COMMENT: CEE risks for (and from) Europe's banks

By bne IntelliNews February 25, 2009

Simon Samuels of Citibank, Russia -

• The €500bn question - A combination of acquisitions and rapid growth means that 17 Western European banks have over €500bn of outstanding loans in CEE;

• Overseas banks dominate - Uniquely for emerging markets, overseas banks account for over 80% of CEE lending. Historically, this has been a positive, but as those banks contend with crises in their home markets, the CEE region may now be vulnerable to widespread withdrawals;

• Bank sector "nationalism" - Western European taxpayers have injected varying levels of capital into their banks and, in return, are expecting them to focus on their domestic businesses and ration capital in their overseas operations. Despite political pleading not to abandon the region, CEE looks very vulnerable;

• A CEE crisis? - On average, emerging market banking crises see non-performing loans (NPLs) rise to about 35% with credit losses of 15-20%. Applying that to CEE could result in credit losses for 17 Western European banks exceeding €60bn (post tax) and core capital ratios falling to around 5%, necessitating significant capital raising;

• Who's exposed? - Under that scenario, we estimate the most vulnerable would be Raiffeisen, Erste, KBC, Commerzbank, Swedbank and UniCredit, as well as several Greek banks (NBG, Alpha, EFG).

As if the problems in developed Europe weren't enough to be getting on with, concerns are growing over the CEE franchises that several Western European banks have aggressively built up over the last decade. Whilst the region boomed, few questions were asked. But, with CEE in danger of slipping into deep recession, so the risk of a nasty emerging market crisis on Western Europe's doorstep is growing.

Moreover, unlike virtually all other emerging markets (Mexico being a notable exception), it's the foreign-owned banks that dominate the geographical area. Whilst having well capitalised, well managed international banks might previously have been viewed as a positive, as they themselves have plunged into crisis and gone to their own taxpayers for bailouts, so the risk that foreign capital exits the region is, we believe, real. This would only exacerbate the already-evident signs of weakness. We remain cautious on several banks with exposure to this region.

At regular intervals over the past 150 years, so-called "emerging markets" have suffered major economic dislocations. As we enter 2009, there is a widening number of emerging markets that investors are growing more and more worried about - from foreign currency borrowing in CEE, to the re-coupling of Latin America's economy with the US, to signs of a sharp fall in China's economic growth rate and the associated impact across the wider Asia region. Indeed, growth forecasts have been aggressively cut across all emerging markets since before the collapse of Lehman Brothers.

In Europe, much of the focus has understandably been in the CEE region given the exposure that many European banks have to this region. On one level, this concern might appear minor - after all, total loans to CEE by Western European banks were only just over €500bn out of sector loan balances of over €10 trillion. However, these risks are highly concentrated. Just over 20 Western European banks have meaningful emerging market exposures and, of this, CEE dominates that exposure for 16 of them.

Why worry?

In addition to the obvious economic slowdown across many emerging markets, banking systems are typically very volatile across these geographies. The table below shows peak non-performing loans across 75 (mainly) emerging markets banking crises over the past 25 years. On average, NPLs reached 34% of loan books.

Assuming a 50% coverage ratio and a resulting 50% loss rate - which might even prove too low given the typically uncollaterised nature of much of this lending - would imply credit losses perhaps reached 15-20% of loan books. For many banks in Europe, a repeat of that could prove deeply damaging. The estimated impact on capital ratios for those 17 banks impacted from a 20% single-year loss on their CEE loan books, we estimate post-tax losses would total over €60bn and the average impact would be to lower equity Tier 1 ratios by over 2%.

Given the exposure to CEE, this region is understandably the area of greatest focus for investors in the European bank sector. Moreover, the economics of the region are also the weakest across all emerging markets. For 2009, our current forecasts anticipate GDP growth of 4.7% in emerging Asia, 3.0% in Africa, 1.2% in Latin America but a (small) GDP decline in CEE. In addition, we note the banking sector is showing clear signs of stress, with rapid credit formation over the past year and relatively high levels of loans/GDP.

Lastly, there is the unresolved issue of foreign currency lending. For domestic mortgages, the reliance on foreign currency lending ranges from 35% to 65%, whilst for corporate from about 10% to over 70%.

Precipitating a CEE crisis

There are several indicators that, at the very least, suggest the risk of a CEE crisis is real. As well as banking system issues, such as rapid loan growth and reliance on hard currency loans, the CEE region has one other region specific risk - "economic nationalism".

Unlike Asia and much of Latin America (Mexico being a notable exception), CEE banking markets are dominated by international banking groups. Whereas foreign banks' claims across emerging Asia account for about 20% of GDP, in CEE it is nearer 80%, having been similar until a decade ago. Foreign ownership exceeds 80% for two-thirds of the 18 countries in the region.

At one stage, this high reliance on overseas banks was viewed as a clear regional positive. Strong international banks - well capitalised, well managed with strong risk controls - were perceived as adding to the stability of the local banking system. That may still be the case long term but, in the meantime, many of these international banking groups have to deal with a crisis in their developed market businesses. As this has intensified, so in turn a large number of these banking groups have had to turn to their national governments - ie. their taxpayers - for assistance. As national governments, understandably, compel the banks in which they are now stakeholders to prioritise their domestic lending, so a potential retrenchment from overseas markets may follow. Hence many CEE countries are acutely exposed to a wholesale rationing of capital.

This also highlights a broader threat from banks "going home." Banks with meaningful exposure to emerging markets may be at risk even if they have focused on high-quality, low-risk lending and are under limited pressure to retrench CEE commitments. This is because widespread credit rationing by other banks can have knock-on macro-economic effects in emerging markets - and be the catalyst to turn otherwise 'good' loans bad.

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