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.

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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)

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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.

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As the creators of these forecasts, we found this both flattering and dismaying. Flattering, because it is nice to be taken seriously. Dismaying, because it was not the reaction we had hoped for.

So, was the reaction justified? Or, to put the question differently: are our forecasts in fact “bearish”, and if so, in what sense?

It makes sense to answer the question by taking the 2009 and the 2010 forecast separately. For 2009, we forecast a deep regional recession, with growth of about -5 per cent on average. This is driven by a -7.5 per cent forecast for Russia and -10 for Ukraine. These numbers are 1.5 and 2 percentage points below, respectively, the latest published IMF forecasts. Because they refer to large countries, they pull down the 2009 regional average below that announced by the IMF, and also below the recent forecast of the European Commission.

Does this make us bearish? Yes and no. Among the published 2009 IFI forecasts for “emerging Europe” right now, ours seems to be the most negative. But this is not driven by a particularly pessimistic view of the future. It is simply an acknowledgment of what we know has happened in the last quarter of 2008, and what we think may have happened – in the case of Russia, based on a government estimate – in the first quarter of this year. Because growth in 2008 was still buoyant in the region until the second quarter and in some countries even the third quarter, the large declines in output in the fourth quarter of last year and the first quarter of this year have a huge impact on the ultimate growth figure for the year, almost irrespective of what happens in the remaining quarters. Even if there is a sharp recovery in the rest of the year, the large contractions we have witnessed in the last two quarter will depress the base from which this recovery happens. The result is a large negative year-on-year growth number.

So, conclusion number one is: for 2009, we are not really bearish. We are simply looking at how much output has already declined (or seems to have declined in the first quarter), and doing the math.

This leads to the more interesting question: our forecasts for 2010. Unlike the 2009 number, which is largely a carryover story, the 2010 number is truly about the future. It reveals what we think about the duration of the recession, and the path to recovery.

On this point, we were torn, reflecting the exceptional uncertainty of the moment. This is described by two polar stories: “You ain’t seen the worst” on the one hand; and “Watch those green shoots” on the other.

“You ain’t seen the worst” points to the fact that the output declines that we have observed in the last two quarters represent the impact effect of the crisis. It is the direct, combined effect of a drop in demand for exports, a sharp financing shock, and a large retreat in commodity prices. The collapse in demand and financing is generating stress in the corporate and household sector. This will result in corporate defaults, rising unemployment, and much higher non-performing loans, putting banking systems under stress, lead to a further tightening in credit, and possibly disrupting corporate supply and payment chains. As a result, there could be a second round of output collapses. The implication of this view is that we may not see a recovery until the financial system has dug itself out from under a pile of bad loans.

“Watch those green shoots” points to recent signs of stabilisation. In most countries for which month-on-month seasonally adjusted industrial output data is available, output does in fact appear to have stabilised beginning in February. In some countries, such as Poland and Turkey, there are even signs of a recent upturn. At the same time, consumer confidence has been stabilising and even turning around in most central European countries (the main exception being Hungary). And except for Lithuania, most of countries on which Eurostat reports are showing tentative revivals of industrial confidence. The green shoots story views this as evidence that the recession has bottomed out, and that the recovery must be just around the corner.

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In our forecasts, we are going with neither of these stories. We are taking the middle ground. Why are we doing that? Part of the reason may be that we are a stodgy old IFI (OK, a stodgy young IFI), so we like to be conservative. But for the most part, the reason is that the middle-ground is backed by the latest and most comprehensive general evidence on the subject available, and that this evidence jives well with what we see on the ground in our countries.

The general evidence on patterns of recovery following financial crises are nicely summarised in Chapter 3 of the IMF’s latest (April 2009) World Economic Outlook. For our purposes, the chapter has three important findings.

Now consider the two polar stories. Clearly, the evidence cuts both ways.

We do not think this will happen, for two reasons:

First, while output declines in emerging Europe have been severe, this crisis is also notworthy for what has been missing: uncontrolled currency collapses, runs on banking systems, coercive policy actions, and political upheaval. These have been the standard staple of emerging market crises in the past. Not here. At EBRD, we think this has to do with the quality of financial and political integration in our region; particularly parent bank financing, and close political and institutional ties with the West. These sources of stability are likely to persist (knock on wood).

Second, there is an unprecedented level of international support: at the macro level, by the IMF and the European Commission; at the micro level, by a triumvirate of IFIs – the EBRD, the EIB, and the World Bank/IFC. In late February, these launched a €25 bn IFI Joint Action Plan to stabilise the financial sector in emerging Europe. The action plan is on track (see for example, the EBRD’s recent deal with Unicredit subsidiaries). It is being complemented by an initiative, joint with the IMF and financial authorities in East and West, to coordinate major foreign-owned banks to maintain their exposures in emerging European countries.

To conclude: the most likely scenario for emerging Europe today is neither a sustained recovery beginning in this quarter, nor a double dip recession with a further generation of output collapses around the corner. Rather, it is a bottoming out of the crisis this quarter and next followed by a slow recovery beginning next year. This is the basic pattern underlying most of our growth forecasts.

This said, there are clearly risks on both sides. In particular, perhaps for the first time in over a year, there is certainly upside risk. It is possible that the dynamic of inventory rebuilding combined with some export stimulus from expansionary policies in the West will generate a virtuous circle of improving confidence and recovering output, even with the financial constraints imposed by weak balance sheets. We cannot assume so at this point, but we certainly hope to be wrong.

[1] “Is Credit a Vital Ingredient for Recovery? Evidence from Industry Level Data”, Box 3.2.

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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.

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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.

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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.

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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.

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The crisis has changed the way we operate. Today’s EBRD is different from that of a year ago. The intensity of work has increased dramatically. Signings of projects are up by more than 30 per cent in the first quarter this year, and the pipeline of projects in preparation has grown far beyond anything previously seen in the twenty-year history of the Bank. Corporate recovery is preparing for a possible increase in demand slumber since the last crisis in the region, and the group responsible for financial institutions is working around the clock.

The changes are equally visible in my own office as we strive to meet the demands of an increased business volume and understand the increasingly complex and rapidly changing context of our projects. The frequency and scope of risk assessments have increased dramatically. There is a heightened sense that things matter – that speed of delivery, but also accuracy, are more important than before. Pressure levels are definitely up, but so is our motivation.

This transformation should not be surprising. In fact this “state-contingent” or “countercyclical” nature, as economist jargon would have it, is what the founders of the EBRD had in mind, at least intuitively, when they signed the Articles Establishing the Bank in 1991. Like the other multilateral development institutions, the EBRD has built up massive stakes in the health of its countries of operation. And like the other regional banks, when its region is particularly affected, as Eastern Europe is by this crisis, the EBRD does not have the option to diversify or concentrate on other parts of the world. As the single largest financial investor in Eastern Europe and with a third or so of its portfolio in equity, the ups and downs of its countries matter greatly.

It is not only that the EBRD by design is vulnerable to economic downturns in its countries of operations, the institution also internalises the many conflicts within and across countries brought out by the crisis. As for the conflicts within countries, the EBRD has a large stake in defending the interests of private entrepreneurs as government bureaucrats may exploit the crisis to expand their empires.

Equally important, national policy responses often also have consequences on other countries, particularly when countries are as closely integrated as in Europe. For some time these interdependencies led to paralysis. Eastern European governments did not address the increasing vulnerabilities in their banking sectors as they thought it was a problem caused by the dominant international banks and their home regulators and supervisors. Governments in Western European felt they could not act without some signs of engagement from their Eastern European counterparts. In the meantime the situation was deteriorating.

When the Western European governments started to address their own banking problems their actions had direct impact on their Eastern European neighbours. Generous deposits guarantees attracted depositors from countries without such guarantees or without the resources to back such guarantees. Over the past six months important bank bailout programmes in Western Europe have helped stabilise the international banks operating in Eastern Europe. Still, there is increasing concern that these programmes will discriminate against subsidiaries abroad.

Moreover, Eastern European governments can also damage the international bank groups by preventing them from transferring profits or adjusting their exposures. The public pressures to interfere are great. Actions by a bank, or a government, in one host country can have consequences for other host countries, either directly or through the balance sheets of the parent banks.

The EBRD with its direct engagement in the countries and through its interests in the health of the international banking groups was set up to internalise these cross-country spillovers. That is the way the Bank has been so active in promoting coordination among regulators, supervisors and banks in Western and Eastern Europe. Through the so-called Vienna Initiative we have – in concert with the other international financial institutions active in our region – brought together the parties in home-host country discussions, public-private sector dialogues and conversations within and among the banks.

A series of meetings in Vienna have produced agreements on the sharing of information and broad outlines of principles for how to share the burden of refinancing and recapitalising the international banks and their subsidiaries between home and host countries. They have also brought about signed commitments in particular countries from the banks to achieve certain levels of refinancing and recapitalisation and from individual governments to implement certain policies.

No matter what their original mandate was the international institutions the global crisis is now testing them. The example of the EBRD illustrates how an institution, in much closer collaboration with its peers, quickly can fill some of the gaps in the European architecture. As the world’s leader further contemplate whether to provide additional capital to these institutions they should also look more closely at how to improve their governance and strengthen their incentives and capacity to respond in a timely and effective manner. There is much to suggest that the international financial institutions will also have a greater role to play in the recovery and in the post-crisis world.

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