Bbee0312 Fitch Banker i Baltikum

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Europe

Special ReportBanking Systems in EmergingEurope Structural Problems RemainExecutive 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 ofthe global financial crisis threw the region into distress 14 months ago.

Based on financial results for the first six months of 2009 (6M09), the fullimpact of the recession given the level of GDP contraction in most bankingsystems, reduced growth in assets, and still elevated funding costs does notappear to have fully filtered through into preprovision profits. Costs of risk,however, vary significantly, with operating profits in the Baltic states beingcompletely eroded in 6M09, whereas other banking systems still have somebuffer to absorb markedly higher credit costs. Net income in 2010 in mostbanking systems will remain under pressure from lower revenues and higherloan impairment charges.

The deterioration in asset quality is still broadly in line with the assumptionsused in the stress tests carried out by Fitch Ratings in Q109. The agencyanticipates a continued inflow of nonperforming loans (NPLs) albeit at aslowing rate, with NPLs peaking in 2010 provided that the operatingenvironment does not deteriorate. Given significant levels of restructuredloans, 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, theaddressing of structural macroeconomic imbalances, together with theprospects of convergence between the banking systems in the region and themore developed banking systems in Europe. The structural issues include theneed for more balanced funding strategies between parents and theirsubsidiaries, a reduction in the proportion of lending in foreign currency, andreplenishing capital.

In respect of the relationship between parents and their foreign banksubsidiaries, the merits of foreign ownership in domestic banking systems mayhave to be reassessed in light of the experiences since the global financialcrisis, as foreign ownership can also act as a constraint to growth.

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

Overall, emerging Europe remains particularly negatively affected by the globalfinancial crisis; some of the countries in the region remain vulnerable onaccount of their financial and economic characteristics. Fitch forecasts thatGDP in emerging Europe will grow modestly by 2.6% in 2010, after contractingby 6.1% in 2009. However, downside risks to economic prospects and credit risksremain. Fitch continues to see wide variation in the economic vulnerabilitiesand credit standing of the countries in emerging Europe, and it is important torecognise that the countries do not form a homogenous unit. Fitch Ratingsconsiders banking systems with greater funding and capital flexibilities (such asTurkey, the Czech Republic, the Slovak Republic, and Poland) to be better

placed to support expected future growth in their respective countries.

AnalystsFinancial Institutions: Michael Steinbarth, London+44 20 7682 [email protected]

Michal Bryks, Warsaw+48 22 338 62 [email protected]

Malek Soubra, London+44 20 7417 [email protected]

Mark Young, London+44 20 7417 [email protected]

Sovereigns: Ed Parker, London+44 20 7417 [email protected]

Douglas Renwick, London+44 20 7417 [email protected]

Eral Yilmaz, London+44 20 7682 [email protected]

Related Research Emerging Europe Sovereign Review: 2009

(October 2009) Major Western European Banks Exposure to

Eastern Europe and the CIS, Downside RiskContained? (April 2009)
http://creditdesk/reports/report_frame.cfm?rpt_id=432956http://creditdesk/reports/report_frame.cfm?rpt_id=477608


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Banking Systems in Emerging Europe Structural Problems RemainDecember 2009 2

Structural Challenges Facing the Banking SystemsIn this section, Fitch summarises some of the structural issues that the bankingsystems in emerging Europe face.

The recent financial market crisis has altered the competitive landscape in thebanking systems covered in this Special Report. However, large transformationaltransactions are currently unlikely, in light of the current capitalmarket conditionsand diverging views on future profitability in the sector. The national governmentsin Poland, Slovenia and Turkey still own majority stakes in domestic banks withlarge market shares. However, these stakes do not appear to be available for sale,although the Turkish government is considering its position. Fitch would expectforeign strategic players in emerging Europe to review their operations to identifyany countries in which their franchises are underdeveloped. This may also betriggered through reviews by the European Commission (EC) as part of state aidreviews. The Belgianbased KBC Bank, for example, has announced its plans to floata minority stake in one of its core subsidiaries in order to raise capital and reduce

assets. Acquisition opportunities may also arise as domestic banks reassess theircompetitive positions. Even banks with previously satisfactory franchises may belooking for stronger partners if the potential for revenues proves insufficient toweather current conditions or more crucially if funding strategies cannot be realigned to the changed market conditions.

As expressed in a Special Report in April 2009, in Fitchs opinion, the likelihood ofparent banks simply letting their international subsidiaries fail is considered remotewhere the banking groups concerned attach a high level of strategic importance tothe region. A default of a foreignowned subsidiary in the region would posereputational damage, a real threat of deposit flight away from foreignowned banksin the same country or may even trigger contagion to the banking systems acrossthe region. As a result, Fitch expects stability both for ownership structures in most

banking systems (assuming an at least satisfactory customer franchise) and the levelof foreign ownership. Foreign ownership has facilitated a transfer of knowhow andresulted 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 reassessedpost global financial crisis. As the controlling shareholder, foreign parent banksdetermine business strategy and have been in part responsible for the rapid loangrowth, 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 toresort to public support in their home countries. Consequently, the parent banksmay have to exit certain noncore banking activities as part of their restructuringactivities. The process of deleveraging capital and/or funding constraints canrequire foreign parent banks to limit balance sheet growth at their foreign

subsidiaries and therefore dampen chances of economic recovery irrespective oftheir public commitment to remain investors in the markets and retain certainlevels of exposure.

Fitch considers the sizeable increase in NPLs as a threat to the health of bankingsystems, as NPLs restrain banks ability to lend. The parameters governing whichloans can be restructured, and how, give banks some leeway in selecting the loansfor restructuring so that the extent of the deterioration in asset quality may not befully transparent. In addition, workout processes are generally timeconsuming,resource and capitalintensive and tie up liquidity. In order to restore confidencein the banking systems and speed up the economic recovery process, banks willneed to clean up their balance sheets and crystallise credit losses.

The established business model of rapid loan growth appears to have beendiscarded at least temporarily. Fitch believes that there is still scope for regionalconvergence between the newer EU member states and the more developedmember states, Turkey and Croatia. The potential for convergence will be the

Table 1: Banking Systemsincluded in the SpecialReport

MPI BSI Croatia 1 DHungary 1 DPoland 2 CSlovenia 2 CBulgaria 2 DCzech Republic 3 CSlovakia 3 CTurkey 3 CRomania 3 DEstonia 3 ELithuania 3 ELatvia 3 ESource: Fitch; as of November 2009.MacroPrudential Indicator (MPI), Banking

System Indicator (BSI).


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driver of future (but slower) loan growth. In order to promote sustainable growthand to avoid the continued buildup 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 excessivelending and possibly of riskier loan products, which in emerging Europe largelyconsist of lending in foreign currency.

Lending in foreign currency is a structural risk common to most banking systems inthe region. In the long term, lending in foreign currency could be reduced byminimising the interest rate differential between local and foreign interest rates onloans. However, this gradual transition to lending in local currency would take time,given the scope and the required rebalancing in some of the local economies. Inaddition, with the likely delay in the euro adoption in some countries in the EU, thiscontingent FX risk will persist. A much faster approach to address the issue involvesregulation. Lending in foreign currency is likely to be subjected to closer regulatoryscrutiny at either national or supranational level. A change in risk appetite at the

parent banks, as recently requested by the Austrian regulators, would thereforealso affect the lending activities of their international subsidiaries. Currently, thereare proposals to amend the EU Capital Requirements Directive to introduceadditional capital requirements for retail mortgage loans in foreign currency if theyexceed a certain loantovalue ratio. Finally, devaluation adds another dimension ofrisk to the asset quality of loans denominated in foreign currency.

Whilst there has been a tendency of regulatory easing during the crisis in mostbanking systems, Fitch considers that postcrisis the level of regulation of thebanking sectors will increase, with the possible downside of constraining bankingprofit. The EC has adopted legislative proposals to strengthen the supervision ofbanks, and may create a European Systemic Risk Board to monitor and assess risk tothe stability of the financial system. One of the crucial elements missing during thecredit market turmoil was a legally binding framework for crossborder crisismanagement in the banking sector. Therefore, in October 2009, the EC started aconsultation process on measures necessary for such a framework. This followeddiscussions by several international groups including the G20, the FinancialStability Board, and the Basel Committee as the issues faced by crossborderbanking groups extend far beyond the EU. The focus of the EC consultation is onsafeguarding financial stability and the continuity of banking services in the eventof crossborder banking crises. Such legislation could potentially have farreachingconsequences for crossborder groups, including in emerging Europe.

Macroeconomic Overview

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Chart 1: FiveYear Credit Default Swaps

Source: Bloomberg, November 2009

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


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in Q408/Q109. This resulted in an extreme widening of spreads for credit defaultswaps (which have narrowed since) as well as a serious liquidity squeeze on theinterbank market. The preservation of liquidity in financial institutions translated

into a very restrictive credit supply to domestic and international borrowers, withsome banks stopping new business altogether. At the same time, banksimplemented much more restrictive lending policies by tightening lending standardsand in some cases initiated a deleveraging process. In addition, demand for creditfrom corporate and retail customers dropped significantly due to cuts to investmentand inventories, uncertainty over the economy and job insecurity. Consequently,the worsening economic conditions, coupled with the collapse of global trade, sooncaused global GDP to severely contract in Q408 and Q109, bringing about arecession. Nominal bank credit growth was contracting across the region on aquarterbyquarter basis (see charts below).

Emerging Europe has been by far the worstaffected region in the world. FitchRatings 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 thananticipated. The agency forecasts that only Poland will be likely to report positiveGDP growth in 2009, while Estonia, Latvia, and Lithuania will suffer doubledigitdeclines 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 favourableglobal conditions. Indeed, it estimates GDP rose by around 1% qoq in Q209, afterplummeting 7% in Q109, led by a rebound in Turkey. But the recovery is likely to besubdued, due to weak investment, rising unemployment, moderate capital inflowsand credit growth, fiscal consolidation and a rebuilding of balance sheets.

External financing and currency risks, which were the main weakspots of manycountries 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 issuanceand relatively resilient privatesector rollover rates. Fitch estimates the regionsgross external financing requirement at USD304bn in 2009 and 2010, down fromUSD363bn in 2008.

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Chart 2: Bank Credit Contracting:Stable/Fixed/ Euro Currency QoQ

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Chart 3: Bank Credit Contracting:Floating Currency QoQ

Source: Datastream, IMF, Turkish BRSA and Fitch

Sovereign rating dynamics remain negative, as indicated by the balance of Positive toNegative 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 beout of recession. The Czech Republic, Poland, Slovakia and Slovenia had onlymoderate macroeconomic imbalances and bank credit booms; and their relativelyrobust credit fundamentals have allowed them to loosen macroeconomic policy


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(with credible, floating exchange rates aiding adjustment in the Czech Republic andPoland, and Slovakia and Slovenia sheltered from external financing pressures inthe euro area). The Czech Republic, Slovakia and Slovenia as well as Hungary are

very open economies (Poland less so hence its much shallower recession), highlyintegrated with German industry and concentrated in cyclical industries such ascars and electronics. These economies have benefited from the revival in Germanoutput, following the slashing of inventories in Q408 and Q109, and the Germangovernments scrappage scheme. However, Hungary remains mired in recession asit suffers under the weight of fiscal retrenchment and the unwinding of privatesector imbalances.

GDP is still declining in the Baltic and Balkan states, according to Q209 data. In thisregion, prior external imbalances were large, bank credit booms were pronounced,governments are having to implement procyclical fiscal tightening and, in the caseof the Baltic states and Bulgaria, exchange rate pegs have constrained the speed ofeconomic 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 seasonallyadjusted qoq data showed growth in Lithuania, although comparable data for theother Baltic states was unavailable at the time of publication.

Public Support MeasuresDomestic Support Banks in emerging Europe have witnessed an unprecedented amount of newregulations and guidelines in 2009, with all 12 countries covered by this SpecialReport witnessing interventions from their respective authorities in the wake of thefinancial crisis (see Appendix 1). Q408, as the international financial crisisintensified, was the starting point for such critical interventions. Increasing thedeposit insurance schemes and lowering the minimum reserve requirements wereamong the first tools used by some authorities in order to increase confidence andimprove liquidity in their particular banking systems. While Fitch believes that theabove measures helped improve depositors confidence, further interventions werenecessary to alleviate pressure on banks from the slowing and in most casescontracting economies in the regions. However, domestic public authorities in theregion 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 respectivecurrencies to the EUR where applicable.

Concerns over asset quality deterioration, present to varying degrees in emergingEurope, and the potential effect on banks profitability and ultimately capital,have also prompted the different authorities to adjust or introduce new regulationsin 2009. Fitch notes that, unlike in many developed countries and some emergingmarkets, there have been relatively few capital injections into banks, although itdid occur in Slovenia (SID Bank), Latvia (Parex banka, rated RD), and Hungary (FHB).The Slovenian government also earmarked funds for a capital strengthening of NLBand NKBM in the annual budget (as the Republic of Slovenia is indirectly a majorityshareholder), but no capital has been injected to date. In some countries, banksbenefited from a relaxation in the regulatory framework. Moreover, in somebanking systems in emerging Europe, local regulators encouraged foreign parentbanks to forego dividends and retain earnings to improve the capital ratios of theirsubsidiaries.

Finally, and perhaps most importantly in the current economic setting, somegovernments in emerging Europe have stepped in to provide loan guarantees toparticular sectors of the economy in an attempt to stimulate economic activity.However, new bank lending activity in the emerging Europe region remains modestdespite such encouragement from the authorities.


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Multilateral International Financial Support Additionally, the IMF, the World Bank and some developed EU member states andother international financial institutions (IFIs) have also provided funds to the more

troubled sovereigns such as Hungary, Lithuania, Latvia and Romania to helpmitigate the imbalances in these countries economies and provide some muchneeded stability for their respective financial sectors. More resilient bankingsystems in more sound operating environments in emerging Europe did not have toresort to international public support measures during the crisis.

IFIs have also been stepping up lending to boost the economies. The European Bankfor Reconstruction and Development (EBRD), European Investment Bank (EIB) andWorld Bank have created a EUR24.5bn banking sector support initiative for banks inthe region. The World Bank is increasing its lending both as part of IMFledpackages and to noncrisis countries, for example through budget support ProgramDevelopment Loans. In response to the crisis, the EBRD plans to invest EUR8bn inemerging Europe in 2009, up over 50% from 2008 levels. The banks annual business

volume reached EUR5.8bn by endAugust 2009, 95% above the volume reached inthe prior year.

The IFIs have also played an important coordination role in bailing in foreignparent banks to support IMF programmes, securing agreements with them tomaintain exposure (though not necessarily at 100% of prior levels) and thuspreventing 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 haveexpected preprovision profitability in the banking systems to have deterioratedmore significantly. Based on the financial results for 6M09, however, it appears thatthe depth of recession has not fully filtered through into preprovision profits,partly due to a time lag. With the exception of the Baltic states and Slovakia,where the decline in preprovision profit was doubledigit (Estonia and Lithuaniaexperienced the sharpest fall of around 45% yoy), the banking systems covered inthis Special Report reported relatively resilient preprovision profits. The Balticstates suffered from a sizeable downturn of their economies, and sharp priceerosion on the local real estate markets, while the Slovak banking system lost FXrevenue streams. Profitability after costs of risk, however, presents a differentpicture in all banking systems.

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Chart 4: H109 YearonYear Key Items Change in the Income Statement

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

Only the Turkish banking system managed to strengthen its pretax resultconsiderably by 32% yoy despite higher loan impairment charges. Theperformance of the Turkish banking system reflects a significant widening ofmargins and resilience to the challenges arising from the global financial crisis. Inthe case of Hungary, performance would be negative if data excluding the branchesof foreign banks were used.


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The economic conditions have affected both lending and transaction volumes,which will lead to pressure on revenues. Bulgaria and Poland are among the fewbanking 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 competitivelandscape. As banks look to rebalance funding structures, the cost of fundingincreased significantly. This arises either from higher fund transfer prices ininternationally active banking groups centralised treasury activities or from thehike in risk premia in respect of countries in this Special Report. To an extent, thebanking systems in emerging Europe, in particular in countries where subsidiaries ofWestern European banks are represented, had already started to gather customerdeposits in order to reach more balanced loans/deposits ratios. This seems to beless of an issue in the Czech Republic, Slovakia, and Turkey, given their lowloans/deposits ratios. As the volume of available deposits in banking systems hasnot grown substantially yoy, the depositgathering efforts have started fiercecompetition on price, which threatens to gradually erode the NIM.

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Chart 5: LLP as % of PreProvision Profit (%)

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

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The increase in loan impairment charges in the region has been substantial between2007 and H109 and Fitch expects loan impairment charges to be the biggest threatto performance in 2010. These are likely to remain at an elevated level, given thecontinued inflow of bad loans. Costs of risk vary significantly between bankingsystems: in the Baltic states, loan impairment charges completely eroded bankspreprovision profits in H109, whereas other banking systems still have some bufferto absorb credit costs through operating profits. While no interim data are availablefor Romania, Fitch understands from the two largest banks in the banking systemthat their combined loan impairment charges accounted for around 50% of theirpreprovision operating profits.

As a reaction to deteriorating profitability, cost control has become critical, with

banks delaying investments and/or large branch expansion programmes and foreignbanking subsidiaries also closing unprofitable branches. These trends have alreadybeen manifested in the financial data for H109 (Lithuania being a notable exception,where goodwill impairments resulted in soaring operating costs (+19% yoy)). Fitchbelieves that banks will continue to manage costs cautiously well into 2010 due tothe revenue contraction. This may include some staff redundancies to adjust banksscale of operations.

To conclude, Fitch assumes that net income in most banking systems will remainunder pressure from lower revenue generation and higher loan impairment charges.Negative marktomarket valuations of securities are less of an issue, provided thatfinancial markets and local economies do not return to a state of deep distress.Ultimately, the subdued earnings capacity affects banks internal capital generation,

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Asset Quality The recessionary operatingenvironment caused NPLs to increasestrongly in most economies. NPLs arestill increasing, but the speed of inflowis gradually falling for most countries sothe peak should be reached some timeduring 2010. Broadly speaking,observed asset quality trends arelargely in line with the level Fitchanticipated in its moderate stressscenario, which resulted in somenegative rating actions in April 2009.Concerns also exist over the currenthigh level of restructured loans in someof the banking systems, as restructuringefforts can mask deterioration ofunderlying asset quality. The comparability of crosscountry asset quality data islimited despite the implementation of IFRS. While Fitch understands that NPLdata are broadly based on loan receivables that are 90 days overdue, the scope ofNPLs can differ from country to country and even within countries, as data can alsovary because of different writeoff policies. For instance, some countries (such asPoland, Bulgaria, Slovenia and Hungary) currently use both qualitative andquantitative factors, which are typically more conservative than IFRSbased rules.This is also valid for asset quality data for Romania which are based on regulatorydata and are typically much higher than IFRS derived ratios. In addition, crosscountry comparisons of loan impairments to problem loans are difficult, due todifferences in disclosure and in the regulatory regimes applied in measuring

impairment charges. Bearing in mind these caveats, Fitch believes that the data onNPLs indicate general asset quality trends and also the speed with which loanquality has deteriorated in the region.

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Chart 7: NPL Ratios Ranked by Growth Since End2008 (%)

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

NPL ratios reached doubledigit percentages in Latvia, Lithuania and Romania.However, as stated above, a more realistic assessment of asset quality would alsoinclude the proportions of restructured loans, which are not consistently available.On an individual bank level in certain markets, Fitch has been informed thatrestructured loans can account for up to 20% of a banks loan book. Despite aforecasted 14.5% contraction of GDP in 2009, Estonia recorded a relatively lowincrease in the level of NPLs compared with Baltic peers; however the relativegrowth of overdue loans Estonia experienced since the onset of the crisis was one ofthe highest in emerging Europe, which may suggest problems over and above thatcaptured by public data on NPLs. In addition, the magnitude of the problem may

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not be fully reflected in official Estonian statistics, since renegotiated orrestructured loans are not disclosed. In other economies in emerging Europe theincrease in NPLs has been less dramatic. At endH109, Fitch estimates that the

coverage ratio has remained in excess of 50% in all banking systems covered by thisSpecial Report, except for Lithuania, where it stood at approximately 26%, which islow. At endH109, parent banking groups made additional provisions for Balticexposures at group level. Nevertheless, the collective reserve coverage ratio ofaround 50% implies that banking systems in the region rely on collateral to mitigatecredit risk, which raises questions about the banks ability to liquidate collateraland whether realistic values have been assigned to collateral. The above coverageratios are low by emerging market standards and are a source of concern, given thechallenging operating environment and fall in asset values. Recent discussions inLatvia on the planned introduction of legislation limiting the recoverable amount oncollateral to the current market value rather the value at loan origination surprisedsome of the Nordic lenders. Although it seems unlikely that this legislation will beintroduced, 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 theeconomies.

At present, there is a difference in most banking systems between the quality oflending to corporate and to retail customers: corporate loans are currentlyperforming more weakly (with the exception of Turkey, Romania, Bulgaria, theCzech Republic and the Slovak Republic). In addition, many banks in emergingEurope have concentrated loan portfolios by borrower, which is an additionalsource of risk. Broadly speaking, corporates in the region tend to be flexible inadjusting their cost base to changes in their market environment. However, giventhe relative openness of the economies in emerging Europe, the scale and speedwith which the global recession affected the markets caught companies off guardand many struggled to meet their working capital requirement against the backdrop

of restricted availability of credit. Most of the economies in emerging Europe relyon exports, making the manufacturing and automotive sectors more vulnerableindustry segments, although the former experienced some stabilisation ascompanies started to replenish their stocks while the automotive sector receivedsome temporary support from the German scrappage scheme. As the latter wasabandoned in Q309, there may be some adverse impact on the automotive sectorsin the region, notably the Slovak Republic and the Czech Republic. Commercial realestate lending, construction, retail and other consumerbased industries, as well assmall and mediumsized entities, are further sectors whose creditworthiness issensitive to economic downturn. Slovenian banks have financed a number ofmanagement buyouts, which are typically highly leveraged and are not performingduring the current downturn in the credit cycle.

To date, the asset quality of the retail loan books has benefited from a relativelyhigh proportion of residential mortgages in the loan portfolios, which has been akey anchor product in the region. Mortgage borrowers are generally less likely todefault on their mortgages compared with other types of debt, as long as theyremain in employment. Consequently, the current delinquency rates observed inmortgage lending, although rising, are still lower compared with delinquencies inunsecured lending. However, as the seasoning of the portfolios progresses, and asunemployment rates in most of emerging Europe are yet to peak, Fitch is concernedabout possible negative trends in asset quality in banks retail mortgage loan books.Some countries including Hungary, Poland and Slovenia have put into place specialguarantee programmes to limit the risk that banks are facing from defaultingmortgage borrowers, provided that certain conditions are met. As theseprogrammes are still nascent, it remains to be seen how effective they are in

practice and whether they create moral hazard. Notably, unsecured consumercredit has been a key driver of asset quality trends in Romania and Bulgaria, as wellas Turkey (credit cards). However, some credit risk mitigation is in place asborrowers (eg in Bulgaria) assign their salaries as collateral, so banks are more

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exposed in an environment withrising unemployment. To someextent, consumer lending

remains a business area that hasremained largely untested in adownward environmentfollowing strong recent growth,as banking systems have beentraditionally lending tocorporates.

Downward adjustments innational real estate markets putfurther pressure on asset quality.Based on data for residentialreal estate prices from the IMF

(see Chart 9), the Balticresidential real estate marketshave experienced the sharpestprice corrections, after years of steep increases in real estate value. Between 2001and 2007, house prices in Lithuania increased by more than 200%, while Latvia andEstonia reported increases of 164% and 156%, respectively. 1 Other banking systemswith a sizeable share of mortgage lending (such as Hungary or Poland) sufferedrelatively moderate falls in residential real estate values, while the Slovak Republicand in particular the Czech Republic appear to have experienced increases inproperty prices, although the most recent data indicate that there could be adecline in real estate values on the supply side.

Fitch is also concerned about trends in property developments in the region. Basedon anecdotal evidence, Fitch understands that transaction volumes have fallensubstantially in some markets after having experienced a property boom, withapartments currently remaining unsold. It also seems that some banks (with theexception of those on the advanced ratingsbased approach) do not review thevalue of their real estate collateral annually, but typically every three years orwhen a mortgage loan becomes impaired. This exposes banks to additionaldownside risk as the market value of real estate has fallen.

Lending in foreign currency dominates the loan books in the Baltics, Croatia,Hungary, Romania, and Bulgaria, as these countries are experiencing an interestrate differential between the foreign and local interest rates. Other bankingsystems with notable lending in foreign currency include Poland and Turkey. Fitchconsiders foreigncurrency lending particularly to retail customers to behigherrisk, as movements in foreign exchange rates are typically unhedged. Risksalso 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 economicadjustment, which may put additional pressure on the currency scheme. Anyprolonged depreciation would have severe repercussions on asset quality in thesebanking systems. In countries with a freefloating currency, such as Hungary,Romania and Poland, a material weakening of the local currencies had a negativeimpact on asset quality, particularly in Q109. In Hungary, both corporate and retailsectors were affected, while in Poland, this mainly affected corporate customers asthey experienced problems in servicing their FX derivatives. New lending in foreigncurrency in CHF in Hungary has been largely curbed, and lending in foreign currencymay become subject to further legislation, as proposed by the National Bank ofHungary. While the weakening of the local currencies translated into an increase ofthe capital burden in Q109, some borrowers benefited from a lower base interest

1 Source: National Bank of Hungary

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Chart 9: Change in House Prices At end-Q109

Data for Croatia, Czech Republic, Hungary, Lithuania,Slovakia as at Q408Source: IMF


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rate in the foreigncurrency, which partially offset the sharp FX movement. InFitchs opinion, this situation is not sustainable in the long term, as interest ratesare likely to rise. The agency notes that recent FX appreciation has eased some of

the pressure on asset quality. FundingThe funding model is a key challenge faced by the various banking systems acrossthe region. The global crisis exposed those with high loans/deposits ratios and thosereliant on external funding sources. Those banking systems that enjoy large savingspools (thus large deposit bases) will be better positioned to support an economicupturn. Systems that need to reduce reliance on foreign sources have had toincrease competition for deposits, which is likely to continue for some time to come.The knockon of this is a higher cost of credit. Banking systems where this feature ismore prominent will be less able to support an economic recovery.

Chart 11 highlights notable differences

between the loans/deposits ratios ofthe various banking systems. The Balticstates, Slovenia, Hungary and to someextent Romania show the highestloans/deposits ratios, indicating agreater dependence on wholesalefunding or funding from foreign banks.This occurrence is attributable in partto the ownership structure. In the runup to the crisis, often highly ratedforeign parents of financially integratedgroups provided funding to theirsubsidiaries in Hungary, the Baltics and

Romania. In one sense, this has beendriven by economic reasoning, as thehead office can typically access cheaper and more diversified sources of funding inthe capital markets. With the global credit crisis, Fitch has identified a change infunding strategy at the parent banks. While the foreign parent banks could stillprovide liquidity support to their subsidiaries if necessary, they have delegatedmore responsibility to their international banking subsidiaries in terms of depositcollection in the local markets. In some markets, this has started a war fordeposits. However, reflecting their comfortable loans/deposits ratios, Turkey,Slovakia and the Czech Republic represent an exception. Latvia has a largeproportion of nonresident and foreigncurrency deposits, which could bevulnerable to deposit flight. The deposit freeze in Parex banka has been extendeduntil endJune 2010 and will be lifted should depositor confidence strengthen andthe banks liquidity position improve. Recent data for Q209 therefore reveal thatLatvia is the only Baltic country where levels of deposits are continuing to fall.Estonias deposit base has been the most stable, with no outflows.

A high loans/deposits ratio can also generally be found in banking systems wherelending in foreign currency predominates. In these economies, foreigncurrencyloan products allowed customers to access more affordable credit, but did not takeinto account the exposure to FX risk. Consequently, during the economic growthexperienced until mid2008, structural liquidity imbalances were building up. Theissues arising from lending in foreign currency are possibly being tackled assupervisors are likely to put in place stronger disincentives to make arguably riskierproducts more capitalintensive and hence less attractive to banks.

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2007 2008 H109 Chart 11: Loans/Deposits Ratios (%)



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Although retail deposits are a key source of funding in emerging Europe, except forthe Baltic states (see Chart 12), only sustainable growth of household savings could

restore the funding gap between loans and deposits. However, given the economicdownturn, rising unemployment rates and reduced wage growth, this is unlikely inthe short term. Consequently, Fitch views positively the current aspirations ofstakeholders to establish a more balanced funding profile, with deposits fundingloans, as the agency believes this to be a key issue in economies which traditionallyhave been dependent on external financing. However, the rebalancing of fundingstructures in countries with excessive loans/deposits ratios may be very difficult toachieve in the medium term as it implies limited availability of new credit, whichwould constrain GDP growth.

The high loans/deposits ratio in the Slovenian banking system also highlights thebanking systems dependence on wholesale funding. Slovenian banks have accessedthe international banking markets in recent years to compensate for slow growing

domestic deposits. In H109, however, deposit growth in Slovenia was the mostdynamic in emerging Europe, mainly due to the state providing liquidity to thebanking sector in form of mediumterm deposits in order to cover some of therefinancing needs for 2009/2010. Although this action has eased some of theliquidity pressure, it does not resolve the funding issue that the relatively smallbanking system has been faced with. The Republic of Slovenia also put into place asizeable government guaranteed debt issuance programme to allow banks to tapthe international banking markets.

2,0004,0006,000

8,00010,00012,000

14,000

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

Q409 2010 2011 Later than 2011

Chart 14: Maturing of Issued Debt and Syndicated Loans Excludes intragroup lending

(EURm)

Excludes intragroup lendingSource: Deallogic

CapitalGiven weaker profitability and asset quality, capitalisation is generally underpressure in the banking systems in emerging Europe, although to varying degrees.The chart below highlights the different levels of capitalisation among the bankingsystems at endH109. Fitch believes that sizeable capital injections will benecessary across the region. While it is still difficult at this stage to determine the

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Chart 12: Deposits EndH109

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Slovenia Czech R. Poland Romania Turkey Hungary Estonia Bulgar ia Lithuania Latvi a Croatia Slovakia

Nonretail Retail Total

Chart 13: Growth of Deposits in H109

(%)



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precise amount of capital needed in each banking system, given the uncertaintyover the length and the depth of the asset quality problems and effective recoveryrates 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 ofnet impaired loans (impaired loans after loan impairment reserves but beforeconsidering collateral) as a percentage of regulatory capital. Banking systems suchas Lithuania, Latvia and Romania appear to have greater reliance on collateral as acredit risk mitigant and are therefore exposed to a fall in collateral value, as somemarkets have seen significant declines in house prices.

Foreign ownership would generally be a source of comfort, as the foreign parentscould be expected to provide support to their subsidiaries, however, given theglobal nature of the crisis they can be capital constrained in some cases. Fitchtherefore believes that in the short term, additional capital from foreign parentswould only be provided if deemed critical, but not to create countercyclicalbuffers for lossabsorption.

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Estonia Turkey Croatia Bulgaria Lithuania Romania CzechRepublic

Hungary Slovenia Latvia Slovakia Poland

End2008 EndH109

Chart 15: Total Capitalisation Ratios

(%)

EndQ109: Lithuania, Romania, no interim data for SloveniaSource: Central Banks

Additionally, the agency notes that foreign parents may use alternative ways ofmaking capital available, including subordinated debt (although this is generally notlossabsorbing in a going concern) and hybrid capital. Strategic investors havemanifested their commitment to the region in public statements and have injectedcapital, for example in subsidiaries in Romania, Hungary and in the Baltic states.

Fitch notes regulators actions to raise the minimum capital requirements (as wasthe case in Romania). In Bulgarias case, the regulators already require a 12%minimum capital ratio, which would be, in Fitchs opinion, an adequate level formost countries in emerging Europe given the risks in their operating environment.As the general economic outlook remains challenging, Fitch considers it likely thatseveral banking systems will make no dividend payments to their parents for thefinancial year end2009 to improve capital.

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Net impaired loans Capital

Chart 16: Net Impaired Loans as a Percentage of Capital Base EndH109

(%)

Source: Fitch


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Appendix 1: Authorities' Interventions to Support and Enhance the Activity of the Banking Systems Since Q408

Central Bank Interventions New RegulationsMinimum reserve requirements and other liquidity measures Provisioning and classification of loans Capitalisation Other regulations

Bulgaria 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 attractedfrom abroad to 5% from 12%.

February 2009 Some relaxation in theregulatory provisioning criteria but theeffect on capital is neutral.

Croatia 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%.

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

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

Czech Republic October 2008 Introduction of a reverse repo facility.EstoniaPoland 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 andcommenced FX swap transactions: USD, EUR and CHF. These swap tenderswill be valid until January 2010.January 2009 repurchase of about PLN8.2bn of bonds prior to theirmaturity (2012).May 2009 Reduction from 3.5% to 3% of the mandatory reserverequirement.

October 2009 Two new instrumentseligible as Tier 1 capital: convertible debtand longterm subordinated debt.

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

April 2009 New regulationpreventing banks from requiringadditional collateral fromresidential mortgage borrowers ifthe LTV increases to over 100% butthe debt is still being serviced.


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Central Bank Interventions New RegulationsMinimum reserve requirements and other liquidity measures Provisioning and classification of loans Capitalisation Other regulations

Slovenia November 2008 Amendment of calculation of liquidity ratios banks areallowed (until end2009) to include their collateral deposits with BOS, inthe Category 1 liquidity ratio.

October 2008 Some statutory deductionsfrom Tier 1 capital (prudential filter)were reduced to zero, which translatedinto capital relief in the banking system.

Turkey October 2008 Steps to improve FX liquidity including launching daily FXauctions and reopening the FX deposits market. These steps were nottargeting individual banks but rather aimed at providing support to the

sector.December 2008 Regulatory reserve requirement lowered to 9% from 11%for FX.October 2009Lowering of regulatory reserve requirement to 5% from 6% forTurkish Lira.

June 2009 Introduction of a newrestructuring scheme for nonperformingcredit cards. Participation is voluntary.

FX lending to retail customers hasbeen banned (it constituted only aminor part of lending anyway).

Hungary October 2008 Introduction of an overnight FX swap facility (following anagreement with the ECB) providing euro liquidity.October 2008 Introduction of two credit facility tenders: a twoweekcollateralised credit facility (25bp + NBH base rate) and a sixmonthfloatingrate collateralised credit facility for counterparty creditinstitutions.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 sevendays at a fixed price. This measure will be in place until January 2010.February 2009 Introduction of a new longerterm instrument with sixmonth maturity, up to EUR5bn.February 2009 Acceptance of municipality bonds as collateral.March 2009 Introduction of a sixmonth EUR/HUF swap tender to provideeuro liquidity entailing the condition that participating commercial banksmust undertake to maintain their domestic corporate loans portfolio at aminimum of end2008 levels throughout 2009.

May 2009 The Hungarian state injectedin HUF30bn (EUR100m) capital into FHB,coming indirectly from the IMF aidpackage, in order to boost the bank'slending activity.

Latvia January to November 2008 Gradual lowering of minimum reserverequirements for deposits and debt securities maturing in over two years to3% (prior to January 8%) and 5% (previously 7%) for all the other liabilitiesincluded in the reserve base.

Lithuania November 2008 Lowering the minimum reserve requirements to 4% from6% on all funds maturing within two years.

March 2009 changes in the provisioningsystem.

Romania November 2008 to July 2009 Gradually lowering the minimum reserverequirement for RON funds to 15% from 20%.MayJulyAugust 2009 Gradually lowering the minimum reserverequirement on FX denominated funds to 30% from 40%. The reserverequirement for longterm FX funds has been annulled. In November 2009,the reserve requirement for FX has been further reduced to 25%.

March 2009 some relaxation in theregulatory provisioning criteria.

March 2009 Inclusion of interim profitsin Tier 1 capital calculation.May 2009 Increase of the minimumsolvency requirement to 10% from 8%, forthree years for the duration of the IMFprogram.

In January 2009, regulations onretail loans have been revised toease lending on secured mortgagesand put pressure on unsecuredlending in foreign currency

Source: Banks and Central Banks in the CEE


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Government Interventions

Recapitalisation Liability guarantees and deposit insurance schemes Asset guarantee schemes to encourage bank lending Other legislation

Aid received from theIMF and developed EUcountries

Bulgaria October 2008 Increase in the deposit guarantee fundto EUR50,000 from EUR20,000.

CroatiaCzech Republic October 2008 Increase in the deposit guarantee fund

to EUR50,000 from EUR25,000.

Estonia October 2008 Increase in the deposit guarantee fundto EUR50,000.Poland October 2008 Increase in the deposit guarantee fund

to EUR50,000 from EUR25,000.1. August 2009 Residential mortgage borrowers whobecame unemployed since July 2008 are supported:maximum amount: PLN1,200 monthly for up to oneyear, then after a twoyear grace period, this supportmust be returned over eight years but with no interest.Response to this form of support has been insignificantto date.2. January 2009 Amendments to a governmentprogramme (enacted 8 September 2006): "Rodzina naswoim" state subsidy for residential mortgagesgranted to families and lone parents for the firsteight years 50% of the interest instalment is subsidised,the loan can only be in PLN and the size of theapartment cannot exceed 75 sq m or 140 sq m forhouses. These amendments allowed more people toparticipate in this program and increased some limits consequently "Rodzina na swoim" was the key driver ofmortgage lending in 2009.

Slovakia November 2008 Unlimited deposit guarantee providedto household deposits.

January 2009 State guarantees of up to 55% for loansto companies employing fewer than 100 people).September 2009 The government approved a stateaid programme for people who have lost their jobs dueto the financial crisis and cannot afford to pay theirmortgages. The total cost of the package is estimatedat EUR12.4m.


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Slovenia Capital increase ofSID bank byEUR160m toEUR300m, injectedby the state.

1 SID and NLB received a state guarantee for securingissue of their MTNs.2 Stateguaranteed mediumterm borrowing of NLB(EUR1bn).3 Stateguaranteed foreign borrowing of SID (EIB:EUR300m; capital markets: EUR200m).4 November 2008 Unlimited State guarantee for netdeposits of natural persons and micro and smallenterprises.5 Additional measures introduced in October 2008targeting entities established in Slovenia: State guarantees to credit institutions and factoring oftheir receivables State loans/capital injections to credit institutions,(reinsurance companies, and pensions companies).

March 2009 Guarantee scheme (max EUR1.2bn) forloans to enterprises (excluding financial institutions),implemented through a stateowned SID bank. Guarantee scheme provided to banks for generalgranting of loans to enterprises Individual state guarantees for enterprises borrowing.

Turkey 1 October 2009 (still not active) State guaranteefund established to support SMEs . Part of the futureNPLs will be taken over by the state. However, totalsize of the fund is relatively small, at TL10bn.2 Subsidised lending to certain sectors and SMEsthough state banks in Q408 and Q109. This is alsosmall, at less than TL1.5bn.

Hungary 13 October 2008 the guarantee for individual bankaccount deposits placed with the domestic creditinstitutions was extended to an aggregate amount ofHUF13m per person.

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 Hungarianstate in order to boost lending activity. Of the totalamount, EUR1.4bn was for OTP and EUR0.4bn for FHB.

The loan (around 245250bp above the relevantbenchmark rates) matures on 11 November 2012, andmust be repaid in eight equal instalments startingNovember 2010.

1. Enactment of the FinancialStabilisation Act: The Hungarian State will provide asum of HUF600bn denominated inFX, which could be utilised between20082010 from the credit facility

provided by the IMF for Hungary A recapitalisation measure to injectnew capital into credit institutions A guarantee measure to guaranteeobligations of credit institutionsarising from a debt security or acredit facility agreement between 23December 2008 and end2009


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Latvia November 2008present Liquidityand capital aidoffered to ParexBank which was

later nationalised.

October 2008 Increase in the deposit guarantee fundto EUR50,000 from EUR20,000

June 2009 New legislation allowingauthorities to take ownership ofbanks when needed.

Lithuania October 2008 Increase in the deposit guarantee fundto EUR100,000 from EUR22,000

Romania October 2008 Increase in the deposit guarantee fundto EUR50,000 from EUR20,000

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

Source: Banks and Central Banks in the CE E

Access Under Arrangements Currently in PlaceIMF aid Other funding

Effective date of arrangement Duration (months)

Amount of arrangement(USDm)

Balance drawn as of Jun09 (USDm) EU (USDm) WB (USDm) Other (USDm)

Total financing package(USDm)

Hungary 06 Nov 2008 17 16,529 11,900 8,400 1,300 0 26,229Latvia 23 Dec 2008 27 2,387 840 4,382 565 3,251 10,585Romania 04 May 2009 24 17,948 6,854 6,550 1,310 1,310 27,118Source: IMF


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