Eastern Europe: The Makings Of A Cross-

Border Banking Nightmare?

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Mary Stokes | Feb 23, 2009

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“ Good article. Really well thought out. I am glad it is not alarmist or sensational like Ambrose.
From what I read, the biggest real threat is consumer... more ”
By cdulan 02-24-2009
“ So no world meltdown due to Eastern Europe, but maybe an Austrian meltdown? Austrian banks
borrowed swiss francs to fund loans to Eastern Europe - see... more ”
By Mikka 02-23-2009
See all blog comments
Ambrose Evans-Pritchard’s piece in the Telegraph last week boldly predicted: “Failure To Save
Eastern Europe Will Lead To Worldwide Meltdown.” The gist of his argument was that Western
European banks’ exposure to economically troubled Eastern Europe will sink Europe’s financial
system. What followed was a crescendo of articles echoing Evans-Pritchard’s claims. Adding fuel
to the fire, Moody’s predicted in a presentation last week that Western European banks, who operate
in the region via subsidiaries, are at risk of rating downgrades because of deteriorating economic
conditions in Eastern Europe.
Then came the more nuanced responses from close watchers of the region. Yes, Eastern Europe has
major vulnerabilities, they say, but the idea of an imminent string of bank failures cascading across
the region and into Western Europe is far from inevitable. (See UBS and Piatkowski/Rybinski)
So which camp is right? How dire is the situation in Central and Eastern Europe’s economies? And
how could CEE problems affect Western Europe’s banking systems?
The general argument is that the strong presence of foreign-owned (primarily Western European)
banks, which now account for 60% to 90% of total assets in most CEE countries, opens the door to
contagion. See my post from April 2008 that raised this issue: Eastern Europe's Strong Foreign
Bank Presence: Potential for Contagion? That is, the exposure of some individual Western
European banks to Eastern Europe is material, and economic/banking problems in Eastern Europe
could adversely affect the position of these banks as a whole. A recent Economist article makes a
good point in noting that many Western European parent banks have more to lose than just their
equity investments in their CEE subsidiaries. They have been major sources of funding to their
subsidiaries so they also stand to lose the credit (via loans) they have been extending to them.
Contagion goes the other way too, as the global credit crunch has made parent banks less able and
willing to finance their CEE subsidiaries. Disturbingly, net bank lending to Emerging Europe (excl.
Russia) is projected be a meager $22 billion in 2009, down from $95 billion in 2008, according to
the Institute of International Finance, which will likely exacerbate the region’s economic slowdown.
Given the CEE’s strong financial links with Western Europe, the health of Eastern Europe’s
economies and its banks is coming increasingly under the microscope as a potential trigger for a
larger European financial system crash.
So how healthy are Eastern European banks?
Financial health indicators show Eastern European banks are generally well- capitalized, have no
exposure to toxic assets and have enjoyed strong profitability in recent years. Nevertheless, there
are grounds for concern as non-performing loans in the region look set to balloon, potentially
destabilizing CEE banking sectors.
Rapid Credit Growth
A large body of literature links credit expansion and banking crises. In recent years, real growth
rates of credit to the private sector in many CEE countries was in the range of 30–50% annually,
double the global average, albeit starting from a low base.
Rapid credit growth can pose a risk to financial stability and conceal worrisome developments in
non-performing loans. As Fitch noted in an April 2008 report, even where fundamentals suggest
there is room for credit to grow rapidly as in many CEE countries, excessive optimism and banks’
aggressive pursuit of market share in the context of low interest rates and open capital accounts can
give rise to over‐lending or poor‐quality lending and subsequent problems in banking sectors.
Now that the tide of credit is abating, we should see these dud loans emerge. It’s just a question of
how much. As Warren Buffett has said: “It's only when the tide goes out that you learn who's been
swimming naked.”
Sharp Economic Contractions/Edge Of Financial Crisis
After high-flying growth through much of the 2000s, CEE economies are rapidly slowing, with
most now expected to descend into recession in 2009. Such rapid contractions set the stage for
sharp upticks in non-performing loans that will strain banking sectors. On top of these severe
contractions, I noted in a post last week the region’s high susceptibility to crisis a la 1997 Asia and
graphically highlighted the warning signs (massive external imbalances, high fx-denominated
lending). See my post on this issue: Eastern Europe: On Crisis Watch.
In the event of such a crisis, the non-performing loan ratio would likely mushroom, thereby posing
a major risk to financial stability, as seen by the ballooning of NPLs in Thailand, Korea and
Singapore during the Asian financial crisis. According to a Lex article, dud loans in 1997 Asia
reached a staggering 20%.

High FX Lending/Weakening Currencies

High levels of foreign currency-denominated lending + weakening currencies are a particularly
nasty recipe for rising NPLs and banking system stress.
In what could be dubbed Eastern Europe’s version of the US’ subprime folly, unhedged households
took out foreign currency loans (attracted by the lower rates), seemingly oblivious to the exchange
rate risk involved. As seen above, fx-denominated lending (usually in the form of euros or Swiss
francs) has been especially popular in Croatia, Hungary, Romania and Poland.
The problem is now that currencies are tanking, many households’ debt burdens are spiking. This,
in turn, will translate into defaults and strain these banking systems.
See related spotlight issue: FX-Denominated Lending: Eastern European Version Of US Subprime
Folly?

Heavy Reliance on Non-Deposit External Funding

High loan-to-deposit ratios signify a heavy reliance on non-deposit foreign funding, which is drying
up, especially in the context of the global credit crunch. So those countries with high ratios are in
for a painful funding drought.
As Citibank notes, “Since 2H08 was characterized by an increase in inter-bank counterparty risk
and by cash-hoarding behavior on the part of large banks, it is no surprise that the countries with
large loan-to-deposit ratios were among the first to be affected by the collapse in global risk
appetite.”
Are All Eastern European Countries In The Same Boat?

Obviously, as can be seen in the graphs above and as noted by Piatkowski/Rybinski, there is
significant variation in CEE countries’ banking sector/economic health. The Czech Republic, for
example, has relatively low levels of external imbalances, a reasonable loan-to-deposit ratio, and
scant fx-denominated lending to households. However, even countries like the Czech Republic
could still be affected by a negative chain reaction sweeping across the region. Banking systems in
the region are likely only as strong as their weakest link – or in this case, weakest country. That’s
because of the ‘common lender’ phenomenon.
Because the same Western European parent banks operate in multiple countries across the region,
this opens the door to contagion via the ‘common lender’ channel. This paves the way for problems
in just one of these countries to have ripple effects into other countries in the region due to the fact
that they share foreign parent bank(s) in common. As the Oesterreichische Nationalbank (Central
Bank of Austria) states in a recent financial stability report: “It should be borne in mind that
contagion may also arise if problems occur at sister banks and, stress spreads to other institutions
within the banking group through the parent bank (e.g. through adverse effects on the parent bank’s
liquidity or capital adequacy).”
The matrix below gives a sense of the high degree to which Eastern European countries’ banking
systems are dominated by a similar concentrated set of Western European banks.
As seen in the chart below, UniCredit (Italy), Raiffeisen (Austria), and KBC (Belgium) each operate
in more than ten emerging Europe countries. A problem in one country could potentially lead these
banks to cut exposure to the rest of the region. Meanwhile, problems in one Baltic state are likely to
strongly affect the other Baltics since the same Swedish foreign parent banks (Swedbank, SEB)
dominate their banking sectors. But as these Swedish parents have scant operations in other CEE
countries, the ‘common lender’ channel between the Baltics and the rest of CEE is weak.

Fitch brings up the point that a major foreign parent bank might be willing to bail out a local
subsidiary in trouble, but may find it more difficult to help out if faced with similar calls for
financing from other subsidiaries in the region. In a different twist on the same point,
Piatkowski/Rybinski say that foreign banks are not likely to be selective about which local
subsidiaries to support – a failure of any CEE subsidiary could lead to a run on subsidiaries in other
countries.
To sum up, Eastern European countries – despite varying degrees of macro vulnerabilities/banking
system soundness are largely in the same boat. Due to the ‘common lender’ channel, not to mention
psychological contagion, banking sector problems in one country are likely to ripple through to
other countries in the region.
How Exposed Are Western European Parent Banks?
So far, we’ve shown that Eastern European banks are likely to see a spike in NPLs this year due to a
number of different vulnerabilities – high fx-denominated lending, weakening currencies, sharp
economic contractions, heavy reliance on non-deposit funding. And we’ve also shown that troubles
in one country’s banking sector have the potential to create a negative chain reaction across the
region via the ‘common lender’ channel. But how much could Eastern Europe’s potential woes
affect Western European countries?

As seen in the graph above, Austria is far and away the Western European country most heavily
exposed to the CEE region (via Austrian-based banks like Raiffeisen and Erste Bank). Notably,
however, other Western European countries’ total exposure is far less. According to a recent IMF
working paper on financial contagion within Europe, the size of the absolute exposure is not
economically significant in France, Germany, Italy and Portugal. This suggests Austria’s banking
system could be in serious trouble if problems in CEE banking sectors arise. Nevertheless, it also
suggests that Evans-Pritchard’s claim that “Failure To Save Eastern Europe Will Lead To
Worldwide Meltdown” is over-dramatic.
What Can Be Done?
As I noted in my April 2008 post, Europe’s regulatory system lags behind banks’ cross-border
reach. It’s currently a fragmented system, which is ill-equipped to deal with a cross-border banking
crisis. There is no harmonization of EU member states’ bank insolvency laws. Guidelines merely
bind the national authorities to favor private-sector rescues where possible, and urge them to decide
in advance who would pay the bill for banks that operate in more than one country if a state bailout
is required. This means that if a cross-border bank needs to be unwound, the process is likely to be
extremely messy. This highlights the need for a single EU regulator, rather than the current swath of
different national regulators. In the meantime, let’s hope a bailout is not required.