THE MITTELEUROPEAN VIEW: Western banks go back to square one in CEE

THE MITTELEUROPEAN VIEW:  Western banks go back to square one in CEE
Asset rankings: KBC is catching up on RBI, and OTP has overtaken SocGen. / bne IntelliNews
By Gunter Deuber of Raiffeisen Research December 21, 2022

The key messages of this year's Raiffeisen Research CEE Banking Sector Report at the industry level are as follows: Geopolitically, the leading CEE banks in Eastern Europe (Russia, Ukraine, Belarus) were not naïve; on the profitability side, things are still running smoothly in Central and Southeastern Europe for the time being, while market concentration continues to increase. However, increasing competition and repeated government interventions will limit the full earnings potential, especially in 2023.

At the individual bank level, the large Austrian CEE banks still lead the regional banking ranking, but re-emerging players such as Belgium's KBC are catching up, while OTP is now overtaking the first cross-border Western player "historically" rooted in the region (Societe Generale) and is catching up on UniCredit. Depending on the further woes of the Russian market (especially at RBI and UniCredit), the EU bank ranking in CEE could be shaken up again in 2023 – possibly in favour of KBC and OTP. In the Western Balkans, local banks tended to benefit from the regulatory-induced Sberbank wind-down in 2022, while the long-term EU advantage in CEE banking appears to be increasing.

The dramatic events in Ukraine have clearly upset the applecart for the CEE banking sector this year. Not only Ukrainian banks had to deal with an unprecedented level of economic hardship and operational risk, but also Russian lenders faced a much stricter sanctions environment (60% of the sector “de-Swifted”, some 80% is under Western sanctions). The latter triggered unseen losses for the Russian banking sector on aggregate (RUB1.5 trillion or ~€18bn in H1 2022, driven, inter alia, by forced liquidation of derivative positions, while the loss has narrowed to RUB400bn or ~€5.6bn as of 10M2022).

On a positive note, geopolitical upheavals in the context of the Ukraine war do not pose an existential threat to the large Western-owned CEE banks, some of which are also active in Russia. We attribute this to cautious regional market strategies that have been in place since 2014/2015. Since 2014/2015, the share of Russia and Eastern Europe in the portfolios of Western CEE banks has fallen from just over 20% to below 10%. Geopolitical naivety is not evident here. Since 2013/2014, major Western banks have adjusted their regional portfolio allocation in such a way that a significant geopolitical escalation in the Eastern European region does not endanger the existence of regional CEE business strategies. As a result of the careful banking business strategies in Eastern Europe in recent years, the Russian banking market has been about as important for Western banks as Slovakia as of Q1 2022.

“Bonanza times” will not be easily repeated

Central banks and their monetary policies have been the key factors for commercial banks’ profitability in 2022. This is especially true for the largest CE/SEE markets, which led front-loaded tightening cycles in the region and where lenders capitalised on the steep ascent in policy rates. Average monetary policy rates in CE/SEE (i.e. in countries with active and independent monetary policies) are currently at 9%+, higher than prior to the Global Financial Crisis and in the times of the CE/SEE "bonanza boom". However, “bonanza times” will not be easily repeated. Despite massive short-term support from rising rates, the mid-term outlook has to been taken with a dose of cautiousness.

Firstly, in a longer-term retrospective the transmission of the upswing in policy rates into banks’ margins is now much more limited than historically. Thus, the recent recovery in net interest margins (NIM) constituted only a marginal move as compared to the central banks’ key rates, which have largely approached (and in some cases topped) the levels of 2008/2009. We attribute this to the changed operating environment in terms of increased market penetration levels and stiffer competition.

We expect these factors to keep a lid on further widening of margins, while some central banks also look ready to call time on the rate-hiking cycle (Poland, Czechia, Hungary). Moreover, most of the rise in interest income is mainly coming from the Czech market, where we see the most leeway for rate cuts going forward. Due to the high gearing towards the country, approximately 75% of the pre-tax profit growth at major Western-owned CEE banks stems just from this country, followed by Croatia and Romania.

An important adverse factor in 2022 was the massive government intervention in Hungary (worth ~€1.2bn, including the windfall profit tax and various interest rate caps), which as a result triggered a pre-tax profit erosion of 15% y/y and hence led to the negative contribution from local banks of approximately -14% y/y in our Western/EU CEE bank coverage universe.

Secondly, the overall situation is becoming less favourable as compared to the COVID-19 years of excess liquidity and declining loan-to-deposit ratios, as deteriorating real incomes make households draw down their savings, while the high-rate environment spurs bank competition for new deposits. It is probably not yet a wide transformation but the customers’ shift toward higher-yielding term deposits is happening.  Looking for instance at Czechia, Hungary and Romania, in terms of new business volumes, term deposits have supplanted around 5-7% of current/overnight accounts in the household segment since the beginning of 2022.

At first blush, this shows only a marginal change in composition, however its impact on the blended cost of deposit funding is actually non-trivial when one considers the large difference in the applied interest rates. Thus, while the market rates on overnight accounts in the given countries have barely bottomed out from virtual zero, the cost of new <1y term deposits in local currency has exceeded mid-single digits. Notably, the latter represents the most expensive bucket in the term structure, reflective of the inverted benchmark yield curves in the markets.

Thirdly, funding profiles of major international and local CEE banks are now also challenged by required MREL debt issuance. Here, in contrast to Western markets, the eastern part of the EU proved slower to implement the bail-in regulation on both the national and single-bank levels. As a result, the lenders are now running into a pitfall of generally uneasy borrowing conditions coupled with the short time before the final legally binding MREL targets (1 January 2024).

In principle, the banks have some leeway in terms of the local debt markets’ capacity and support from multilateral creditors — we calculate that the EBRD alone invested more than €300mn in MREL bonds (local and international) of CEE banks in 2022, for a ~20% participation rate on average. Indeed, MREL issuance in local currency is actively used, for example, by Czech and Romanian systemic banks, where they can often secure a relative price advantage as compared to the international market (we envisage a similar strategy for Polish majors given the relative depth of the local debt market).

Having said that, there is still little alternative to the Eurobond market when seeking to borrow larger amounts. International investors, moreover, prove much more demanding when it comes to CEE risk these days, so even the established subsidiaries of European MPE [Multiple Point of Entry resolution strategy] banks and entrenched investment-grade local players have to pay considerable premiums currently to get the deal done.

On top of all the funding challenges described above, banks also face a round of step-ups in capital buffer requirements. Among others, these include sector-wide countercyclical capital buffers (in Croatia, Hungary, Romania – for the first time ever) and further bank-specific add-ons for systemic importance (major O-SII buffers increases in Hungary and Poland).

Coupled with the gloomier economic outlook, this does not set an inviting backdrop for active organic credit growth, but rather adds incentive to the banks’ more defensive stance on underwriting standards – something we read from both lending surveys and actual high-frequency data on real (net of inflation) loan growth. Overall, we should not get confused by bumper nominal loan growth rates. Currently deflated real loan growth rates are similar, i.e. just slightly positive or even negative, to the times of regional banking sector weakness in 2012/2013. 

In the meantime, it is not all rosy as some governments target banks among other sectors for skimming off “excessive” profits in order to help them close budget gaps. The “windfall tax” has already entered into force in Hungary, will be imposed in the Czech Republic in 2023-2025 and is being discussed in Croatia. 

Based on all available information about already implemented, approved and announced government interventions (excluding increased regular deposit insurance charges), we calculate the total burden at around €6.4bn, with the biggest chunk coming from Poland (€3.8bn, excluding FX mortgage provisioning) and the rest from Hungary (€2.0bn, of which €1.25bn was in 2022), Czechia (€0.6bn, 2023) and Croatia (€70mn, 2023).

Moreover, additional costs will enter banks’ P&L through other lines (typically as a “loan modification loss”). Negative mark-to-market revaluation of fixed income securities due to higher (government) benchmark yields adds another piece to the mosaic, though a large part of this has probably already materialised during 9M2022 and for single banks could have been mitigated by a shorter duration of the portfolios.

In sum, the high interest rates are a low-hanging fruit for lenders; however, it is not exceptionally sweet given the broader context it has emerged in.

Russian market affects bank rankings

The environment in the CEE banking business is certainly not a foregone conclusion. However, the attractiveness for deep-rooted players seems to be given, as multi-layered market trends show.

Within the cohort of major Western cross-border CEE banking groups the Austrian friendly competitors Erste and RBI continue to lead, while KBC has been clearly catching up as #3, closely rivalling RBI, followed by UniCredit as #4. On the other side, upon the exit from Russia in April 2022, SocGen remained active in only two CEE markets (Czechia, Romania) and hence eventually lost the race to be regional #5 to OTP, which topped the €90bn mark in asset size this year (including Slovenia’s Nova KBM). The chance of further market share reshuffling, largely benefiting KBC and OTP, cannot be ruled out.

To a varying degree, a local presence in Russia remains a factor for five Western CEE banks, incuding RBI (Q3 2022: €13bn in loans to customers), UniCredit (€9.6bn), OTP (€2.6bn), ING (€0.6bn) and Intesa (€0.3bn). Depending on further rouble exchange rate developments, possible further local balance sheet reduction and/or active exposure reduction (until market exit), the further fate of Russian business at RBI and UniCredit could again significantly shift the CEE bank ranking in 2023.

The sketched market trends do show the willingness of dedicated players to expand in the region – and beyond. Belgium's KBC Group, at number three, is catching up strongly and is now the largest foreign cross-border player in Central Europe, ahead of Erste.

The regulatory enforced Sberbank windown also offered interesting M&A opportunities, largely benefiting locally-embedded players.  Ironically, Sberbank Europe had been already on track for an orderly sale of select CEE subsidiaries at the end of 2021, however the deal largely failed upon the bank’s crisis and the sanctions hit in February/March 2022. Eventually, among the acquirers in the course of selective bail-outs, local players were able to make a swift decision on the takeover and hence gained market share, including markets such as Croatia, Slovenia or Bosnia and Herzegovina.

Overall, we see the much-needed resolution of Sberbank Europe as managed rather smoothly. Sberbank’s (enforced) withdrawal hence added to the changing balance of market power towards domestic banking groups in smaller markets of the Western Balkans, which has already been underway in the last five years.

Otherwise, in larger CE/SEE markets the lively consolidation trend did not alter much the participation rate of foreign players in 2021/2022, i.e. recent redistributions and combinations of market shares were largely within the groups of either foreign or local players. From a longer-term view, Serbia is perhaps a rare exception where the market share of foreign banks has increased notably in the last five years to top 75% on the back of acquisitions of local banks by OTP and NLB.

Echoing the brisk M&A activity in the last few years, the market concentration ratios (top-5 banks) have trended up across the largest CE/SEE markets, which, in turn, mean that there are now fewer “easy” options to pick up business scale, so a more prudent approach to choose future M&A targets will be warranted.

Refocus on Central Europe

Overall, it seems that Western players are more and more coming back to square one of their regional banking sector expansion. The longer-lasting regional re-focussing of Western CEE banks – well ahead of the Ukraine war – has translated in a rise of the CE banking markets and (current) EU markets in regional portfolios of Western-owned CEE banks. 

Currently, EU markets represent 86% of exposures (2013 "only" 71%, 2003: 84%), Central European markets are back to the all-time heights at the early stages of the regional CEE banking boom at close to 70%, relative exposure ratios last seen in 2002-2005.

The "return" to EU and Western CEE markets reflects a complex interplay of various factors over time. First, simple "convergence bets" have not materialised on many levels. The adoption of the euro by CE/SEE markets has progressed more slowly than expected at the beginning of the 2000s or has been put on the back burner in some cases. Moreover, through-the-cycle profitability in more risky/exotic markets had been possibly less favourable than assumed (or economic/political convergence had been less successful than hoped for).

Secondly, political and geopolitical risks have long been a relevant factor in CEE business. This applies to the issue of Russia/Ukraine and also the Western Balkans. It remains to be seen whether clearer EU-perspectives in the Western Balkans may change the calculus once again. On an interesting note, the traditionally more emerging market risk tolerant RBI is currently gearing towards CE markets, having grown into #4 market position in CE-3 (Czechia, Hungary, Slovakia).

European or EU banks have been particularly exposed to the Russian market for years. Some European banking sectors (among them France, Italy and Austria) have even made significant (market share) gains there in some cases. In the short term, these trends could intensify. In the future, EU banks should be careful with strategies that carry an element of catching market share from “geopolitical more sensitive actors" such as banks from the USA or UK. Credit institutions from the Anglo-Saxon world trimmed their Russia-related exposures much earlier than EU banks. 

However, it should also be noted that EU banks are currently less exposed to China than credit institutions from the USA or UK. As we will show later on, further differentiated country or geographic strategies of international banks should continue to emerge, driven by country-specific risk factors related to relevant ESG classifications or ESG country ratings.

Russian exit dilemmas

Moreover, recent developments in the international banking business in Russia show how complex it is to scale back exposure once a geopolitical confrontation is well underway. And the potential market exit in case of Russia is currently hitting several regulatory and practical hurdles. This holds especially true for major cross-border CEE banks. In this environment, many of the Western players resort to a downsizing strategy (increasing local loss absorption capabilities), despite certain benefits to revenues currently. Longer-term business prospects lie in a haze of uncertainty, while no rouble earned is allowed to leave Russia in the meantime. Basically, we see an “exit” dilemma on various fronts.

Firstly, any transaction would require an eligible counterparty plus full local consent, i.e. by Russian and Western authorities. Russian authorities, by and large now represented by the Kremlin, are possibly a more consolidated counterpart to negotiate with. Hence a sanction waiver might be more feasible to get (depending on the discount). The same holds possibly true for the US and OFAC. However, within the complex EU structures European banks would have to negotiate a more complex market exit deal with several competent national and/or supra-national authorities.

Secondly, any divestment is definitely not a “normal” M&A transaction where long due-diligence periods and/or deal walk-away options are feasible. Not to mention complex accounting issues plus valuation topics given overall (FX) market dislocations and blocks to outright capital transfers. Furthermore, the question of operational feasibility of previous “Western banking models” under new ownership is not given.

Thirdly, currently the feasibility of any bold strategic movement is getting more and more limited in light of ever tightening sanctions and worsening of the conflict. Among the big foreign lenders only SocGen managed to arrange a quick withdrawal in April, which cost the group €3.2bn, though it still seems to have been a special case (divestment of the Rosbank subsidiary basically to the same investor – Interros Group – from whom it was purchased in 2006-2008).

Otherwise, the window for orderly exits was promptly shut with the adoption of a presidential bill that banned foreign banks from selling their stakes in Russian entities. Even though special waivers are possible, the government clearly has an upper hand in negotiations over exit strategies for investors from “unfriendly states”.

And let’s not forget that for the time being both sides possibly have a certain interest in keeping channels for (limited) economic and financial exchange open. Any further divestments by Western/EU owners would possibly change the rules of the game here.

For the time being EUR and USD payments are still in demand, although note the high speed of switching to alternative currencies in Russian export settlements. The Q4 respective shares of dollar and euro were down to 33.9% and 18.7% (FY 2021: 54.5% and 29.7%, correspondingly), replaced mainly by the RUB and CNY already representing 50% of export settlements (close to 15% in CNY), up from just below 20% in 2021. Here we assume the largest local state banks will dominate in payment services on the Russian side.

The Russian military aggression against Ukraine has caused a super-adverse environment for the Ukrainian banking sector. In particular, credit and operational risks increased tremendously due to the seizure and destruction of assets as well as a significant deterioration in the financial performance of both customers and the banks. 

It was not a surprise to us to see a deterioration in the quality of banks’ loan portfolios caused by the war. Hence, NPL rates have increased from 31.5% to 37.5% for the corporate sector and from 15.9% to 27.6% for the household sector over the first seven months of the war. We expect that NPLs will continue to increase on the risks tied to war, but it is unlikely they will exceed the 55% maximum recorded after the previous crisis in 2014-15 given the clean-up effort made by the regulator since then.

Therefore, the probability of a mass bankruptcy of the sector (in the manner of 2014-2015) remains low, while recapitalisation needs will be possibly shared within the IFI community (if needed). It is worth noticing that the war has not been as disastrous for the hryvnia as during the previous crisis in 2014-2015. A sound volume of foreign currency reserves and emergency measures applied by the NBU saved the market from collapse at the beginning of the war. Therefore, in the first nine months of 2022, the banking sector posted still a remarkable positive (!) return on equity of 4%.

So much for the "good" news from the war-torn country. In the context of the previously sketched geopolitical risk awareness of Western banks, it is somewhat bitter that risk reduction in the case of Ukraine has led to Western banks now having lower exposures here (at around 1% of their CEE assets) than in the case of Slovenia. Definitely, this is not the exposure needed for a sustainable rebuilding of Ukraine.

This opinion piece was written Gunter Deuber, Ruslan Gadeev, Jovan Sikimic and Oleksandr Pecherytsyn of Raiffeisen Research in Vienna & Kyiv. The full report it was based on can be accessed here.