Peer pressure, positive market reaction to previous stress tests, and risks of leaks in the European multi-player setting can argue for publishing the results of the CEBS stress tests in some form, and back them up financing plans. These can include raising capital from markets and use of unutilized national bank support packages (raising the issue of burden sharing between home and host authorities); at the margin, IFI/EBRD equity support for bank subsidiaries in the region can also help. Careful use of new EU competition policy to avoid abrupt deleveraging will be very important. Coordination with the IMF with regards to both the results and their communication would be also necessary.

Background Central banks and regulators increasingly use stress testing to assess the quality of their banks’ portfolios in the wake of the ongoing financial crisis. This is used to determine the amount of any additional capital that banks may need so as to reach an acceptable level of capitalisation in the face of shocks.   In the face of persistent uncertainty about bank portfolio quality, markets have learnt to expect these assessments. Many observers consider that such information and ensuing measures are critical to reduce market uncertainty so that banks can resume lending with reasonably “clean books.” 

  Currently, two major Europe-wide stress testing exercises are underway with very similar timetables.   At the request of the EFC, stress tests are being performed on the 22 EU-based largest bank groups that, as with the US, also cover over 60% of EU banking sector assets (the list is not public). There is no plan for publication of the results at this point. In parallel, the IMF is also conducting a regional stress test. As before, the IMF is expected to publish its results at least at the aggregate level, also in the autumn. Finally, several Central European countries (Czech Republic, Hungary, Poland, etc) have embarked on a harmonized stress testing of their banks, but it is unclear how far this exercise is going.

Three issues to consider:

1. Communication/publication of the results.

  2. Financial plan for the results. The real challenge for policy makers is to prepare for the results with a credible financing plan. As with the US, financing could be a combination of private solutions and access to unutilized portions of already announced national bank support packages:

  3. Careful application of the European Union’s Competition Policy.  The Commission has just revised, with effect through end-2010, its competition policy in the financial sector, with the objective of addressing earlier serious concerns over applying “corrective measures” that normally accompany the approval of state aid for an economic entity in an EU member state for Europe’s crisis-ridden banks of systemic importance.  The new policy appears to be more flexible – providing more time for adjustments –; focussing more on competition issues and less on “corrective measures” to cut exposures; and it is also more explicit in discouraging home-bias (see for example para. 33). That said, the new rules are likely to be tested in the context of possible recapitalisations using state aid in the context of stress tests and it will be important to ensure that EU competition policy does not encourage home market-oriented, disruptive exposure cuts to emerging Europe.

Share on Facebook

When the  global financial crisis hit the transition region, worries among policy makers  centred on the local banking systems and the potential for financial contagion  from west to east. And when unemployment started to rise and output declined sharply  as of Q4 2008, the attention shifted towards the real-economic impact of the  crisis.

Now, notwithstanding more frequent discussions about green shoots and a  bottoming-out of the crisis, the focus is   moving back again to the financial sector. The main question is to what  extent the problems of (credit-constrained) households and firms may backfire and  lead to a second round of financial-system stress. The development of banks’  non-performing loans (NPLs) may provide a partial answer to the question of where we are going to end up in 2010.

To this  end, this blog takes a look at recent detailed information on the development  of NPLs in 21 of EBRD’s countries of operation. A methodological caveat upfront:  widely differing definitions and limited data availability pose serious  constraints to this kind of exercise¹.

Given these challenges it is advisable to focus the analysis of NPL ratios on  relative rather than absolute changes. Moreover, the NPL numbers presented here  only present the ‘official’ picture: rating agencies have repeatedly underlined that ‘true’ NPLs may be substantially  higher in a number of countries. An important reason for the sometimes diverging  official and unofficial statistics is that some banks pre-emptively restructure  or roll-over bad loans. In such cases official NPL figures are edging up only  slowly. Our focus on relative changes can alleviate but not solve this  information problem. With that out of the way,  a number of interesting patterns emerge:

First, Figure 1 reflects the wide variation in NPL  dynamics across the transition region. Roughly speaking there are – as yet –  moderate increases in Central Europe, more pronounced dynamics in South-Eastern  and Eastern Europe, and stronger increases in the Baltics, Russia, Central Asia  and Mongolia. While it is too early for a final verdict, there seems to be a  negative correlation between the increase in NPLs and the foreign ownership of  local banking systems. Latvia would be  the main exception to this observation.

Figure 1: Relative changes of non-performing loan ratios since June 2008

The strongest dynamics are seen in Russia,  Central Asia, Mongolia,  Georgia and Latvia.  In all of these countries NPLs increased more than two-fold between June 2008  and March 2009. For instance, Mongolia’s NPL indicator climbed to 3.6 times its June 2008 value,  reflecting the liquidity and solvency crisis in the Mongolian banking system in  the wake of a protracted period of very high inflation, increasingly  overindebted borrowers, and tugrug depreciation. Also in Latvia NPLs increased  more than 3 times,  followed by Estonia (2.6x), Russia (2.4x), Kazakhstan (2.4x), and Tajikistan (2.2x). Georgia is an interesting outlier in the sense that NPLs doubled  immediately after the armed conflict in August 2008 and then continued to  increase at a slower pace.

Second, and in sharp contrast to the above, the increases  in the three Central European countries in our sample have so far been much  smaller. The Hungarian NPL ratio fell during the second half of 2008 and showed  only a slight uptick in Q1 2009. The Slovak NPL ratio increased to  only 1.4 times its June 2008 level. The Polish NPL ratio has barely moved. The  pessimist will note that this reflects a strategy of procrastination among  banks as they consistently and persistently roll-over their dubious loans. The  optimist, however, will point out that this pattern may also reflect that the  upgrading of risk-management systems by foreign parent banks across Central Europe  is bearing fruit in these difficult times. The jury is still out and more  information will become available in the coming months.

Third, the South-Eastern and Eastern European countries are  sandwiched somewhere between Central   Europe on the one side and the  harder-hit countries further east on the other side. Countries like FYR  Macedonia (1.1x), Bulgaria (1.4x) and Serbia (1.6x) appear to be closer to  Poland and the Slovak Republic, while Albania, Romania, Turkey and Ukraine saw  their NPL ratios double.

Fourth, NPL ratios  increased across the board in April and May this year. On the low end, we find  (again) Poland and the Slovak Republic with only moderate increases. On the high end, we find a  remarkable increase in Kazakhstan from 15.2 per cent in April to 29.2 per cent in May, i.e.  5.7 times the June 2008 level. Three factors are likely to have contributed to  this sharp recent increase.

First, some of the large banks have been in debt  restructuring talks and as such may have had to come clean about their  portfolio quality. While Kazakhstan was hit by the crisis as early as August 2007 NPL ratios  did not move much for about a year, a period during which some banks rolled  over past due loans to both corporate and retail clients. Second, the February  2009 Tenge devaluation has gradually been feeding through the real economy as  unhedged FX borrowers found it difficult to repay their bank loans. Third, the  increasing NPLs also reflect further price declines of Kazakh real estate, a  sector to which the main Kazakh banks were overexposed.

Fifth, the  fate of the Kazakh banks reveals a broader relationship between NPL increases  and real estate developments. We find that collapsing real house prices and  relative increases in NPLs go hand in hand in other countries, too (Figure 2).

Figure 2: Correlation between house price collapses and relative changes in non-performing loans

It is a well-known fact that loan quality lags the business  cycle. During good times banks quickly expand their credit portfolios, the age  of the average loan is low, and non-performing loans are few and far between. In  contrast, during a business cycle downturn or a crisis, the inflow of ‘fresh’  loans is reduced, the average loan portfolio of banks matures and loan problems  become increasingly apparent over time. NPL  ratios increase particularly fast as they combine the effect of weaker loan quality in  the numerator with lower loan growth in the denominator. We expect therefore  that during the next couple of months, when economic ‘green shoots’ will hopefully  become increasingly visible, we may be confronted with the lagged legacy of the  2007-2009 crisis in the form of a further increase in non-performing loans.

¹ Only half of the countries use 90 days as the threshold  after which an overdue  loan is considered non-performing, for 6 countries  there is no methodological information, and 9 countries offer no monthly or  quarterly data. In this blog, we use March 2009 as the latest date since data  availability is spotty afterwards.

Share on Facebook

First, one needs to make a clear distinction between cross-border foreign bank lending and local lending. In the former case, multinational banks lend from their headquarters to a company abroad. In the latter case, they use a local network of branches and subsidiaries. The latter form of foreign bank lending is much more stable than the former (García Herrero and Martinez Peria, 2007). Peek and Rosengren (2000) find for Latin America that cross-border lending did in some cases diminish during economic slowdowns, whereas local lending by foreign banks was much more stable. For Central and Eastern Europe, De Haas and Van Lelyveld (2004) find that reductions in cross-border credit were generally met by increases in lending by foreign bank subsidiaries, either because new subsidiaries were established or because the lending of existing affiliates increased.

Emerging markets that allow cross-border bank lending, but put up (in)formal barriers to brick-and-mortar foreign bank entry thus do themselves a disservice. Of course, such countries could choose to not allow any form of foreign bank lending, neither cross-border nor through local affiliates. This brings me to a second important issue.

Discussions about the supposed fickleness of foreign banks often ignore the question of what is an adequate comparison group or counterfactual. Since all bank lending tends to be procyclical, in particular during crisis periods, an important question is whether foreign bank lending is less (or more) stable compared to lending by domestic banks. It may be less stable, because parent banks reallocate capital to other countries when an emerging market goes through a business cycle downturn. Parent banks redistribute group capital across various subsidiaries on the basis of expected investment opportunities (De Haas and Naaborg, 2006). It may be more stable, because parent banks usually can support subsidiaries that somehow get into financial difficulties (domestic banks lack such parents with deep pockets). This latter argument has often been used to argue why foreign bank entry in transition countries has contributed to more stable financial systems in this region.

In a forthcoming article, Iman van Lelyveld and myself analyse a large bank-level dataset of foreign bank subsidiaries across the world, to compare lending by foreign bank subsidiaries with lending by domestic banks. The dataset includes 45 multinational banks from 18 home countries with 194 subsidiaries across 46 countries (see figure 1). For each host country, we also collect data for a benchmark group of up to five of the largest domestic banks. In the empirical analysis, we look at how yearly credit growth is affected by a number of bank-specific financial variables, macroeconomic determinants, as well as an indicator of whether the host country is experiencing a banking crisis.

We find that subsidiaries of stronger parent banks – with high net interest margins or low loan loss provisioning – grow faster and that parent banks trade off lending across countries. Importantly, as a result of parental support, foreign bank subsidiaries do not typically rein in their lending during a financial crisis. In sharp contrast, we find that domestic bank lending decreases substantially during local banking crises. Apparently, subsidiaries can rely on parental support during a financial crisis, a form of support that is not available to domestic banks. This finding confirms similar results reported by De Haas and Van Lelyveld (2006) for a sample of transition countries.

Figure 1: Parent banks (black) and their foreign subsidiaries (white)

(click to enlarge)

These findings imply that across the board, openness to multinational bank subsidiaries may actually benefit host countries. Multinational banks provide a stabilizing factor during local financial turmoil in particular. Our results also show, however, that the health of parent banks matters a lot: weak parent banks can provide less support and their subsidiaries grow more slowly. Lending by foreign subsidiaries may even be scaled back in order to free up capital for the parent bank, leading to contagion from home to host countries. Of course, this caveat has become quite acute during the current global financial crisis, which has clearly been testing the resilience of the support effects that we document in our research.

So far, however, the anecdotal evidence suggests that multinational banks and their foreign subsidiaries have been behaving more or less as can be expected on the basis of historical patterns. That is, cross-border lending – in particular syndicated lending – has decreased significantly, but many multinational banks have so far continued to support foreign subsidiaries. Given the extreme circumstances of the current crisis, in some cases this parental support has been complemented by coordinated efforts of a number of International Financial Institutions. And, as in earlier crises, lending by domestic banks seems to have been hit equally hard, if not harder. Across many transition countries – from Latvia, to Hungary, Ukraine, and Kazakhstan – the domestic shareholders of some of the largest domestic financial institutions have been unable to come up with the additional capital support that these systemic banks needed. As a result, bank lending by these banks has contracted severely, some of them (almost) defaulted, and local governments needed to step in. While foreign bank entry is not a panacea to all banking problems emerging markets struggle with, the empirical evidence seems to suggest that the presence of foreign bank subsidiaries may add to financial stability rather than reduce it.

References

De Haas, Ralph and Iman van Lelyveld (2004), Foreign bank penetration and private sector credit in Central and Eastern Europe, Journal of Emerging Market Finance, 3(2), 125-151.

De Haas, Ralph and Iman van Lelyveld (2006), Foreign banks and credit stability in Central and Eastern Europe. A panel data analysis, Journal of Banking and Finance, 30, 1927-1952.

De Haas, Ralph and Iman van Lelyveld (2009), Internal capital markets and lending by multinational bank subsidiaries, Journal of Financial Intermediation, forthcoming.

De Haas, Ralph and Ilko Naaborg (2006), Foreign banks in transition countries: To whom do they lend and how are they financed?, Financial Markets, Institutions and Instruments, 15(4), 159-199.

García Herrero, Alicia and Maria Soledad Martínez Pería (2007), The mix of international banks’ foreign claims: determinants and implications, Journal of Banking and Finance, 31(6), 1613-1631.

Peek, Joe and Eric Rosengren (2000), Implications of the globalization of the banking sector: The Latin American experience, New England Economic Review, September/October, 45-63.

• Click here – to be notified each time a new article is posted to the EBRD blog.

Share on Facebook

New BIS data for the last quarter of 2008 show that BIS-reporting banks significantly reduced their asset holdings across major regions of the world. While in absolute terms most of the reduction took place in advanced countries, in relative terms, emerging markets were hit harder. Our region has thus far been least affected. Furthermore, the decline has been concentrated on a few countries; all others experienced no change or even some increases in net bank capital inflows. Net bank outflows tend to have happened in the most financially integrated countries, but not necessarily in countries with weaker fundamentals; with large outflows both from countries that have already been hard hit by the crisis (Ukraine) and countries that have been resilient so far (Poland).[1]

BIS has reported that, after virtual no change in Q3 2008, the global external claims of BIS-reporting banks shrank by 5.4% in (US$ 1.8 trillion) in Q4 2008, the largest recorded decline ever. The following points are noteworthy:

Among the emerging markets, emerging Asia has taken the hardest hit both in absolute and relative terms. Emerging Europe is the least hit in absolute and relative terms, although the declines (US$ 57 billion) are still very significant.

(click to enlarge)

Within Emerging Europe, the outflows are concentrated in a few countries: Russia, Turkey, Ukraine, as well as Poland, the Czech Republic, and Slovenia. This is a mixture of countries with very different fundamentals and crisis impact. Russia and Ukraine have suffered large external shocks, where the crisis had been unfolding for some time. On the other hand, countries like Poland and Czech Republic have stronger financial systems, and the direct impact of the crisis had been less pronounced. This is in line with earlier crisis experiences which showed that investors withdraw liquidity not only from countries with weaker fundamentals but also from markets in the same region that are deeper and more liquid.

(click to enlarge)

Looking forward, similar trends are expected to have continued – if not deepened – in Q1 of 2009. Develeraging is an inevitable part of banks’ balance sheet adjustment in the context of the global financial crisis. As part of Bank’s crisis response, under the Joint IFI Action Plan, the Bank, together with other IFIs, aims to avoid/limit the destructive, uncoordinated develeraging due to failure of collective action by the key stakeholders: bank groups, home and host authorise, and IFIs.

(click to enlarge)

 

Footnotes:

[1]. Data refers to all cross-border loans, deposits, and securities held by bank offices located in one of the 41 BIS-reporting countries. This includes assets held vis-à-vis all economic sectors, i.e. private and public, or bank and non-bank. BIS uses the category “developing” countries; this note uses “emerging” countries instead.

• Click here – to be notified each time a new article is posted to the EBRD blog.

Share on Facebook