Chapter

IX. Financial Sector

Author(s):
James Roaf, Ruben Atoyan, Bikas Joshi, and Krzysztof Krogulski
Published Date:
October 2014
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After incomplete reform that led to banking crises across the region in the 1990s, almost all countries adopted a model based on strong bank supervision and high participation in local banking sectors by Western European parent banks. This brought much needed know-how and access to foreign financing—but also contributed to the major credit boom in the 2000s, exacerbating the effects of the global financial crisis at the end of the decade. Current policy priorities include addressing crisis legacies of bad debts and slow credit growth, as well as adapting to the new regulatory environment in the euro zone.

Communist legacy and early banking crises

During the communist era, financial systems in the region had a purely passive role, with “monobanks” administratively channeling resources into politically-selected tasks and projects by state enterprises. Due to this reduced, record-keeping role, these banks did not engage in evaluations or risk assessments of the loans extended, and services provided to the general public were very modest or non-existent.

With the onset of transition, a two-tier banking sector was developed as a crucial element of the market economy, to help allocate resources to productive use. The creation of central banks, and modern financial systems was an unprecedented challenge, involving building from scratch a number of pillars to underpin a functioning system. These included prudential regulation, supervision, and an appropriate framework for competition. In this process, all the transition economies benefited from external technical assistance provided by the IMF, the World Bank and by foreign experts sent from various central banks.1 Progress in implementing these reforms was mixed across the region, as with other necessary supporting reforms such as improved contract enforcement and sound monetary policy implementation.

As large (and mostly state-owned) enterprises to which banks had lent underwent stress associated with their new exposure to market forces, banks quickly found themselves with serious bad loan problems. These problems quickly escalated as banks were coerced into new lending to keep these companies alive, while interest rates were rising on the back of macroeconomic stabilization programs. Recovery of nonperforming loans turned out to be almost nonexistent, reflecting both the soft budget constraints that provided little incentive to companies to restructure, and also strong political unwillingness to let companies go bankrupt.

Post-transition banking crises

Private banks were also allowed to operate, but often featured low capitalization and close connections to businesses, reflecting lenient supervision requirements. Deep-rooted weaknesses in the sector were addressed by a string of inadequate solutions, including repeated recapitalizations without requiring restructuring, unsuitable privatizations to connected parties with little know-how and expertise, and sales of minority shares that did not significantly reduce strong political influence.

The ineffectively functioning banking sectors created a vacuum in the supply of financial services. This tended to be filled by some legitimate microcredit operations, but also by fraudulent entities which, in the context of still weak regulatory environments abused inexperienced clients and damaged trust in the financial system. Given this background across the financial industry, most countries faced full-fledged financial crises during the 1990s.

Modernization and foreign inflows

In the aftermath of these traumatic crisis episodes, it became clear that deeper reforms were required. While some CIS countries relied more on tighter state oversight, in other countries—especially where the prospect of EU membership served as an institutional anchor—the political will emerged to engage strategic investors in the sector via privatizations. In some cases, like Poland, budget needs also helped make bank privatizations politically feasible. With improving macroeconomic conditions and attractive valuations, investor appetite was strong, and a wave of privatizations took place, usually involving Western European banks. At the same time some banks started operations in the region through greenfield investments.

The completion of the process in the early 2000s saw the creation of modern, market-oriented and independent banking systems. In most CEE countries, banking became the sector with the highest private and foreign participation, and foreign bank ownership was also higher than in other emerging market regions. Foreign parent banks, mostly from mature markets, brought know-how, technology, a new culture of service, high supervision standards, and brand names that instilled confidence among battered depositors. On the other hand, they brought new sources of risks, including exposure to foreign shocks and exposure to specific banks. The pattern of parent banks differed across the region, with Baltic countries benefiting to a disproportionate extent from Swedish investment, while at the other extreme Poland was host to a very diverse group of countries and banks.

Foreign bank participation

(percent of banking sector assets)

Source: EBRD, Bankscope.

The presence of foreign banks brought easy funding from abroad. They often followed a model of centralized funding, whereby parents shifted large amounts of liquidity to wherever it was deemed to be needed most. At the same time, ample financing on money markets transmitted the tide of capital inflows also to countries where the share of foreign-owned banks was lower. Large European banks were pursuing an aggressive strategy of expansion of cross-border lending, with the EU accession countries appearing especially attractive, leaving CIS countries much less affected. But as discussed in Chapter VIII, the vastly improved access to finance came with considerable drawbacks: large volumes of lending were channeled into consumption and nontradable sectors, contributing to significant imbalances which unwound precipitously in the wake of the 2008 global financial crisis.

Foreign banks operating in CEE

* Other banks include Alpha Bank, Citibank, DNB, Eurobank, GE Money, Millennium BCP, National Bank of Greece, Santander and Sparkasse.

Note: Figure shows ownership structure of CEE banking sectors. Each parent bank is linked to a country, where its subsidiary operates. Volume of each block reflects balance sheet size of parent banks or total assets of host banking sectors.

Source: Raiffeisen Research; Bankscope.

Crisis and retrenchment

The eruption of the global financial crisis in 2008 triggered high risks of banking instability in the region. It was feared that a potential disruptive adjustment of exchange rates and macroeconomic imbalances, along with the expected unwinding of real estate booms, could wreak havoc on bank balance sheets. But in the event, banking crises were generally avoided, as macroeconomic adjustment proceeded more smoothly than expected and portfolio losses were gradually absorbed by considerable preexisting buffers. Notable exceptions were the collapse of a large bank in Latvia, widespread problems in Ukraine, and relatively small and targeted recapitalization in other countries (such as Slovenia).

A variety of factors were at play to prevent disruptive macroeconomic adjustments. The IMF, together with the EU in member countries, put in place a number of lending arrangements while EBRD, European Investment Bank (EIB) and World Bank provided funds to the banking system. Bank funding flows to the region were initially affected, but not in as destabilizing a way as originally feared, and were subsequently stabilized through 2010. Banking systems benefited from the prevalence of parent-subsidiary relationships, which proved to be a more stable source of flows, in some specific cases aided by coordinated action and more explicit commitments in the form of the Vienna Initiative (see Box 8). As the euro zone crisis heated up in late 2011, parent banks started to experience considerable renewed distress, with several requiring state intervention. Against this backdrop, cross-border exposures to the region came under pressure again, but once again without disruptive macroeconomic effect.

The deleveraging process was concentrated on host countries that had seen the strongest inflows during the boom—including the Baltics, Bulgaria, Hungary and Slovenia—regardless of the share of foreign-owned banks. But there were no large-scale divestments in transition countries, and foreign banks continued to dominate the landscape.2

Deleveraging

Exchange rate adjusted changes in claims of foreign banks on selected economies as percent of average GDP (2004-2013)

Note: See country code box for country flags.

Source: BIS locational statistics.

Significant exposures to embattled sectors (mainly construction) and the prolonged slump of economic activity translated gradually into an increase in nonperforming loans (NPLs). As banks provisioned for these loans, profitability in the system was hurt. High NPL levels and low profitability have slowly been overcome in some countries—especially the Baltics—but continue to be a very serious problem in others, especially in Southeast Europe.

Nonperforming loans

(percent of gross loans)

Source: IMF, Financial Soundness Indicators.

Evolution of principal bank funding sources*

(Percent of GDP, 4-quarter moving average, exchange-rate adjusted)

* Excludes Russia, Montenegro and Kosovo because of data unavailability.

Sources: BIS, Locational Banking Statistics; IMF, International Financial Statistics; IMF, WEO; and IMF staff calculations.

Bank lending growth remained very weak throughout the crisis, with various countries experiencing creditless recoveries. While contracting demand for credit was a major force at play, supply factors were also important.3 NPLs hampered credit growth by tying up bank funding and managerial resources. Deleveraging also played a role, affecting especially banks with higher initial levels of foreign funding or subsidiaries with a less solid parent, which both saw larger reductions in credit growth.4 But domestic credit fell significantly less than cross-border credit, because of alternative sources of funding and deposit growth, leading to an emerging model of decentralized banking in which subsidiaries are increasingly self-funded. Small and medium enterprises (SMEs) have faced the most difficulties in accessing credit, being seen as riskier, especially in environments of weak property rights and slow collateral enforcement.

A challenge going forward is how to revive credit provision and expand SME access to finance. Quick action to tackle weaknesses in the business environment, as well as making adequate use of guarantee schemes (including from international financial institutions) are natural steps to kick-start demand and expand access. In addition, most banks need to address legacy assets more decisively, in order to focus on opportunities for new lending. In some cases—most urgently in Southeast Europe—governments also need to do more to aid resolution of NPLs, including removing obstacles to developing markets for distressed assets, stronger tax and supervisory incentives, improvements to legal and insolvency systems, and facilitating debt restructuring (including out-of-court procedures).5 The ongoing adoption of the decentralized banking model is likely to make new lending more sustainable, by reducing funding risks. However, the shift in this direction poses challenges. If done too fast it could hamper the recovery in credit (as alternative sources of funding are unlikely to be developed quickly enough), and if taken too far it could imply a suboptimal allocation of resources at a regional level.

At the EU level, the new banking union and regulatory harmonization are shaping a new landscape of banking. These developments are expected to bring positive spillovers for the transition countries in general, by enhancing financial stability and reducing fragmentation. This in turn raises the possibility of further benefits for EU members that decide to join the banking union, reducing compliance costs for cross-border banks and reducing problems of home-host supervision issues, albeit at the cost of loss of autonomy at the individual country level. Either way, the process of adapting to the new frameworks is likely to bring fresh challenges for transition countries in coming years, including for non-EU members.

Box 8.The Vienna Initiative

At the height of the global financial crisis in the fall of 2008, concerns ran high that the CEE economies would suffer a contagious financial meltdown. High external deficits and debt, widespread foreign-currency lending, and foreign-dominated banking raised the specter of an uncoordinated “cut and run” by Western banks, which had extended funding of some US$450 billion to the region—corresponding to over 50 percent of GDP in many countries—thereby triggering a succession of collapsing financial systems and exchange rates throughout the region. Moreover, any multilateral financial assistance granted to CEE countries would prove futile if it merely financed funding withdrawals by Western banks. Another worry was that home country authorities would limit public support schemes for Western cross-border banks groups to their domestic operations, leaving CEE affiliates to fend for themselves.

The Vienna Initiative sought to address the need to coordinate between the major public and private stakeholders for an effective response to these risks. Following informal discussions, the inaugural meeting was held in Vienna in January 2009. It brought together the key Western parent bank groups, home- and host-country authorities (central banks, supervisory agencies, and finance ministries), and multilateral organizations (EBRD, European Commission, EIB, IMF and World Bank). Parent banks committed in letters signed by top management to maintain CEE funding levels and recapitalize their local subsidiaries as needed for five countries with programs supported by the IMF and the EU (Bosnia and Herzegovina, Hungary, Latvia, Romania, and Serbia). Home-country authorities agreed that any public support for parent banks would not discriminate between the groups’ domestic and foreign operations, while host-country authorities likewise pledged to treat domestic and foreign banks equally. In the context of the “Joint IFI Initiative,” the EBRD, World Bank, and EIB disbursed €33 billion to strengthen banks in the region, complementing the financing provided under IMF- and EU-supported programs. The Vienna Initiative also held annual “full-forum meetings” to facilitate broader policy discussion between representatives across CEE, their Western counterparts, and multilateral organizations.

In the event, the feared financial meltdown did not materialize. Banks remained engaged not only in the five countries with explicit exposure maintenance agreements but in the region as a whole. Overall funding by Western banks for CEE declined by less than funding to other emerging market regions at the peak of the crisis. The initiative’s activities diminished as the global financial crisis subsided over the course of 2010. Exposure maintenance agreements with banks were often relaxed and some lapsed as IMF and EU-supported programs ended.

The initiative was re-launched as “Vienna 2” in January 2012 in response to renewed risks for the region from the euro area crisis. Its focus shifted to fostering home and host authority coordination in support of stable cross-border banking and guarding against disorderly deleveraging. Western banking groups continued to play an important role in the initiative, both by supporting the coordination efforts and by doing their own part to avoid disorderly deleveraging. The initiative developed numerous inputs for the design of the European banking union with a view to fostering integrated and effective financial sector oversight of banks throughout CEE. For non-EU countries in the region it facilitated “Host Country Cross-Border Banking Forums” to improve practical aspects of cooperation between the authorities of a host country and the authorities of the home countries of its banks. While “Vienna 2” did not involve exposure maintenance arrangements for banks, the evolution of foreign funding for CEE banks and their lending activity was closely monitored, with the main findings published in quarterly “CESEE Deleveraging and Credit Monitors.”

Prepared by Christoph Klingen. See www.vienna-initiative.com for further details and publications.

See Ingves (2001) for a fuller description of IMF involvement.

See IMF (2013a) and “CESEE Deleveraging and Credit Monitor”, Vienna Initiative, various editions.

The relative roles of supply and demand factors in the deleveraging process have been a subject of considerable debate (See Avdjiev et al. 2012).

IMF (2013a), Feyen et al (2012), and Ongena et al (2013). Possibly because foreign banks tend to have larger foreign fund needs, earlier literature also showed more aggressive credit curtailing by foreign banks. De Haas et al. (2013) and Popov and Udell (2012) find that multinational bank subsidiaries in Emerging Europe cut lending more than domestic banks. Cull and Martinez Peria (2012) find that foreign banks lent less during the crisis.

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