COMMENT: Banking System Indicators for US, Switzerland fall

By bne IntelliNews April 9, 2008

Richard Fox, Gerry Rawcliffe and James Moss of Fitch Ratings -

This report updates the bank systemic risk indicators introduced by Fitch Ratings in 2005. The Banking System Indicator (BSI) measures a system's stand-alone strength on a scale from 'A' (very strong) to 'E' (very weak) and is derived from current bank Individual Ratings, both published and - for systemically important non-rated banks - unpublished. The Macro-Prudential Indicator (MPI) is designed to highlight potential systemic stress of a type that has often been preceded by a combination of rapid bank lending growth and bubbles in asset markets and/or the real exchange rate. It gauges this risk on a scale from '1' (low) to '3' (high), with the reference period in this report pushed forward a year to 2005-2007.

Large, global banks in several major developed countries have been hardest hit by the US subprime crisis, marking the current financial crisis out from more familiar, country specific banking crises. The BSIs of the US and Switzerland have both fallen to 'B' (strong) from 'A' (very strong). This is still on a par with most other developed country systems and Fitch does not expect any further fall, despite the likelihood of continued stress, especially in the US. Total losses and writedowns to date fall well short of aggregate US banking system capital, a conventional measure of the severity of a banking crisis and the one used to calibrate Fitch's MPI.

Moreover, much of this has reduced profits rather than capital and Fitch has been impressed by the ability of US banks to raise capital of over $60bn so far. Official action has also been aggressive. Both the US and Switzerland remain MPI 2, the same as two-thirds of developed-country systems, including the UK, where problems have been contained and which remains one of only five BSI 'A' (very strong) systems - all in developed countries. In the US, although property prices were elevated on the eve of the crisis, they were no more so than in many developed countries. Four developed countries are in the highest (MPI 3) risk category - Australia, Canada, Iceland and Ireland, the latter rejoining the category in this report. Of these, Iceland continues to give most cause for concern, with the three main Icelandic banks placed on Rating Watch Negative last week.

Global real credit growth accelerated to a new peak of over 14% in 2007, though it was already slowing in developed countries and is now set to slow sharply to 9%.

Growth remained around 30% on average in emerging Europe and helps explain the move of four more countries in the region to MPI 3 - Kazakhstan, Romania, Slovakia and Turkey, where they join Azerbaijan and Russia. All have weak (BSI 'D') banking systems except Slovakia, which at BSI 'C' is relatively strong for an emerging market, and Azerbaijan, which is "very weak" (BSI 'E'), but where credit/GDP is still low and a mitigating factor. Credit growth remains a concern where credit/GDP is already high and still growing rapidly, as in the Baltics.

Emerging Europe

As explained in previous reports, Fitch uses a modified methodology to assess macro-prudential risk in emerging Europe. Because of the difficulty of assessing trend credit levels where data series are relatively short or display major discontinuities and, more fundamentally, major structural change is taking place, Fitch has shifted the focus of its analysis to real credit growth rather than deviations of credit/GDP from trend. Specifically, real credit growth above a "speed limit" of 15% per annum over a two-year period is sufficient to attract an MPI 2 score, with an additional trigger based on the behaviour of either the real exchange rate or stock markets needed for an MPI 3 score. 12 Regional real credit growth continued at around 30% in 2007 - much the same as since 2005 and double the global average, despite a slowdown in some countries.

Average real credit growth still exceeds the 15% trigger value for 2006-2007 everywhere except Hungary. Hungary is, therefore, the only country in the region to attract a score of MPI 1; all other countries are at least MPI 2 and six are now MPI 3.

Russia and Azerbaijan have been MPI 3 for some time. These two and the four new MPI 3 countries - Kazakhstan, Romania, Slovakia and Turkey - trigger the higher score because of the strength of their real exchange rates. The new MPI 3s were anticipated in the September report, based on forecasts for 2007. However, as explained in previous reports, Fitch has preferred not to base MPI scores on forecasts since the indicators used are quite difficult to forecast. The formal move into the higher MPI category had therefore to await this report, which includes 2007 actuals for the first time. In the case of the four new MPI 3 countries, credit has been growing for some time at a pace which would have supported an MPI 3 score; it is the strength of the real exchange rate in 2007 that has finally pushed them into the higher risk category, notwithstanding recent currency weakness in Turkey and Romania. In Slovakia and Turkey, credit growth is towards the lower end of the range seen in Emerging Europe and less of a cause for concern than in the other MPI 3 countries in the region.

Countries with higher credit growth than these trigger MPI 2 rather than MPI 3 because neither the real exchange rate nor stock market display evidence of excessive appreciation. Of these MPI 2 countries, only Armenia comes close to MPI 3, with high and accelerating credit growth and strong real exchange rate appreciation.

(In Armenia, Azerbaijan, Belarus and Georgia, stock market series are not readily available and their MPI scores are therefore not based on as full information as for other countries. Property price data are also sparse. This could result in MPI scores in these countries being biased downward.) The deepening of financial intermediation throughout Emerging Europe is part of the process of countries' financial structures and income levels converging with Western European levels. Unfortunately, economic theory does not provide clear answers about the appropriate "equilibrium" level (i.e. in line with fundamentals) of credit/GDP or a safe speed to converge on it. The general conclusion is that credit/GDP ratios are still generally below equilibrium, with the exception of those countries with the highest ratios (Estonia and Latvia, at near 100%) and approaching it in Croatia with a ratio of over 70%. The 15% speed limit for the MPI 2 designation is certainly conservative given the pace of credit growth seen in the region in recent years. Rapid credit growth is clearly of more concern where credit/GDP is already high, especially in Latvia and the other Baltics, but also in Ukraine and Kazakhstan, notwithstanding the more recent slowdown there. Rapid credit growth is less of a concern where credit/GDP is relatively low, as in Azerbaijan and Armenia.

Countries can now be divided into three groups according to whether credit growth is slowing, stabilising or still accelerating. Countries where credit growth is clearly slowing are Belarus, Croatia, Estonia, Kazakhstan, Latvia and Turkey, though in Kazakhstan and Belarus nominal credit growth is still around 50% y-o-y. Credit growth is stabilising in Azerbaijan, Hungary, Lithuania, Romania, Russia, Slovakia and Ukraine, though apart from Hungary and Slovakia credit growth remains rapid. The third group of countries, where credit growth is still accelerating, includes Armenia, Bulgaria, Czech Republic, Georgia, Poland and Slovenia, with growth particularly rapid in Armenia, Georgia and Bulgaria.

The beginning of a slowdown in credit growth, especially in some countries with relatively high credit/GDP, has begun to bring a more plausible negative correlation between the level and growth rate of credit across the region, as shown in chart 10.

Even where fundamentals suggest there is room for credit to grow rapidly, however, excessive optimism and banks' aggressive pursuit of market share in the context of low interest rates, open capital accounts and, in many countries, pegged exchange rates may give rise to over-lending or poor-quality lending and subsequent problems in banking sectors, particularly in the event of negative shocks. These were amongst the concerns leading Fitch to take negative rating actions in a number of countries in the region earlier this year.

Of the existing and new MPI 3 countries, Slovakia is the only with a relatively strong banking system in emerging-market terms, scored BSI C. At the other extreme, Azerbaijan has one of the weakest systems in the region, at BSI E, though in this case the low level of credit/GDP is a mitigating factor. The other four MPI 3 countries - Kazakhstan, Romania, Russia and Turkey - are all BSI D systems.

BSI D scores are typical of emerging markets, reflecting banking systems that are relatively small and undeveloped, with high risk concentrations and greater exposure to potentially more volatile operating environments. Most banking systems in the region have become increasingly foreign owned, primarily by strong banks.

This has benefits in terms of support, access to improved management, new products and systems, access to capital etc. However, the high price investors have been willing to pay has been based on a rapid-growth business model. This process has risked becoming unsustainable, with recent entrants having to pay even higher multiples, necessitating even more aggressive growth. While such growth is often from a low base, it is taking place in untested markets, some of it in hard currency, and in some cases funded internationally (often by the bank's parent if foreign owned) and leading to tighter capital ratios. These risks have tended to outweigh the benefits of foreign ownership and as a result there has not been a significant improvement in BSIs in the region to date. Where foreign ownership is limited, rapid growth has still been a feature, with a sizeable proportion funded internationally (e.g. Kazakhstan). Risks relating to this funding reliance are currently being highlighted, with the pressures leading to a rapid slowdown in credit growth, raising asset quality concerns as the economy slows.

Kazakhstan's transition to MPI 3 comes as credit growth is slowing sharply from the triple-digit rates of summer 2007, precipitated by a severe tightening in Kazakh banks' access to international funding. Nevertheless, credit growth in 2007 as a whole remained above the relevant trigger level and combined with real exchange rate appreciation to move Kazakhstan into the higher risk category. The financial system faces a challenging period as loans extended during the period of rapid growth, when credit standards may well have eased, season in a difficult macroeconomic environment of slowing growth and a steep rise in inflation, which has boosted the REER. The KZT has been stable despite the bank external funding shock, causing the REER to appreciate, sustained by the authorities' decision to supply FX liquidity to the economy and allow reserves to fall, a decision motivated partly by concerns over the impact on the heavily dollarised financial system of a fall in the KZT.

Credit growth in Romania has also exceeded the reference "speed limit" for some time and the move to MPI 3 in 2007 was also precipitated by currency appreciation in the first half of 2007 and, when that was more than reversed in the second half of the year, rising inflation. Volatility of the nominal and real exchange rate, and the strength of pass through to inflation, is a risk to the stability of Romania's economy and financial system, particularly as 55% of loans are FX-denominated.

Rapid lending growth in Russia remains a concern, although it is mitigated by the still moderate level of penetration and currently favourable credit environment.

The growth is likely to slow in 2008 due to the reduced availability of global and domestic capital market funding. The funding squeeze has also resulted in a tighter liquidity environment and higher interbank rates, although the Central Bank of Russia has taken a number of measures to support sector liquidity. Asset quality has been sound in recent years, supported by the buoyant economy, but impairment is increasing in unsecured retail portfolios, albeit mitigated by still high lending rates.

In Azerbaijan, extremely rapid credit growth is a major concern, making it difficult to maintain credit underwriting standards and increasing operational risks. However, this is mitigated by the banking sector's very small size (end-2007 credit/GDP was just 15%), and a generally favourable credit environment on the back of the buoyant economy, resulting in historically low loan impairment levels to date.

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