22 The biggest cross-border issues involved ensuring that foreign owners would and could stand by their subsidiaries, particularly in the turbulent weeks after the failure of Lehman Brothers. The central bank’s move to lift the marginal reserve requirement in October 2008 facilitated foreign banks’ efforts to provide liquidity support to their subsidiaries. Together, the foreign owners and the central bank, along with the Croatian Government, which raised the deposit insurance level from HRK 100,000 to HRK 400,000, succeeded in stabilizing the situation.

An additional concern as the crisis continued was that parent banks would seek to compensate for losses in their home markets through large dividend payments or capital decreases in the subsidiaries. Considerable moral pressure was exerted by the central bank to prevent this from happening. In addition, the Vienna Initiative proved to be a very important international effort to prevent foreign banks from abandoning markets in the Central and East European region. Overall, it seems fair to say that these efforts succeeded.

There were no failures of foreign banks in Croatia during the financial crisis. For this reason, the issue of burden sharing did not materialize. Since all the foreign banks were organized as subsidiaries, any recapitalization or restructuring would have come exclusively under Croatian law. However, if a foreign subsidiary were to fail in the future, it would be difficult to imagine the Croatian Government stepping in and using taxpayers’ money to recapitalize the bank. More likely, the burden would be placed on the parent’s owners, or the home country government.

# _5.2. Capital flows: Looking ahead_

Although the financial crisis has substantially decreased capital inflows, it seems reasonable to think that Croatia will experience substantial inflows in the future. Croatian borrowers are likely to turn to European sources when they can because interest rates remain more favorable outside of Croatia, particularly in the euro zone. Croatia’s expected accession to the EU and subsequent membership in the euro zone would likely erode this differential, but will not eliminate it quickly.

In addition, Croatian banks are likely to turn to international debt markets again. In the near term, the need for debt financing will be limited by slow loan demand from both domestic enterprises and households. However, once economic growth accelerates, one would expect a return to international debt markets by Croatian banks.

Another form of capital inflows that should be anticipated is FDI. Croatia’s domestically owned banks, which are mainly small and medium sized, are already perceived to be attractive takeover targets for foreign banks seeking entry into the Croatian market. Even though tight regulation may limit profit rates relative to the high levels achieved in the past—the return on average equity of the Croatian banking system has fallen from a high of 16.1 percent in 2004 to only 6.4 percent in 2009—the growth potential of the Croatian market seems far greater than that of developed European markets.<sup>17</sup> This implies continued FDI in the banking industry.

FDI in other sectors of the economy can also be anticipated, especially as EU accession improves the legal and regulatory framework. However, Croatia still has work to do on streamlining procedures for business establishment and decreasing corruption. These obstacles 17 Data from www.hnb.hr, ―SPF‖. http://www.hnb.hr/publikac/hpublikac.htm