An EBRD delegation took to the Swiss Alps this week for the traditional World Economic Forum in Davos. An annual get-together of the great and the good, it’s the sort of place where you can’t walk more than 50 yards without spotting a Nobel laureate, a prime minister or another G8 central bank governor.

London Mayor Boris Johnson was a draw for a lot of the UK press. German Chancellor Angela Merkel opened the meeting with a speech that made clear she was determined to work towards a resolution of the eurozone crisis, but financier George Soros issued a stark warning about the dangers of too much austerity.

One senior UK editor said he had been told by his London desk that the mood in Davos was more optimistic than expected. But that wasn’t his own impression in the snow-laden streets of the Swiss ski resort.

It had stopped snowing by the time the EBRD delegation arrived but WEF founder Klaus Schwab had said earlier that he had not witnessed so much snow in the run-up to this year’s event since the Forum was set up more than four decades ago.

EBRD President Mirow’s meetings included a discussion with Ukrainian President Viktor Yanukovych, which received wide press coverage in the Ukrainian media. On Thursday he participated in a panel discussion looking at the outlook for the “political, social and economic landscape for Russia in 2012″ before heading for a series of bilateral meetings with senior representatives of shareholder countries, key players in our countries of operations and leaders of other international organisations.

In meetings with the media, both President Mirow and Chief Economist Erik Berglof outlined the risks to growth in eastern Europe from a failure to deal with the crisis in the west. They also outlined the coordination measures being undertaken by the EBRD and others to help deal with the impact of western bank deleveraging in the region.

Share on Facebook

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

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

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.

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

Share on Facebook