Bbee0312 Fitch Banker I Baltikum

Banks  Europe  Special Report 

Analysts  Financial Institutions: Michael Steinbarth, London +44 20 7682 7468 [email protected]

Banking Systems in Emerging Europe Structural Problems Remain  Executive Summary ·

This Special Report looks at 12 banking systems in emerging Europe (see Table 1 for full list) and how these have fared in the period since the intensification of the global financial crisis threw the region into distress 14 months ago.

·

Based on financial results for the first six months of 2009 (6M09), the full impact of the recession — given the level of GDP contraction in most banking systems, reduced growth in assets, and still elevated funding costs — does not appear to have fully filtered through into pre‐provision profits. Costs of risk, however, vary significantly, with operating profits in the Baltic states being completely eroded in 6M09, whereas other banking systems still have some buffer to absorb markedly higher credit costs. Net income in 2010 in most banking systems will remain under pressure from lower revenues and higher loan impairment charges.

·

The deterioration in asset quality is still broadly in line with the assumptions used in the stress tests carried out by Fitch Ratings in Q109. The agency anticipates a continued inflow of non‐performing loans (NPLs) albeit at a slowing rate, with NPLs peaking in 2010 — provided that the operating environment does not deteriorate. Given significant levels of restructured loans, which do not feature in NPL numbers, and growing reliance on collateral, particularly in property, sizeable losses will be incurred.

·

The keys to future growth will be the extent of asset quality weakening, the addressing of structural macro‐economic imbalances, together with the prospects of convergence between the banking systems in the region and the more developed banking systems in Europe. The structural issues include the need for more balanced funding strategies between parents and their subsidiaries, a reduction in the proportion of lending in foreign currency, and replenishing capital.

·

In respect of the relationship between parents and their foreign bank subsidiaries, the merits of foreign ownership in domestic banking systems may have to be re‐assessed in light of the experiences since the global financial crisis, as foreign ownership can also act as a constraint to growth.

·

Event risk remains considerable. This could take the form of the devaluation of a local currency, collapse of market confidence over a large international cross‐ border group or social/political pressures arising from economic conditions.

·

Overall, emerging Europe remains particularly negatively affected by the global financial crisis; some of the countries in the region remain vulnerable on account of their financial and economic characteristics. Fitch forecasts that GDP in emerging Europe will grow modestly by 2.6% in 2010, after contracting by 6.1% in 2009. However, downside risks to economic prospects and credit risks remain. Fitch continues to see wide variation in the economic vulnerabilities and credit standing of the countries in emerging Europe, and it is important to recognise that the countries do not form a homogenous unit. Fitch Ratings considers banking systems with greater funding and capital flexibilities (such as Turkey, the Czech Republic, the Slovak Republic, and Poland) to be better placed to support expected future growth in their respective countries. 

Michal Bryks, Warsaw +48 22 338 62 93 [email protected] Malek Soubra, London +44 20 7417 6321 [email protected] Mark Young, London +44 20 7417 4268 [email protected] Sovereigns: Ed Parker, London +44 20 7417 6340 [email protected] Douglas Renwick, London +44 20 7417 6340 [email protected] Eral Yilmaz, London +44 20 7682 7554 [email protected] 

Related Research · Emerging Europe Sovereign Review: 2009 (October 2009) · Major Western European Banks’ Exposure to Eastern Europe and the CIS, Downside Risk Contained? (April 2009)

www.fitchratings.com 

3 December 2009 

Banks Table 1: Banking Systems included in the Special Report Croatia Hungary Poland Slovenia Bulgaria Czech Republic Slovakia Turkey Romania Estonia Lithuania Latvia

MPI 1 1 2 2 2 3 3 3 3 3 3 3

BSI D D C C D C C C D E E E

Source: Fitch; as of November 2009. Macro‐Prudential Indicator (MPI), Banking System Indicator (BSI).

Structural Challenges Facing the Banking Systems  In this section, Fitch summarises some of the structural issues that the banking systems in emerging Europe face. The recent financial market crisis has altered the competitive landscape in the banking systems covered in this Special Report. However, large transformational transactions are currently unlikely, in light of the current capital‐market conditions and diverging views on future profitability in the sector. The national governments in Poland, Slovenia and Turkey still own majority stakes in domestic banks with large market shares. However, these stakes do not appear to be available for sale, although the Turkish government is considering its position. Fitch would expect foreign strategic players in emerging Europe to review their operations to identify any countries in which their franchises are underdeveloped. This may also be triggered through reviews by the European Commission (EC) as part of state aid reviews. The Belgian‐based KBC Bank, for example, has announced its plans to float a minority stake in one of its core subsidiaries in order to raise capital and reduce assets. Acquisition opportunities may also arise as domestic banks re‐assess their competitive positions. Even banks with previously satisfactory franchises may be looking for stronger partners if the potential for revenues proves insufficient to weather current conditions or more crucially if funding strategies cannot be re‐ aligned to the changed market conditions. As expressed in a Special Report in April 2009, in Fitch’s opinion, the likelihood of parent banks simply letting their international subsidiaries fail is considered remote where the banking groups concerned attach a high level of strategic importance to the region. A default of a foreign‐owned subsidiary in the region would pose reputational damage, a real threat of deposit flight away from foreign‐owned banks in the same country or may even trigger contagion to the banking systems across the region. As a result, Fitch expects stability both for ownership structures in most banking systems (assuming an at least satisfactory customer franchise) and the level of foreign ownership. Foreign ownership has facilitated a transfer of know‐how and resulted in capital investment and the provision of credit to the banking systems, but it can also be seen as a mixed blessing, with its merits having to be re‐assessed post global financial crisis. As the controlling shareholder, foreign parent banks determine business strategy and have been in part responsible for the rapid loan growth, but they can also act as constraint to growth. Until the start of the crisis, foreign parent banks were available as a steady source of funding and capital, however, the systemic distress also affected them, to the extent that some had to resort to public support in their home countries. Consequently, the parent banks may have to exit certain non‐core banking activities as part of their restructuring activities. The process of de‐leveraging capital and/or funding constraints can require foreign parent banks to limit balance sheet growth at their foreign subsidiaries and therefore dampen chances of economic recovery — irrespective of their public commitment to remain investors in the markets and retain certain levels of exposure. Fitch considers the sizeable increase in NPLs as a threat to the health of banking systems, as NPLs restrain banks’ ability to lend. The parameters governing which loans can be restructured, and how, give banks some leeway in selecting the loans for restructuring so that the extent of the deterioration in asset quality may not be fully transparent. In addition, work‐out processes are generally time‐consuming, resource‐ and capital‐intensive and tie up liquidity. In order to restore confidence in the banking systems and speed up the economic recovery process, banks will need to clean up their balance sheets and crystallise credit losses. The established business model of rapid loan growth appears to have been discarded — at least temporarily. Fitch believes that there is still scope for regional convergence between the newer EU member states and the more developed member states, Turkey and Croatia. The potential for convergence will be the

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

2 

Banks driver of future (but slower) loan growth. In order to promote sustainable growth and to avoid the continued build‐up of structural imbalances in business models, however, business models need to be adapted to a new environment. Factors to be considered include a more balanced funding profile, the prevention of excessive lending and possibly of riskier loan products, which in emerging Europe largely consist of lending in foreign currency. Lending in foreign currency is a structural risk common to most banking systems in the region. In the long term, lending in foreign currency could be reduced by minimising the interest rate differential between local and foreign interest rates on loans. However, this gradual transition to lending in local currency would take time, given the scope and the required re‐balancing in some of the local economies. In addition, with the likely delay in the euro adoption in some countries in the EU, this contingent FX risk will persist. A much faster approach to address the issue involves regulation. Lending in foreign currency is likely to be subjected to closer regulatory scrutiny at either national or supra‐national level. A change in risk appetite at the parent banks, as recently requested by the Austrian regulators, would therefore also affect the lending activities of their international subsidiaries. Currently, there are proposals to amend the EU Capital Requirements Directive to introduce additional capital requirements for retail mortgage loans in foreign currency if they exceed a certain loan‐to‐value ratio. Finally, devaluation adds another dimension of risk to the asset quality of loans denominated in foreign currency. Whilst there has been a tendency of “regulatory easing” during the crisis in most banking systems, Fitch considers that — post‐crisis — the level of regulation of the banking sectors will increase, with the possible downside of constraining banking profit. The EC has adopted legislative proposals to strengthen the supervision of banks, and may create a European Systemic Risk Board to monitor and assess risk to the stability of the financial system. One of the crucial elements missing during the credit market turmoil was a legally binding framework for cross‐border crisis management in the banking sector. Therefore, in October 2009, the EC started a consultation process on measures necessary for such a framework. This followed discussions by several international groups including the G‐20, the Financial Stability Board, and the Basel Committee as the issues faced by cross‐border banking groups extend far beyond the EU. The focus of the EC consultation is on safeguarding financial stability and the continuity of banking services in the event of cross‐border banking crises. Such legislation could potentially have far‐reaching consequences for cross‐border groups, including in emerging Europe. 

Macroeconomic Overview  Chart 1: Five‐Year Credit Default Swaps (in bps)

Latvia

Lithuania

Romania

Estonia

Croatia

Hungary

Turkey

Czech

Slovakia

Poland

Bulgaria

1,400 1,200 1,000 800 600 400 200 0 Jan 07

Apr 07

Aug 07

Nov 07

Mar 08

Jun 08

Sep 08

Jan 09

Apr 09

Jul 09

Nov 09

Source: Bloomberg, November 2009

Triggered by the default of Lehman Brothers Holdings Inc. in September 2008 and market concerns regarding emerging markets with substantial macroeconomic imbalances, the financial markets temporarily lost confidence in emerging Europe

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

3 

Banks in Q408/Q109. This resulted in an extreme widening of spreads for credit default swaps (which have narrowed since) as well as a serious liquidity squeeze on the interbank market. The preservation of liquidity in financial institutions translated into a very restrictive credit supply to domestic and international borrowers, with some banks stopping new business altogether. At the same time, banks implemented much more restrictive lending policies by tightening lending standards and in some cases initiated a de‐leveraging process. In addition, demand for credit from corporate and retail customers dropped significantly due to cuts to investment and inventories, uncertainty over the economy and job insecurity. Consequently, the worsening economic conditions, coupled with the collapse of global trade, soon caused global GDP to severely contract in Q408 and Q109, bringing about a recession. Nominal bank credit growth was contracting across the region on a quarter‐by‐quarter basis (see charts below). Emerging Europe has been by far the worst‐affected region in the world. Fitch Ratings has revised its forecast for 2009 emerging Europe GDP to −6.1% from −4.6% in its June forecast, owing to an even steeper drop in output in H109 than anticipated. The agency forecasts that only Poland will be likely to report positive GDP growth in 2009, while Estonia, Latvia, and Lithuania will suffer double‐digit declines in GDP. Fitch Ratings has raised its 2010 growth forecast for the region to 2.6% (from 1.5%), reflecting the unwinding of the deeper 2009 contraction and the more favourable global conditions. Indeed, it estimates GDP rose by around 1% qoq in Q209, after plummeting 7% in Q109, led by a rebound in Turkey. But the recovery is likely to be subdued, due to weak investment, rising unemployment, moderate capital inflows and credit growth, fiscal consolidation and a rebuilding of balance sheets. External financing and currency risks, which were the main weak‐spots of many countries in emerging Europe in the initial phase of the crisis, have eased somewhat, though remain material. This reflects a rapid reduction in current account deficits (CADs), substantial multilateral assistance, a boom in sovereign external issuance and relatively resilient private‐sector roll‐over rates. Fitch estimates the region’s gross external financing requirement at USD304bn in 2009 and 2010, down from USD363bn in 2008. Chart 2: Bank Credit Contracting: Stable/Fixed/ Euro Currency ‐ QoQ

Chart 3: Bank Credit Contracting: Floating Currency ‐ QoQ

Latvia

Lithuania

Bulgaria

Czech R.

Poland

Hungary

Estonia

Slovenia

Slovakia

Turkey

Romania

Croatia

(%)

(%)

18

24 18

12

12 6 0

6 0

‐6

‐6 Q107

‐12 Q407

Source: IMF and Fitch

Q308

Q209

Q107

Q407

Q308

Q209

Source: Datastream, IMF, Turkish BRSA and Fitch

Sovereign rating dynamics remain negative, as indicated by the balance of Positive to Negative Outlooks and Watches, though this has improved slightly since August 2009. It is no surprise that the central European countries are the first in the region to be out of recession. The Czech Republic, Poland, Slovakia and Slovenia had only moderate macro‐economic imbalances and bank credit booms; and their relatively robust credit fundamentals have allowed them to loosen macroeconomic policy

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

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Banks (with credible, floating exchange rates aiding adjustment in the Czech Republic and Poland, and Slovakia and Slovenia sheltered from external financing pressures in the euro area). The Czech Republic, Slovakia and Slovenia as well as Hungary are very open economies (Poland less so — hence its much shallower recession), highly integrated with German industry and concentrated in cyclical industries such as cars and electronics. These economies have benefited from the revival in German output, following the slashing of inventories in Q408 and Q109, and the German government’s scrappage scheme. However, Hungary remains mired in recession as it suffers under the weight of fiscal retrenchment and the unwinding of private‐ sector imbalances. GDP is still declining in the Baltic and Balkan states, according to Q209 data. In this region, prior external imbalances were large, bank credit booms were pronounced, governments are having to implement pro‐cyclical fiscal tightening and, in the case of the Baltic states and Bulgaria, exchange rate pegs have constrained the speed of economic adjustment. The Baltic states have seen the greatest drop in GDP from its peak, though in all three cases it is still above Q105 levels. Q309 seasonally adjusted qoq data showed growth in Lithuania, although comparable data for the other Baltic states was unavailable at the time of publication. 

Public Support Measures  Domestic Support Banks in emerging Europe have witnessed an unprecedented amount of new regulations and guidelines in 2009, with all 12 countries covered by this Special Report witnessing interventions from their respective authorities in the wake of the financial crisis (see Appendix 1). Q408, as the international financial crisis intensified, was the starting point for such critical interventions. Increasing the deposit insurance schemes and lowering the minimum reserve requirements were among the first tools used by some authorities in order to increase confidence and improve liquidity in their particular banking systems. While Fitch believes that the above measures helped improve depositors’ confidence, further interventions were necessary to alleviate pressure on banks from the slowing and in most cases contracting economies in the regions. However, domestic public authorities in the region are not always able to intervene as their reserves are generally limited and, in most cases, would be mainly used to defend the peg of their respective currencies to the EUR where applicable. Concerns over asset quality deterioration, present to varying degrees in emerging Europe, and the potential effect on banks’ profitability and — ultimately — capital, have also prompted the different authorities to adjust or introduce new regulations in 2009. Fitch notes that, unlike in many developed countries and some emerging markets, there have been relatively few capital injections into banks, although it did occur in Slovenia (SID Bank), Latvia (Parex banka, rated RD), and Hungary (FHB). The Slovenian government also earmarked funds for a capital strengthening of NLB and NKBM in the annual budget (as the Republic of Slovenia is indirectly a majority shareholder), but no capital has been injected to date. In some countries, banks benefited from a relaxation in the regulatory framework. Moreover, in some banking systems in emerging Europe, local regulators encouraged foreign parent banks to forego dividends and retain earnings to improve the capital ratios of their subsidiaries. Finally, and perhaps most importantly in the current economic setting, some governments in emerging Europe have stepped in to provide loan guarantees to particular sectors of the economy in an attempt to stimulate economic activity. However, new bank lending activity in the emerging Europe region remains modest despite such encouragement from the authorities.

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

5 

Banks Multilateral International Financial Support Additionally, the IMF, the World Bank and some developed EU member states and other international financial institutions (IFIs) have also provided funds to the more troubled sovereigns such as Hungary, Lithuania, Latvia and Romania to help mitigate the imbalances in these countries’ economies and provide some much‐ needed stability for their respective financial sectors. More resilient banking systems in more sound operating environments in emerging Europe did not have to resort to international public support measures during the crisis. IFIs have also been stepping up lending to boost the economies. The European Bank for Reconstruction and Development (EBRD), European Investment Bank (EIB) and World Bank have created a EUR24.5bn banking sector support initiative for banks in the region. The World Bank is increasing its lending — both as part of IMF‐led packages and to non‐crisis countries, for example through budget support Program Development Loans. In response to the crisis, the EBRD plans to invest EUR8bn in emerging Europe in 2009, up over 50% from 2008 levels. The bank’s annual business volume reached EUR5.8bn by end‐August 2009, 95% above the volume reached in the prior year. The IFIs have also played an important coordination role in “bailing in” foreign parent banks to support IMF programmes, securing agreements with them to “maintain exposure” (though not necessarily at 100% of prior levels) and thus preventing the much feared exit of key strategic investors in the region. 

Profitability  Given the level of GDP contraction in most banking systems in emerging Europe, reduced growth in assets, and a general increase in funding costs, Fitch would have expected pre‐provision profitability in the banking systems to have deteriorated more significantly. Based on the financial results for 6M09, however, it appears that the depth of recession has not fully filtered through into pre‐provision profits, partly due to a time lag. With the exception of the Baltic states and Slovakia, where the decline in pre‐provision profit was double‐digit (Estonia and Lithuania experienced the sharpest fall — of around 45% yoy), the banking systems covered in this Special Report reported relatively resilient pre‐provision profits. The Baltic states suffered from a sizeable downturn of their economies, and sharp price erosion on the local real estate markets, while the Slovak banking system lost FX revenue streams. Profitability after costs of risk, however, presents a different picture in all banking systems. Chart 4: H109 Year‐on‐Year Key Items Change in the Income Statement (%)

Revenue

Costs

Pre‐provision profit

100 75 50 25 0 ‐25 ‐50 Lithuania Estonia Slovakia

Latvia

Poland Bulgaria Slovenia Croatia Czech R. Turkey Hungary Romania

Slovenia: Change for 7M09 yoy. Croatia and Romania for 2008/07 Source: National sources and Fitch;

Only the Turkish banking system managed to strengthen its pre‐tax result considerably — by 32% yoy — despite higher loan impairment charges. The performance of the Turkish banking system reflects a significant widening of margins and resilience to the challenges arising from the global financial crisis. In the case of Hungary, performance would be negative if data excluding the branches of foreign banks were used. Banking Systems in Emerging Europe Structural Problems Remain December 2009 

6 

Banks The economic conditions have affected both lending and transaction volumes, which will lead to pressure on revenues. Bulgaria and Poland are among the few banking systems to have still shown loan growth. While some banks are able to pass on their liquidity premia to their customers, this depends on the competitive landscape. As banks look to rebalance funding structures, the cost of funding increased significantly. This arises either from higher fund transfer prices in internationally active banking groups’ centralised treasury activities or from the hike in risk premia in respect of countries in this Special Report. To an extent, the banking systems in emerging Europe, in particular in countries where subsidiaries of Western European banks are represented, had already started to gather customer deposits in order to reach more balanced loans/deposits ratios. This seems to be less of an issue in the Czech Republic, Slovakia, and Turkey, given their low loans/deposits ratios. As the volume of available deposits in banking systems has not grown substantially yoy, the deposit‐gathering efforts have started fierce competition on price, which threatens to gradually erode the NIM. Chart 5: LLP as % of Pre‐Provision Profit H108

(%)

2008

Latest

350 300

350

328 255

250 200 150 100 50 0 Latvia Lithuania Estonia Slovenia Poland Bulgaria Hungary Slovakia Czech R. Turkey

Croatia Romania

Latest data: Q209 ‐ PL, HU, SK, CZ; Aug 09 ‐SI, BL, TR; Q309 ‐ LA, LI, ES Source: National sources and Fitch

The increase in loan impairment charges in the region has been substantial between 2007 and H109 and Fitch expects loan impairment charges to be the biggest threat to performance in 2010. These are likely to remain at an elevated level, given the continued inflow of bad loans. Costs of risk vary significantly between banking systems: in the Baltic states, loan impairment charges completely eroded banks’ pre‐provision profits in H109, whereas other banking systems still have some buffer to absorb credit costs through operating profits. While no interim data are available for Romania, Fitch understands from the two largest banks in the banking system that their combined loan impairment charges accounted for around 50% of their pre‐provision operating profits. As a reaction to deteriorating profitability, cost control has become critical, with banks delaying investments and/or large branch expansion programmes and foreign banking subsidiaries also closing unprofitable branches. These trends have already been manifested in the financial data for H109 (Lithuania being a notable exception, where goodwill impairments resulted in soaring operating costs (+19% yoy)). Fitch believes that banks will continue to manage costs cautiously well into 2010 due to the revenue contraction. This may include some staff redundancies to adjust banks’ scale of operations. To conclude, Fitch assumes that net income in most banking systems will remain under pressure from lower revenue generation and higher loan impairment charges. Negative mark‐to‐market valuations of securities are less of an issue, provided that financial markets and local economies do not return to a state of deep distress. Ultimately, the subdued earnings capacity affects banks’ internal capital generation, which can be a challenge for those systems with weaker capital bases.

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

7 

Banks Asset Quality 

Croatia

Romania

Slovenia

Bulgaria Czech Republic Slovakia

Poland

Hungary

Turkey

Estonia

Lithuania

Latvia

The recessionary operating environment caused NPLs to increase Chart 6: Costs of Risk strongly in most economies. NPLs are (%) 2008 H109 still increasing, but the speed of inflow 8 is gradually falling for most countries so 6 the peak should be reached some time 4 during 2010. Broadly speaking, 2 observed asset quality trends are largely in line with the level Fitch 0 anticipated in its moderate stress scenario, which resulted in some negative rating actions in April 2009. Concerns also exist over the current Croatia, Romania ‐ no data for H109 high level of restructured loans in some Source: National sources and Fitch of the banking systems, as restructuring efforts can mask deterioration of underlying asset quality. The comparability of cross‐country asset quality data is limited — despite the implementation of IFRS. While Fitch understands that NPL data are broadly based on loan receivables that are 90 days overdue, the scope of NPLs can differ from country to country and even within countries, as data can also vary because of different write‐off policies. For instance, some countries (such as Poland, Bulgaria, Slovenia and Hungary) currently use both qualitative and quantitative factors, which are typically more conservative than IFRS‐based rules. This is also valid for asset quality data for Romania which are based on regulatory data and are typically much higher than IFRS derived ratios. In addition, cross‐ country comparisons of loan impairments to problem loans are difficult, due to differences in disclosure and in the regulatory regimes applied in measuring impairment charges. Bearing in mind these caveats, Fitch believes that the data on NPLs indicate general asset quality trends and also the speed with which loan quality has deteriorated in the region. Chart 7: NPL Ratios ‐ Ranked by Growth Since End‐2008 (%) 2006

2007

2008

Latest

15

10

5

0 Latvia Lithuania Bulgaria Estonia Romania Poland

Hungary Slovenia Czech R. Slovakia

Turkey

Croatia

Latest: Q109 ‐ CR; Q209 ‐ CZ, HU, RO, SK, TR; Aug09 ‐LI, SI; Q309 ‐ BL, ES, LV, PL Source: National sources and Fitch

NPL ratios reached double‐digit percentages in Latvia, Lithuania and Romania. However, as stated above, a more realistic assessment of asset quality would also include the proportions of restructured loans, which are not consistently available. On an individual bank level in certain markets, Fitch has been informed that restructured loans can account for up to 20% of a bank’s loan book. Despite a forecasted 14.5% contraction of GDP in 2009, Estonia recorded a relatively low increase in the level of NPLs compared with Baltic peers; however the relative growth of overdue loans Estonia experienced since the onset of the crisis was one of the highest in emerging Europe, which may suggest problems over and above that captured by public data on NPLs. In addition, the magnitude of the problem may Banking Systems in Emerging Europe Structural Problems Remain December 2009 

8 

Banks Chart 8: Loan Book at End‐ H109 Retail other Retail mortgages

Non‐retail

(%) 100 80 60 40

Poland Romania Croatia Estonia Czech R. Lithuania Hungary Slovakia Latvia Bulgaria Turkey Slovenia

20 0

Source: National sources and Fitch

not be fully reflected in official Estonian statistics, since renegotiated or restructured loans are not disclosed. In other economies in emerging Europe the increase in NPLs has been less dramatic. At end‐H109, Fitch estimates that the coverage ratio has remained in excess of 50% in all banking systems covered by this Special Report, except for Lithuania, where it stood at approximately 26%, which is low. At end‐H109, parent banking groups made additional provisions for Baltic exposures at group level. Nevertheless, the collective reserve coverage ratio of around 50% implies that banking systems in the region rely on collateral to mitigate credit risk, which raises questions about the banks’ ability to liquidate collateral and whether realistic values have been assigned to collateral. The above coverage ratios are low by emerging market standards and are a source of concern, given the challenging operating environment and fall in asset values. Recent discussions in Latvia on the planned introduction of legislation limiting the recoverable amount on collateral to the current market value rather the value at loan origination surprised some of the Nordic lenders. Although it seems unlikely that this legislation will be introduced, the plans indicate that the legal rights of a lender over collateral differ from country to country and that political and social pressures are mounting on the economies. At present, there is a difference in most banking systems between the quality of lending to corporate and to retail customers: corporate loans are currently performing more weakly (with the exception of Turkey, Romania, Bulgaria, the Czech Republic and the Slovak Republic). In addition, many banks in emerging Europe have concentrated loan portfolios by borrower, which is an additional source of risk. Broadly speaking, corporates in the region tend to be flexible in adjusting their cost base to changes in their market environment. However, given the relative openness of the economies in emerging Europe, the scale and speed with which the global recession affected the markets caught companies off guard and many struggled to meet their working capital requirement against the backdrop of restricted availability of credit. Most of the economies in emerging Europe rely on exports, making the manufacturing and automotive sectors more vulnerable industry segments, although the former experienced some stabilisation as companies started to replenish their stocks while the automotive sector received some temporary support from the German scrappage scheme. As the latter was abandoned in Q309, there may be some adverse impact on the automotive sectors in the region, notably the Slovak Republic and the Czech Republic. Commercial real estate lending, construction, retail and other consumer‐based industries, as well as small and medium‐sized entities, are further sectors whose creditworthiness is sensitive to economic downturn. Slovenian banks have financed a number of management buy‐outs, which are typically highly leveraged and are not performing during the current downturn in the credit cycle. To date, the asset quality of the retail loan books has benefited from a relatively high proportion of residential mortgages in the loan portfolios, which has been a key anchor product in the region. Mortgage borrowers are generally less likely to default on their mortgages compared with other types of debt, as long as they remain in employment. Consequently, the current delinquency rates observed in mortgage lending, although rising, are still lower compared with delinquencies in unsecured lending. However, as the seasoning of the portfolios progresses, and as unemployment rates in most of emerging Europe are yet to peak, Fitch is concerned about possible negative trends in asset quality in banks’ retail mortgage loan books. Some countries including Hungary, Poland and Slovenia have put into place special guarantee programmes to limit the risk that banks are facing from defaulting mortgage borrowers, provided that certain conditions are met. As these programmes are still nascent, it remains to be seen how effective they are in practice and whether they create moral hazard. Notably, unsecured consumer credit has been a key driver of asset quality trends in Romania and Bulgaria, as well as Turkey (credit cards). However, some credit risk mitigation is in place as borrowers (eg in Bulgaria) assign their salaries as collateral, so banks are more

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

9 

Banks exposed in an environment with rising unemployment. To some extent, consumer lending remains a business area that has remained largely untested in a downward environment following strong recent growth, as banking systems have been traditionally lending to corporates.

Chart 9: Change in House Prices  At end­Q109  ­60 

­50 

­40 

­30 

­20 

­10 

0 

10  Czech Republic  Slovakia  Croatia  Hungary  Poland  Slovenia  Bulgaria 

Downward adjustments in Lithuania  national real estate markets put Estonia  further pressure on asset quality. Latvia  Based on data for residential Data for Croatia, Czech Republic, Hungary, Lithuania,  real estate prices from the IMF Slovakia as at Q408  Source: IMF (see Chart 9), the Baltic residential real estate markets have experienced the sharpest price corrections, after years of steep increases in real estate value. Between 2001 and 2007, house prices in Lithuania increased by more than 200%, while Latvia and Estonia reported increases of 164% and 156%, respectively.1 Other banking systems with a sizeable share of mortgage lending (such as Hungary or Poland) suffered relatively moderate falls in residential real estate values, while the Slovak Republic and in particular the Czech Republic appear to have experienced increases in property prices, although the most recent data indicate that there could be a decline in real estate values on the supply side. Fitch is also concerned about trends in property developments in the region. Based on anecdotal evidence, Fitch understands that transaction volumes have fallen substantially in some markets after having experienced a property boom, with apartments currently remaining unsold. It also seems that some banks (with the exception of those on the advanced ratings‐based approach) do not review the value of their real estate collateral annually, but typically every three years or when a mortgage loan becomes impaired. This exposes banks to additional downside risk as the market value of real estate has fallen.

Chart 10: Share of Lending in FX (%) 100 80 60 40 20 Latvia Estonia Croatia Lithuani Hungary Romani Bulgaria Poland Turkey Czech Slovenia Slovakia

0

Source: National sources and Fitch 

Lending in foreign currency dominates the loan books in the Baltics, Croatia, Hungary, Romania, and Bulgaria, as these countries are experiencing an interest rate differential between the foreign and local interest rates. Other banking systems with notable lending in foreign currency include Poland and Turkey. Fitch considers foreign‐currency lending — particularly to retail customers — to be higher‐risk, as movements in foreign exchange rates are typically unhedged. Risks also depend on the different exchange rate regimes in the countries of the region: some economies have a currency peg (Latvia) or currency boards (Estonia, Lithuania, and Bulgaria). These currency mechanisms constrain the speed of economic adjustment, which may put additional pressure on the currency scheme. Any prolonged depreciation would have severe repercussions on asset quality in these banking systems. In countries with a free‐floating currency, such as Hungary, Romania and Poland, a material weakening of the local currencies had a negative impact on asset quality, particularly in Q109. In Hungary, both corporate and retail sectors were affected, while in Poland, this mainly affected corporate customers as they experienced problems in servicing their FX derivatives. New lending in foreign currency in CHF in Hungary has been largely curbed, and lending in foreign currency may become subject to further legislation, as proposed by the National Bank of Hungary. While the weakening of the local currencies translated into an increase of the capital burden in Q109, some borrowers benefited from a lower base interest 1

Source: National Bank of Hungary

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

10 

Banks rate in the foreign‐currency, which partially offset the sharp FX movement. In Fitch’s opinion, this situation is not sustainable in the long term, as interest rates are likely to rise. The agency notes that recent FX appreciation has eased some of the pressure on asset quality. 

Funding  The funding model is a key challenge faced by the various banking systems across the region. The global crisis exposed those with high loans/deposits ratios and those reliant on external funding sources. Those banking systems that enjoy large savings pools (thus large deposit bases) will be better positioned to support an economic upturn. Systems that need to reduce reliance on foreign sources have had to increase competition for deposits, which is likely to continue for some time to come. The knock‐on of this is a higher cost of credit. Banking systems where this feature is more prominent will be less able to support an economic recovery.

Turkey

Czech R.

Croatia

Slovakia

Poland

Bulgaria

Hungary

Romania

Slovenia

Latvia

Estonia

Lithuania

Chart 11 highlights notable differences Chart 11: Loans/Deposits Ratios between the loans/deposits ratios of the various banking systems. The Baltic (%) 2007 2008 H109 states, Slovenia, Hungary and to some 190 extent Romania show the highest loans/deposits ratios, indicating a 160 greater dependence on wholesale 130 funding or funding from foreign banks. This occurrence is attributable in part 100 to the ownership structure. In the run up to the crisis, often highly rated 70 foreign parents of financially integrated groups provided funding to their subsidiaries in Hungary, the Baltics and Source: National sources and Fitch Romania. In one sense, this has been driven by economic reasoning, as the head office can typically access cheaper and more diversified sources of funding in the capital markets. With the global credit crisis, Fitch has identified a change in funding strategy at the parent banks. While the foreign parent banks could still provide liquidity support to their subsidiaries if necessary, they have delegated more responsibility to their international banking subsidiaries in terms of deposit collection in the local markets. In some markets, this has started a “war for deposits”. However, reflecting their comfortable loans/deposits ratios, Turkey, Slovakia and the Czech Republic represent an exception. Latvia has a large proportion of non‐resident and foreign‐currency deposits, which could be vulnerable to deposit flight. The deposit freeze in Parex banka has been extended until end‐June 2010 and will be lifted should depositor confidence strengthen and the bank’s liquidity position improve. Recent data for Q209 therefore reveal that Latvia is the only Baltic country where levels of deposits are continuing to fall. Estonia’s deposit base has been the most stable, with no outflows. A high loans/deposits ratio can also generally be found in banking systems where lending in foreign currency predominates. In these economies, foreign‐currency loan products allowed customers to access more affordable credit, but did not take into account the exposure to FX risk. Consequently, during the economic growth experienced until mid‐2008, structural liquidity imbalances were building up. The issues arising from lending in foreign currency are possibly being tackled as supervisors are likely to put in place stronger disincentives to make arguably riskier products more capital‐intensive and hence less attractive to banks.

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Banks Chart 12: Deposits End‐ H109

Chart 13: Growth of Deposits in H109 Non‐retail

(%) (%)

Non‐retail

Retail

100

Retail

Total

30 20

80

10

60

0

20

‐10

0

‐20

Poland Croatia Slovenia Turkey Slovakia Romania Czech R. Hungary Bulgaria Latvia Estonia Lithuania

40

Slovenia Czech R. Poland Romania Turkey Hungary Estonia Bulgaria Lithuania Latvia

Croatia Slovakia

Source: National sources and Fitch

Source: National sources and Fitch

Although retail deposits are a key source of funding in emerging Europe, except for the Baltic states (see Chart 12), only sustainable growth of household savings could restore the funding gap between loans and deposits. However, given the economic downturn, rising unemployment rates and reduced wage growth, this is unlikely in the short term. Consequently, Fitch views positively the current aspirations of stakeholders to establish a more balanced funding profile, with deposits funding loans, as the agency believes this to be a key issue in economies which traditionally have been dependent on external financing. However, the rebalancing of funding structures in countries with excessive loans/deposits ratios may be very difficult to achieve in the medium term as it implies limited availability of new credit, which would constrain GDP growth. The high loans/deposits ratio in the Slovenian banking system also highlights the banking system’s dependence on wholesale funding. Slovenian banks have accessed the international banking markets in recent years to compensate for slow growing domestic deposits. In H109, however, deposit growth in Slovenia was the most dynamic in emerging Europe, mainly due to the state providing liquidity to the banking sector in form of medium‐term deposits in order to cover some of the refinancing needs for 2009/2010. Although this action has eased some of the liquidity pressure, it does not resolve the funding issue that the relatively small banking system has been faced with. The Republic of Slovenia also put into place a sizeable government guaranteed debt issuance programme to allow banks to tap the international banking markets. Chart 14: Maturing of Issued Debt and Syndicated Loans Excludes intra‐group lending (EURm)

Q409

2010

2011

Later than 2011

14,000 12,000 10,000 8,000 6,000 4,000 2,000 ‐ Turkey Hungary Czech Slovenia Poland Slovakia Romania Latvia

Croatia Lithuania Bulgaria Estonia

Excludes intra‐group lending Source: Deallogic 

Capital  Given weaker profitability and asset quality, capitalisation is generally under pressure in the banking systems in emerging Europe, although to varying degrees. The chart below highlights the different levels of capitalisation among the banking systems at end‐H109. Fitch believes that sizeable capital injections will be necessary across the region. While it is still difficult at this stage to determine the

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Banks precise amount of capital needed in each banking system, given the uncertainty over the length and the depth of the asset quality problems and effective recovery rates due to the sharp correction on the local real estate markets, Fitch estimates that recapitalisation requirements for Lithuania and Latvia could be substantial. These results were in line with Chart 16. In this chart, Fitch shows the proportion of net impaired loans (impaired loans after loan impairment reserves but before considering collateral) as a percentage of regulatory capital. Banking systems such as Lithuania, Latvia and Romania appear to have greater reliance on collateral as a credit risk mitigant and are therefore exposed to a fall in collateral value, as some markets have seen significant declines in house prices. Foreign ownership would generally be a source of comfort, as the foreign parents could be expected to provide support to their subsidiaries, however, given the global nature of the crisis they can be capital constrained in some cases. Fitch therefore believes that in the short term, additional capital from foreign parents would only be provided if deemed critical, but not to create counter‐cyclical buffers for loss‐absorption. Chart 15: Total Capitalisation Ratios End‐2008

(%)

End‐H109

25 20 15 10 5 0 Estonia

Turkey

Croatia Bulgaria Lithuania Romania

Czech Hungary Slovenia Republic

Latvia

Slovakia

Poland

End‐Q109: Lithuania, Romania, no interim data for Slovenia Source: Central Banks

Additionally, the agency notes that foreign parents may use alternative ways of making capital available, including subordinated debt (although this is generally not loss‐absorbing in a going concern) and hybrid capital. Strategic investors have manifested their commitment to the region in public statements and have injected capital, for example in subsidiaries in Romania, Hungary and in the Baltic states. Fitch notes regulators’ actions to raise the minimum capital requirements (as was the case in Romania). In Bulgaria’s case, the regulators already require a 12% minimum capital ratio, which would be, in Fitch’s opinion, an adequate level for most countries in emerging Europe given the risks in their operating environment. As the general economic outlook remains challenging, Fitch considers it likely that several banking systems will make no dividend payments to their parents for the financial year end‐2009 to improve capital. Chart 16: Net Impaired Loans as a Percentage of Capital Base End‐H109 Net impaired loans

(%) 100

Capital

80 60 40 20 0 Lithuania

Latvia

Romania

Poland

Hungary

Czech Slovenia Bulgaria Slovakia Republic

Estonia

Turkey

Source: Fitch

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

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Banks Appendix 1: Authorities' Interventions to Support and Enhance the Activity of the Banking Systems Since Q408  Central Bank Interventions – New Regulations Bulgaria

Croatia

Minimum reserve requirements and other liquidity measures November 2008 ‐ Lowering of the reserve requirement to 10% from 12%. This includes all customer deposits. January 2009 ‐ Lowering of the reserve requirement on funds attracted from abroad to 5% from 12%. November 2008 ‐ Abolishment of the marginal reserve requirement (requiring banks to hold additional reserves for foreign currency borrowing) and easing the mandatory reserve rate to 14% from 17%.

Czech Republic Estonia Poland

October 2008 ‐ Introduction of a reverse repo facility.

Slovakia

November 2008 ‐ Introduction of new liquidity regulation, stating that the ratio of liquid assets/volatile liabilities must not be lower than 1.

October 2008 ‐ Additional liquidity to the system through repo transactions (extended list of eligible securities. October 2008 ‐ Conclusion of an agreement with the ECB and SNB and commenced FX swap transactions: USD, EUR and CHF. These swap tenders will be valid until January 2010. January 2009 ‐ repurchase of about PLN8.2bn of bonds prior to their maturity (2012). May 2009 ‐ Reduction from 3.5% to 3% of the mandatory reserve requirement.

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

Provisioning and classification of loans February 2009 ‐ Some relaxation in the regulatory provisioning criteria but the effect on capital is neutral.

Capitalisation

Other regulations

Banks required to hold additional capital (i.e. increased risk weightings applied) for lending to unhedged borrowers in FX (introduced pre‐crisis).

Loan growth limit of 1% per month (excludes lending to the public sector).

October 2009 ‐ Two new instruments eligible as Tier 1 capital: convertible debt and long‐term subordinated debt.

April 2009 ‐ New regulation preventing banks from requiring additional collateral from residential mortgage borrowers if the LTV increases to over 100% but the debt is still being serviced.

14 

Banks Central Bank Interventions – New Regulations Slovenia

Turkey

Hungary

Latvia

Lithuania Romania

Minimum reserve requirements and other liquidity measures November 2008 ‐ Amendment of calculation of liquidity ratios ‐ banks are allowed (until end‐2009) to include their collateral deposits with BOS, in the Category 1 liquidity ratio.

Provisioning and classification of loans

October 2008 ‐ Steps to improve FX liquidity including launching daily FX auctions and re‐opening the FX deposits market. These steps were not targeting individual banks but rather aimed at providing support to the sector. December 2008 ‐ Regulatory reserve requirement lowered to 9% from 11% for FX. October 2009‐Lowering of regulatory reserve requirement to 5% from 6% for Turkish Lira. October 2008 ‐ Introduction of an overnight FX swap facility (following an agreement with the ECB) providing euro liquidity. October 2008 ‐ Introduction of two credit facility tenders: a two‐week collateralised credit facility (25bp + NBH base rate) and a six‐month floating‐rate collateralised credit facility for counterparty credit institutions. February 2009 ‐ The NBH joined the weekly EUR/CHF FX swap operations (SNB provides the NBH with CHF against the euro) with a term of seven days at a fixed price. This measure will be in place until January 2010. February 2009 ‐ Introduction of a new longer‐term instrument with six‐ month maturity, up to EUR5bn. February 2009 ‐ Acceptance of municipality bonds as collateral. March 2009 ‐ Introduction of a six‐month EUR/HUF swap tender to provide euro liquidity entailing the condition that participating commercial banks must undertake to maintain their domestic corporate loans portfolio at a minimum of end‐2008 levels throughout 2009. January to November 2008 ‐ Gradual lowering of minimum reserve requirements for deposits and debt securities maturing in over two years to 3% (prior to January 8%) and 5% (previously 7%) for all the other liabilities included in the reserve base. November 2008 ‐ Lowering the minimum reserve requirements to 4% from 6% on all funds maturing within two years. November 2008 to July 2009 ‐ Gradually lowering the minimum reserve requirement for RON funds to 15% from 20%. May‐July‐August 2009 ‐ Gradually lowering the minimum reserve requirement on FX denominated funds to 30% from 40%. The reserve requirement for long‐term FX funds has been annulled. In November 2009, the reserve requirement for FX has been further reduced to 25%.

June 2009‐ Introduction of a new restructuring scheme for non‐performing credit cards. Participation is voluntary.

Capitalisation Other regulations October 2008 ‐ Some statutory deductions from Tier 1 capital (prudential filter) were reduced to zero, which translated into capital relief in the banking system. FX lending to retail customers has been banned (it constituted only a minor part of lending anyway).

May 2009 ‐ The Hungarian state injected in HUF30bn (EUR100m) capital into FHB, coming indirectly from the IMF aid package, in order to boost the bank's lending activity.

March 2009 ‐ changes in the provisioning system. March 2009 ‐ some relaxation in the regulatory provisioning criteria.

March 2009 ‐ Inclusion of interim profits in Tier 1 capital calculation. May 2009 ‐ Increase of the minimum solvency requirement to 10% from 8%, for three years for the duration of the IMF program.

In January 2009, regulations on retail loans have been revised to ease lending on secured mortgages and put pressure on unsecured lending in foreign currency

Source: Banks and Central Banks in the CEE

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

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Banks Government Interventions Recapitalisation Bulgaria Croatia Czech Republic Estonia Poland

Slovakia

Liability guarantees and deposit insurance schemes October 2008 ‐ Increase in the deposit guarantee fund to EUR50,000 from EUR20,000.

Asset guarantee schemes to encourage bank lending Other legislation

Aid received from the IMF and developed EU countries

October 2008 ‐ Increase in the deposit guarantee fund to EUR50,000 from EUR25,000. October 2008 ‐ Increase in the deposit guarantee fund to EUR50,000. October 2008 ‐ Increase in the deposit guarantee fund to EUR50,000 from EUR25,000.

1. August 2009 ‐ Residential mortgage borrowers who became unemployed since July 2008 are supported: maximum amount: PLN1,200 monthly for up to one year, then after a two‐year grace period, this support must be returned over eight years but with no interest. Response to this form of support has been insignificant to date. 2. January 2009 ‐ Amendments to a government programme (enacted 8 September 2006): "Rodzina na swoim" ‐ state subsidy for residential mortgages granted to families and lone parents ‐ for the first eight years 50% of the interest instalment is subsidised, the loan can only be in PLN and the size of the apartment cannot exceed 75 sq m or 140 sq m for houses. These amendments allowed more people to participate in this program and increased some limits ‐ consequently "Rodzina na swoim" was the key driver of mortgage lending in 2009. November 2008 ‐ Unlimited deposit guarantee provided January 2009 ‐ State guarantees of up to 55% for loans to household deposits. to companies employing fewer than 100 people). September 2009 ‐ The government approved a state aid programme for people who have lost their jobs due to the financial crisis and cannot afford to pay their mortgages. The total cost of the package is estimated at EUR12.4m.

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

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Banks Government Interventions

Slovenia

Recapitalisation Capital increase of SID bank by EUR160m to EUR300m, injected by the state.

Liability guarantees and deposit insurance schemes 1 ‐ SID and NLB received a state guarantee for securing issue of their MTNs. 2 ‐ State‐guaranteed medium‐term borrowing of NLB (EUR1bn). 3 ‐ State‐guaranteed foreign borrowing of SID (EIB: EUR300m; capital markets: EUR200m). 4 ‐ November 2008 ‐ Unlimited State guarantee for net deposits of natural persons and micro‐ and small enterprises. 5 ‐ Additional measures introduced in October 2008 targeting entities established in Slovenia: ‐ State guarantees to credit institutions and factoring of their receivables ‐ State loans/capital injections to credit institutions, (reinsurance companies, and pensions companies).

Turkey

Hungary

13 October 2008 ‐ the guarantee for “individual” bank account deposits placed with the domestic credit institutions was extended to an aggregate amount of HUF13m per person.

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

Asset guarantee schemes to encourage bank lending Other legislation March 2009 ‐ Guarantee scheme (max EUR1.2bn) for loans to enterprises (excluding financial institutions), implemented through a state‐owned SID bank. ‐ Guarantee scheme provided to banks for general granting of loans to enterprises ‐ Individual state guarantees for enterprises borrowing.

1 ‐ October 2009 (still not active) ‐ State guarantee fund established to support SMEs . Part of the future NPLs will be taken over by the state. However, total size of the fund is relatively small, at TL10bn. 2 ‐ Subsidised lending to certain sectors and SMEs though state banks in Q408 and Q109. This is also small, at less than TL1.5bn. In late March 2009, as part of the IMF package, Hungary's top bank OTP and listed mortgage bank FHB (largest lenders without a foreign parent bank) received a total EUR1.8bn in loans from the Hungarian state in order to boost lending activity. Of the total amount, EUR1.4bn was for OTP and EUR0.4bn for FHB. The loan (around 245‐250bp above the relevant benchmark rates) matures on 11 November 2012, and must be repaid in eight equal instalments starting November 2010.

Aid received from the IMF and developed EU countries

1. Enactment of the Financial ü Stabilisation Act: ‐ The Hungarian State will provide a sum of HUF600bn denominated in FX, which could be utilised between 2008‐2010 from the credit facility provided by the IMF for Hungary ‐ A recapitalisation measure to inject new capital into credit institutions ‐ A guarantee measure to guarantee obligations of credit institutions arising from a debt security or a credit facility agreement between 23 December 2008 and end‐2009

17 

Banks Government Interventions

Latvia

Recapitalisation November 2008‐ present ‐ Liquidity and capital aid offered to Parex Bank which was later nationalised.

Lithuania Romania

Aid received from the IMF and developed EU countries

Liability guarantees and deposit insurance schemes October 2008 ‐ Increase in the deposit guarantee fund to EUR50,000 from EUR20,000

Asset guarantee schemes to encourage bank lending Other legislation June 2009 ‐ New legislation allowing ü authorities to take ownership of banks when needed.

October 2008 ‐ Increase in the deposit guarantee fund to EUR100,000 from EUR22,000 October 2008 ‐ Increase in the deposit guarantee fund to EUR50,000 from EUR20,000

ü ü

"First home" program launched by the government to provide a guarantee for customers purchasing their first homes. The package totals EUR1bn. Some banks, however, claim that it is not easy to find eligible clients for this scheme.

Source: Banks and Central Banks in the CEE

Access Under Arrangements Currently in Place

Hungary Latvia Romania

Effective date of arrangement 06 Nov 2008 23 Dec 2008 04 May 2009

IMF aid Amount of arrangement Balance drawn as of Jun (USDm) 09 (USDm) Duration (months) 17 16,529 11,900 27 2,387 840 24 17,948 6,854

Other funding EU (USDm) 8,400 4,382 6,550

WB (USDm) 1,300 565 1,310

Other (USDm) 0 3,251 1,310

Total financing package (USDm) 26,229 10,585 27,118

Source: IMF

Banking Systems in Emerging Europe Structural Problems Remain December 2009 

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Banks

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