Financial Development and Small Firms Financing in Slovenia.

I. Introduction

Economies whose financial markets and institutions are well developed grow faster and more consistently than those with weaker financial systems. In addition, such economies are better at adjusting to destabilizing shocks.(1) Also, recent literature on financial markets has shown that asymmetric information creates problems in credit allocation by distorting the flows of funds and, in doing so, puts small business borrowers at a disadvantage.(2)

This being the case, the allocation of available credit across different groups of potential borrowers is a crucial issue for former socialist economies.

Indeed, it is during the transition from a planned to a market economy that the new productive structure of those countries takes shape. The transition stage is the one during which productive strategies, in terms of both output choices and industry structure, have the strongest lock-in effect for the future of the economy. Thus, the availability of credit for a particular industry, type of activity, or group of borrowers may determine if that particular component of the economy will flourish or disappear. In the long run, it may determine the growth rate of the country and a country's ability to compete on international markets.

In this context, it is particularly surprising that Slovenia be relatively neglected.(3) Indeed, it is our belief that, because of its peculiarities, this country represents a particularly interesting case within the group of economies in transition. In addition to an enviable geographic location, Slovenia enjoys the highest per capita income among Central and East European economies, a stable political system, social harmony, and a well-educated population. Table 1 shows that, at $8,110, Slovenian per capita GDP is significantly higher than that of the Czech Republic, the second richest economy in transition, and much higher than that of other former Yugoslavian countries such as Croatia and Macedonia.

Table 1: Comparative Social Indicators (1996)

Country       Population    GDP in   Literacy   Infant
              in Millions   US$(1)              Mortality(*)

Slovenia       1.98          8,110    99         7
Croatia        4.78          2,640    97        10
Macedonia      2.14            900    89        30
Czech R       10.33          7,539   100         8
Slovak R       5.38          6,070   100        11
Hungary       10.21          5,700    99        12
Bulgaria       8.37          3,830    98        16
United King   58.49         17,980   100         6
Austria        8.02         17,500   100         6

Country       Male Life    Female Life
              Expectancy   Expectancy

Slovenia      71           79
Croatia       69           77
Macedonia     70           74
Czech R       70           78
Slovak R      69           77
Hungary       64           74
Bulgaria      67           75
United King   74           79
Austria       73           80

Source: World Bank Development Report, 1997.

(1) GDP data are for 1994.

(*) Deaths per thousand of live births.

Table 1 also shows that Slovenian social indicators, such as literacy level, infant mortality and life expectancy, are higher than in other former Yugoslavian countries and comparable to those of much richer Western economies such as Austria and the United Kingdom. Slovenia, therefore, unlike most former socialist economies, possessed from the start of its transition several characteristics necessary for its economic take-off.

Although during the period 1991-1997 the Slovenian economy grew successfully in many areas, its privatization process has progressed somewhat slowly, in particular with respect to financial markets. This delay, of course, has significant effects on the restructuring of the country's productive structure. In particular, we claim, small firms and start-ups are unable to borrow and as a result their development is impaired.(4) With the banking reform in progress and supporting legislation in the making (bankruptcy laws, collateral laws, etc.) we discuss the provision of bank loans as well as non-traditional financing arrangements such as those provided by venture capital and by state and local agencies.(5) Our purpose is to show, using the example of Slovenia, how significant financing constraints may prevent the efficient allocation of credit among different groups of borrowers. Consistent with the credit-channel view of monetary policy, we find that a high degree of banking concentration tends to penalize small firms and start-ups more than larger firms. In the context of comparative studies we believe such a study to be an important one, since it enables us to evaluate alternative structures of the banking industry and their influence on the economy.

The paper contributes in several ways to the ongoing study of transition economies. First, our paper provides an update on the Slovenian transition process, which so far has been missing in the literature. Second, the paper provides evidence of the importance of new and small firms in creating jobs and documents the significance of financing constraints they face because of limited opportunities to obtain external financing. Third, our paper makes a compelling argument that such constraints are related to the poorly developed banking sector.

In the rest of the paper, we first review the general economic outlook of Slovenia at the onset of its independence from Yugoslavia in 1991. Second, we describe the development of the productive structure in Slovenia since 1991 and the role assumed by small firms in this process. Specifically, we review the main sources of financing available to those companies, namely venture capital, public funds and bank lending. Third, we analyze in detail the structure of the banking industry. In this section we focus on the paucity of bank lending to small firms and its implications for small-firm growth. Fourth, we describe the institutional and regulatory framework within which Slovenian banks operate. Last, we summarize our findings and suggest a possible linkage between small-firm development and banking structure.

II. Slovenia Before Its Independence

Most of Slovenia became part of the Habsburg feudal domain in the thirteenth and fourteenth century. In 1918, Slovenia-joined Serbia and Croatia to form the Kingdom of Serbs, Croats, and Slovenes. When the latter transformed into the Socialist Federal Republic of Yugoslavia, Slovenia became one of its six Republics. After World War II, most property was nationalized, and only a small part remained in private hands or in cooperative ownership. In 1948, the regime of Marshal Tito broke away from Stalin and gradually abandoned the centralized Soviet style system. As a result, the type of Communism implemented in Yugoslavia was significantly different from the one enforced, for example, in the Soviet Union. Specifically, a system of "market socialism" was introduced.

Market socialism was based on three principles: 1) Social ownership of capital. 2) Reliance on market forces to coordinate economic activities. 3) Worker self-management. Because of the self-management principle, Workers' Councils became the final decision units within each enterprise. Workers maintained the right to elect managers, to decide on major investments, and to determine their own wages. Thus, property was not state but socially owned. Since a large majority of enterprises were socially owned, the government had no right to impose central planning. As a result, at least in principle, economic activities remained coordinated by a market system, albeit a very imperfect one.(6) Unfortunately, as in other socialist economies, less productive companies were not allowed to fail and, consequently, there were no incentives for enterprises to be more efficient or productive. Instead, a massive redistribution took place through soft budget constraints that allowed the proceeds from taxing profitable enterprises to be used to subsidize unprofitable ones. In addition, poorly defined property rights and the existence of a single political party favored the development of the black market, and rendered the Yugoslavian experience with market socialism overall very disappointing.

On the financial side, Yugoslavia experienced significant inflation during the 1980s. Toward the end of 1989 prices rose at monthly rates of 60 percent. This hyperinflation was the result of a significant and prolonged increase of the money supply caused by the need to service a large budget deficit and a significant external debt. Since most wages were indexed, about 80 percent of household savings held in foreign currency, and repayments of external debt closely monitored by the IMF, accelerating inflation was the only way for the government to collect an inflation tax.(7) Being part of Yugoslavia, Slovenia experienced all of these phenomena. In addition, as the richest and most productive of the republics, it was required to use a portion of its GDP to subsidize less developed regions and republics. A sense of injustice followed, exacerbated by the economic frustration, and precipitated the Slovenian secession from Yugoslavia.

In June 1991, six months after a referendum in which about 90 percent of the population voted in favor of independence, Slovenia claimed its autonomy.(8) Simultaneously, the rest of Yugoslavia entered a terrible civil war. Promptly, Slovenian authorities recognized the need to protect the country from being destabilized by the inflow of a large quantity of dinars that the Yugoslavian government, opposing independence, was trying to orchestrate. Thus a new currency, the tolar, was introduced. The currency switch protected Slovenia from the economic turmoil that spread to the rest of the dinar area and allowed the government to quickly contain inflation. By the end of 1991, Slovenia was considered a prime candidate to become a transition success story. In addition to possessing from the start several characteristics necessary for its economic take-off, Slovenia enjoyed an export-oriented industry.(9) But, most of all, the country benefited from the relative openness of the Yugoslavian communist regime, in which comparatively more decision-making authority and autonomy had been left to small business owners.

The principle of self-management had led to the idea of social ownership. Legally, social ownership had been determined on the basis of how many people worked in an enterprise. Any enterprise employing more than five workers was considered part of the social sector and was, therefore, socially owned. This classification made very small enterprises, whose profits could be privately retained, highly desirable. Thus, a rich tradition of very small business and private ownership not only continued, but indeed prospered. In spite of severe legal restrictions, small companies fostered the culture of private enterprise and self-initiative. Through these enterprises, Slovenia preserved the intangible human capital of entrepreneurship required for the development of small firms. As a result, in spite of the extensive nationalization of production, and unlike most former socialist economies, Slovenia maintained a strong entrepreneurial tradition and an appreciation for small business ownership.(10) This explains, in part, the importance quickly gained by small firms in the post-independence economic structure of Slovenia.

III. The New Productive Structure of Slovenia

Between 1988 and 1993, the introduction of new Laws changed significantly the conditions for small-business development in Slovenia. Specifically, in 1988 the Law on Enterprise lowered the amount of legally required start-up capital, while the Law on Crafts eliminated restrictions on the allowed number of employees. Furthermore, in 1993, a Law on Commercial Companies established a uniform set of legal rules for all private companies, whether belonging to the craft or the non-craft sector of the economy. By providing a common set of rules, these new laws increased legal transparency and provided better protection for investors. By lowering risk they also created better incentives and, as a result, many new companies were founded. Table 2 shows that, between 1990 and 1997, enterprises categorized as small firms grew faster than any other group and, already by 1992, more than 90 percent of all companies registered in Slovenia belonged to the small business category.(11) Specifically, the percentage of small firms increased from 81.1 percent in 1990 to 93.6 percent in 1997. During the same period, because of the privatization efforts, the percentage of firms categorized as large declined from 6.2 percent in 1990 to 2.4 percent in 1997. Unexpectedly, also the share of medium size firms, which during this period have been significantly supported by the government, declined from 12.7 percent in 1990 to 4 percent in 1997.(12)

Table 2: Number of Firms by Size

         Small Firms   Medium Firms   Large Firms   Total#
         (1)     (2)    (1)     (2)   (1)   (2)     of Firms

1990    6,439   81.1   1,004   12.7   492   6.2      7,935
1991   11,733   88.2   1,114    8.4   462   3.5     13,309
1992   18,697   92.1   1,142    5.6   463   2.3     20,302
1993   26,165   93.8   1,170    4.2   567   2.0     27,902
1994   29,001   93.7   1,199    3.9   741   2.4     30,941
1995   31,393   93.4   1,350    4.0   866   2.6     33,609
1996   33,356   93.2   1,578    4.4   852   2.4     35,786
1997   34,370   93.6   1,478    4.0   869   2.4     36,717

Note:

Small enterprises have to fulfill at least two of the following three criteria: less than 50 employees, annual income of less than Slovene tolars (SIT) 200 million [U.S. $1.16 million], and average value of assets of less than SIT 100 million [US $0.58 million].

Medium enterprises have to fulfill at least two of the following three criteria: between 50 and 250 employees, annual income between SIT 200 and 800 million [US $1.16 million to $4.62 million], and average value of assets between SIT 100 and 400 million [US $0.58 million to 2.31 million].

Large enterprises have to fulfill at least two of the following three criteria: exceeded 250 employees, more than SIT 800 million [US $4.62 million] of annual income, and more than SIT 400 million [US $2.31 million] of average value of assets. All banks, insurance companies and inter-connected companies are considered to be large companies.

(1) Number of firms in that group size.

(2) Percentage of firms in that group size.

Source: Agencija za Placilni Promet Zavod za Statistiko in Informacije. Ljubljana, Slovenia. (Agency of the Republic of Slovenia for Payments, Department for Statistics and Information.)

In addition to the relative number of small, medium and large firms, the massive restructuring of the Slovenian economy significantly changed labor markets. Between 1990 and 1997 many jobs were lost in existing enterprises. The growing number of small firms, however, provided a significant shelter for workers displaced by the change in the economic structure of the country. As shown in Table 3, between 1990 and 1997, only small firms absorbed an increasing number of workers, whereas the numbers of workers employed by both large and medium size firms declined. The total number of workers employed by the three groups of firms also declined, from 652,669 in 1990 to 460,376 in 1997. Specifically, the percentage of workers employed by large firms declined from 67.1 percent in 1990 to 58.7 percent in 1997. The percentage of workers employed in medium size firms declined from 25.6 percent in 1990 to 18.1 in 1997. On the other hand, the percentage of workers employed by small firms increased from 7.3 percent in 1990 to 23.2 percent in 1997.(13)

Table 3: Employment by Firm Size

              Small Firms            Medium Firms

          (1)     (2)    (3)     (1)      (2)    (3)

1990    47,620    7.3          167,372   25.6
1991    67,455   11.4    .35   173,963   29.3     .04
1992    85,442   16.3    .24   148,508   28.4    -.16
1993    85,990   17.9    .01   128,519   26.7    -.14
1994    92,223   19.4    .07    95,273   20.0    -.30
1995   107,260   22.1    .15    82,100   16.9    -.15
1996   103,223   22.1   -.04    77,974   16.7    -.05
1997   106,766   23.2    .03    83,437   18.1     .07

              Large Firms

         (1)      (2)    (3)   Total
                               Empl.(*)

1990   437,677   67.1          652,669
1991   352,207   59.3   -.22   593,625
1992   288,779   55.2   -.20   522,729
1993   266,116   55.4   -.08   480,625
1994   287,764   60.5    .08   475,260
1995   295,242   60.9    .03   484,548
1996   286,041   61.2   -.03   467,238
1997   270,173   58.7   -.06   460,376

(1) Number of workers in firms of that group size.

(2) Percentage of workers in firms of that group size.

(3) Annual growth rate in the number of workers in firms of that group size; growth rate defined as [X.sub.t] = ln [X.sub.t] - ln[X.sub.t-1].

(*) This column reports the total number of workers registered as employees of the three groups of firms. It does not include the portion of the labor force registered as self-employed, as well as workers employed by the public sector.

Source: Agencija za Placilni Promet Zavod za Statistiko in Informacije. Ljubljana, Slovenia. (Agency of the Republic of Slovenia for Payments, Department for Statistics and Information.)

Figure 1 shows the cumulative employment growth rate for firms by firm size. Between 1990 and 1997, employment declined 5.5 percent for large firms and more than 50 percent for medium size firms. On the other hand, employment in small firms increased 124.2 percent. In addition, the number of people registered as self-employed increased from 99,800 in 1992 to 111,700 in 1996, bringing the total number of people mobilized in the entrepreneurial and small business sector, for 1996, to 212,813.(14) Estimates for 1997 indicate a further increase of self-employed individuals.(15)

[Figure 1 ILLUSTRATION OMITTED]

Overall, our empirical evidence supports the suggestion that Slovenian small firms have the potential to be a driving force behind the Slovenian transition process and, in general, a key factor for the growth and development of the country.

IV. Financing Options and Slovenian Small Firms

Given the importance of small enterprises in the Slovenian transition process, the government set out to support their development through a variety of public policy instruments. Although a variety of financial provisions were created to stimulate small businesses, a cross-country survey indicated that, among all respondents, Slovenian entrepreneurs expressed the strongest frustration with respect to credit availability.(16) The survey, conducted by the European Foundation for Entrepreneurship Research (EFER), studied 750 fast growing companies in five countries of Central Europe, namely Poland, Slovakia, Czech Republic, Hungary and Slovenia.(17) While the EFER Report is based on a relatively small sample from each country, there is a consistent difference in respondents' satisfaction across these countries. Such a consistency is significant. Also significant is the discrepancy between alternative sources of financing across the five countries studied. Table 4 shows that, among all responses received, 81 percent of the 150 Slovenian respondents financed their new businesses with personal savings and loans from friends and family. Furthermore, the table shows that 61 percent of financing came from reinvested profits in the second year of operation and only 4 percent of financing of start-ups came from bank loans against 42 percent in the Czech Republic and 41 percent in Slovakia.

Table 4: Sources of Financing in Five Central European Countries

                          Check
Percent of Total         Republic    Hungary   Poland   Slovakia

Sources of
Start-Up Capital

Savings                     28         57        60        31
Bank loans                  42          9        12        41
Profits                     14          7        10        17
Venture Capital              4         16         4         3
Other                       12         11        14         8

Current Production and
Investment Financing
in Past Two Year

Savings                      3         17        18         6
Bank loans                  38         20        23        31
Profits                     46         44        36        52
Venture Capital              0          5         1         2
Other                       13         14        22         9

Future Investment
Financing

Savings                      1         14        11         2
Bank loans                  42         28        26        45
Profits                     37         27        48        41
Venture Capital              9         11         3         6
Other                       11         20        12         6

Percent of Total         Slovenia

Sources of
Start-Up Capital

Savings                     81
Bank loans                   4
Profits                      6
Venture Capital              3
Other                        6

Current Production and
Investment Financing
in Past Two Years

Savings                     19
Bank loans                  13
Profits                     61
Venture Capital              1
Other                        6

Future Investment
Financing

Savings                      8
Bank loans                  32
Profits                     43
Venture Capital              4
Other                       13

Source: EFER, 1994, pp. 41-43

Analogously to most other countries, Slovenian small firms have access to three sources of external financing, namely venture capital, government agencies, and banks. As shown in Table 4, the percentage of external financing available via venture capital in Slovenia is comparable to that in other Central European countries and represents a very small portion of overall financing opportunities. Rules and regulation on the use of ventures in Slovenia are detailed in the Law on Commercial Companies. According to that law, foreigners are allowed to freely enter Slovenia and are only required to register with the Court Register of Legal Persons which operates in conjunction with regional courts. However, foreign investors usually enter indirectly, through various funds jointly established with domestic banks or state institutions. This is the result of both, lack of knowledge on the part of investors, and lack of confidence in local institutional arrangements. In addition, because of the lack of information about small firms, most available venture capital is directed to financing or restructuring medium size enterprises and only a small fraction flows to small firms.(18)

In addition to venture capital, small firms can obtain external financing through government agencies. At the end of 1991, a Law was passed to create a Small Business Development Fund (SBDF).(19) The Fund was established to provide loans and credit guarantees for small business projects, coinvest in projects and infrastructures, subsidize interest rates, and facilitate financial transactions between banks and investors. From its inception, the Fund's resources proved insufficient and its management, as well as its purpose, have been the subjects of substantial controversy. Initially, the Fund was supposed to be operated jointly by the Slovenian government (providing 25 percent of the funding), the EBRD (providing 50 percent), and a consortium of Austrian banks (providing 25 percent). This distribution was supposed to guarantee transparency during the application and approval processes, and to reduce political interference in the management of the Fund. The proposal, however, was rejected and the Fund is currently managed by a board of directors chaired by the State Secretary for Small Business. Fund support is granted only to investments that fulfill certain criteria. For example, the maximum investment value cannot exceed $438,000, and the maximum value of the loan cannot exceed 50 percent of the investment value. In addition, 30 percent of financing has to come from own sources, the pay back period cannot be longer than the economic value of the project, and any other form of financing has to be approved by the Fund. Thus, although it is supposed to be the most important external source of financial services for small size enterprises, because of its strict requirements, the Fund receive only a small number of applications.(20)

In addition to the Fund for Small Business Development, the Slovenian government created the Technology Development Fund. The general goal of this fund is to stimulate the development of high-tech small and medium-sized companies. Once again, however, most of the financial support provided by the fund is channeled to medium size enterprises.(21) Overall, the financial support that small businesses received from state agencies decreased from 27 percent of their total budget in 1993 to only 6 percent in 1996.(22)

In alternative to the state, municipalities also offer public support to small businesses. Municipalities are legally able to conduct all public affairs, including the creation of adequate conditions for local economic development. Thus, they may include in their budgets earmarked funds for the purpose of developing certain activities such as small businesses. Municipal assistance takes usually the form of loans, guarantees, and interest rates subsidies. Indeed, within municipalities, the dominant type of small business support is based on debt. In the majority of cases, municipalities deposit their budgetary resources in non-interest bearing accounts at a bank. The bank, in exchange, offers loans to local small businesses at below market rates, and the municipalities recuperate their deposits according to the loan pay out scheme. Municipalities allocate their funds primarily to create business premises and fixed assets, to supply working capital for overcoming liquidity problems, and to create or preserve jobs. The main recipients of municipal support are unincorporated entrepreneurs, small commercial companies, and individuals seeking to obtain craft licenses or to be recognized the status of individual entrepreneur. Unfortunately, as with SBDF loans, in order to obtain long-term support, small businesses must satisfy very restrictive banking covenants. Unless politically or socially connected, not many are able to do so.(23)

Finally, the third, and traditionally most important, source of external funds for small firm is the banking industry. In Slovenia, however, bank loans account only for a negligible percentage of small firm financing. The monetary problems faced before independence, and the restrictive regulations that followed them, made Slovenian banks very cautious in granting loans. In addition, after 1991, the government's attempt to protect the banking industry from an epidemic of failures radically limited banks' ability to decide freely how to distribute their asset portfolio. Primarily because of regulatory restrictions, in the last five years, Slovenian banks maintained a significant percentage of their assets in the form of government bonds and increased only the percentage of loans to individuals or to other banks. As a result, the amount of credit allocated to commercial loans has declined, in particular at the expenses of small firms and start-ups that are traditionally perceived as being riskier.(24) Borrowing from foreign banks is also not a viable solution, since Slovenian companies wishing to finance their activities with loans obtained abroad face stiff financial costs. Specifically, when converting foreign loans into tolars, companies are required to deposit a large percent of the loan amount in noninterest bearing tolar accounts. Such requirements can be as high as 40 percent of the borrowed amount for foreign loans with maturity of up to seven years.(25)

In conclusion, our survey of small firms, and of their role in the new productive structure of the country, suggests their potential to be the most dynamic part of the Slovenian economy and a point of strength for the country. Our description, however, also indicates that the volume of financing available to them may prevent this from happening. Since traditionally bank loans represent the main vehicle for financing small firms, it is important to understand what characteristics of the current Slovenian banking environment are preventing this linkage from developing. We believe the causes of this anomaly to be rooted in the current institutional and regulatory structure of the banking industry.(26)

V. Banking In Slovenia

Regulations on borrowing and the monetary measures of the Bank of Slovenia are of major importance when analyzing banks' lending behavior. The Central Bank of Slovenia, constituted on June 25, 1991, imposes a minimum reserve requirement on all banks and savings institutions, as well as on credit cooperatives. The average reserve ratio on tolar denominated deposits decreased from 12.5 percent in 1992 to 6.4 percent in 1996.(27) The declining reserve requirement should have provided opportunities for banks to create further deposits via their lending practices. During this period, however, banks' main goal was increased safety. In 1995, for example, banks highly exceeded the minimum capital requirements of 8 percent and exhibited, on average, capital adequacy ratio exceeding 20 percent.(28) In general, throughout the 90s, Slovenian banks did not alter their assets distribution and pursued very safe lending practices. In 1996, only 41.8 percent of banks' assets were used for loans to non-banks compared to, for example, more than 63 percent in the U.S.(29) Also, since consumer loans are traditionally less risky than commercial loans, Slovenian banks increased the share of non-banks lending allocated to individuals from 15.9 percent in 1995 to 29.4 percent in 1996.(30) Since the amount of total lending to non-banks in this period did not increase, we can conclude that the increase in consumer loans came at the expense of commercial lending.

Immediately after independence the number of Slovenian banks increased significantly to 32. However, since 1991, their number decreased from 32 to 28.(31) In addition to one failure, in three cases a large bank acquired a smaller one.(32) Of the 28 remaining banks most spun off from Ljubljanska Banka that, during its existence within Yugoslavia, was by far the biggest Slovenian financial institution. A few other banks have developed from branches of former Yugoslav banks, some are new, and four are subsidiaries of primarily foreign owned banks.(33) The increase in the number of banks since the Yugoslavian years has generated no significant difference in the concentration of the Slovenian banking sector, whose concentration ratio is, indeed, much higher then the number of banks itself would suggest. Defining market share as the ratio of banks' assets to total banking industry assets, table 5 shows that, in 1996, the seven largest banks controlled almost 70 percent of the market, and the three largest banks alone controlled more than 50 percent. Furthermore, the table shows that foreign owned banks controlled in total about 5 percent of all banking assets, while half of the domestic banks controlled, each, less than 2 percent.

Table 5: Balance Sheet Assets of Slovenian Banks in 1996 and 1995

                                 Balance     Percentage
                                  Sheet      of Banking
                                 Assets       Industry
                                1996(US$)   Total Assets

                                                1996

Nova Ljubljanska Banka          2,831,820       28.4
SKB Banka                       1,193,370       12.0
Nova Kredima Banka Maribor      1,139,168       11.4
Banka Koper                       575,904        5.8
Banka Celje                       538,538        5.4
ABANKA                            510,356        5.1
Gorenjska Banka                   414,958        4.2
Dolenjska Banka                   307,355        3.1
LB Pomurska Banka                 279,290        2.8
Bank Austria                      230,869        2.3
Banka Vipa                        207,169        2.1
Krekova Banka                     179,408        1.8
Banka Creditanstalt               161,063        1.6
LB Koroska Banka                  148,048        1.5
LB Splosna Banka Velenje          138,463        1.4
Slovenska Zadruzna
 Kmetijska Banka                  134,069        1.3
Probanka                          139,147        1.3
LB Banka Domzale                  125,268        1.3
Slovenska Investicijska Banka     106,188        1.1
LB Banka Zasavje                  101,995        1.0
Postna Banka Slovenije             98,224        1.0
Volksbank Ljudska Banka            84,090        0.8
UBK Banka                          75,985        0.8
M Banka                            74,588        0.7
Factor Banka                       60,016        0.6
Hmezad Banka                       58,540        0.6
Banka Societe Generale             52,203        0.5
Hipotekarna Banka                  23,705        0.2

                                Balance      Percentage
                                Sheet        of Banking
                                Assets        Industry
                                1995(US$)   Total Assets

Nova Ljubljanska Banka          2,489,767       29.0
SKB Banka                       1,038,297       12.1
Nova Kredima Banka Maribor        973,591       11.4
Banka Koper                       477,441        5.6
Banka Celje                       436,445        5.1
ABANKA                            396,088        4.6
Gorenjska Banka                   380,742        4.4
Dolenjska Banka                   229,491        2.7
LB Pomurska Banka                 242,901        2.8
Bank Austria                      189,682        2.2
Banka Vipa                        162,175        1.9
Krekova Banka                     128,529        1.5
Banka Creditanstalt                71,819        0.8
LB Koroska Banka                  125,170        1.5
LB Splosna Banka Velenje          119,948        1.4
Slovenska Zadruzna
 Kmetijska Banka                  105,472        1.2
Probanka                          103,859        1.2
LB Banka Domzale                  108,254        1.3
Slovenska Investicijska Banka      95,687        1.1
LB Banka Zasavje                   85,175        1.0
Postna Banka Slovenije             62,578        0.7
Volksbank Ljudska Banka            51,972        0.6
UBK Banka                          80,160        0.9
M Banka                            70,717        0.8
Factor Banka                       47,910        0.6
Hmezad Banka                       49,626        0.6
Banka Societe Generale             18,969        0.2
Hipotekarna Banka                  25,006        0.3

Source: Slovenian Business Report. Fall 1997, p. 31.

In addition to a low propensity for lending and a high concentration ratio, the Slovenian banking industry continues to be characterized by the unresolved issue of ownership. Besides some smaller banks, the state still owns the majority of shares in Nova Ljubljanska Banka and Nova Kreditna Banka Maribor, which jointly control about 40 percent of the market. Thus, the state is still the biggest shareholder in the banking industry, controlling about 50 percent of the market.(34) Furthermore, the appointment of new presidents and CEOs of banks is subject to the approval of the Bank of Slovenia, and foreign investors can only acquire shares in Slovenian banks with the permission of the Bank of Slovenia and for an amount not exceeding 49 percent of equity capital.(35)

Overall, during the first few years of Slovenia's transition process, the privatization of the banking industry proceeded slower than that of other sectors. The analysis of regulation imposed since 1991 by the Bank of Slovenia, and of the balance sheet of Slovenian banks at the time of the declaration of independence, sheds light on the reasons of such delay. At the time of the newly acquired independence and of the ongoing war in the rest of Yugoslavia, Slovenian banks found themselves holding a large portion of their asset portfolios in the form of non-performing loans, or frozen in repossessed Yugoslavian assets.(36) To prevent the collapse of the banking system, the new Slovenian government enacted a bank rehabilitation program aiming at supporting banks until a substantial improvement of their positions was achieved. While these measures prevented an epidemic of bank failures, they also reduced banks' incentives to become more competitive and to improve their efficiency and range of services. In addition, the regulatory restrictions crippled banks' ability to redistribute their assets. As a result, the opportunity costs of maintaining financial stability has been a financial constraint imposed on bankdependent borrowers. Specifically, because of the difficulty in assessing risk and the lack of clear laws on collateral, and since the amount of consumer loans has increased significantly, a financial constraint has been imposed on small firms and start-up companies.

VI. The Banking Rehabilitation Program

The rehabilitation program enacted by the Bank of Slovenia included strong restrictions on the use of foreign currency holding, the exchange of bad assets for newly issued government bonds, and the enforcement of severe screening procedures with respect to the issue of new loans.

The first provision of the banking rehabilitation program called for the issue of government bonds to be exchanged by banks for deteriorated assets. The issues of government bonds for bank rehabilitation purposes went through two phases. Previous to 1995, bond issues were long term (30 years) and denominated in deutsche marks. Their interest rate was eight percent, and they could not be transferred for a period of five years. Thus, by holding them, banks gained default-free interest-bearing assets. But, being unable to withdraw from the investment, they lost some asset management flexibility. On the other hand, bonds issued since 1995 are characterized by different maturity periods, and are freely negotiable and redeemable in tolars.(37) Thus, by holding new bonds, banks have gained back in balance sheet flexibility and have the possibility, through sales, of withdrawing from their claims against the state and redistribute their assets by shifting toward other forms of investment. As a

result, although the convertibility provision may have opened up new possibilities for future loans, the current fluidity of the market makes government bonds very desirable and encourages banks to hold onto them.

Second, the bank rehabilitation program imposes restrictions on the use of foreign currency accounts held by Slovenian banks. Such restrictions are the result of serious historical liquidity problems associated with these accounts in the ex-Yugoslavia. Although foreign currency accounts are permitted, the liquidity requirements imposed by the Bank of Slovenia are very substantial, ranging from 100 percent for demand deposits to 5 percent for time deposits. These requirements significantly limit banks' ability to transform these deposits into loans. Moreover, since 1991, Slovenia has experienced a structural surplus of its balance of payments. Specifically, the foreign currency reserves of the banking system have increased from about $1,204.8 million in January 1993 to about $4,424.5 million at the end of 1997.(38) Such surpluses have caused an increase of net foreign holdings on banks' balance sheets and, as a result, because of the liquidity requirements, a further decrease in banks' assets flexibility.

Last, and most important, the bank rehabilitation program imposes severe screening procedures and heavy controls on interest rates in order to increase bank safety and capital ratios. Within this context, in 1995, Slovenian banks entered into a cartel agreement setting ceilings on interest rates paid on deposits of different duration. This agreement was supported by the Central Bank on the ground that it would favor increasing net interest margins and, as a result, the recapitalization of banks through retained earnings.(39) Indeed, banks' net interest margins increased from 4.9 percent in 1995 to 5.5 percent in 1996.(40) As expected, the increase did not stem from efficiency improvements, but resulted from a slower decrease of the lending rates compared to the decrease in the maximum deposit rates. In 1996, for example, bank lending rates on short-term loans in real terms ranged between 8 and 17 percent, while long term rates in real terms ranged between 9.75 and 18 percent.(41) Figure 2 shows the spread between the average real rate on loans and the average real rate on deposits for Slovenia and a few other economies in transition between 1991 and 1997.(42) In the Figure, only Romania shows a higher spread, and that only for 1994 and 1996. Although Figure 2 shows only the spread for four selected economies, available data suggests that, in spite of inflation rates comparable to those of western European economies, the Slovenian spread has been consistently among the highest of all transition economies.(43)

[Figure 2 ILLUSTRATION OMITTED]

Given the fast declining inflation, the relatively high real cost of borrowing is a further barrier for the access of small companies to the loan market. In some cases, to reduce the incidence of interest payments, the state guarantees short-term loans for small borrowers categorized as safer. The scope of these state guarantee obligations, however, is determined through a special law for each particular budgetary year. Such a system creates incentives for banks and small firms to grant and seek, respectively, very short-term financing. As a result, forced by the scarcity of available credit, small firms have adopted the costly habit of financing long-term investment with very short-term loans.

Overall, the legal requirements imposed on banks by the rehabilitation program have succeeded in maintaining the financial stability of the country through the initial, and probably most delicate, part of the transition process. Such stability, however, has come at the cost of a slower privatization process, especially with respect to the banking industry. A new banking law is currently being debated and is expected to significantly change the degree and nature of banking competition, in particular with respect to foreign banks. Specifically, this law will enable foreign banks to open branches in Slovenia directly. But, until this Law is approved, it is not surprising that protective government regulation, high degree of concentration, and standardized interest rates have resulted in the provision of costly and inefficient banking services. Ultimately, therefore, stability may have come at the expense of those economic agents, such as small firms, whose development relies crucially on bank loans.

Since bank lending represents one of their primary sources of funding, the effects of banks' behavior on small firms may be quite significant. When protected from foreign competition and able to implement price collusion, banks maximize profits by extracting monopolistic rents in the form of above market profit margins. If, simultaneously, because of balance sheet constraints, the amount of lending allocated to commercial loans decreases, the credit crunch faced by small firms and start-ups may be quite significant. This is the result of the reduction of lending funds which, coupled with the high cost of borrowing, squeezes small firms, that have no history, less collateral and no financial alternative to banks, out of the market. On the other hand, when the banking industry is characterized by a high degree of competition, banks cannot extract monopolistic rents and are forced to generate profits by acquiring informational advantages to compete for potential customers. Like in any other industry, in a more competitive environment, the likelihood that borrowers will switch to competitors forces banks to protect, at least in part, small firms from changes in general credit conditions. Thus, under a competitive regime, small firms are less likely to suffer a rationing problem.

VII. Conclusion

In this paper, after briefly reviewing the conditions of Slovenia at the onset of its independence, we have described the new productive structure of the country. We found the development of small firms and start-ups to be a very important element for the future growth of the country. In addition to constituting the most dynamic sector of the economy, small firms have had an important stabilizing effect on labor markets, where they have absorbed a large percentage of the labor force left unemployed by the dissolution of nationalized enterprises. Of course, at a time when the productive structure of the country is in the making, the development of small firms depends crucially on their ability to find adequate financing. Traditionally, bank loans represent the main source of external financing for small firms. Thus, our analysis focused on the investigation of credit availability to small firms and on the importance of the Slovenian banking system. Relatively to the small business sector, the banking industry appears static and inefficient, with banks behaving as a cartel. Such a behavior is largely explained by the fact that the Slovenian government protects domestic banks from foreign competition and the Central Bank, committed to transition gradualism and financial stability, supports their monopolistic practice of setting common deposit rates.

Although the effort of the Central Bank has been largely successful in maintaining financial stability, our claim is that stability may have come at the cost of an overall lower economic growth.(44) The competitive structure of the banking industry in Slovenia will certainly change when the country becomes part of the European Union. Its entry, currently under review, is in fact contingent upon the liberalization of capital flows.(45) In 1999, Slovenia is scheduled to open up its monetary and capital markets to the EU. The existing severe restrictions on foreign borrowing will have to be lifted at that time. This will put pressure on the banks and on the domestic monetary policy, since Slovenian companies will have the option to borrow from foreign banks at more competitive rates. As a result, we can expect the interest rates to drop further and even the largest domestic banks to undergo massive restructuring.(46) Because of the abolition of barriers to entry and the resulting international competition, it is likely that Slovenian banks will change their strategy and target those portions of the domestic markets in which access to local information is more costly to outsiders. This being the case, we should observe the establishment of new long-term bank-customer relationships and a larger portion of domestic credit to be redirected to small firms.

Until the opening of its capital markets, however, we interpret the Slovenian example as supporting the hypothesis that a highly concentrated banking industry tends to penalize small firms and start-ups relative to large firms and, in doing so, contributes to the establishment of a possibly suboptimal productive structure. Indeed, financial flows are a key determinant of the selection process through which a country in transition locks-in its future competitive structure and, ultimately, its growth potential in the long run. Our evidence, although only suggestive, is consistent with what is observed in other countries, and supports the hypothesis that a high degree of banking competition is especially useful when the development of small firms is desired. The intuition behind this argument is that, for example, when the government implements a restrictive monetary policy, banks and firms of different size modify their lending and borrowing behaviors. Such behavioral changes, however, are not the same across banks and firms. Differences depend, to a large extent, on firm and bank size. When banks have no incentives to compete with each other for customers, small firms and start-ups, which are traditionally perceived as being riskier, end up being penalized relative to large firms.

In conclusion, the contribution of this paper is twofold. First we have provided an updated outline of the Slovenian economy that, to our knowledge, has been missing from the literature thus far. Second, using the example of Slovenia, we have provided a new illustration of the important connection between financial markets and development of the productive structure. In the near future, the expected entrance of Slovenia in the European Union, the consequent opening of its capital markets, and the resulting possibility of comparing two clearly distinguished financial regimes, will provide a natural experiment to even better understand how credit markets influence the productive structure of a country. These developments make this issue certainly worth of further investigation.

Notes

(1.) See King and Levine, 1993.

(2.) For example see Bernanke and Gertler (1995), and Gertler and Gilchrist (1991).

(3.) Among a few exceptions are Pleskovic and Sachs (1994), and Smith, Cin and Vodopivec (1997).

(4.) The EBRD Transition Report for 1997 estimates only 50 percent of Slovenian GDP to be generated by the private sector. This percentage, among the lowest, ranks Slovenia with Bulgaria and Macedonia well below most other economies in transition. EBRD (1997) p. 14-15.

(5.) For example, about a third of new investments in the country are financed by leasing contracts. This is so because the collateral legislation is not yet fully defined and, therefore, they are easier to award when the financial history of the company is short or nonexistent.

(6.) The system involved, for example, extensive price regulation and explicit "cooperative" agreements between firms. Such agreements included market sharing and price fixing, which all resulted, of course, in less competitive outcomes.

(7.) See Pleskovic and Sachs, 1994.

(8.) Slovenia declared independence on June 25, 1991. In response, on June 26, the Yugoslavian army invaded the country. On July 7, a decisive agreement between all concerned parties and EC negotiators was quickly reached and a war avoided. Slovenia agreed to stop further implementation of the declaration of independence for three months and the Yugoslav side promised to end the hostilities and withdrew its army.

(9.) Unlike most socialist economies, Yugoslavia maintained active trade relationships with Western European economies. Companies that traded with Western customers enjoyed particular freedom in setting prices and were, as in the case of Vileda and Elan, successful in entering brand-name competition.

(10.) Specifically, between 1945 and 1988, the only legally permitted form of private enterprise was in the crafts sector. The craft sector, however, in Slovenia was defined very loosely and it included retail and import/export enterprises. In fact, until 1988, the craft sector included practically all small enterprises.

(11.) The note to Table 2 explains the method used by the Agency of the Republic of Slovenia for Payments to classify firms into small, medium or large. A more straightforward method, such as a classification based solely on the number of employees would have been more desirable. It would have, in fact, avoided possible problems associated with income and balance sheet variables. Unfortunately, we have been unable to obtain raw data and, as a result, we have adopted the Slovenian classification.

(12.) Although data on the contribution to GDP of firms by group size are not available, industries accounting for increasing shares of GDP and fastest improving productivity rates are the same industries with the largest concentration of small firms, such as services and retail. The reverse, instead, is true for mining, transportation, and manufacturing where larger firms are concentrated. Institute of Macroeconomic Analysis and Development. 1997, pp. 18-27 and pp. 37-40.

(13.) Employment figures in table 3 report only the number of workers employed by the three groups of firms. Thus, such figures do not represent the entire labor force. In particular, by not including self-employment, they significantly underestimate the role played by the small-business sector.

(14.) Institute of Macroeconomic Analysis and Development. 1997, p.75.

(15.) Ibid. As suggested by our referee, a more satisfactory measurement of the contribution of each group of firms to overall employment would be obtained by calculating the growth rate of employment for a size category including only firms already in that group. Unfortunately, our data do not allow us to identify firms switching group size over time.

(16.) Zizek and Liechtenstein. 1994, pp. 30-31.

(17.) The survey consisted of 87 close-end questions. To be included in the survey, entrepreneurs needed significant ownership and management control. In addition, each company had to meet minimum sales turnover of one million ECU, employ at least 10 persons, and have some export sales. The survey results indicated that sales turnover and number of employees grew extremely fast and that the business environment (taxes, bureaucracy, etc.) was a major obstacle to development. Most important, the survey revealed the paucity of external sources of financing and the resulting limits imposed on the growth potential of those companies, especially in Slovenia. (Zizek and Liechtenstein. 1994, p.41.)

(18.) The most important among venture funds is the one administered by the European Bank of Reconstruction and Development (EBRD) of London. EBRD financing relies on the Slovenian Capital Development Fund, the Special Restructuring Project Fund, and on the Horizonte Fund. The largest of the three is the Slovenian Capital Development Fund that finances primarily private or privatized medium size enterprises. This Fund operates with about $25 million of capital and acts as a limited liability share holding company. The Special Restructuring Project Fund, instead, aims to restructure small and medium firms with financial problems caused by bad credit or loss of markets. Both Funds direct most of their financing to medium enterprises. Finally, the Horizonte Fund is the only one to provide a significant amount of capital and substantial management assistance to new and small private companies. For a detailed description see OECD, 1996, pp. 106-108.

(19.) Uradni List Republike Slovenije. 1991. N. 18.

(20.) In 1996, for example, the Fund registered only 12 demands for short-term loans, four of which were approved for a total value of only $340,010. Also, 259 long-term loan requests were registered, but only 59 were approved for a total amount of $5,821,979. The fact that most applications concern long-term loans, and that only 59 requests were approved, is an indication of the difficulty of satisfying the Fund criteria and, at the same time, of the excess demand for long-term small firm financing characterizing the Slovenian market. Kapital. October 16, 1996, pp. 26-27.

(21.) The Technology Development Fund operates as a risk fund offering capital investments, credit at a six per cent interest rate, and insurance on movables, real estate, and patents in the sphere of R&D projects. The Fund also subsidizes interest rates on credits for technological development, and grants subsidies to technological centers and parks. The capital potential of the Fund is $7.78 million. Loans approved by the Fund do not require a deposit, have a one-year repayment moratorium, lower interest rate, and are valid for five years.

(22.) OECD Proceedings, 1996, p. 103.

(23.) To reduce screening costs and promote transparency, the Association of Entrepreneurs has suggested the introduction of entrepreneurship cards. These cards would be based on previously given estimations, opinions and guarantees, and would provide a quick and inexpensive way to obtain information while, simultaneously, speeding up the fund-raising process. The Association also suggested the creation of special mutual associations where entrepreneurs would deposit and share resources as consortium members. As of August 1998, however, the suggestions of the Association have not yet found a concrete application.

(24.) Consistently with our claim, Rovan, Mramor and Horvat (1997) use multiple correspondence analysis and a sample of 926 randomly selected companies to show that, although the demand for bank financing from young companies is very strong, their credit capacity is very weak.

(25.) OECD. 1997, p. 46.

(26.) In addition to traditional financial intermediaries, Slovenia is currently developing its own capital market. This market is young and relatively small. The Ljubljana Stock Exchange was officially founded at the end of 1989, and the 1995 turnover totaled to about $0.58 billion. Besides the security market, for which strict rules apply, in 1995 an off-the-exchange open market was introduced where freely transferable securities, which do not meet the quotation requirements, are traded. While small companies are not financed in these markets, the OTC market could become, in the near future, an efficient and inexpensive financing vehicle for medium firms. This new option for medium-size companies, in turn, could benefit small firms by increasing the credit available to them from more traditional financing channels. For a description and analysis of Slovenian capital markets see Mramor (1994).

(27.) Bank of Slovenia. 1992, p.20 and 1996, p. 23.

(28.) Bank of Slovenia. 1995, p.41.

(29.) Bank of Slovenia, 1996, and Board of Governors of the Federal Reserve System, 1996.

(30.) Bank of Slovenia. 1996, p.39.

(31.) Ibid. p.35.

(32.) In 1996 Bank Celje acquired Banka Noricum from Ljubljana, while Nova Ljubljanska Banka acquired Maribor based E Banka, and Posavska Banka, a regional bank from Krsko.

(33.) Namely, Bank Austria, Kreditanstalt, Volksbank and Societe Generale. Currently, foreign banks must establish a fully capitalized local bank or a joint venture. Both options are more expensive than opening a branch.

(34.) An important exception is SKB bank, currently the second largest bank in Slovenia and the biggest private financial group. This institution, that used to specialize in mortgages, has aggressively pursued foreign investors. In 1996, SKB completed the sale of 19 percent of its equity to the Bank of New York and became the first Slovenian company to gain listing on an international stock exchange.

(35.) Bank of Slovenia. 1996, p.36.

(36.) Most non-performing loans had been made to Slovenian companies that had lost their markets in other Yugoslav republics.

(37.) OECD. 1997, pp. 74-75.

(38.) Bank of Slovenia. 1998. January, p. 54.

(39.) Bank of Slovenia. 1996, p. 16.

(40.) Bank of Slovenia. 1996, p. 37.

(41.) Kapital. October 16, 1996.

(42.) The Macrostatistics Database of the World Bank Group includes time series for all economies in transition. Unfortunately, not all series are complete.

(43.) The Slovenian inflation rate, calculated as the annual average rate of change of the CPI, declined from 117.7 in 1991 to 6.5 in 1997. The World Bank Group. Macrostatistics Database.

(44.) It is important to note that the aim of this paper is not to evaluate the choices that Slovenian authorities made, or could have made, with respect to the privatization process. Our goal is simply to use the case of Slovenia to gain some insights on the general connection between banking structure, credit distribution and productive structure of the economy.

(45.) In July 1997, Slovenia and the EU have reached an agreement that gives the former a four-year transition period to put in place, among other things, the conditions necessary for the liberalization of capital markets.

(46.) Since Slovenian banks are small compared to foreign competitors, it is likely that, after the opening of capital markets, a wave of mergers will characterize the domestic banking industry. In 1996, for example, the total assets of Nova Ljubljanska Banka, the largest Slovenian bank, were only one fourth of Komercni Banka in the Chezch Republic, the largest Central European Bank.

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Gertler, Mark, and Simon Gilchrist. 1991. "Monetary Policy, Business Cycles and the Behavior of Small Manufacturing Firms." NBER Working Paper No. 3892.

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Pleskovic, Boris and Jeffrey Sachs. 1994. "Political Independence and Economic Reform in Slovenia." In The Transition in Eastern Europe. Olivier Blanchard and Kenneth Froot Eds. NBER and The University of Chicago Press.

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We thank Roger Koopl, Dusan Mramor, Ivan Ribnikar and an anonymous referee for helpful comments and suggestions. We also thank the Agency of the Republic of Slovenia for Payments (Agencija Republike Slovenije za placilni promet) for help with the data. All errors remain ours.

Maria Minniti

Babson College 

Lidija Polutnik

Babson College3