Some lessons and prospects for financial stability in the EU and CESEE

1. Some lessons and prospects for financial stability in the EU and CESEE Mauro Grande European Central Bank 1st Bank of Greece Workshop on the Economies of the Eastern European and Mediterranean Countries Athens, 14 May 2010

2. CESEE countries: some facts Inter-linkages between EU and CESEE countries Possible impact of the new EU supervisory framework Conclusions Outline 2

3. Prior to the crisis The region’s economic and financial performance was (and still is) rather heterogeneous However, some common risks could be identified High credit growth in most countries → Risk of credit boom Overheatedfinancial and real estate markets→ Risk of asset price bubbles Widening current account deficits→ Increased funding liquidity risks High share of foreign currency loans→ Risk of correlated losses (i.e. market and credit risks) in case of currency depreciation Overall, systemic risks built up gradually in most countries in the years preceding the recent crisis CESEE countries: some facts 3

4. During the crisis Economies in CESEE hit by a severe external financial shock which had material adverse impacts also on the real economies in the region Substantial decline in GDP growth Falling asset prices (housing prices, stock exchange etc.) Sharp devaluation of currencies in countries with flexible exchange rate regimes Deteriorating balance sheet positions of borrowers and banks Credit contraction (or growth moderation) Overall, the risks that had built up prior to the crisis materialised in the last 1.5-2 years Crisis managementmeasures became necessary with the involvement of the IMF and the EU in some cases CESEE countries: some facts 4

5. Inter-linkages between EU and CESEE countries • The highly integrated, small open economies of the region pose certain specific risks to financial stability for the EU via economic and financial inter-linkages: • Intense expansion of some EU banks in CESEE • made their profitability significantly dependant on activities in CESEE. However, this activity somewhat protected these EU banks from the impact of complex structured products • increased risk of contagion from a country-specific shock in the region through confidence and common creditor channel • increased risk of correlated losses (i.e. market and credit risks) in case of currency depreciation • Despite deteriorating profitability and material losses suffered by banks in the region, there was no substantial spill over from CESEE countries to the euro area/EU

6. EU banking system exposures vis-à-vis CESEE and the quality of the portfolio Exposures of EU banking systems to the CESEE countries (% of 2008 lending country’s GDP) Non-performing loan (NPL) ratio and provisioning rate (% of loans) Source: IMF FSI, CBD 2008, June 2009 BSC/WGMA survey. Note: For some countries data for mid-2009 refers to end-March. Provisioning rate is a ratio of provisions to NPLs; for RO provisioning rate refers to Dec 2008 and allows for collateral. Source: BIS. Note: Largest three exposures for each particular CEE country are shown in the graph, smaller exposures are combined under other countries.

7. Contribution of CESEE subsidiaries to selected EU banks’ profits Contribution of CESEE subsidiaries to “most exposed” EU banks’ profits, pre-crisis (% of group profits) Contribution of euro area banks’ subsidiaries in the CESEE countries to the profits of selected EU banking groups(% of group assets) Source: individual institutions’ financial reports Source: individual bank reports 7

8. Inter-linkages between EU and CESEE countries • The close financial inter-linkages pose certain risks also to the financial stability of CESEE economies: • provision of high risk products (e.g. foreign currency loans) to customers who may not be aware of the associated risks (un-hedged position) • tendency to retrench during the crisis in case the activity is not relevant for the group as a whole (but could be so for the host country) • increased funding liquidity risks, due to high concentration of bank funding sources to a specific country/group of countries • However, parent banks have recently committed themselves to maintain business activities in host countries and to provide liquidity for subsidiaries • The “Vienna initiative” is a good example of cooperation between banks and authorities in home and host countries • In sum, both stabilizing and de-stabilizing forces could be observed during the crisis, therefore it is difficult to draw firm conclusions as regards the overall impact

9. CESEE banking sector funding vulnerabilities:Reliance on external funding: high and concentrated CESEE countries’ reliance on borrowing from EU large banks (% of 2008 borrowing country’s GDP) Shareof external funding in total banking sector funds (%) Source: ECB, BSC/WGBD Note: Share of external funding = (External liabilities)/ (Total liabilities – Capital&Reserves - Remaining liabilities) Source: BIS. Note: Largest three exposures for each particular CEE country are shown in the graph, smaller exposures are combined under other countries.

10. Inter-linkages between EU and CESEE countries • Given the close inter-linkages and the existing contagion channels, risks between euro-area/EU and CESEE countries should be identified, analysed and assessed in a more effective and timely manner • Availability and accessibility of data should be improved • Analytical tools and modelling techniques need to be enhanced • Effective and coordinated policy response is necessary • Home-host cooperation is key in developing and implementing policy measures efficiently • Regulatory arbitrage should be avoided. Risks of circumvention of rules through • Branches or cross-border provision of services • Non-regulated entities New EU supervisory framework should help address these issues

11. A new EU framework for macro-prudential supervision is being set up A new body – the European Systemic Risk Board (ESRB) – will be set up in the EU to oversee systemic risk The ESRB will monitor developments within the EU financial sector and in the interplay between the financial sector and the real economy It will identify systemic risks at the EU level and assess the impact of their materialisation on financial stability It will issue risk warnings and policy recommendations mainly in the regulatory and supervisory field It will collaborate closely with the IMF and the FSB on macro-prudential issues The ECB will provide the analytical, statistical, logistical and administrative support to the ESRB Possible impact of the new EU supervisory framework: ESRB 11

12. The ESRB could have an important role to play also in relation to financial stability inter-linkages between EU and CESEE countries The ESRB will promote better data availability and analytical tools for identifying and assessing systemic risks The ESRB will monitor potential sources of risks originating from outside the EU having an impact on the EU financial system and the other way round The ESRB might issue recommendations concerning individual countries or set of countries in the EU that can have a bearing on financial stability in non-EU countries The ESRB, together with the ESA, could promote cooperative arrangements among banks in light of macro-prudential considerations Possible impact of the new EU supervisory framework: ESRB 12

13. An enhanced EU framework for micro-prudential supervision is being pursued A new supervisory system – the European System of Financial Supervision (ESFS) – will be set up in the EU The ESFS will consist of a network of national financial supervisors working in tandem with new European Supervisory Authorities (ESAs) The ESAs will have the power to adopt binding supervisory standards and possibly take binding decisions in some supervisory areas leading to enhanced convergence in supervisory requirements and practices The ESAs will have a strong coordination role concerning the functioning of the colleges of supervisors Possible impact of the new EU supervisory framework: ESFS 13

14. The ESFS is also likely to have an important role on the financial stability inter-linkages between EU and CESEE countries. In particular, the ESAs - through their coordination role - could: promote a more effective monitoring by the colleges of supervisors of risks incurred by the individual financial groups as a whole and therefore contribute to their stability favour enhanced cooperation between home and host supervisors including in terms of balanced assessment of relevant risks for home and host (including non EU) countries promote avoidance of regulatory arbitrage by banks Possible impact of the new EU supervisory framework: ESFS 14

15. The are financial stability inter-linkages between euro area/EU and CESEE countries that need to beidentified, analysed and assessed more effectively The new supervisory architecture in the EU is expected to contribute positively to this objective, thus having a positive effects with regard to the overall financial stability This needs to be seen in conjunction with: the necessary improvement of risk management practices to be pursued by banking groups in Europe the enhancement of capital and other prudential requirements being considered by the BCBS that will be reflected in EU legislation Conclusions 15