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Croatia's parliament has approved the conversion of loans denominated in Swiss francs into euros, in a move that banks have already threatened to challenge in international courts. The move is likely to cost banks around HRK8bn (€1.05bn), the central bank has estimated, imposing losses equal to three years’ worth of expected profits. 

The change in legislation comes just months before general elections are held and is expected to increase support for the ruling SDP party, lagging behind the opposition HDZ party in polls. The Croatian government had already fixed the Swiss franc’s exchange rate for the loans at 6.39 kuna for a year,  the rate before the Swiss central bank’s decision to allow the franc to appreciate. 

The Croatian government bill converts loans denominated in Swiss francs converted into euros, with part of the principal being written off and all the costs being borne by the banks. The government, in return would recognise those losses as tax deduction. The law, passed on September 18, should come into force at the end of the month.

The European Central Bank warned on September 18 the conversion may result in a decline in Croatia’s international reserves which may have “undesired consequences” on the country’s macroeconomic stability.

Moreover, the legislation might also have some negative effects if it were to lead to a deterioration of foreign investor sentiment because of a perceived increase in legal uncertainty and country risk, the ECB noted. It therefore suggested that the Croatian authorities carry out a thorough analysis of the possible effects on the economy of introducing the proposed measures.

The loan conversion would also have a negative impact on the profitability, capitalisation and the future lending capacity of the affected banks. The ECB noted that the measure would mostly affect eight of the largest banks in Croatia, most of them being foreign-owned. Foreign banks hold around 90% of assets in the Croatian banking sector.

A consortium made up of Austria’s Erste Group Bank, Italy's UniCredit, Russia's OAO Sberbank, Austria's Raiffeisen Bank International and the Austrian Hypo Group Alpe Adria has said Croatia’s decision breaches EU legislation and bilateral investment contracts. An unnamed source quoted by Reuters on September 14 said banks operating in Croatia which are subject to this legislation would submit the dispute to arbitration through the International Center for Settlement of Investment Disputes in Washington.

The finance ministries of the European Union – most of the banks subject to the painful conversion are Austrian – have also asked the European Commission to investigate Croatia’s plans. EU finance ministers have asked the EC that by October 6 it analyses proposals by Croatia and Poland to convert mortgage loans pegged to the Swiss franc to the euro, diplomatic sources reported.

On the other hand, ratings agency Fitch said on September 18 banks' capitalisation will remain robust, although Croatia's plan to convert Swiss franc loans into euro-denominated ones will impose significant one-off losses on the banking sector.

“The conversion process is complex and has a very short timetable, creating operational challenges. The banks will have to recalculate all past and future repayments and the principal owed as though the loan had originally been made in euros. We expect customer take-up to be high, as the entire cost of the conversion is borne by the banks, although the actual benefit to customers will depend on when they took out the loan,” Fitch said.

The ratings agency estimates that the largest Croatian bank, Zagrebacka Banka (ZABA), would face a total cost of conversion of around HRK1.8bn (pre-tax) based on its 23% share of sector Swiss franc housing loans at end-2014 and assuming costs are evenly distributed. The costs should be largely covered by 2015 earnings.

The Croatian banking system reported a pre-tax profit of HRK1.48bn in the first six months of the year, down from HRK1.57bn a year before. The share of bad loans held by the banking sector rose to 17.3% at the end of June from 17.14% at the end of March.

Loans in Swiss francs became popular in the Adriatic country in the 2000s because of the attractive low interest rates.  At the end of last year, Swiss franc-denominated loans made up 16% of all lending in the country and some 38% of all mortgage loans were denominated in the Swiss currency, according to data from the Croatian central bank. Following the Swiss central bank’s surprise decision to abandon its ceiling of CHF1.20 to the euro in January, around 55,000 Croatians with such loans experienced soaring borrowing costs.