans to Banks 18.4; EU 7.6; Non-EU 5.2; Ex-Yugo 2.2.
  - Foreign classified assets (percent of total assets): Loans to Banks 14.4; EU 3.0; Non-EU 3.6; Ex-Yugo 2.1.
  - Provisions (percent of foreign classified assets): Loans to Banks 0.5; EU 10.5; Non-EU 5.5; Ex-Yugo 5.5.
  - Provisions for loans to non-residents are about 9 percent compared to about 4 percent for all loans.
  - 78 percent of lending in Croatia, and 85 percent in Serbia (long-term lending) is denominated in non-domestic currency.
  - Loans to subsidiaries are classified as A-rated on a rating scale from A to E.
  - Conclusion: exposures to SEE remain modest (exposure at 3 percent of banks’ balance sheets) but warrant close monitoring; provisioning may underestimate risks for subsidiaries and onlending.
- Liquidity (sudden stop) stress tests — design and subgrouping:
  - Liquidity ratio = liquid assets / short-term liabilities. Liquid assets = interbank assets + cash reserves + government bonds available for sale + debt instruments and equities held for trading + other short-term non-banking sector assets. Short-term liabilities = liabilities to foreign banks + liabilities to domestic banks + short-term liabilities to non-banking sector.
  - Bank groups: large domestic (six); small domestic (seven); foreign owned banks (nine).
  - Two shock scenarios: withdrawal of liabilities to foreign banks by 20 percent and by 100 percent.
- Key balance sheet and liquidity statistics (In Euro bln):
  - Total assets: 36.4
  - Interbank assets: 3.6
  - Cash reserve: 0.6
  - DIC: 6.9
  - Securities held for trading: 2.0
  - Short-term NBS assets: 6.5
  - Other assets: 16.7
  - Liabilities to foreign banks: 9.8
  - Liabilities to domestic bank(s): 0.6
  - ST Liabilities to NBS: 9.5
  - Other liabilities: 16.4
  - Liquidity ratio (overall): 0.99 (subgroups: Domestic banks 0.92; Large banks 1.03; Small banks 1.37; Foreign banks 0.58)
- Liquidity shock outcomes (selected, EUR mln):
  - Weighted change interest spread (In percent): Overall 3.67; Large domestic banks 4.25; Small domestic banks 2.71; Foreign-owned banks 3.03.
  - Foreign liquidity shock 20 percent — Overall: Before shock 3,673; After shock 2,300; In Profit -67.
  - Foreign liquidity shock 100 percent — Overall: Before shock 3,673; After shock 0; In Profit -338.
  - Large domestic banks, 100 percent shock: Before shock 2,381; After shock 29; In Profit -209.
  - Small domestic banks, 100 percent shock: Before shock 1,383; After shock 3; In Profit -4.
  - Foreign-owned banks, 100 percent shock: Before shock 294; After shock -96; In Profit -125.
- Vulnerabilities and contagion:
  - About one half of total assets and liabilities are short-term.
  - Share of short-term liabilities provided from abroad: Domestic banks: 40 percent; Foreign-owned banks: three quarters.
  - Smaller banks have the most comfortable liquidity ratio; foreign-owned banks have lowest liquidity ratios.
  - Under test assumptions (liquidation without counterparty effects), domestic banks can sustain complete withdrawal but foreign-owned banks are vulnerable; complete withdrawal would cause losses for all foreign-owned banks and two large domestic banks.
  - If liquidation of interbank assets triggers feedback effects, large domestic banks could be left with insufficient liquidity ratios.
- Stress test policy recommendations:
  - Diversify funding base to spread risks.
  - Develop broader stress tests including combined shocks (sudden decline in foreign funds + deterioration in credit quality of foreign loans).
  - Improve reporting of credit risks in SEE and obtain more thorough information on credit quality of non-resident loans and foreign subsidiaries’ loan portfolios.
  - Strengthen cross-border supervisory cooperation and coordination; use memoranda of understanding for crisis prevention.

### Capital markets, investor base, and the TUVL case
- TUVL trading platform (September 2005) — outcomes and trade-offs:
  - Clearing costs were negotiated to be less than 10 percent of the normal fee levied.
  - Trading volume increased by eight times in the first month of operation.
  - The average trade size doubled.
  - Inward investment in securities has grown to 12 percent of all Slovene securities.
  - Foreign investors have a 2.3 times higher turnover ratio than domestic investors.
  - Free float capitalization of the prime market is 61 percent of total capitalization; DAX free float is 88 percent.
  - For 18 smaller companies (data available), the free float stands at only 35 percent.
  - Assets under Management, 2005 (percent of GDP) — Insurance: 10.7, Mutual: 8.0, Pension: 1.9.
  - Annual growth — 14.0% 6.8% 9.9% 9.6%.
  - TUVL increased liquidity and transparency quickly, but trading migrated to the pan-European MTS platform, reducing local trading; MTS offers better access to foreign investors and the possibility to implement the MTS repo facility.
- Investor base diversification and product supply:
  - Remaining portfolio constraints: minimum required return requirements for pension funds; restrictions on investments in the unregulated market.
  - Allowing non-UCITS funds with riskier strategies could introduce hedge-fund-like products and widen risk-return choices.
  - Barriers to retail participation: high brokerage fees; lack of internet-based brokerage services.
  - Barriers to foreign participation: high set-up costs of local presence; limited investment opportunities.
  - Listing more companies—start with state-held firms—would enlarge investable supply; secondary public offerings (e.g., Telekom Slovenije listing in 2006) can double market capitalization and increase free float.
- Market infrastructure and regulation recommendations:
  - Pursue a hybrid strategy: globalize investor base; integrate infrastructure via strategic partnerships with foreign stock exchanges and CSDs; harmonize regulation, taxation, and supervision (implement and enforce MiFID; reform takeover law; address capital gains and withholding taxes; conclude memoranda of understanding for supervisory cooperation).
  - Demutualize the CSD and make fee structures internationally competitive.
  - Improve reporting of off-market trades; align block trading with order-book trading; promote market makers; introduce automated market maker facilities.
  - Strengthen surveillance and enforcement; consider unified supervision across banking, financial markets, and insurance; develop derivatives law and surveillance for new products.
- SME financing and securitization:
  - Encourage SME securitization and product innovation, with caution on state guarantees to avoid fiscal contingent liabilities and moral hazard.
  - Spanish SME securitization example: Approximately 60 Spanish banks participated; 2004 SME securitization = EUR 9 billion (18 percent of total issuance EUR 52 billion).

### Fiscal framework, medium-term budgeting, and institutional recommendations
- Fiscal targets and projections:
  - Slovenia intends to reduce the structural deficit to 1 percent of GDP by 2009 and to a structural balance by 2011.
  - Anticipated revenue decline: "revenues will decline by almost 4 percent of GDP, from 45.8 percent of GDP in 2005 to 41.7 percent of GDP in 2009," of which "about 3 percent of GDP can be attributed to the decline in the tax burden."
  - Projected expenditure reduction: "expenditures are projected to be lowered by 4½ percent of GDP, primarily in the areas of social transfers and gross fixed capital formation."
  - Long-term age-related pressures: "Pension and health care expenditures are expected to increase by around 7 percent of GDP by 2050 under current policies."
  - Debt has remained around 28 percent of GDP and fiscal deficits "at about 1½ percent of GDP in 2005."
- Existing framework and procedures:
  - Slovenia has a two year rolling budgetary framework; IMAD prepares macroforecasts.
  - The two year system provides medium-term orientation but lacks automatic countercyclical features.
- Fiscal rule options and institutional design:
  - Authorities discuss introduction of an annual deficit rule; expenditure rule considered less viable given conflict with annual deficit target.
  - Revenue rule for local governments limits borrowing to less than 20 percent of revenues of the previous year; proposals to extend to regional governments.
  - Preconditions for successful fiscal rules include political consensus, developed fiscal institutions, simple and monitorable rules, independent monitoring, and enforceability.
  - MTBFs complement rules by defining legal frameworks for multi-year fiscal policies and can introduce countercyclical features via expenditure ceilings.
  - Independent fiscal institutions can enhance MTBF credibility by monitoring, producing forecasts, and enforcing non-discretionary assessments.
- Specific policy recommendations:
  - Consider rules targeting a cyclically adjusted deficit or an expenditure rule combined with an MTBF to allow automatic stabilizers to operate.
  - Base medium-term targets on long-term sustainability given aging pressures; consider aiming for structural balance or surplus if pension/health reforms fail.
  - Improve MTBF design: extend horizon to match electoral cycles, specify expenditure ceilings at an aggregated level for the second year and beyond, and require reform programs with quantified measures and timing.
  - Consider a ‘golden rule’ to allow borrowing for investment or amortization with caveats on potential circumvention and fiscal effectiveness.
  - Strengthen independent assessment (IMAD role) and consider adding prudential margins to forecasts; expand IMAD or an independent institution’s role to assess fiscal trends, yields of measures, and adherence to rules, with reporting directly to Parliament.

### Role of independent assessment and concluding policy messages
- IMAD already provides macroeconomic assumptions; historical analysis since 1995 shows no systematic bias in projections.
- Consider applying a prudential margin to growth forecasts and expanding independent roles to enhance transparency and reduce political bias.
- Conclusions:
  - Slovenia faces significant fiscal reform and sustainability challenges.
  - Strengthening the medium-term budgetary framework, combining rules and independent monitoring, and improving expenditure flexibility and consolidation are key to meet medium-term fiscal targets and sustain fiscal credibility.

*Source: IMF staff team; _cr07182 — Republic of Slovenia: Selected Issues (Prepared by Anita Tuladhar, Rudolfs Bems, Jochen Andritzky; Approved by European Department; May 2, 2007)._

### 2007. The views expressed in this document are those of the staff team and do not necessarily reflect

### _cr07182 - 2007. The views expressed in this document are those of the staff team and do not necessarily reflect

### Introduction and overview
- Publication and administrative details:
  - Prepared by Anita Tuladhar, Rudolfs Bems (both EUR), and Jochen Andritzky (MCM).
  - Approved by European Department.
  - Date: May 2, 2007.
  - Copies price: $18.00 a copy.
- Core objectives of the paper (four issues examined):
  - How efficient is the Slovene banking sector in the EU context and how contestable is the market?
  - To what extent has the rapid rise in cross-border financial flows increased vulnerabilities in Slovene banks?
  - What is the state of development of Slovene capital markets and how can the contribution of these markets to growth and financial stability be enhanced?
  - How could the fiscal institutional framework be strengthened to advance expenditure reform and preserve fiscal discipline?
- High-level assessment:
  - Slovenia is performing well macroeconomically but faces challenges from EU financial integration, limited capital market development, and a rigid public spending structure.
  - Key recommended direction: strengthen bank efficiency and contestability, monitor cross-border exposures, deepen capital markets via a hybrid strategy, and consider an expenditure-based fiscal rule to preserve fiscal discipline.

### Efficiency of the Slovene banking sector in the EU context — main findings
- Sector structure and market position:
  - The Slovene banking sector is dominated by a few large, state-owned banks.
  - The three largest state-dominated banks constitute 60 percent of the Slovene banking sector by asset size.
- Cost and efficiency indicators:
  - Cost-to-income ratios in Slovenia have remained higher than in comparator NMS and EMU countries; the three largest state-dominated banks show especially high ratios.
  - Labor costs drive the higher cost-to-income ratios in Slovenia.
    - The share of labor costs in total costs in the NMS is at 80 percent of EMU levels.
    - In Slovenia the labor cost share is "only 5 percent below the EMU average."
    - Personnel expenses per employee in Slovenia in 2005 were "about one third of those in the EMU" and broadly similar to those in the NMS—implying overstaffing relative to peers.
- Profitability and provisioning:
  - Pre-tax profits in Slovenia (share of total operating income) and ROAE were considerably lower than in the NMS and EMU in 2005 and showed no increase from previous years.
  - Stricter provisioning rules in Slovenia until 2006 affected profits; with IFRS harmonization, preliminary estimates show provisions in Slovene banks decreased from 13 to 8 percent of operating income during 2005–06.
  - Profitability in 2006 still remained below EMU and NMS levels.
- Net interest margins and competition:
  - Net interest margins in Slovenia declined by around 2 percentage points over the five years preceding 2005, while they were broadly flat in EMU and NMS over the same period.
  - By end-2006, net interest margins in Slovenia had decreased further but remained about 1 percentage point above the EMU average (EMU average = 1.51 in the presented data).
  - The still-high interest margins in Slovenia suggest low market contestability; competition increased only recently after EU accession in 2004 and in anticipation of euro adoption in 2007.

### Quantitative assessment of cost efficiency (stochastic frontier analysis)
- Methodology and specification:
  - Stochastic frontier (best-practices) approach used to estimate indirect levels of costs for given outputs and input prices.
  - Output proxied by total earning assets (intermediation approach); inputs proxied by:
    - Lp: personnel expenses divided by number of employees (price of labor).
    - Kp: other operating and administrative expenses divided by fixed assets (price of equipment and fixed capital).
    - Fp: interest expenses divided by all funding (price of funding).
  - Total costs (TC) defined as sum of interest expenses and total operating expenses.
  - Costs and outputs normalized with equity to minimize heteroscedasticity.
  - Cost efficiency measure: CE = exp(−u), where CE = 1 denotes frontier efficiency.
- Empirical results:
  - Slovene banks are on average less cost-efficient than banks in the EMU and NMS.
  - No clear efficiency difference between EMU and NMS banks in the sample.
  - The three biggest Slovene banks have average efficiency below the Slovene banking sector average.
- Robustness checks and alternative specifications:
  - Results robust to alternative output definitions (loans, deposits, other earning assets instead of earning assets alone).
  - Additional specifications tested included separate frontiers for NMS and EMU, adding balance-sheet ratios as controls, inclusion/exclusion of commission and fees, and alternative normalizations of capital price.
  - A common cost frontier estimated for 2000-05 with time dummies showed similar results.

### Market contestability and its implications
- Qualitative conclusion:
  - Indicators point to low market contestability in Slovenia compared to EU peers.
- Possible determinants highlighted:
  - Market concentration and ownership structure (dominance of one large bank and a significant share of state ownership).
  - The least efficient banks are state-owned, suggesting privatization could raise sector efficiency.
- Policy implications:
  - Further privatization and measures to enhance local market competition could yield potentially large efficiency gains.
  - Policymakers should prioritize improving contestability to mitigate continuing pressure on profitability as integration deepens.

*International Monetary Fund — Republic of Slovenia: Selected Issues. Prepared by Anita Tuladhar, Rudolfs Bems (EUR), and Jochen Andritzky (MCM); Approved by European Department; May 2, 2007.*

### 23.      Market contestability is analyzed using an index that measures the extent of the

### _cr07182 - 23.      Market contestability is analyzed using an index that measures the extent of the

### Methodology
- Market contestability is measured using the Panzar and Rosse (1987) (PR) methodology, which infers contestability from the pass-through of input price changes to bank revenues.
- Under PR assumptions, revenues under perfect competition increase one-for-one with input prices, holding output quantity constant and output prices rising proportionally; with less-than-perfect competition, pass-through is less than one-to-one.
- The H-statistic measures the extent to which changes in factor prices are reflected in revenues:
  - H = sum of βj for j ∈ {F, L, K} (βF + βL + βK).
  - H = 1 implies perfect competition; 0 < H < 1 implies monopolistic competition.
- Baseline revenue equation (benchmark specification):
  - ln Yp_it = βF ln Fp_it + βL ln Lp_it + βK ln Kp_it + Const + ε_it
  - Where Yp is interest income divided by all earning assets (price of bank output); Lp, Kp, Fp are input prices.
- Long-run equilibrium tests for each market were performed (see Table 3 references in the source).

### Benchmark specification and estimation details
- Dependent variable: interest income to total earning assets (ln form).
- Baseline controls and alternative specifications employed in robustness checks included:
  - Time dummies and loans/assets, deposits/assets and equity/assets ratios;
  - Inclusion of commission and fee income in price of funds and output;
  - Changing normalization of price of capital from fixed assets to total assets;
  - Estimates with OLS and GLS with fixed bank-specific effects.
- Sixteen alternative specifications were examined.
- Data source: Bankscope; sample covers 16 countries, eleven-year period 1995–2005, total 579 banks (see Appendix).

### Key empirical results — contestability rankings and magnitudes
- For the total sample period, 1995-2005:
  - Market contestability was lowest in Slovenia and several NMS (Lithuania, Hungary, Slovak Republic).
  - EMU markets were generally more competitive; Belgium, Austria, and the Netherlands had the highest scores.
- Benchmark competitiveness index (selected country H-statistics from Table 3, Competitiveness index = βF+βL+βK):
  - AUT: 0.65
  - BEL: 0.70
  - CZE: 0.15
  - EST: 0.61
  - ESP: 0.47
  - FIN: 0.59
  - GRC: 0.30
  - HUN: 0.31
  - IRL: 0.48
  - LTU: 0.31
  - LVA: 0.45
  - NLD: 0.64
  - POL: 0.53
  - PRT: 0.47
  - SVN: 0.30
  - SVK: 0.32
- Table 2 baseline regression sample indicators (selected):
  - SVN βF = 0.58 | No. of obs. = 124 | R2 = 0.76
  - IRL βF = 0.76 | No. of obs. = 110 | R2 = 0.86
  - NLD βF = 0.74 | No. of obs. = 171 | R2 = 0.86
- Histogram and ranking evidence: Slovenia ranks low across specifications (e.g., Bikker and others (2006) report Slovenia ranks 10th, 14th and 15th out of 16 depending on model specification).

### Robustness and time variation
- Results are robust to the 16 alternative specifications and to shortening the sample period to 1999-2005.
- Estimates for three subperiods with time dummies — 1995-99, 2000-02 and 2003-05 — show no statistically significant variation in the H-statistic (no detected trend over time).
- For Slovenia, existence of a long-run equilibrium was not rejected in any specification.

### Determinants of efficiency and contestability (empirical correlations and institutional factors)
- Simple correlations (Slovene banking sector):
  - Contestability index vs. net interest margin: correlation = -0.74 (negative).
  - Contestability index vs. cost efficiency: correlation = 0.61 (positive).
- Cross-country determinants noted in the literature:
  - Market entry and activity restrictions reduce contestability and efficiency.
  - State ownership generally negatively affects bank efficiency and contestability; foreign ownership tends to have opposite effect.
  - Bank size and market concentration tend to negatively affect efficiency and contestability (evidence mixed).
- Slovene sector specifics:
  - Government direct ownership of the largest bank = 35 percent.
  - Government indirect ownership through state-owned funds and nonbank corporations = 16 percent.
  - One large state-controlled bank accounts for 40 percent of total assets.
  - Herfindahl index for 2005 ranks Slovenia as the 6th most concentrated among 16 sample countries (ECB, 2006).

### Policy implications and recommended measures
- Improving efficiency and contestability would enhance growth and financial stability by better intermediation of finance to efficient uses and by offering more sophisticated pension savings products for an aging population.
- Specific measures to enhance efficiency and accountability where the state retains dominant ownership:
  - Raise corporate governance standards to EU levels for board members.
  - Define a longer-term growth strategy for state-dominant banks.
  - List these banks on the stock exchange to increase management accountability and transparency.
  - Maintain strong bank supervision to monitor bank performance and risks.
- The government plans further bank privatizations, but retaining majority shares may require the additional measures above to ensure continued efficiency improvements.

### Select sample and estimation statistics (preserved figures)
- Sample coverage:
  - Period: 1995 to 2005.
  - Countries: 16.
  - Total banks: 579.
  - Data expressed in U.S. dollars; consolidated statements used when available.
  - Data filtering eliminated 10.2 percent of sample observations.
- Data-filter rule examples (Table A1 fallouts):
  - Commissions and fee income/interest income upper bound = 100 (fallout 3.7 percent).
  - Equity/total assets upper bound = 0.5 (fallout 3.4 percent).
  - Personnel expenses/employment lower bound = 1,100 and upper bound = 1,000,000 (fallout 0.2 percent).
- Stochastic frontier cost estimates (Table 1):
  - Mean efficiency (Assumed output: Earning Assets) = 0.826.
  - Mean efficiency (Assumed output: Loans, Deposits, Other Earning Assets) = 0.756.
  - sigmaU/sigmaV = 2.68 (first specification) and 2.23 (second specification).
  - sigma2 = 0.14 (0.02) and 0.26 (0.004) [standard errors in parentheses where shown].

*Source: Staff calculations; Bankscope.*

### References

### _cr07182 - References

### References (bibliography)
- Bank of Slovenia, 2006, Financial Stability Report, (Ljubljana: Bank of Slovenia).
- Berger, A., and others, 2004, “Bank Concentration and Competition: An Evolution in the Making,” Journal of Money, Credit and Banking, Vol. 36, (June), pp. 433–51.
- Bikker, J., and K. Haaf, 2002, “Competition, Concentration and Their Relationship: An empirical Analysis of the Banking Industry,” Journal of Banking and Finance, Vol. 26, pp. 2191–214.
- Bikker, J., L. Spierdijk, and P. Finnie, 2006, “Misspecification of the Panzar-Rosse Model: Assessing Competition in the Banking Industry,” mimeo, De Nederlandsche Bank, November.
- Claessens, S., and L. Laeven, 2004, “What Drives Bank Competition? Some International Evidence,” Journal of Money, Credit and Banking, Vol. 36, (June), pp. 563–92.
- ECB, 2006, EU Banking Structures, (Frankfurt: ECB).
- Gelos, G., and J. Roldos, 2002, “Consolidation and Market Structure in Emerging Market Banking Systems,” IMF Working Paper 02/186 (Washington: IMF).
- Giannetti, M., and others, 2002, “Financial Market Integration, Corporate Financing and Economic Growth,” European Economy Economic Papers, No. 179 (Brussels: EC, Directorate General for Economic and Financial Affairs).
- Kumbhakar, S., and K. Lovell, 2000, Stochastic Frontier Analysis, (Cambridge: Cambridge University Press).
- Micco, A., U. Panizza, and M. Yanez, 2004, “Bank Ownership and Performance,” IADB Working Paper No. 518 (Washington: Inter-American Development Bank).
- Panzar, J., and J. Rosse, 1987, “Testing for ‘Monopoly’ Equilibrium,” Journal of Industrial Economics, Vol. 35, (June), pp 443–56.

### Summary (findings)
- Slovene banks are increasingly relying on foreign funding to finance credit, mostly on loans from EU banks.
- Banks are increasing their exposure into regions with wider margins, such as the rest of former Yugoslavia, to boost profits.
- The expansion of cross-border lending and borrowing can increase vulnerability to:
  - interest rate and funding risks;
  - credit and currency risks when lending in riskier countries.
- Stress tests do not point to high vulnerabilities given the still small share of foreign assets, but:
  - information on foreign credit exposure could be improved;
  - future developments should be closely monitored;
  - stress tests should include more disruptive scenarios of combined shocks.

### Introduction (context and motivation)
- Profitability pressures since EU integration and euro adoption:
  - greater competition is narrowing interest margins;
  - revenues from foreign exchange transactions are being reduced.
- Banks’ responses:
  - expansion of cross-border lending and capital investments in high-margin regions (e.g., Southeastern Europe);
  - increased foreign borrowing to finance credit demand as depositors shift to higher yielding mutual funds.
- Identified risks from foreign operations:
  - interest rate risk;
  - direct or indirect currency risk;
  - credit risk from riskier markets;
  - funding risk if foreign banks reduce lending.
- Assessment approach:
  - stress tests based on Bank of Slovenia results analyze exposure to interest rate, credit, currency, and liquidity risk.

### Extent of Cross-Border Lending and Borrowing (key statistics)
- Loans to non-residents increased from 6 percent in 2004 to about 8 percent of banks’ balance sheets in 2006.
- Exposure to the rest of former Yugoslavia reached 3.3 percent of banks’ balance sheets in 2006.
- Foreign loan exposure of Slovenian banks grew from 2 to 12 percent of GDP between 2002-05.
- Annual growth of over 50 percent in recent years helped finance domestic credit growth at around 20 percent annually.
- Liabilities to foreign banks account for 30 percent of total liabilities.
- Slovenia: Sources of Growth of Bank Balance Sheets, 2001-05 (In percentage points of GDP, y-on-y change; Annual GDP (Billions of SIT))
  - Annual GDP (Billions of SIT): 4,800; 5,355; 5,814; 6,272; 6,620
  - Total bank assets (percent of GDP): 83; 80; 82; 85; 100
  - Selected items y-on-y change (2001–2005): Private sector credit 2.3; 0.5; 2.4; 4.7; 7.6; Government credit 0.3; -0.1; -0.3; 0.9; 0.4; Foreign assets 6.5; -7.8; -0.9; 0.2; 4.7; Foreign liabilities 0.9; 2.3; 3.4; 4.0; 12.4
- Net Interest Margin (percent), 2000–2005: charts show Slovenia, Serbia, Macedonia, EMU, Bosnia and Herzegovina (data presented graphically; text highlights)
- Net interest margins in 2006:
  - domestic banks: 2.3 percentage points;
  - foreign-owned banks: 1.8 percentage points.
- Other SEE countries offer margins that can go up to 7 percentage points.
- Slovenia: Banking Sector Soundness Indicators, 2003-05 (In percent; end of period)
  - Regulatory capital to risk-weighted assets: 11.5; 11.8; 10.6 (2003, 2004, 2005)
  - Net interest margin to average interest bearing assets: 3.2; 2.8; 2.5
  - Return on average assets (before tax): 1.0; 1.1; 1.0
  - Average short-term assets to average short-term liabilities: 93.2; 88.4; 84.8
  - Variable rate contracts (share of new loans of largest 8 banks): 30.1; 38.5; 54.5

### Box: Foreign Expansion of Nova Ljubljanska Banka (NLB) (highlights)
- NLB accounts for 40 percent of total Slovene banking sector assets and is majority owned directly and indirectly by the state.
- Foreign asset exposure through subsidiaries in South-Eastern Europe and Switzerland more than doubled over 2000-05.
- Assets in Macedonia, Serbia, Bosnia and Herzegovina, and Switzerland grew from 3 percent in 2000 to 8 percent of total in 2005.
- Contribution of the four countries to group profits grew from 1 percent to 19 percent over 2000–2005.

### Stress Tests with Risks from Cross-Border Finance (methodology & groups)
- Stress tests assess shocks to interest rate, credit, currency, and liquidity risks using Bank of Slovenia model results.
- Banks divided into three groups for tests:
  - large domestic (six);
  - small domestic (seven);
  - foreign owned banks (nine with foreign controlling stakes).
- Details on methodology and assumptions are in the Annex.

### Interest rate risk (test results and implications)
- Interest rate dynamics:
  - a two standard deviation shock to interest rates (2.4 percentage points) increases the effective interest rate by less than 2 percentage points.
  - interest revenue and expenses are higher in 2006 and 2007 compared to baseline, but net interest revenue falls.
  - capital adequacy is affected more by reduced loan growth than by lower profits, which improves the capital adequacy ratio (CAR) at time of shock.
- Maturity/repricing structure:
  - about two-thirds of domestic deposits mature within one year;
  - only 12 percent of banks’ foreign loans are short-term;
  - 94 percent of domestic deposits are repriced within one year;
  - 88 percent for foreign credit are repriced within one year;
  - average time to repricing of foreign assets fell from 19 to 16 months between 2005-06;
  - average time to repricing remained broadly stable at 6 months for foreign liabilities.
- Margin shock:
  - a 0.5 percentage point reduction of the net interest rate margin (corresponding to a rise in foreign funding costs by about 2 percentage points) is absorbed through lower profits with CAR broadly unaffected (no balance sheet effects assumed).
  - an earlier IMF assessment applied a shock that halved interest margins, leading to losses and three banks requiring capital injection.
- Conclusion:
  - Slovene banking system can absorb moderate interest rate and margin shocks;
  - foreign borrowing has reduced maturity mismatch and interest rate sensitivity;
  - larger shocks or combined shocks (credit deterioration, sudden stop of foreign funding) remain to be tested and could reveal greater vulnerabilities.

### Credit and currency risk (exposures and provisioning)
- Balance Sheet and Off-Balance-Sheet Assets of Banks and Special Provisions (September 2006):
  - Foreign claims (percent of total assets): Loans to Banks 18.4; EU 7.6; Non-EU 5.2; Ex-Yugo 2.2
  - Foreign classified assets (percent of total assets): Loans to Banks 14.4; EU 3.0; Non-EU 3.6; Ex-Yugo 2.1
  - Provisions (percent of foreign classified assets): Loans to Banks 0.5; EU 10.5; Non-EU 5.5; Ex-Yugo 5.5
- Key observations:
  - Credit and currency risks mainly arise from exposures to SEE.
  - Euro adoption and EU membership have reduced some currency risks for Slovenia; indirect currency risks remain since loans in SEE tend to be in foreign currencies.
  - Provisions for loans to non-residents are about 9 percent compared to about 4 percent for all loans.
  - NPL ratio estimates in some SEE areas range from 3 to 10 percent.
  - Loans to subsidiaries are classified as A-rated on a rating scale from A to E.
  - 78 percent of lending in Croatia, and 85 percent in Serbia (in particular for long-term lending) is denominated in non-domestic currency.
  - Concern that provisioning is low for loans to subsidiaries of Slovene banks and to Slovene enterprises in SEE because onlending by foreign subsidiaries is not fully visible—this may underestimate credit risks in Slovenia’s balance sheets.
- Overall:
  - despite rapid growth in lending to SEE, exposure at 3 percent of banks’ balance sheets remains small;
  - together with euro adoption, overall risks from exposure to SEE are judged low but warrant close monitoring.

### Liquidity risk (concentration and contagion channels)
- Growing dependence on external funds increases liquidity vulnerability—risk of contagion from a SEE downturn includes simultaneous credit quality deterioration and a sudden stop of foreign funding.
- Concentration of foreign funding:
  - Austria is the most dominant provider of capital to Slovenia (and to SEE in general), followed by Germany.
  - By end-2005, half of all Eastern European foreign owned bank assets were concentrated in eight bank groups.
- Figure 1 (Foreign Bank and Portfolio Investment by Residence of Investor, 2005) presents bilateral flows and country shares in billions of U.S. dollars (chart details in source).
- Eastern European Bank Asset Structure, by Key Bank Groups, end-2005 (In percent of total CEE banking sector assets) shows distribution across bank groups (percentages listed for individual groups in source).

*Source: IMF staff summary of the document titled "_cr07182 - References" and associated chapter content.*

### 54.      The vulnerability of Slovene banks to sudden stops was tested with changes to

### The vulnerability of Slovene banks to sudden stops (Stress test results and capital market implications)

### Liquidity stress test design and scenarios
- Liquidity ratio defined as the ratio between liquid assets and short-term liabilities.
- Liquid assets defined as the sum of interbank assets, cash reserves, government bonds available for sale, debt instruments and equities held for trading, and other short-term non-banking sector assets.
- Short-term liabilities defined as the sum of liabilities to foreign banks, liabilities to domestic banks and short-term liabilities to the non-banking sector.
- Two shock scenarios:
  - Withdrawal of liabilities to foreign banks by 20 percent.
  - Withdrawal of liabilities to foreign banks by 100 percent (complete withdrawal).
- Upon reduction in liabilities to foreign banks, assets are adjusted by liquidating the most liquid assets first before rationing long-term credit business.
- Profit impact calculated based on current weighted interest margins and assumed that short-term assets can be liquidated without problems (note: this may slightly underestimate broader macroeconomic repercussions).

### Key balance sheet and liquidity statistics (actual, Dec-05 / Sep-2006 context)
- Total assets: 36.4 (In Euro bln)
- Interbank assets: 3.6 (In Euro bln)
- Cash reserve: 0.6 (In Euro bln)
- DIC: 6.9 (In Euro bln)
- Securities held for trading: 2.0 (In Euro bln)
- Short-term NBS assets: 6.5 (In Euro bln)
- Other assets: 16.7 (In Euro bln)
- Liabilities to foreign banks: 9.8 (In Euro bln)
- Liabilities to domestic bank(s): 0.6 (In Euro bln)
- ST Liabilities to NBS: 9.5 (In Euro bln)
- Other liabilities: 16.4 (In Euro bln)
- Liquidity ratio (overall): 0.99 (actual); subgroups: Domestic banks 0.92; Large banks 1.03; Small banks 1.37; Foreign banks 0.58

### Stress test outcomes — impact on liquidity ratios and pre-tax profits (weighted change and profit impact)
- Weighted change interest spread (In percent): Overall 3.67; Large domestic banks 4.25; Small domestic banks 2.71; Foreign-owned banks 3.03
- Foreign liquidity shock of 20 percent — Impact (EUR mln) and In Profit (EUR mln):
  - Large domestic banks: Before shock 2,381; After shock 196; In Profit -42
  - Small domestic banks: Before shock 1,383; After shock 80; In Profit 0
  - Foreign-owned banks: Before shock 294; After shock -25; In Profit (not separately listed beyond amounts)
  - Overall: Before shock 3,673; After shock 2,300; In Profit -67
- Foreign liquidity shock of 100 percent — Impact (EUR mln) and In Profit (EUR mln):
  - Large domestic banks: Before shock 2,381; After shock 29; In Profit -209
  - Small domestic banks: Before shock 1,383; After shock 3; In Profit -4
  - Foreign-owned banks: Before shock 294; After shock -96; In Profit -125
  - Overall: Before shock 3,673; After shock 0; In Profit -338

### Vulnerabilities by bank type and contagion considerations
- About one half of total assets and liabilities in the Slovene banking system are short-term.
- Share of short-term liabilities provided from abroad:
  - Domestic banks: 40 percent.
  - Foreign-owned banks: three quarters.
- Liquidity ratio patterns:
  - Smaller banks have the most comfortable liquidity ratio.
  - Liquidity ratio is lowest in foreign-owned banks, reflecting their role of transferring funds from parent banks to long-term loans in Slovenia.
- Stress test implications:
  - Domestic banks can sustain the complete withdrawal of foreign funding without incurring liquidity problems under the test’s assumptions (short-term assets liquidated without problems).
  - Foreign-owned banks are more vulnerable; in case of a complete withdrawal, foreign banks would suffer insufficient liquidity ratios and would need to liquidate long-term assets.
  - With a 20 percent withdrawal of liabilities to foreign banks, six of the nine foreign-owned banks would make losses.
  - In case of a complete withdrawal, all foreign-owned banks and two large domestic banks would incur losses.
- Feedback effects and system-wide contagion:
  - Current test assumes liquidation of interbank loans without counterparty effects.
  - If liquidation of interbank assets triggers feedback effects, large domestic banks could be left with insufficient liquidity ratios; complete liquidation of interbank assets may be unrealistic because it would send shock waves through the system.
  - The stress-test scenario assuming foreign subsidiaries are abandoned by parent institutions is unlikely, which may overstate the extreme scenario.

### Conclusions on liquidity risk and policy implications
- Overall assessment:
  - Liquidity risk in Slovenia is judged low, though some vulnerability to sudden stop shocks exists.
  - Occurrence of sudden-stop shocks in Slovenia is likely to be small.
  - A shock in SEE may cause foreign banks to reduce regional exposure, but Slovenia is likely to be differentiated given EU and euro area membership.
  - Slovenia’s exposure in SEE is still modest and unlikely to create major systemic concerns domestically.
- Remaining concerns:
  - Slovenia remains highly reliant on foreign borrowing from a few sources to finance asset growth, implying vulnerability to a slowdown in foreign credit.
  - Diversification of the funding base would spread risks and reduce vulnerability to liquidity shocks.
- Recommendations for monitoring and further testing:
  - Closer monitoring, particularly of credit risks, is warranted.
  - Broader stress tests should be developed, including scenarios that combine a sudden decline in foreign funds with a simultaneous deterioration of credit quality of foreign loans, including those to foreign subsidiaries of Slovene banks.
  - Better reporting of credit risks in SEE and more thorough information about the credit quality of non-resident loans and loan portfolios of Slovene banks’ foreign subsidiaries are necessary to monitor the appropriateness of provisions.
  - Cross-border supervisory cooperation and coordination between EU countries should be strengthened; memoranda of understanding could encompass crisis prevention.

### Related stress test assumptions (interest rate and margin tests)
- Interest rate stress test:
  - Shock: temporary interest rate increase of 2.4 percentage points (corresponds to two standard deviations over the last 11.5 years).
  - Assumes yield on 60-day tolar bills and one-year EURIBOR are raised for four consecutive quarters (Q4 2006-Q3 2007) before receding.
  - Non-banking sector responses modeled: loan growth 0.4 percentage points lower in 2006 than baseline; most impact manifests in 2007.
- Net interest margin shock test:
  - Shock: net interest rate margin shock of 0.5 percentage point in Q4 2006, reversing one year later.
  - Modeled to affect only interest expenses (mimicking a rise in the cost of foreign funding).
  - Corresponding rise in foreign interest rates assumed highest in the first quarter of the shock, rising by 2.3 percentage points; subsequent quarters: 2 percentage points in second quarter, 1.9 in third, and 1.8 in fourth quarter.

*Source: Bank of Slovenia; IMF staff analysis as presented in the source document.*

### Box 1. The Rise and the Fall of TUVL

### Box 1. The Rise and the Fall of TUVL

### Overview of the TUVL initiative
- An over-the-counter trading platform for government bills and bonds, named the “TUVL”, was created in Slovenia in September 2005 to increase market liquidity and transparency.
- To promote trading, the issuer assumed the trading cost, and clearing costs were negotiated to be less than 10 percent of the normal fee levied.
- The issuer’s measures aimed to concentrate formerly fragmented trading activity and lower trading costs.

### Effects on liquidity, transparency, and trading activity
- Trading volume increased by eight times in the first month of operation.
- The average trade size doubled.
- Pre- and post-trade transparency improved as market maker quotes were accessible through a public web page maintained by the LJSE.
- The initiative helped to concentrate formerly fragmented trading activity and greatly reduced trading costs.

### Decline, migration to MTS, and trade-offs
- Trading volumes at the TUVL declined recently when issuance activity migrated to the euro government bond market (using the pan-European MTS trading platform).
- Although this will cease local trading, the adoption of MTS brings significant advantages:
  - Better access to foreign investors.
  - The possibility to implement the MTS repo facility.
- The initial investments in the TUVL infrastructure did not pay off, illustrating the need for a long-term strategy for capital market development in small, internationally integrating markets.

### Key statistics and market context (preserved exactly as presented)
- Clearing costs were negotiated to be less than 10 percent of the normal fee levied.
- Trading volume increased by eight times in the first month of operation.
- The average trade size doubled.
- Inward investment in securities has grown to 12 percent of all Slovene securities.
- Foreign investors have a 2.3 times higher turnover ratio than domestic investors.
- Free float capitalization of the prime market is 61 percent of total capitalization.
- DAX free float is 88 percent.
- For 18 smaller companies (data available), the free float stands at only 35 percent.
- Assets under Management, 2005 (percent of GDP) — Insurance: 10.7, Mutual: 8.0, Pension: 1.9.
- Annual growth — 14.0% 6.8% 9.9% 9.6%

### Lessons learned and policy implications
- Short-term subsidies and infrastructure investment can rapidly boost liquidity and transparency, but may not be sustainable if issuance and trading migrate to larger integrated markets.
- Small, open markets face trade-offs between sustaining local trading venues and integrating with pan-European platforms that offer scale economies and broader investor access.
- The TUVL case highlights the importance of:
  - Developing a long-term, strategic approach to capital market development before committing to infrastructure investments.
  - Assessing the likely trajectory of issuer behavior (e.g., migration to euro markets) when designing local trading platforms.
  - Weighing local market benefits (domestic liquidity, local repo and clearing facilities) against gains from integration (foreign investor access, implementation of MTS repo).

### Recommended actions (drawn from broader capital-market recommendations in the source)
- Pursue a hybrid strategy that:
  - Globalizes the investor base (remove constraints to international investors; review indirect barriers to foreign investors).
  - Integrates infrastructure (strategic partnership with foreign stock exchange; strategic partnership with foreign CSD; enable foreign intermediaries to become trading and settlement members).
  - Harmonizes regulation, taxation, and supervision (implementation and enforcement of MiFID; reform takeover law and minority shareholder protection; address capital gains and withholding taxes; conclude memoranda of understanding for supervisory cooperation).
- For domestic market development:
  - Promote listing of large companies and measures to increase the free float.
  - Introduce market segments suited to SMEs.
  - Facilitate ABS issuance and the use of market makers.
  - Demutualize the CSD and make fee structures internationally competitive to attract settlement business.
  - Set incentives for consolidation of trading activity to deepen order books.

*Source: Bank of Slovenia; LJSE; KDD; OECD; Securities Market Agency; Insurance Supervision Agency; staff estimates (as presented in the original Box).*

### 92.      To diversify the investor base, restrictions on portfolio selection should be

### _cr07182 - 92.      To diversify the investor base, restrictions on portfolio selection should be

### Investor base diversification and portfolio restrictions
- Removal of foreign investment restrictions in 2001 enhanced portfolio diversity by incorporating foreign securities.
- Remaining constraints limiting portfolio selection:
  - Minimum required return requirements for pension funds.
  - Restrictions on investments in the unregulated market.
- Allowing operation of funds not compliant with EU legislation (i.e., non-UCITS compliant funds) with more risky strategies (including derivative and leveraged investments) could facilitate the establishment of hedge fund products.
- Expected benefits of hedge fund products:
  - Widen the choice of risk-return profiles.
  - By pursuing active investment strategies, improve trading liquidity.
- Barriers to direct retail participation:
  - High brokerage fees.
  - Lack of easy-to-access internet-based brokerage services.
- Barriers to direct foreign investor participation:
  - High set-up costs of local market presence.
  - Limited investment opportunities offered, making investment unattractive.

### Supply of securities and listings
- Listing more companies at the stock exchange would enlarge the supply of securities.
- Priorities suggested:
  - Start with listing companies in which the state holds a significant stake.
  - Listing of state-dominated financial companies would greatly enhance the universe of investable securities.
  - Implement current bank privatization program via a secondary offering of one of the banks—as opposed to a private sale—to draw attention to the equity market and increase the free float using appropriate allocation rules.
- Empirical example:
  - The listing of Telekom Slovenije in 2006 is cited as an example: "The secondary listing of the Telekom has roughly doubled the market capitalization and added an actively traded stock that has already been incorporated in the local market indices."

### Product innovation, corporate governance, and SME securitization (Box 2)
- Measures to enhance supply of products:
  - Encourage companies to present themselves for capital markets.
  - Actively promote development of financial innovations, such as asset-backed securities.
  - Improve corporate governance to reduce companies' reluctance to be subject to market oversight.
  - Initiatives for capital market education to complement reforms.
  - Put necessary legislation for innovative financial products in place and consider concerted initiatives to jump-start issuance (example referenced: Spain).
- Caution on credit enhancement schemes:
  - When considering state guarantees or other credit enhancement schemes, ensure careful design to avoid fiscal contingencies, moral hazard, and reputational risks.
- Box 2 — Spanish SME securitization (summary of mechanics and outcomes):
  - Originator transfers SME loans to a special purpose vehicle (SPV).
  - The Treasury guarantees specific tranches issued by the relevant SPV, provided the originator holds a minimum percentage of bank loans to SMEs in its portfolio.
  - Originator commits to reinvest part of liquidity gained from the sale in SME financing.
  - Supported by a master agreement signed with the Ministry of Economy.
  - Participation and volumes:
    - Approximately 60 Spanish banks have participated in the scheme.
    - In 2004, SME securitization in Spain amounted to 18 percent of the total volume of securitization issuance—EUR 9 billion out of a total issuance volume of EUR 52 billion.

### Market infrastructure, trading, and settlement
- Recommendation: Align trading and settlement systems with international standards.
- Status and reforms:
  - Listing and trading rules at LJSE are broadly in line with international practice.
  - Demutualization of the LJSE transformed the stock exchange into a “for profit” entity, improving competitiveness.
  - Demutualization of KDD (local clearing and depository house) is recommended to put it on equal footing with competitors.
- Order-book trading, transparency, and liquidity improvements:
  - Improve reporting requirements for off-market trades to enhance transparency regarding type, amount, and price of securities traded (as envisioned by MiFID).
  - Consider measures (fee structure, timely reporting requirements) to align block trading with order-book trading or reduce dominance of negotiated deals.
  - Introduce more immediate reporting requirements via a trading facility for negotiated trades to improve post-trade transparency.
  - Create incentives by adjusting fee structure or increasing minimum size of block trades to boost attractiveness of order-book trades.
  - Promote presence of market makers to enhance liquidity of small and less-traded stocks.
  - Low broker interest in market making is linked to lack of automated market maker facilities, which would reduce costs versus continuous manual quoting.

### Surveillance, enforcement, and new products
- Strengthen surveillance and enforcement as the market expands.
- Suggested actions:
  - Unify banking, financial market, and insurance supervision under one roof to improve cross-market surveillance.
  - Step up surveillance capabilities of financial markets, including improvements in IT infrastructure to detect market abuse by better monitoring trading activity.
  - Develop an adequate surveillance framework for new financial products, such as derivatives, ideally supported by a derivatives law.

### Equity culture and financing of SMEs
- Challenge: European financial culture often treats market financing as appropriate for larger companies and bank financing for SMEs.
- Slovenia-specific observation:
  - The banking system has tended to focus on providing credit to existing clients rather than to new enterprises.
- Benefits of greater equity culture:
  - Directly finance SMEs through stock markets.
  - Indirectly enable banks to refinance corporate loan portfolios, possibly via asset-backed securitization.
- Preconditions for success:
  - Investors need to accept SME characteristics: more volatile business environment, higher bankruptcy rates, innovative business models, and a high share of intangible assets that are hard to evaluate.

### Conclusions and policy recommendations (capital markets)
- Capital market development strategy:
  - Leverage existing local setup in an integrated European market; adopt a hybrid market model that allows issuers and investors to benefit from the single European market while preserving a local market segment for domestic issuers.
- Key measures to promote local capital market development and international integration:
  - Structural issues:
    - List state-owned companies with the option to subsequently sell a state-owned stake at the stock exchange.
    - Set incentives to foster financial innovation.
    - Support efforts to establish international partnerships for the stock exchange and the clearing and depository house.
  - Regulatory issues:
    - Fully implement MiFID as well as EU guidelines for corporate governance.
    - Remove remaining restrictions for local investments by foreign investors as well as foreign investments by locals.
  - Supervisory issues:
    - Step up surveillance and enforcement, in particular with regard to transparency in securities trading.
    - Streamline administrative procedures.

### Fiscal framework (selected findings relevant to broader policy context)
- Fiscal challenges and projections:
  - Slovenia intends to reduce the structural deficit to 1 percent of GDP by 2009 and to a structural balance by 2011.
  - Anticipated revenue decline: "revenues will decline by almost 4 percent of GDP, from 45.8 percent of GDP in 2005 to 41.7 percent of GDP in 2009," of which "about 3 percent of GDP can be attributed to the decline in the tax burden."
  - Projected expenditure reduction: "expenditures are projected to be lowered by 4½ percent of GDP, primarily in the areas of social transfers and gross fixed capital formation."
- Long-term age-related fiscal pressures:
  - "Pension and health care expenditures are expected to increase by around 7 percent of GDP by 2050 under current policies."
- Historical fiscal stance and risks:
  - Debt has remained at around 28 percent of GDP and fiscal deficits "at about 1½ percent of GDP in 2005."
  - Fiscal performance 2000-03 showed cyclically adjusted balances narrowed from a deficit of almost 4 percent of GDP to 2 percent.
  - Risk of policy relaxation after Euro adoption, given historical experience of weaker fiscal discipline post-EMU entry.
- Institutional recommendations:
  - Strengthen fiscal institutional framework, including fiscal rules or a medium term budgetary framework with expenditure ceilings.
  - Consider a fiscal responsibility law embodying a permanent target or expenditure-based fiscal framework to lend credibility to tax reforms and complement the EU’s Stability and Growth Pact.

*IMF staff report content as provided in the source PDF.*

### 112.     As an EU and EMU member, Slovenia has maintained a strong reputation for

### _cr07182 - 112.     As an EU and EMU member, Slovenia has maintained a strong reputation for

### Fiscal prudence, institutions, and performance
- Slovenia’s fiscal deficit has stayed safely within the 3 percent margin and the 60 percent debt to GDP threshold under the Stability and Growth Pact.
- The Slovene budget fares well relative to the Central European and EMU members in terms of the quality of budgetary institutions and transparency.
- The finance minister’s role is ranked particularly strong in the planning and decision-making phases of the budget formulation process, while that of the Parliament during the legislative phase is relatively weak.
- These institutional features have been shown to contribute to greater fiscal discipline among European countries (Ylaoutinen, 2004).

### Budget framework and procedures
- Slovenia currently has a two year rolling budgetary framework.
- Macroforecasts for the budget are prepared by Institute for Macroeconomic Analysis and Development (IMAD), an external economic forecasting agency.
- The draft Budget Memorandum to the Government is presented by the Prime Minister, the Minister of Finance and the Director of IMAD and includes:
  - revenue forecasts based on IMAD projections,
  - nominal overall expenditure framework,
  - deficit and debt targets,
  - budget priorities for the subsequent four years.
- The Ministry of Finance undertakes detailed negotiations with line ministries for the upcoming budget and the subsequent year following government guidelines.
- The government sets disaggregated expenditure ceilings in the second budget session.
- The Minister of Finance submits the budget amendment for the upcoming year, the budget for the subsequent budget year, and the Budget Memorandum to the National Assembly after line ministries submit financial plans and development programs.
- The two year budgeting system provides a medium term orientation akin to a multiannual expenditure framework but without automatic countercyclical features.
  - Since expenditure ceilings need revision in light of changes in macroeconomic circumstances and fiscal policy objectives, the system prevents the functioning of automatic stabilizers embodied in multiyear expenditure ceilings (Kraan and Wehner, 2005).
  - The high share of non-discretionary spending in the budget structure limits scope for a countercyclical role for expenditure policy (IMF, 2006).
  - By providing a longer term horizon and limiting scope of amendments to the upcoming year, the two year system narrows requests for additional spending and contributes to budgetary discipline.

### Current policy discussions and proposals
- Authorities are discussing introduction of a fiscal rule focused on an annual deficit rule.
  - Under this rule, in case of revenue underperformance, expenditures would need to be reduced to ensure compliance with the annual deficit target.
  - An expenditure rule is not considered viable given likely conflict with adherence to an annual deficit target.
  - Proposals include a golden rule that would allow borrowing for investment or amortization of debt.
- A revenue rule exists for local governments that limits borrowing to less than 20 percent of revenues of the previous year.
  - Proposals are being considered to extend the rule for soon-to-be-formed regional governments.

### Experience with fiscal rules in the EU (summary of lessons)
- Several EU countries have fiscal rules in addition to SGP (EDP) debt and deficit rules; national rules are often stricter and reflect internal pacts among government levels.
- Numerical fiscal rules can promote fiscal discipline if there is sufficient political commitment; they constrain a deficit bias from the ‘common pool’ problem.
- Empirical evidence favors deficit reduction following introduction of a rule, though subject to endogeneity bias (Debrun, 2007).
- Drawbacks of numerical deficit rules include:
  - Rigid annual deficit stance can lead to procyclical policy; thus deficit targets are often set in structural terms or as averages over a medium term horizon, which is difficult to calculate for a transition economy.
  - Strict adherence may lead to poor quality of fiscal adjustment with cuts falling on discretionary capital expenditures rather than efficiency-based spending; some countries introduce a ‘golden rule’ excluding investment.
  - Governments can resort to creative accounting and off-budget circumventions.
  - Lack of enforceability is a major challenge at central and general government levels; enforcement often relies on reputational costs and voter awareness.

- Preconditions for successful fiscal rules (IMF, 2005a):
  - Wide-ranging political consensus for prudent fiscal policies.
  - Sufficiently developed fiscal institutional framework, including budgetary institutions and expenditure management.
  - Rules should be well defined, simple, transparent, and monitorable.
  - Independent monitoring and credible enforcement mechanisms are important.
  - Broad-based coverage and appropriate degree of hardness for the rule, particularly in coalition governments.

- MTBFs often complement fiscal rules:
  - MTBFs define legal frameworks for multi-year fiscal policies to promote transparency and accountability.
  - An expenditure rule as a ceiling introduces a countercyclical feature by allowing automatic stabilizers to operate on the revenue side.
  - Key MTBF design choices: length of horizon (fixed or rolling), frequency and flexibility of ceiling updates, whether ceilings are in constant or current prices, and coverage (aggregate vs subcategories).
  - MTBFs have been important where large fiscal adjustments were undertaken, provided political will exists and MTBFs are integrated into annual budget processes.
  - Regular reviews and ex post explanations of projection errors improve realism and accountability.

- Independent fiscal institutions can enhance MTBF credibility by monitoring fiscal policy, increasing transparency, and serving as guardians of ex-ante fiscal objectives. Their roles commonly include:
  - independent monitoring and analysis of fiscal developments;
  - preparation of macroeconomic forecasts and assumptions for annual and MTBFs;
  - enforcement of sanctions on a non-discretionary basis and assessment of compliance.

### Policy issues and recommendations for Slovenia
- Fiscal rule design:
  - Rules targeting a cyclically adjusted deficit may be considered.
    - Although estimates of potential output and cyclical adjustment are highly uncertain in a transition economy, an agreed method of calculating potential output by an independent institution could form the basis for estimating cyclically adjusted revenue or deficit for policy formulation and assessment.
    - While basing formal rules on cyclically adjusted measures may be challenging, fiscal policy discussions should incorporate attention to development of cyclically adjusted revenues and expenditures.
  - Long term fiscal sustainability should guide the deficit target underlying the fiscal rule.
    - Studies highlight fiscal sustainability challenges from aging pressures, suggesting the need to run fiscal surpluses (Stability Report, 2006).
    - Medium term fiscal targets need to incorporate longer term debt sustainability considerations, particularly if pension reforms fail to take hold.
    - The MTBF can serve as an effective communication device to analyze implications of delaying reforms in age-related expenditures.
- Medium term budgeting framework improvements:
  - Spell out reform programs in a detailed framework while simplifying budgetary procedures.
    - Include specific reform measures within a prespecified time horizon that achieve deficit targets under the rule along with estimates of savings from these measures.
    - Consider extending MTBF time horizon to match the electoral cycle to lend credibility to incoming government fiscal strategy and raise reputational costs of non-adherence.
    - Specify expenditure ceilings at a more aggregated level for the second year and beyond to minimize need for detailed line-item negotiations and amendments in subsequent cycles.
  - Consider an expenditure rule combined with an MTBF based on a cyclically adjusted deficit rule to promote fiscal consolidation and provide flexibility for countercyclical policy by letting automatic stabilizers work on the revenue side.
    - Expenditure ceilings could be set on the basis of a spending review analyzing objectives and performance of spending areas.
    - Law could require increases in mandatory spending program budgets to be budget-neutral through offsetting measures.
- Golden rule consideration:
  - To safeguard productive infrastructure spending from being cut, a ‘golden rule’ could be considered to exclude borrowing for investment or amortization of debt.
  - Caveats: exclusions are criticized because returns on public investment may not exceed cost of borrowing and distinctions between capital and current spending can be unclear, enabling circumvention of ceilings.
- Independent assessment:
  - Establishing independent assessment of fiscal trends and budget plans and implementation is implied as a complementary measure to strengthen monitoring, transparency, and credibility of rules.

*Source: IMF staff report content as provided in the supplied PDF excerpt.*

### 130.     Independent assessment of fiscal trends could enhance the credibility of a new

### Independent assessment of fiscal trends could enhance the credibility of a new fiscal framework

### Role of independent macroeconomic institution (IMAD) and prudential margins
- In Slovenia, Institute for Macroeconomic Analysis and Development (IMAD) already provides macroeconomic assumptions and projections for the underlying budgets (such as growth, inflation, and market interest rates).
- Analysis of macroeconomic assumptions since 1995 do not suggest evidence of a systematic bias in macroeconomic projections.
- It may be prudent to consider a cautionary bias by applying a prudential margin to its growth forecasts for budgetary assumptions as practiced in Canada and Unites Kingdom.
- To strengthen the role of independent institutions, in line with international practices, additional roles could also be considered.

### Possible additional roles for an independent institution
- Assessment of medium- and long-term fiscal trends by producing fiscal baseline projections (based on unchanged policies and legislation);
- The yield of new fiscal measures in annual or medium-term budgets;
- A normative assessment of fiscal policy implementation, including on adherence to fiscal strategy and rules;
- The factors responsible for deviations from annual and medium-term budget targets.
- Purposes of such assessments:
  - Enhance transparency and improve the methodology of projecting macroeconomic developments, budget revenue and expenditure;
  - Eliminate political bias in the budget formulation process.
- Institutional design consideration:
  - The independence of the institution could be strengthened by requiring it to report its assessment directly to Parliament, readily available to the public.

### Conclusions on Slovenia’s fiscal challenges and policy objectives
- Slovenia faces significant challenges in reforming fiscal policy in the coming years.
- For fiscal policy to be an effective instrument for economic stabilization, increased budgetary flexibility particularly on the expenditure side will be required.
- Slovenia also needs to implement significant expenditure consolidation to meet its medium-term fiscal targets while accommodating tax reforms.
- In light of long-run sustainability concerns, fiscal policy will need to aim for a structural balance or a surplus, if systemic pension and healthcare reforms are not addressed soon.
- A stronger fiscal framework that incorporates these fiscal targets will help to:
  - signal the commitment to the objectives of the fiscal reform package;
  - specify the underlying measures;
  - thus enhance the credibility of the medium-term fiscal goals.
- The paper examined considerations for strengthening the fiscal framework in Slovenia.

### Strengthening the medium-term budgetary framework
- Strengthening the medium term budgetary framework with underlying fiscal rules and greater transparency on adherence to the fiscal objectives could help enhance fiscal discipline.
- Slovenia’s fiscal deficit targets that are anchored on debt-sustainability analysis need to be better integrated in the medium term budgetary framework.
- Introducing a fiscal rule for expenditures that is based on a structural deficit target could impose more fiscal discipline while allowing short term flexibility through revenue stabilizers.
- An increased role for independent monitoring of budgetary plans and an assessment of the budget implementation against the stated objectives could:
  - allow more public debate and voter awareness;
  - help to enforce the framework and preserve fiscal discipline.

*Source: _cr07182 - 130. Independent assessment of fiscal trends could enhance the credibility of a new (IMF PDF).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07182.pdf_