Barely recovered from the 2008-09 sub-prime crisis, asset quality is now battered by banks’ exposures to sovereign risk in the euro-zone periphery.

The European Banking Authority (EBA) has consequently instructed banks to increase core tier 1 capital to 9 per cent by mid-2012. This means that banks either have to raise a substantial amount of new equity, not easy in the current climate, or have to reduce their risk-weighted assets (i.e. to deleverage).

International banks are also experiencing difficulties in rolling over maturing bonds. This further constrains their ability to lend, both at home and abroad. According to Morgan Stanley, banks may need to get rid of USD 3,300 billion of assets over the next couple of years.

What does this imply for the host countries where these banks are operating branches and subsidiaries? This blog post presents the results of a recent working paper (De Haas and Van Lelyveld, 2011) in which Iman Van Lelyveld and myself compare the lending of stand-alone domestic banks with lending by multinational bank subsidiaries. We focus on the 2008-09 financial crisis, the previous ‘perfect storm’ that hit multinational banks.

Global versus local

Our analysis is a follow-up to De Haas and Van Lelyveld (2010) where we used similar data to examine bank lending during earlier and more contained bouts of financial turmoil.

At the time we found that during such local crises, subsidiaries of financially strong parent banks typically did not rein in their lending whereas domestic banks had to do so. Strong parent banks can use their internal capital market to provide subsidiaries with capital and liquidity and such financial support has helped stabilise local lending.

The 2008-09 crisis, which struck at the core of the international financial system and affected virtually all large banking groups, clearly calls for a reappraisal of this evidence. Just as strong parent banks supported subsidiaries during local crises, weak parent banks may have discontinued such support during the global crisis.

Weakened parent banks, hit by a reduction in inter-bank liquidity and other funding, may even have used their internal capital market to repatriate funds from subsidiaries to headquarters. Indeed, according to publications in the business press, multinational bank subsidiaries in Russia and the Czech Republic used local liquidity to support their foreign headquarters in Italy and France in the wake of the Lehman Brothers collapse as well as during the current euro crisis.[1]

To analyze these issues, we create a comprehensive dataset on the world’s largest multinational banking groups as well as a benchmark group of stand-alone domestic banks. Chart 1 provides a geographical representation of our sample of multinational bank subsidiaries. It consists of 48 multinational banks from 19 home countries with 199 subsidiaries across 53 countries. Most parent banks and subsidiaries are based in Europe, reflecting the numerous ownership links between western European banks and their subsidiaries in emerging Europe.

Chart 1: Geographical location of multinational bank subsidiaries

Darker colours indicate a larger number of subsidiaries in a country.
Source: BankScope and banks’ web sites.

We also create a benchmark group of domestic banks that consists of the five largest domestically owned banks in each of the host countries in our dataset. This results in a sample of 202 domestic banks.

Multinational banking: a double-edged sword

Our analysis reveals that multinational bank subsidiaries had to curtail credit growth more aggressively than domestic banks – about twice as much – during the recent crisis.

We also find that access to deposits, a relatively stable funding source during the crisis, became a stronger determinant of credit growth. Domestic banks, which tend to rely more on local deposits to fund credit growth, were therefore better positioned to continue to lend.

The relative increase in the importance of deposits as a funding source was particularly high for multinational bank subsidiaries. Such subsidiaries typically have better access to alternative (foreign) funding sources, such as the international bond and syndicated loan markets as well as parent-bank funding.

However, when such alternative funding dried up, these banks had to reduce lending more. Indeed, we find that those subsidiaries of parent banks that relied to a greater extent on wholesale funding had to slow down credit growth the most.

Parent banks that could not access external (wholesale) markets were apparently no longer in a position to allocate liquidity to their subsidiary network via the group’s internal capital market. This finding is in line with Huang and Ratnovski (2009) who focus on the funding structure of Canadian banks and show that a lower share of wholesale funding in total liabilities made bank lending more resilient during the recent crisis.

In all, we conclude that while multinational banks may contribute to financial stability during local bouts of financial turmoil, as shown in De Haas and Van Lelyveld (2010), they also increase the risk of ‘importing’ instability from abroad.

Foreign bank subsidiaries’ access to parent and wholesale funding, one of their main competitive advantages before the crisis, turned out to be a mixed blessing when these alternative funding sources dried up after the Lehman Brothers collapse. Banks’ excessive reliance on wholesale funding may have negative effects on financial stability, both at home and abroad.

Outlook

Our findings do not bode well for countries whose banking systems are to a large extent owned by multinational banking groups. The funding pressures that many of these banking groups are currently experiencing may be more severe than they were three years ago.

The urge to deleverage will therefore be higher too. An important risk is that banks may feel pressure to let this deleveraging take place abroad rather than at home. Although the EBA has announced that banks should not put ‘undue pressure’ on their lending to countries where they operate branches and subsidiaries, there are early signs that multinational banks are increasing their ‘home bias’.

Italian UniCredit has announced to review and narrow down its operations in Emerging Europe and German Commerzbank will temporarily reduce its foreign lending (except forPoland, where it operates a subsidiary).

It will be of paramount importance for those countries at the receiving end that regulatory measures do not interfere with multinational banks that try to support foreign subsidiaries. Two weeks ago, the Austrian financial supervisors, worried about their country’s AAA status, instructed their main banks to limit their lending to Central andEastern Europe, including to these banks’ own subsidiaries.

Future credit growth of these subsidiaries will need to be financed mainly through local (deposit and other) funding. The new prudential limits set by the home-country supervisor imply that for new lending flows the loan-to-deposit ratio should be below 110 per cent. This means that parent banks can only to a limited extent ‘top up’ local funding by allocating additional liquidity through the group’s internal capital market.

As a result of such partial ring-fencing, subsidiaries will increasingly have to stand on their own financial feet, raising local deposits and other local funding to finance their local lending.

While such prudential limits may cushion the cross-border transmission of financial shocks going forward, national regulators should ensure that their actions do not unduly exacerbate multinational banks’ home bias in the short term.

Such uneven deleveraging would put further pressure on economic growth across large parts of Emerging Europe.

References

De Haas, R. and I.Van Lelyveld (2010), “Internal Capital Markets and Lending by Multinational Bank Subsidiaries”, Journal of Financial Intermediation 19(1), 1–25.

De Haas, R. andI.Van Lelyveld (2011), “Multinational Banks and the Global Financial Crisis: Weathering the Perfect Storm”, EBRD Working Paper No. 135, European Bank for Reconstruction and Development,London.

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What has been the impact on the EBRD region thus far?

Financial market volatility increased. The region’s main equity markets suffered significant losses of 15 or more per cent since the beginning of August, with Ukraine’s stock market losing over a quarter of its value.

Risk premiums increased and have remained elevated, although well below their 2008-9 peaks. Volatility of exchange rates in most countries with floating rates has increased, with Polish zloty and Turkish lira markedly depreciating vis-à-vis the euro and US dollar, respectively.

The exchange rate of the Hungarian forint vis-à-vis the Swiss franc has moved to an all-time low, before the recent move by the Swiss National Bank (SNB) to devalue the franc.

Output has slowed in some large countries, but not uniformly. Recent data releases and advance macroeconomic indicators suggest that output growth has slowed markedly in some large countries, most notably in Bulgaria, Hungary, Romania, Russia, and Ukraine.

This could already reflect growth deceleration in Europe in the second quarter and, in the cases of Russia and Ukraine, lower commodity prices. At the same time, other countries such as Kazakhstan, Poland, and Estonia recorded healthy growth rates, even above the Q2 rates that we were expecting in July.

Policy responses to these developments in the EBRD’s countries of operations have been limited. In Russia, the central bank had to intervene in the foreign exchange market for the first time this year, and the Treasury committed to placing up to around US$ 7 billion equivalent in rouble deposits with commercial banks.

As a result, liquidity in rouble markets has been largely maintained, with no significant interest rate spikes. The Turkish central bank has reduced the policy rate by 50 basis points in anticipation of further output slowdowns. In June, Hungary announced a scheme to shield household borrowers from the adverse impact of foreign exchange fluctuations until 2015 (implying large fiscal or financial sector liability).

A similar programme was announced in Croatia in mid-August. Hungarian municipalities have also demanded easing of debt service to banks on Swiss franc-denominated loans. The Polish government has sought reduction of transaction costs on servicing of foreign currency mortgages, although so far has opposed intervention to ease the debt service burden.

In light of more limited fiscal space compared to the pre-crisis period, fiscal tools have largely remained unutilised.

Global financial markets risk indicators

Parent banks’ risks (CDS, in basis points)

Equity market (index, January 2011=100)

Output growth in Q2 of 2011 (q-on-q, seasonally adjusted, annualised)

Is the region in a better shape today than before Lehman collapse?

Would the economies of the EBRD region be able to withstand further external shocks? How does the situation today compare to that before the 2008-9 crisis?

In a number of countries, macroeconomic vulnerabilities are elevated.

• Just like in 2008, many countries in the EBRD region are highly integrated with Western Europe and hence vulnerable to a slowdown in the European Union. Countries in Central and Southern Europe are particularly heavily exposed to the Eurozone through various linkages, notably exports, FDI, cross-border financial claims and remittances. Several neighbouring countries also depend on EU demand for their exports.
• As financial sector fragility is expanding beyond Greece, a larger group of countries could be affected through financial channels. A number of countries with financial systems most integrated with eurozone’s banking groups are likely to experience credit growth slowdown and potential new wave of de-leveraging as parent banks hoard liquidity. Parent banks’ commitment to further recapitalisation of their subsidiaries would be limited by their constrained ability to raise new capital.
• Stocks of private external debt largely accumulated during the pre-crisis boom years remain large. In many countries, much of the accumulated debt continues to be of short maturity;
• Rollover needs for public debt have increased as stocks of public debt and fiscal deficits are now larger in many countries;
• Dollarisation of the financial sector remains high despite some progress in this area, thus leaving little room for monetary policy to respond to re-emerging output gaps as external demand deteriorates. In several countries (including Hungary and Poland), large shares of household mortgages are denominated in Swiss francs with negative implications of banks’ capital, mitigated to some extent by the recent SNB action;
• Capacity to use official financial assistance maybe more limited as a number of countries have already benefited from large official financing programmes during the crisis and as the level of public debt has risen;
• The level of non-performing loans remains high, and, partly related to this, banks are cautious about lending;
• Energy export dependent economies (e.g., Azerbaijan, Kazakhstan and Russia) may suffer from a large decline in energy prices, although their oil funds are large and should provide some room for manoeuvre.

However, there is an upside too.

On a number of measures of macroeconomic vulnerability, the region looks better than before the last crisis:

• Current account deficits have declined from their pre-crisis excessive peaks; so a new stop of capital flows would not result in demand and import compression of the same magnitude experienced in 2008-9 and lower exchange rate pressures.
• Capitalisation of the banking sectors is also higher, helping to mitigate risks from the large stock of nonperforming loans.
• Liquidity and funding structures—including loan-to-deposit ratios—have also improved.
• Some de-dollarisation has taken place in many countries as the regulatory environment has tightened against foreign exchange lending to unhedged borrowers and banks’ risk management practices have improved to take more account of risks from lending to unhedged borrowers.

• Compared to the pre-crisis period, the strength of public and private balance sheets is not overstated by cyclical factors and rapid capital inflows.
• With the possible exception of Turkey, most countries in the region did not attract significant inflows of hot money as monetary conditions in the US and Europe eased.
• Many countries have demonstrated ability to adjust their fiscal sectors after the crisis. Although stocks of public debt are higher now, in most countries they remain at reasonable levels.

It is difficult to come to a definitive view on whether the region is more or less vulnerable than it was just before the Lehman collapse.

In some important respects, the region’s economic fundamentals have improved compared to 2008. A lot of external adjustment has already happened, banking systems have been recapitalised and there are no bubbles waiting to be pricked.

In some other respects, the situation has worsened: there is less fiscal space, the stocks of nonperforming loans remain high and the international community may have less firepower to help, although most of the transition countries are relatively small compared to the available IMF resources.

As the region is closely integrated with the EU and domestic demand and credit growth are still relatively weak, the recovery is very fragile. Output growth has already been weakened by recent developments, and it will likely stall unless a further slowdown in growth in Europe and the US can be avoided and markets recover reasonably quickly.

The future of the European banking groups is a new significant source of uncertainty. Potential financial shock to the region would be much more significant than in 2008 if international policy community is unable to prevent significant deleveraging or, in extreme, failure of a significant international bank.

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Ringing the changes

The Vienna Initiative, a framework for coordinated crisis management between EU-based cross-border bank groups in emerging Europe co-founded by the EBRD in 2009, has now reached a new phase. It has moved out of crisis management and resolution, and in to crisis prevention. The new phase has been called Vienna Plus.

To mark this shift in this historically unique public-private partnership, the EBRD has produced a timeline of events so far.  

What is the Vienna Initiative?

The Initiative was set up to provide a framework for coordinating the crisis management and crisis resolution of financial sector issues that were highlighted by the economic downturn.

It brings together public and private sector stakeholders of EU-based cross-border bank groups present in emerging Europe, including:

• IFIs (IMF, EBRD, EIB, the World Bank)
• European Institutions (European Commission, ECB as observer)
• home and host country regulatory and fiscal authorities of large cross – border bank groups
• the largest bank groups operating in the EBRD region.

The EBRD was a lead founder of the Initiative, using its unique relationships with the private sector as well as governments and its mandate to promote transition and development through the private sector.

The timeline

The timeline enables a fresh look at the achievements of the Initiative, from its organic evolution as a spontaneous response to the crisis by IFIs, governments and cross-border banks, to providing policy focus which stimulated market confidence and trust.

The first phase covers the period September 2008 to March 2011, highlighting the main events and selected related documents. It shows that after Lehman’s collapse, the Initiative began as a spontaneous drive by some IFIs, governments and cross-border banks with deep concern that the crisis may damage or even rip apart Europe’s deeply integrated markets.

They wanted to promote a pan-European coordinated policy response at the time when the latter was, during the early shocks of the crisis, limited to largely uncoordinated national responses with potentially large negative cross-border spill-overs.

The timeline shows that the Initiative evolved and adapted quickly and flexibly as circumstances warranted it. By virtue of its unique private-public sector composition and informal but close-knit network, it managed to be “ahead of the curve” and detect or bring into policy focus new issues as they emerged. Virtually all crisis responses in Emerging Europe – by the IFIs, European institutions and governments – were brought together under the Vienna Initiative’s umbrella, giving rise to unique synergies as well as improving market confidence and trust.

Consensus building, good communication and transparency with gentle peer pressure among all its stakeholders – not only banks but also their home and host authorities and the IFIs – have also been instrumental in making the Initiative thrive and succeed.

Vienna Plus

The next phase of the Initiative, known as Vienna Plus, is more about crisis prevention and much less about crisis management. As such, Vienna Plus may become part of Europe’s financial safety net.

Yet its network remains ready to deal with additional post-crisis aftershocks; its successful approach to private sector involvement is now also being considered for the euro zone (see: The Conclusions of the European Council March 24/25 2011).

In the future, other regions that are subjected to major shocks could also benefit from the collective action of public and private sector stakeholders.

RELATED LINKS

See our Vienna Initiative timeline here

For more information about the Vienna Initiative, the EBRD has published a factsheet, available here

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With the exception of those countries with the largest pre-crisis credit booms, credit growth is recovering across the region.

From the end of October to the end of November 2010, credit to the private sector had been steadily growing for several months in most countries, and most strongly for those countries with:

• strong capital inflows (Turkey, Armenia, Poland);
• state-supported lending (Belarus); or
• strong deposit growth following withdrawals during the financial crisis and/or during the Greek sovereign debt crisis (Serbia, FYR Macedonia, Moldova, Georgia).

Credit growth remains slow where the recovery lags (South-Eastern Europe and Slovenia) and negative where pre-crisis credit booms are unwinding or regulatory policies have restricted lending.

In Hungary in particular regulatory policies to restrict mortgage lending in foreign currency combined with underdeveloped local currency funding alternatives contributed to a contraction in household lending.

In Ukraine, private sector credit is growing only slowly, as the unwinding of the pre-crisis credit bubble is offsetting the impact of a return of deposits that were withdrawn during the crisis and before the presidential election.

In those countries such as the Baltics, Montenegro and Kazakhstan, where pre-crisis credit booms were the strongest,  credit continues to contract (Chart 1).

Chart 1

How long might such de-leveraging continue? For example, following three years of contraction, Kazakhstan’s private sector credit stabilized in mid-2010, at levels twice as high, relative to GDP, as in pre-boom 2004.

In contrast, credit relative to GDP only began falling in the Baltics and Ukraine in 2010, whereas in the initial phase of the financial crisis economic activity contracted more sharply than banks reduced their exposures (Chart 2).

Chart 2

At current rates of contraction, it would take Latvia, Lithuania, and Estonia five, eight, and ten years, respectively, to return to a credit-to-GDP ratio about twice that of 2004.

With few exceptions, credit growth has been driven by local currency lending (Charts 3a-b).[1]

Chart 3a

Chart 3b

The exception is Armenia which has received capital inflows, remittance inflows or export receipts because of sharply rising copper prices.

As a result, foreign currency lending contributed more to credit growth than local currency lending.[2] The balance is now also tilting towards foreign currency lending in some countries with strong capital inflows (Poland, Ukraine).[3] Slowdowns in foreign currency credit growth were typically associated with slowing overall credit growth (in the Baltics, Bulgaria, Albania, and Azerbaijan).

Household lending drove credit growth in CEB countries and Kazakhstan and corporate lending elsewhere.

• In the CEB countries and Kazakhstan, corporate credit was still contracting or stagnant at end-November 2010, although mitigated by robust household lending growth in Poland and Slovenia. However, the balance began to tilt over the course of 2010: credit growth of households has accelerated faster than that of corporates.
• Elsewhere in the region, corporate credit has been robust and stronger than household lending growth. In Ukraine in particular, robust corporate credit growth offset the contraction in household credit (Chart 4a).

Both household and corporate lending was typically driven by local currency, except in Poland and Armenia which, as mentioned, have received capital inflows.

[2] Data for much of South-Eastern Europe in principle suggest a similar trend. However, the data does not correct for foreign-currency indexed lending. In Serbia, for example, there has been a pronounced switch away from foreign-currency index lending towards outright foreign currency and (mostly) local currency lending.

[3] In Turkey, despite strong capital inflows, most lending tends to be local currency denominated. Regulation restricts lending in foreign currency to borrowers without matching foreign currency income.

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Disclaimer: The views expressed in this column are those of the authors only and do not necessarily reflect the views of the EBRD, De Nederlandsche Bank or their respective Boards.

In the wake of the 2007–2009 economic crisis, the virtues and vices of financial globalization are being re-evaluated.

Financial links between countries, particularly bank lending, have been singled out as a key channel of international crisis transmission. The International Monetary Fund and the G-20 have identified the volatility of cross-border capital flows as a priority related to the reform of the global financial system.

Indeed, cross-border capital flows declined substantially in the wake of the crisis. For example, after the collapse of Lehman Brothers, syndicated cross-border lending declined on average by 53 percent. Figure 1 illustrates, however, that the magnitude of this reduction differed substantially across countries. An important question therefore is why cross-border bank lending to some countries is much more stable than to other countries. In a recent working paper, we show that access to borrower information is a key determinant of lending stability in times of crisis.

Distance, borrower information and lending stability

Banks’ ability to screen and monitor varies across borrowers: agency problems are more pronounced for opaque companies. When screening and monitoring is difficult, the scope for adverse selection and moral hazard remains high and banks resort to credit rationing (Stiglitz and Weiss, 1981).

Screening and monitoring intensity also varies over time. An adverse economic shock increases the marginal benefits of screening and monitoring as the proportion of firms with a high default probability increases (Ruckes, 2004).

Adverse selection and moral hazard will also increase in reaction to firms’ lower net worth. However, banks face difficulties in offsetting increased agency problems if borrowers are opaque. In response to an adverse shock they therefore resort to credit rationing of intransparent borrowers in particular (Bernanke, Gertler and Gilchrist, 1996).

In a similar vein, we expect that during the recent crisis banks reduced cross-border lending more to countries where they were unable to generate additional borrower information and had to resort to credit rationing instead. We test this hypothesis by using a number of variables that capture the ease with which banks’ can screen and monitor foreign borrowers.

A first factor that determines banks’ ability to screen and monitor effectively is distance to the borrower. It is particularly difficult to collect ‘soft’ information on remote borrowers. As a result, banks tend to lend less to far-away clients (Jaffee and Modigliani, 1971). In line with such geographical credit rationing, we expect that distant firms saw a sharper decline in the supply of cross-border bank lending during the crisis than less remote companies.

Second, the ability to screen and monitor may be positively affected by the establishment of a local subsidiary as local loan officers tend to be better placed to extract soft information from firms. However, while a local subsidiary reduces the physical distance between firm and loan officer, it also creates ‘functional distance’ within the bank. Banks may experience difficulties in efficiently passing along (soft) information from the subsidiary to headquarters (Aghion and Tirole, 1997).

Whether the presence of a subsidiary makes cross-border lending more stable or not therefore depends on whether the positive effect of the shorter physical distance is offset by the negative effect of a longer functional distance.

Third, cooperation with domestic banks can positively affect banks’ ability to generate (additional) information about their clients, as domestic banks tend to have better access to information about the creditworthiness of local firms. We therefore expect that international banks find it easier to lend in times of crisis to countries where they are well-integrated in a network of domestic banks.

Finally, we expect that during the financial crisis banks reduced their lending to a lesser extent to countries where they had built up substantial pre-crisis lending experience. A bank that is more familiar with the culture, institutions, and customs in a country may have less problems in generating useful information about borrowers.

We use a unique dataset with detailed information on international syndicated loans to test whether the abovementioned factors did indeed determine the stability of cross-border bank lending during the crisis. We recreate the monthly lending flows of the 118 largest international banks to all countries of operations. For each bank-destination country pair we calculate the change in average monthly cross-border bank lending in the year after the collapse of Lehman Brothers compared to the pre-crisis period January 2005-July 2007.

We then use OLS and logit regressions to analyse to what extent access to borrower information determined the change in bank lending during the crisis.

Empirical findings

We find that during the crisis banks were better able to keep lending to countries that are geographically close, in which they are well integrated into a network of domestic co-lenders, and in which they had gained experience by building relationships with (repeat) borrowers.

For emerging markets, where trustworthy ‘hard’ information is less readily available and a local presence may be more important, we also find (weak) evidence that the presence of a local subsidiary stabilises cross-border lending.

These findings hold for lending to both first-time and repeat borrowers. Interestingly, the stability of syndicated lending to bank borrowers was not affected by any of these factors. Agency problems and mistrust in the market for long-term inter-bank lending were simply too large for banks to mitigate them in any meaningful way. As a result, the sudden stop in cross-border lending was significantly larger for banks than for non-banks.

Because international banks were more inclined to keep lending to some countries than to others, we document substantial variation in the severity of the sudden stop. Figure 2 illustrates that most countries were unable to offset the decline in cross-border lending through increasing domestic syndicated lending. The left-hand pane shows that there were only a few countries – India, China, Japan – where increased lending by (often state-owned) banks more than compensated for the drop in cross-border inflows.

The right-hand pane shows that most countries experienced a decline in total syndicated lending very similar to the decline in cross-border syndicated lending (observations on the 45º line). This imperfect substitutability between cross-border and domestic syndicated loans implies that the results we document in this column are likely to have had severe consequences for the total lending supply in the destination countries.

Policy implications

Our results bear on the policy debate on financial globalization and in particular on whether and how countries should integrate with global financial markets.  A key feature of cross-border lending that has been a focus of debate, and further underlined by the recent crisis, is its unstable character.

Our findings provide some first answers to the question of when cross-border lending is particularly volatile and when it is not. Perhaps somewhat controversially, we find that banks that are further away from their customers are less reliable funding sources during a crisis.

Clearly, policy-makers not only need to make a decision on whether to open up their banking system but also to whom.

A second finding is that international banks with a local presence on the ground may be more stable providers of credit. For emerging markets that are considering to open up their banking system this implies that stimulating banks to ‘set up shop’ may kill two birds with one stone. Not only do foreign bank subsidiaries provide for a relatively stable credit source themselves, but their presence may also stabilize the cross-border component of bank lending.

Rather than imposing capital controls to reduce the volatility of cross-border lending, countries may thus contemplate allowing international banks to also set up a local affiliate.

References

Bernanke, B., M. Gertler, and S. Gilchrist (1996), The financial accelerator and the flight to quality, Review of Economics and Statistics, 78, 1-15.

De Haas, R. and N. Van Horen, “Running for the Exit: International Banks and Crisis Transmission”, EBRD Working Paper No. 124 and DNB Working Paper No. 279.

Aghion, P. and J. Tirole (1997), “Formal and Real Authority in Organisations”, Journal of Political Economy 105, 1-29.

Jaffee, D.M. and F. Modigliani (1971), “A Theory and Test of Credit Rationing”, American Economic Review 59, 850-872.

Ruckes, M. (2004), “Bank competition and credit standards”, Review of Financial Studies, 17, 1073-1102.

Stiglitz, J. and A. Weiss (1981), Credit rationing in markets with imperfect information, American Economic Review, 71, 393-410.

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How to foster sustained growth in CEE countries

Before the onset of the global financial crisis, transition countries, particularly in Central and Eastern Europe, had embarked on what appeared to be strong and sustainable growth paths.

However, the global financial crisis has brought into question the sustainability of this process and has heightened the need to develop a new growth agenda across the region. A recent working paper by Philippe Aghion (Professor of Economics at Harvard University), Heike Harmgart (Principal Economist at the EBRD) and Natalia Weisshaar (economist at the Royal Holloway College, University of London) responds to this need by proposing a general framework for designing medium-term growth-enhancing policies in CEE countries which devotes particular attention to specific policies relating to competition, education and finance.

Beyond the “one size fits all” approach

The starting point for thinking about policy design is to understand and acknowledge that countries and regions differ profoundly in several important ways and that this heterogeneity call for more nuanced policy recommendations taking into account the country specific circumstances. In particular, it has to be kept in mind that CEE countries differ not only in terms of their level of income, education and infrastructure at the onset of transition. They also differ substantially in the extent to which they have been integrated into the European Union and been able to develop market institutions.

Furthermore, the level of dependency on natural resources varies across the region. Countries relying heavily on such resources tend to suffer from high exchange rates that reduce the scope for economic diversification. More importantly, and particularly when institutions are weak, resource-rich countries also tend to have higher levels of corruption, poorer governance and spending priorities that can adversely affect growth.

Last but not least, income per capita varies widely across the region today; real GDP per capita is highest in CEB, followed by SEE and then the CIS+M resource-rich countries. The authors also find evidence on the positive long-run impact of quality of education on growth, and hence the high return on public investment in education, particularly at the primary and secondary level. The private sector’s role in overcoming skill mismatches will benefit from deepening financial intermediation and reducing constraints in access to finance. The fact that even in CEB per capita GDP is still only 55 per cent of the OECD average signifies the scope for all these economies to catch up.

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The global financial crisis originated in the US sub-prime mortgage market, where banks had gradually relaxed their screening and monitoring standards (Keys et al., 2010). In a recent working paper, Neeltje van Horen (Dutch central bank) and myself analyse whether, when sub-prime losses materialised in the autumn of 2007, banks reassessed their screening and monitoring standards (De Haas and Van Horen, 2010). To answer this question we study changes in the syndicated loan market. This market is particularly well-suited to assess changes in screening and monitoring because the structure of lending syndicates reflects the importance that banks attach to the screening and monitoring of borrowers (Sufi, 2007). A short primer on syndications will make this clear.

Syndicated lending and “skin in the game”

Syndicated loans are provided by a group of financial institutions – the syndicate – to a single borrower. A typical syndicate consists of two tiers: arrangers and participants. The arrangers comprise the senior tier and negotiate the lending terms with the borrower. Arrangers usually allocate a substantial part of a loan to a junior tier of syndicate members, the participants. Participants have a more passive role: they buy a portion of the loan but are neither involved in its organisation nor in the screening and monitoring of the borrower.

Participants use arrangers as delegated monitors (Diamond, 1984). A downside of this functional division is that arranging banks have a reduced incentive to screen and monitor. To resolve this agency problem arrangers can retain a large enough loan portion on their own balance sheet (retention rate). Such “skin in the game” is an efficient mechanism to ensure that arrangers sufficiently screen and monitor (Pennacchi, 1988). We consequently argue that if participant banks became more concerned about screening and monitoring at the start of the crisis – a wake-up call – this should be reflected in a significant increase in retention rates.

By syndicating part of the loans they structure, arrangers free up space on their balance sheet. This allows them to originate additional loans and earn fee income. When arrangers only need to retain a small portion of each loan, they can originate many syndicated loans and the supply of lending is high. Conversely, when capital-constrained arrangers are required to retain a large loan portion, they can syndicate fewer loans and the supply of syndicated credit is lower. Fluctuations in retention rates may thus be inversely related to the supply of syndicated lending. Indeed, Chart 1 shows how at the onset of the crisis in mid-2007 a sharp increase in retention rates was accompanied by a steep decline in syndicated lending.#

  Graph 1. Retention rate and syndicated lending volume (click to expand)

Main findings

The econometric analysis in our paper shows that – even when we control for changes in inter-bank liquidity and borrower risk – the outbreak of the crisis led to a significant and robust increase in arrangers’ retention rates. This increase materialised during the early phase of the crisis – before the collapse of Lehman Brothers and the ensuing sharp output decline – and persisted over time.

In a next step we test whether loan retention increased in particular when information asymmetries between the syndicate and the borrower were large. Lenders likely became most concerned about adequate screening and borrowing in the case of such opaque loans. Similarly we expect that when information asymmetries were large within a syndicate – that is: between participants and arrangers – retention rates increased more as well. To analyse both layers of agency problems – between lenders and borrowers and among lenders – we exploit detailed information on market, borrower and lender heterogeneity.

As expected, we find that retention rates increased significantly more – both in statistical and economic terms – when information asymmetries were high. Table 1 shows the economic magnitude of some of the significant differences we document in the working paper. While the retention rate for loans to first-time borrowers increased by almost 11 per cent, arrangers of syndicated loans to borrowers with average borrowing experience (two and a half loans) only needed to increase their retention rate by 7.6 per cent. The necessary increase in loan retention was even much smaller in case either the arrangers or the participants themselves had previously lent to a specific borrower (or in case they had substantial prior experience in lending to a borrowers’ industry or country). Finally we find that experienced arrangers needed to increase their retention rates much less than less experienced arrangers. Reputation limited the crisis-related increase in agency problems within lending syndicates.

Chart 1. Economic significance of crisis impact on retention rates (click to expand)

Policy implications

We find that more transparent borrowers, more experienced participants, and more reputable arrangers all helped to contain the crisis-related correction in screening and monitoring intensity and thus in retention rates. This strong link between the severity of information asymmetries and the increase in retention rates further underlines that the overall increase in retention rates at the onset of the crisis, and the subsequent decline in syndicated lending, was at least partially caused by stricter screening and monitoring. To the extent that this reflects a reversal of the pre-crisis loosening of lending standards, banks’ continuing reluctance to lend may prove to be quite persistent even when banks’ own funding constraints would gradually become less binding.

Our findings also bear on the current regulatory debate about minimum “skin in the game” retention rates for originating banks. In July 2009 the European Parliament amended the Capital Requirements Directive by including a 5 per cent retention requirement for securitisations, while in May 2010 the US Senate passed the Financial Reform Bill which announces the introduction of similar regulations. Earlier plans to let minimum retention requirements not only apply to securitisations but also to syndicated loans have (at least for the time being) been shelved. At first sight our results confirm that regulatory retention requirements may indeed not be necessary for syndicated loans. After all, we document a strong, broad-based but market-driven increase in retention rates among syndicate arrangers. Participants, concerned about arrangers’ lax screening and monitoring, were in many cases able to take corrective action without regulatory intervention. Although syndicated lending declined sharply, the market did not break down. This stands in contrast to the securitisation market, where the link between the originator and the ultimate investors was too severed to make any corrective (and collective) action possible.

However, when the market for syndicated lending will expand again, and financial institutions once more start to compete heavily to participate in (oversubscribed) syndicated loans, the pressure on arrangers to retain loan portions that are high enough to guarantee sufficient screening and monitoring may gradually erode. Without the introduction of some form of mandatory retention rates for syndicated loans, the risk exists that old practices will soon return. This may in particular be the case if the secondary market for syndicated loans, where both arrangers and participants can offload their loan stakes, revives again. One way to reduce such a negative impact of subsequent loan sales is to require arrangers to hold on to the loan portion they retained at origination. Although such a requirement could be introduced through legislation, participants themselves could also more often demand that restrictions on subsequent loan sales by arrangers are included in loan contracts.

References

De Haas, R.T.A. and N. Van Horen (2010), The crisis as a wake-up call. Do banks tighten screening and monitoring during a financial crisis? EBRD Working Paper No. 117, London.

Keys, B.J., Mukherjee, T., Seru, A. and V. Vig (2010), “Did securitization lead to lax screening? Evidence from subprime loans”, Quarterly Journal of Economics 125, 307-362.

Pennacchi, G. (1988), “Loan sales and the cost of bank capital”, Journal of Finance 43, 375-396.

Sufi, A. (2007), “Information asymmetry and financing arrangements: Evidence from syndicated loans”, Journal of Finance 62, 629-668.

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We’ve just published our latest update on Emerging Europe and Central Asia’s economic outlook which indicates that the recovery in the transition economies is progressing with important exceptions, and highlights the key factors behind this diverse picture.In many countries economic activity was strong in the first half of the year, but the outlook is dimmer, due to the short-term negative demand impact of fiscal austerity  packages and/or global exiting from crisis-related macro policy loosening: (i) in advanced EU countries (main export markets for emerging Europe), (ii) in transition countries themselves  (dampening domestic demand); and (ii) globally, as the rest of the world exits from crisis-related expansionary macro economic policies, weakening global demand for natural ressources and commodities.  Balance sheet pressures on banks active in the region also weigh on credit growth. Significant uncertainty remains both on the downside and upside; however, the balance of risks has shifted to the downside since May.

As a result, the growth forecast for the EBRD’s region of operations has been revised downward by 0.2 percentage points since the last EBRD forecasts in May to 3.5 per cent in 2010, and by 0.1 percentage point to 3.9 percent in 2011:

• The downward revision is most pronounced in both years for South-Eastern Europe where the recession appears to be lingering.
• In Central-Eastern Europe, stronger than projected recent growth, while lifting 2010 growth, is expected to fade in 2011. Some Central European countries have recently witnessed stronger than expected growth, which may spill into 2011; at the same time policy uncertainty can also affect investor confidence in cases such as Hungary.
• Central Asia is expected to grow somewhat more than previously projected on the back of good prospects for commodity exports.

A recovery appears to be underway in the second quarter of 2010, although with notable exceptions. On the back of a global recovery in trade, growth in industrial production and exports increased in most countries in the second quarter. In the largest emerging market countries of the region (Russia, Turkey and, since the presidential election, Ukraine), a return of capital inflows has also contributed to growth. Strong commodity prices, despite some market volatility, have benefited commodity exporters (Russia, Kazakhstan, Armenia and Mongolia).

In contrast, output growth continues to be near zero or negative in most countries of south-eastern Europe, and neighbouring Croatia and Slovenia. Here, recovering exports were offset by weak domestic demand, and financial systems suffered some pressure from the turmoil in Southern European sovereign debt markets. In several countries, net capital inflows remain subdued and credit to the private sector contracted or stagnated. In addition, flood damage reduced GDP in some countries. Another exception to regional recovery is the Kyrgyz Republic where political turmoil has disrupted economic activity.

Inflation pressures continued to subside across the region. In those countries where inflation has picked up since end-2009, the increase was caused by hikes in administered energy prices (FYR Macedonia, Kazakhstan, Moldova and Slovenia), VAT and excise tax rises (Bosnia and Herzegovina, Bulgaria and Estonia), or sharp depreciations (Georgia).

Source: CEIC database and national statistical offices.

The outlook for the remainder of 2010 and for 2011 is generally weaker than recent economic activity suggests. Central and Eastern European countries depend heavily on trade and financial links with the EU. Given the weakening outlook for the Eurozone – as fiscal austerity programmes are implemented and financial markets are likely to remain volatile – the external environment may be less benign than previously projected. Credit growth is expected to remain weak as long as banks’ balance sheets remain under pressure, regulatory uncertainty lingers, and the cost of capital are elevated. In addition, country-specific developments will constrain growth. Several countries have announced additional fiscal tightening measures (e.g., Lithuania, Romania and Serbia). Resource-rich countries in the Caucasus and Central Asia will be affected by a slowdown in commodity prices resulting from shrinking demand from Asia.

Downside risks, mostly due to the external environment, have intensified. The “fan chart” below, which is estimated for EU member states in the transition region plus Croatia, illustrates how the risks have become increasingly tilted to the downside. Fiscal consolidation in Europe and monetary tightening in China may still trigger a sharper slowdown in global growth than currently projected. In this downside scenario, trading partner growth could turn negative in the second half of 2010 and remain negative in 2011. This could be compounded by further deleveraging in the financial sector if capital and liquidity remain scarce and risk aversion rises. Financial market volatility could rise significantly. In addition, if market nervousness over fiscal sustainability intensifies, several countries may require austerity packages to convince markets of the sustainability of public finances. While expenditure-based fiscal consolidation may benefit competitiveness in the medium-term, it would dampen growth in the short-term.

At the same time, prospects for fiscal sustainability are better than in many advanced economies and may result in upside risks. Compared with advanced economies and other emerging markets, public debt-to-GDP ratios in the region are generally low. Many countries are implementing significant fiscal consolidation programmes which, if focussed on expenditure cuts that typically produce more lasting improvements in fiscal balances than revenue increases, should improve fiscal sustainability as well as competitiveness. In addition, medium-term growth prospects are typically stronger than in advanced countries which are planning to implement austerity programmes. As a result, capital flows in search of yield may be attracted to debt markets in the EBRD’s region of operations, helping to push growth in the whole region possibly above 4 per cent this year and closer to 5 per cent next year.

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Participants will be able to assess the latest political, economic and social changes and business opportunities in the country and across our region of operations, as well as a chance to network and to enjoy the host country’s cultural programme.

The Bank’s shareholders will be making important decisions about the strategy of the EBRD for the coming years and how it can be best equipped to carry out its role. The Board of Governors’ sessions will be chaired by the EBRD Governor for France Christine Lagarde, who is also France’s Minister of Economy, Industry and Employment.

A further 19 country presentations will give the Bank’s countries of operations a chance to articulate current investment opportunities. In parallel with the official AM programme, the EBRD and Croatia will co-host an informal meeting of heads of government of South-Eastern Europe on 14 May. The meeting is held in the format of the South East Europe Cooperation Process, which includes Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Greece, Moldova, Montenegro, Romania, Serbia, and Turkey.

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