The challenge of building The challenge of building financial sectors ahead of the financial sectors ahead of the

euroeuro

Piroska M. NagyPiroska M. NagyEBRDEBRD

July 11, 2006July 11, 2006

Main messages Main messages

• There is no convergence – “Maastricht” - criterion for financial sectors

• Despite - or because of ? - this, the EU-8’s financial sector has converged to that of the euro zone probably more than any other sector or policy area This has been the combined result of “top-down”legal/regulatory Europeanization and “bottom-up”Europe-affinity via privatization to EU-15 foreigners Structures and regulatory frameworks have converged rapidly but systemic risks in EU15 and EU-8 are different a main issue for euro membership

TodayPrivatisation mostly completeFewer banks but still too manyMany banks owned by foreign strategic investorsMaturities extended

1989State ownership

Too many banks initially

Many banks owned as domestic ‘pocket banks’

Very limited medium and long term lending

Reform progress in the financial sector Reform progress in the financial sector of the EUof the EU--88

Reform progress in the financial sector Reform progress in the financial sector of the EUof the EU--88

TodayHigher level of deposits

Legal reform has taken place

EU convergence –Basel II/CRDStock markets set up and capital market products gradually introduced

1989Lack of confidence and hence banking sector depositsLegal uncertainty and law not market-orientatedLow regulatory standardsNo capital markets

A very bumpy processA very bumpy process

Starting point: absolute state interventionEarly period: chaotic, with mixed state ownership and private banks with insider interest and still no proper regulatory frameworkSeries of bank crises resulting from past liabilities as much as poor financial market governance (bank corporate governance & regulatory framework). Costs up to 20% of GDP

Source: P. M. Nagy in Enlarging the Euro Area, edited by K. Dyson, Oxford University Press, November 2006

A very bumpy processA very bumpy process

“Bottom up” European affinity. Privatization primarily to EU-based foreigners. Major improvements in corporate governance“Top down” Europeanization. Regulatory framework convergence as precondition for EU accessionSo how ready are financial sectors for the euro?

Low level of bank intermediation -credit

Domestic credit to GDP

Slovenia

Austria

Germany

Italy

US

SEE average

SEE candidates average

Czech Rebublic

EstoniaLatvia

Lithuania

Hungary

Poland

SlovakiaCEB average

EU-15 average

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

- 5,000 10,000 15,000 20,000 25,000 30,000 35,000

GDP per capita (2004)

Dom

estic

cre

dit t

o G

DP

(200

4)

0102030405060708090

Albania BiHBulgari

aCroatia

Czech Republic

Estonia

HungaryLatv

iaLithuania

Poland

RomaniaRussi

aSerb

iaSlovakiaSlovenia

Ukraine

Non-government credit/GDP in %, 2004

Source: EBRD, updating and extending the model by Cottarelli et al (IMF)

PredictedActual

Private sector credit in the region is lower Private sector credit in the region is lower than predicted by economic modelsthan predicted by economic models

Where bank loans go? Where bank loans go? To householdsTo households

Share of loans in total loans (%)

0%

10%

20%

30%

40%

50%

60%

CEE EU15

Corporate loans/totalloansHousehold loans/totalloansMortgage loans/totalloans

Stock market capitalization in % of GDP 2004

0%

20%

40%

60%

80%

100%

120%

140%

Slovakia

Romania

Czech R

ebublic

Hungary

Lithuan

iaPolan

dAustr

iaCro

atiaGerm

any

Italy

Estonia

France

United K

ingdom CEB SEE

EU-15

Stock market capitalization has reached that Stock market capitalization has reached that of Austriaof Austria’’s and approaching that of s and approaching that of GermanyGermany

0%

20%

40%

60%

80%

100%

CEE average EU15 average

Structure of Corporate Financing

Financing of corporates is indeed Financing of corporates is indeed changing rapidlychanging rapidly

Source: EBRD

0%

50%

100%

150%

CEE average EU15 average

Corporate financing as % of GDP

Stock market

Debt issue

Loans

Deposit to GDP

Slovenia

Austria

Germany

Italy

US

SEE average

SEE candidates average

Czech Rebublic

Estonia

Latvia

Lithuania

HungaryPoland

SlovakiaCEB average

EU-15 average

0%

20%

40%

60%

80%

100%

120%

- 5,000 10,000 15,000 20,000 25,000 30,000 35,000

GDP per capita (2004)

Dep

osit

to G

DP

(200

4)

Low level of bank intermediation -deposits

Savings allocation (% of GDP)Savings allocation (% of GDP)

0%

50%

100%

150%

200%

CEE average EU15 average

Savings Allocation % of GDP

0%

20%

40%

60%

80%

100%

CEE average EU15 average

Structure of Savings

Deposit

Pension funds

Life insurance

Growth ratios of different saving pools in Hungary 2003-2006

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

UCITS Life insurancereserves

assets managed bypension funds

households deposit

Lowest growth

Corporate governance in the regionCorporate governance in the region

4426144Total

830Caucasus and Central Asia4130Russia

21984SEE and CIS-Europe 38800

EU-8 plus Croatia

Number of

banks2 tier

separation2 tiermixedUnitary Region

* 2004

Survey on board structures in EBRD's investee banks by region *Survey on board structures in EBRD's investee banks by region *

While in the EU15 While in the EU15 ……

The dominant structure is still the unitary board (E-8 has ‘leap-frogged?’)Regulations focus on ensuring truly independent board members and disclosure requirements (often mandatory for listed banks)

Foreign ownership is much higher in EUForeign ownership is much higher in EU--8 8 with a few banks dominating the marketswith a few banks dominating the markets

0%10%20%30%40%50%60%70%80%90%

100%

German

yIta

lyFra

nce

United K

ingdom

Austria

Romania

Hungary

Poland

Czech R

ebublic

Lithuan

iaCro

atiaSlova

kiaEsto

niaCEB SEE

EU-15

Share of foreign banks in total bank assets (%)

And the EUAnd the EU--88’’s regulatory framework s regulatory framework is EU compliantis EU compliant

Basel II CRDDeposit insuranceSolvency II

… you name it

Rapid credit growth reduces capital Rapid credit growth reduces capital adequacyadequacy

05

10152025303540

2000 2001 2002 2003 2004 2005

BulgariaCroatiaCzech REstoniaHungaryLatviaLithuaniaPolandRomaniaSlovak RRussia

Basel

CEE capital adequacy and portfolio CEE capital adequacy and portfolio quality (%)quality (%)

While capital ratios have reduced to below EU15 average in the EU8

… asset quality (e.g., NPLs) is still weaker in the EU8

0

5

10

15

2005

Basel

0

1

2

3

4

5

2005

EU15EU8 EU8

EU15

Different types of systemic risks Different types of systemic risks

Systemic risks of the financial sector can be markedly different:– Foreign ownership and Basel II/CRD: (i)

asymmetric shock transmission; (ii) CRD home-host issue; (iii) ownership concentration

– High banking sector concentration top 5 banks own almost 70% of assets on average

– High risk concentration: large exposure, forex without hedging

– Yet lack of risk mitigation/transfer– Risks inherent in any very rapid credit expansion

Systemic risk matrix for the EBRD Systemic risk matrix for the EBRD countriescountries

BSIE BEL KYR

AZR RUS SER MOL UKRUZB TKM ARM GEO TAJ

BiH KAZD ALB

POL MAC BUL ROM LATCRO SLK SLV LIT HUN

C

CZEB

ESTA

1 2 3 4

Macroprudential indicator

UK

Belgium, Switzerland

Austria, Germany

South Africa

Italy, Portugal, Spain

China, Argentina, Egypt

ConclusionsConclusions

In terms of levels, financial sectors are rapidly catching upIn terms of structures, catch-up is almost completeIn terms of financial market governance, convergence is almost completeHowever, systemic risks of the financial sector can be markedly different, which can become a problem when joining the euro.