Joint IIF-EBRD Conference on Financial Systems in Emerging Europe,
Cross-Border Banking in the Transition Region: Lessons from the Crisis and Beyond
14. May 2010. | 10:38
Ladies and Gentlemen,
It is a pleasure to welcome you today at this joint IIF-EBRD conference one the eve of our Bank’s Annual Meeting here in Zagreb. Co-hosting this event with the Institute of International Finance is a great pleasure for us. It also demonstrates the importance we attach to working closely with cross-border banks as key partners in supporting financial sector development and financial integration in Europe.
Today I would like share with you my thoughts about cross-border banking and financial integration in Europe – its history, record and future from the vantage point of the EBRD region. This topic is at the centre of debate in Emerging Europe and also the global financial system.
The EBRD has traditionally supported cross-border banking in its countries of operation and, more broadly, financial integration between East and West. We have contributed to the development of cross-border banking through our investments in our countries of operations and we have supported the expansion of major Western banking groups into the region.
We have done so because a modern market economy requires effective financial sectors and because sound and balanced financial development is a source of sustainable economic growth. Cross-border banking groups were viewed as bringing effective practices from West to East and as agents of financial development.
We believe that this model has produced some impressive results. A modern and effective financial sector has been established in many countries. Cross-border banks brought capital, know-how and good governance to the region. They jump-started financial development in Central Eastern Europe after the demise of communism. Investment and consumption grew rapidly and access to finance increased dramatically. This underpinned growth, led to rising incomes and growing convergence between East and West.
The model has been challenged by the global financial crisis. Financial integration was clearly – although naturally – a source of contagion. Perhaps more disturbingly, cross-border banking is widely regarded as a significant factor in the overexpansion of credit, often in foreign currency, which was a contributing factor in the crisis. And finally, the crisis management of large cross-border groups has proven to be challenging and complex in many countries, lying bare the significant gaps in crisis management and resolution between home and host country authorities of banking groups in many countries around the world.
This has prompted us to have a critical look at the impact of financial integration and the role of cross-border banks in our region. Our research, including the findings of the 2009 EBRD Transition Report, points out the complex role of cross-border banking in the run-up as well as during the crisis. What are the main findings?
· First, our research clearly shows the substantial long term growth benefits of financial integration in our region. Capital inflows in our countries have led to higher average growth over an extended period, not just during the boom years. This finding is remarkable in itself, but particularly because it seems to be unique to the region. In other emerging markets the link between capital inflows and growth appears to be far more tenuous.
· Second, the role of cross-border banking during the crisis has been more complex than is generally appreciated. While cross-border flows were one channel through which the crisis was transmitted from West to East, the structure of cross-border finance – in particular, the fact that much of it was intermediated by subsidiaries on the ground as opposed to direct cross-border lending – turned out to be a source of resilience. Parent banks stood by their subsidiaries during the crisis, and – with support and incentives by EU, IMF, World Bank, EIB and EBRD under the Vienna Initiative – generally maintained their exposures. This cushioned the reversal of financial flows in the transition region. Banks also recapitalized their subsidiaries appropriately, thus directly supporting financial sector stability.
· Third, while financial integration has done more good than harm, we cannot close our eyes to the harm it has done. By competing for market share in an environment of ample global liquidity cross-border banking became the chief instigator of an unprecedented credit boom in the transition region. The result was high private sector indebtedness, which in turn can be linked directly to the output decline in the crisis and which is a major obstacle for recovery today. Foreign funding also exacerbated domestic lending in foreign currency. Large numbers of household and corporates borrowed in foreign exchange – Euro, Swiss franc, Dollar, even Yen. This exposed many economies to the threat of mass bankruptcy in case of devaluation. It also complicated the crisis response by limiting the use of the exchange rate as shock absorber and reducing monetary policy effectiveness.
· Finally, it is clear that the lack of an appropriate crisis management and resolution framework for cross-border banking could have proven to be a source of instability. Here, the Vienna Initiative helped to mitigate risks by filling an institutional gap. The EBRD is a proud co-initiator of this endeavour.
For the EBRD there are hence two main lessons from the crisis and the preceding decade:
- · First, financial integration has by and large been a success story. As such, it must be preserved.
- · Second, financial integration has encouraged some countries to take unacceptable risks. This must be stopped. We must find ways to avoid the excesses of financial integration and to better manage the remaining risks.
I think I can safely say that there is a fair measure of agreement on these conclusions: no country is seriously thinking about reversing financial integration. At the same time, there is a widespread consensus that unhedged foreign currency borrowing is a source of risk that must be tamed. On occasion, I still hear the argument that because default rates on FX loans have not been significantly different from those on local currency loans, FX exposures could not have been a source of problems. But this ignores the fact that tens of billions of Euros of official support were mobilised and domestic interest rates hiked precisely to avoid large depreciations and the consequent defaults on FX loans.
Policy makers have naturally acted to address these twin vulnerabilities. Several countries are taking steps to develop longer term local currency funding by removing obstacles to local capital market development. Many are also attempting to regulate foreign currency exposures, in some cases going so far as to impose blanket prohibitions on foreign currency lending – this is mistaken, to my mind. Others are carefully calibrating new regulation in the context of macro-prudential regulatory frameworks or reinforced consumer protection. Poland and Hungary are leading the way in host countries while Austria with other key home country partners in home countries.
An integrated financial system in emerging Europe that is more resilient and self-reliant is in the interest not only of governments and IFIs, but also of the private sector. There is thus a unique opportunity to work together to take financial integration to the next level. We do believe that the critical task of shifting from foreign currency lending to sustainable local currency lending and the development of local capital markets must be widely shared. We all have responsibility in this regard:
Governments, backed by the advice of international financial institutions, must create better conditions for local currency lending.
- This requires more credible macroeconomic policy frameworks leading to a shrinking differential between local currency and foreign currency lending rates. Helped by falling inflation we already see this trend in some countries, although this drop in inflation is cyclically-induced, i.e. related to still weak domestic demand conditions. It does, however afford us with a unique opportunity to anchor inflation expectations by strengthening policies now.
- At the same time, regulatory measures that favour local currency lending within macro-prudential frameworks and level the playing field for commercial banks can be helpful and necessary in many countries – provided local currency funding is available. The coordinated action of home country authorities in this area can also be supportive of, and complementary to, these efforts.
- Governments must also create the institutional conditions for the development of local currency capital markets. They need to focus on the development of the domestic government market, creating, where possible a local currency yield curve and active secondary market. This is critical because without a local government bond market and a related domestic capital market, there will be no longer term local currency funding that can be used for local currency lending. Governments need to take legislative-regulatory measures to remove obstacles to market development and in doing so ensure that international standards are adopted to reap the benefits and efficiency of financial market integration. In this effort, governments can be supported by institutions such as the EBRD and other investing IFIs.
· Commercial banks should differentiate lending standards according to the currency denomination of lending. Short-term unsecured consumer lending in foreign currency should be phased out. More generally, the ability of the borrower to take foreign currency risks must become an explicit part of the due diligence process, establishing the currency composition of assets and preexisting liabilities and requiring higher creditworthiness of unhedged borrowers when lending in foreign currency than when lending in local currency. Commercial banks and the broader private sector are also key in the development of the local capital markets, by issuing bonds in the market build-up, acting as arrangers and market makers, supporting the domestic and international investor base and by helping to improve the payments, clearing and settlement system.
· Finally, investing IFIs such as the EBRD can help to develop local currency markets through both lending, securities investment and funding operations in local currency. Local currency bond issues can make fledgling markets more liquid. We can also support the development of the domestic investor base – pension and insurance funds and asset managers – with some of our products.
Two questions are frequently asked with regards to local capital market development in our region.
· The first question is about the size of these markets: Can small countries realistically aim at building up local currency lending and capital markets? We think that size matters – but not that much. Clearly a very small country may not have sufficient scale for a liquid stock exchange or derivatives market. But even a relatively small country can mobilise term deposits in local currency and create a basic government debt market in local currency into which other agents – chiefly banks – can issue if they wish.
· Second, about eventual euro zone membership. Here my answer – and message - is that making a country’s financial system and growth model more resilient is a source of strength that serves a country well under any circumstances. We all know that entering a monetary union without full preparation may prove difficult down the road; the current troubles of the euro are partly a reflection of that fact. Local capital market development and use of local currency in the financial system are characteristics of sound financial systems. In that sense, they are not a detour on the way to the euro, but part of a good preparation process.
Reducing foreign currency lending and excessive reliance on foreign savings requires the collaboration of many parties, including host and home country authorities, IFIs and private financial institutions.
For this reason the EBRD is proposing a coordinated approach to local currency and capital market development in transition countries that builds on the model of collaboration across host and home countries and private and public sectors that we built during the crisis – the Vienna Initiative.
At our Annual Meeting here in Zagreb, we will be hosting a meeting of the major stakeholders to kick off this initiative. I hope many of you will be able to join. Together, we can carry the spirit and practice of private and public collaboration into the post-crisis world.
Thank you for your attention.