Nicholas Watson in Prague -

The crisis in the banking system well and truly arrived on continental Europe's shores in October when European governments from Reykjavik to Rome were forced to step in to help out their ailing banks. While Central Europe's banking sector has, so far, escaped any major disruption and regulators in those countries insist that should remain the case, investors are still nervously casting around to see which are at most risk either because of a problem at a parent bank or one of their own making.

Certainly, the sanguine and sometimes smug tone in a lot of research about how Europe's banking industry was in better shape than the US to weather the economic storm began to sound hollow at the end of September when the huge Belgium-Dutch bank Fortis began to buckle, forcing a partial then full nationalisation. This was followed by similar actions in Iceland, Germany and an historic rescue package for the entire UK banking sector.

With the International Swaps and Derivatives Association confirming on October 8 that the collapse of Iceland's Landsbanki as well as Glitnir Bank had triggered Europe's first credit event for credit default swap contracts, which means investors who bought protection against the default of such debt could now exercise their insurance claims, the record CDS rates in many emerging European countries were set to balloon. In early October, the five-year CDS spread for Ukraine was at more than 700 basis points, while the spread had more than doubled over the last month for Kazakhstan, Russia and Latvia (now at 430, 254 and 330, respectively). While Central European countries also suffered a surge in CDS spreads in that month, they still had a relatively lower risk perception than other countries in the region and - with the exception of Hungary - their CDS spreads were far below 100 basis points, according to analysts.

During this time, the biggest player in Central and Southeast Europe with a question mark hanging over it was UniCredit Group. The Italian bank has found itself the largest lender in the region after gobbling up Germany's HVB Bank in 2005, which shoved it out of Italy's ultra-conservative lending market and into what is, relatively speaking, the "wild east." Inevitably, the bank was ill prepared for the coming storm and after botching a €6.6bn capital hike, the market hammered its shares, forcing the bank's chief to admit the bank had underestimated the scale of the global financial crisis.

However, other than UniCredit and Hungary's OTP Bank, which has found its business crimped by the domestic economies' troubles over the past couple of years and its stability questioned, banks operating in the region have remained largely unaffected by what's been going on around them, especially given their minimal exposure to the toxic loans that are poisoning so many western banks. "With loans growing 25% on year, profits soaring 20% and asset quality still at all-time lows in the first half of 2008, CEE banks seem to be living on a different planet when compared to their western peers," says Jiri Stanic at Wood & Company.

Adding to this sense of detachedness are the region's solid economies. Compared to their peers in Western Europe, the economies of emerging Europe are roaring. While Eurozone growth slowed to just 1% annualised in the first half of 2008 and is now flirting with recession, the "Visegrad" economies of Czech Republic, Slovakia, Hungary and Poland plus Slovenia are reckoned by UniCredit to grow 4.7% this year.

Even so, that growth is lower than many had been predicting six months ago and the slowdown further west is clearly starting to bite. "Until now, many countries have maintained their growth thanks to vibrant domestic economies," says Mikael Johansson of SEB Economic Research. "Today, however, pressure on the region's economies has greatly increased as the Eurozone has stagnated and the repercussions of the international financial and credit market crisis intensify."

As Datamonitor puts it bluntly: "Predictions of an economic separation of Eastern Europe from the wider world have turned to be out unfounded."

The question is, therefore, which banks will suffer most from this slowdown?

A matter of geography

Looking geographically, SEB's Johansson says Slovakia, the Czech Republic and Hungary will all be relatively hard hit by the Eurozone slowdown, while Poland will experience a soft landing. As well as having relatively open economies, the Czechs and Slovaks are also dangerously over-reliant on the cyclical car industry. Indeed, Robert Fico, Slovakia's prime minister, recently told bne that, "We are nervous that a huge proportion of investments are in car production." He was echoed by his finance minister, Jan Pociatek, who warned that not only is the country's dependence on the car industry already too big, the situation could even be "dangerous" for Slovakia.

Wood & Company estimates that Czech automobile production represents about 10% of Czech GDP. Assuming 90% of these cars are exported, then a 10% decline in demand for cars made in the Czech Republic could reduce GDP by around 0.9%. "With a 16% year-on-year sump in the sale of new cars in Western Europe in August, the pressure seems like it's on the way," the brokerage says.

The slowdown is already affecting its biggest carmaker. Volkswagen's subsidiary Skoda has announced production cuts as export demand from its Western European market begins to slacken. "Company sources believe that overall output could fall by as much as 13,000 vehicles," say analysts at Business Monitor International.

In Slovakia, the Franco-Belgium-Luxembourg lender Dexia Bank, which has the unfortunate slogan, "short term has no future," is already in trouble. Despite putting together a €6.4bn bailout package, the three governments on October 9 were reported to be planning to create a special vehicle to absorb the toxic assets held by the troubled bank and provide fresh liquidity. The Slovak government moved on the previous day to guarantee savers' deposits at all the local banks.

In the Czech Republic, Komercni Banka, part of the Société Générale Group, is regarded by Wood & Company's analysts at least as "one of the safest bets in CEE." The brokerage says it's well capitalized and highly liquid with a loan/deposit ratio of 64%. It is also well placed to withstand the slowdown due to its conservative lending strategy. "If you are looking for a conservative play in a positive sense, a bank with minimal excitement but hefty support, go for this one."

Apart from UniCredit, the biggest beasts in the region are the two Austrian Banks, Raiffeisen Zentralbank and Erste Bank Group.

Raiffeisen's emerging market arm, Raiffeisen International, saw its shares fall another 18% on October 8, extending its losses to over 50% since the beginning of September. The bank responded by insisting to analysts that it has no significant exposure to the troubled financial institutions such as Lehman Brothers, AIG or other US investment banks or insurance companies. Two weeks previously, the bank reiterated at an investor meeting in St Petersburg, Russia, that it expects to make a net profit of €1bn this year, see annual asset growth of 20% until 2010 and a return-on-equity of 25% by that time. Though not exposed to the toxic US debt assets that are poisoning other banks' balance sheets, it is still feeling the pinch of rising wholesale funding costs, even though it receives most of its funding from parent RZB. Analysts also say that being a pure emerging market play and exposed to risky and overheated markets like Russia, Ukraine and Romania, Raiffeisen International will suffer from negative headlines for some time to come.

Erste, meanwhile, suffered a terrible start to the month. On October 10, the bank was forced to admit that its exposure to the beleaguered Iceland, mainly in the form of senior bank debt split between the major Icelandic banks, totalled €300m, "a shocking amount," says Jiri Stanik of Wood & Company. "This means that Erste - assuming this not is a part of the trading loss already announced - is going to announce another loss equal to 3.5% of its market cap and equity, reducing its profit forecast by further 20%."

Just three days previously on October 7, Erste said its profits would fall well short of previous expectations this year as the financial turmoil and the subsequent increase in wholesale funding would cut into profits and impair the value of its estimated €2.7bn portfolio of structured products. Operating profit is expected to grow just 15% this year as its strong customer base supports sustainable growth in the loan business - "while keeping the loan to deposit ratio below 115%" - which will offset slower growth at its investment banking business. However, net profit will reach more than 50% because of the timely sale of its insurance business, the €1.1bn from which will boost its Tier-I capital to a solid 8%.

Another regional player, Hungary's OTP, on the other hand is not as large nor has the management experience to deal so effectively with the problems that operating in risky markets like Bulgaria, Ukraine and Russia will throw up. The market knows this and has hammered the bank's shares down more than most, prompting the deputy-CEO Laszlo Urban to despair that the stock is falling victim to panic rather than any fundamental issues about the bank's financial position. "Our capital position is extremely strong," Reuters quoted Urban as saying. "We have enough liquidity to survive for our operations until the end of 2009 without raising a single dime from capital markets." Even so, with the Hungarian economy also being more exposed than most to the economic slowdown, analysts say that OTP now looks very much like a takeover candidate.

Polish banks as a whole will benefit from the country being less open to the economic slowdown happening beyond its borders. However, within the sector exists a wide divergence of assets. At the bottom end is Kredyt Bank, which together with Millennium Bank, has been one of the worst performing bank stocks in Poland. It's a risky play, having aggressively expanded its loan portfolio since 2006 in a desperate bid to increase its market share so that its loan/deposit ratio stands at more than 100%.

At the other end of risky is Bank Slaski, which has the lowest loan/deposit ratio of all the banks in Central Europe (43%) while its non-performing loans are less than 2%. Also, rock solid is the country's largest lender PKO BP, whose biggest risk is nothing to do with the market but the constant state interference such state-controlled companies always endure in Poland.

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