The 2008-09 Financial Crisis:Likely impact on ECA countries &

Policy Responses

Fernando Montes-Negret, Director Finance and Private Sector Development Department

Europe & Central Asia Region, The World Bank

May, 2009

WORLD BANK

Agenda

Sequence of Major Events

Phases of a Financial Crisis

Potential Risks in ECA

Market Perceptions of Risks

Role of Policy Makers and Supervisors

Sequence of Major Events

Detonator: US sub-prime mortgage crisis (mid-2007); Limited international contagion (Germany); Amplifier (1): Highly leveraged financial institutions;

Rapid de-leveraging & downward spirals Risk aversion; Lack of trust & counterparty risk; Liquidity and “fluidity” crises;

Mitigator (1): Central Banks flooding market with liquidity;

Amplifier (2): Lehman Brother’s failure (Fall-08); US piecemeal approach; Loss of confidence & collapse of stock markets (world wide);

Mitigator (2): TARP, Blanket Dept. Insurance, …

Mid-size detonator, huge bomb!

“The Crisis was caused by the largest leveraged asset bubble and credit bubble in the history of humanity, where excessive leveraging and bubbles were not limited to housing in the US but also housing in many other countries and excessive borrowing by financial institutions and some segments of the corporate sector and of the public sector in many and different economies: a housing bubble, a mortgage bubble, an equity bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector de-leveraging since the Great Depression”.Nouriel RoubiniRGE Monitor, Oct.9/08

Dangerous Spirals: Over-Sold Markets

Mark to Market Accounting

Change in Net Worth (equity)

Liquidity Changes

Asset Price Changes

Vicious Cycles

“A liquidity vicious cycle- in which asset prices fall, people sell and therefore prices fall more;

A Keynesian vicious cycle- where people’s incomes go down, so they spend less, so other people’s income falls and they spend less; and a

Credit accelerator, where economic losses cause financial problems that cause more real economic problems”.

Larry Summers

“Fed believes US will avoid deep recession”, FT, March 13, 2008

Crisis of the prevailing Intermediation Model- The End of an Era

Bank-Intermediated Model (originate & retain): Banks as dominant financial intermediaries w/assets valued at historical cost; Versus …

Securitized or Market-based Finance (originate and transfer): Most financial intermediation takes place in the market by trading securities (primary & re-packaged). Ex. MBS, CDOs, and ABS).

Shadow Financial System (“boomerangs”): Limited/partial transfers of risk, in view of: SIVs, Conduits, Off-Balance Sheet operations without capital. => Huge increase in total bank assets, but flat Risk-Weighted Assets!.

1 8

Major Structural Changes in the US and International Financial System

=> Self-contained institutions transformed into an inter-linked NETWORK, making very difficult to disentangle and let one particular institution fail (ex. Bear Sterns). Often it became impossible to know who had the risk!!.

=> Loss of Confidence paralyzed money and inter-bank markets.

Significant second round impacts are being felt globally …

Huge (paper) wealth losses:$2.5 trillion erased from global equities market

Global credit crunch, affecting banks and corporates alike Inter-bank rates soared:

Euribor at record 538bp 3m Libor at record 539bp 3m USD LIBOR-OIS at

record 348bp Corporate short term

borrowing rates soared: Yields on overnight US

commercial paper jumped by 94bp to 3.68%

CP debt outstanding fell by 15% ($264 bn) to a 3-year low level of $1.5 trillion

Note: data as at Oct. 9, 2008

… including in emerging markets

Stock markets have declined significantly:

Markets closed in Russia, Indonesia, Romania and Ukraine

Sharp declines in Brazil, Poland, etc.

Banks are facing increasing difficulties and runs:

Depositors’ runs (e.g. Brazil, Taiwan, Korea, Serbia)

Major Stock Exchanges since April 2008

2000

2200

2400

2600

2800

3000

3200

3400

3600

3800

4000

04/01/2008 05/01/2008 06/01/2008 07/01/2008 08/01/2008 09/01/2008 10/01/20080

500

1000

1500

2000

2500

3000

DJ Euro Stoxx 50Poland WIG20 INDEXNew Europe IndexRussiaKazakhstan

Increase in NPLs (e.g. Estonia, Latvia) Bank failures (e.g. Ukraine)

Liquidity is out-flowing emerging markets: Large outflows (around $30 bn so far in 2008) from emerging market funds; $16 bn

out of Russia in 3rd Q Large repatriation of funds to HQ by foreign banks (e.g. Citibank from Mexico to

US) Drastic reduction in interbank lines from international banks to domestic banks

Source: Bloomberg

Contagion and Real Sector Impacts

Un-chartered Territory but .. Typically the liquidity and market

shocks are followed by slower growth, company insolvencies, and solvency problems in banks, as liquidity tightenss and loan portfolios deteriorate and NPLs rise.

Greatest concern about: Weak banking systems (poorly

capitalized & provisioned banks with weak regulation, supervision & enforcement and disclosure);

Vulnerable Banks with high (Loan-to-Deposit Ratios, high rollover & refinancing risks);

Countries with large or increasing Macroeconomic imbalances, particularly large CADs;

Policies with poor policy responses & policy mixes.

EU & OtherCountries’

Financial Systems

Slower GrowthREAL ECONOMYCorporate Sector

Failures

US FinancialSystem

Typology of ECA countries

CIS Countries

EU Members

EURO or not

ECACOUNTRIES

WITH or WITHOUT OIL/GAS (FXR)

Capital Flight & Falling FDI

Deteriorating Terms of Trade and Large CADs

Policy Mix,Institutions & Response

Exposed banks: high (L/D) Ratios

DEBT LEVELS & PROFILE

Other

Turkey

1 13

Phases of the Crisis

Liquidity crisis Economic crisis Solvency crisis

ECA countries are exposed to three main channels of contagion

ECA countries are exposed to four potential channels of contagion: Parent banks’ troubles Liquidity crunch:

Impact of global credit crunch on domestic banking system Credit contraction at the level of subsidiaries of European

banks Borrowers’ defaults:

Large exposures to interest rates Large exposures to exchange rates Large exposure to real estate prices (losses and weaker

collaterals) Negative market sentiment towards emerging economies

The liquidity crunch (external refinancings & possible run of deposits) and rising NPLs are already bringing Ukraine into a serious crisis.

(L/D) Ratios

Country Name 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008Latvia 115% 130% 135% 171% 183% 193% 200% 224% 239% 245% 278%Estonia 155% 135% 135% 131% 148% 167% 185% 168% 182% 209% 211%Lithuania 140% 131% 108% 97% 105% 125% 123% 141% 153% 174% 208%Hungary 93% 93% 108% 112% 120% 136% 142% 147% 153% 163% 176%Romania 96% 75% 67% 68% 71% 86% 81% 88% 101% 125% 146%Poland 100% 102% 96% 94% 105% 112% 112% 106% 111% 122% 140%Bulgaria 83% 77% 72% 70% 86% 101% 110% 109% 100% 117% 137%Croatia 145% 143% 121% 97% 112% 113% 115% 125% 126% 120% 130%Slovak Republic 145% 150% 149% 137% 139% 96% 98% 109% 106% 112% 108%Czech Republic 115% 110% 90% 83% 78% 82% 80% 83% 89% 95% 100%Slovenia 103% 108% 104% 94% 94% 100% 113% 127% 142%Russian Federation 164% 160% 141% 142% 134% 133% 137% 126% 131% 133% 149%Ukraine 132% 115% 116% 121% 123% 122% 117% 117% 141% 161% 216%Turkey 110% 109% 125% 99% 112% 123% 125% 129% 123% 125%

Source: IFS

Parent bank troubles could have a significant impact on a number of countries

Swedish banks account for 51 to 85% of the banking sector of Baltic countries Austrian banks are present in 8 ECA countries, accounting for up to 48% of their banking sector

Countries where foreign banks play a dominant role are particularly exposed: e.g. Raiffeissen in Albania (45%), Unicredit in Croatia (23%)

EU and Balkan countries are particularly exposed to Swedish and Austrian banks

Share of Swedish and Austrian banks in loan portfolios (2005)

85%

51%

69%

0% 0% 0% 0% 0% 0% 5% 0%0% 0% 0%

48%

31% 31%23%

10% 7% 3%

36%

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

Share of Sw edish banks (2005) Share of Austrian banks (2005)

Source: Bakscope, staff calculations

While all top European banks seem strongly committed to the region…

… faced with difficulties, their decisions re. subsidiaries will depend on global markets and domestic risks

High profitability of ECA subsidiaries may lead parent banks to protect their franchise value

But, ultimately, the global credit crunch may force them to contract their funding to them

Their decisions will also depend on their perception of risks in ECA countries, including household leverage, real estate risk, etc

Also, the internal structures of subsidiaries may play a role (e.g. Raiffeissen can easily sell off its ECA franchise structured in an independent holding company)

Raiffeisen may face liquidity constraints

Source: Unicredit

The liquidity crunch is affecting Ukraine, Kazakhstan, and the Baltics

Banks in ECA financed growth through cross-border financing

ECA is by far the region most dependent on debt financing and the most exposed to the current liquidity crunch

A sudden stop in cross-border capital can cause a sudden stop in credit markets and have a material impact on domestic activity

Romania, Bulgaria, and Hungary are also at high risk

Source: Unicredit

Borrowers in many ECA countries are over-exposed to financial risks…

Most mortgage loans, and loans in general, have been extended in Euro, Swiss Francs, Yen, at variable interest rates, on the basis of rapidly rising real estate prices

Thus, borrowers, and banks, are exposed to Variations in exchange rates

and interest rates Real estate prices (sales of

collateral in thin markets can create a financial accelerator effect)

Source: Unicredit

…and NPLs have already started to increase in some countries

Market Perceives High Risk especially in Ukraine, Kazakhstan, the Baltics, Romania and Bulgaria…

Note: A credit default swap (CDS) is a contract in which a buyer pays a series of payments to a seller, and in exchange receives the right to a payoff if a credit instrument goes into default.

Source: Bloomberg

CDS 5-year sovereign spreads

0200400600800

10001200140016001800

Poland

Czech

Rep

ublic

Croati

a

Turkey

Russia

Bulgar

ia

Hunga

ry

Estonia

Roman

ia

Lithu

ania

Kazak

hstan

Latvi

a

Ukraine

09/26/2008

05/07/2009

bp

… as well as for some Western banks with a significant presence in ECA

Source: Bloomberg

Foreign banks in CEE: 5-year CDS spreads

0

100

200

300

400

500

600

04/18/08 06/05/08 07/23/08 09/09/08 10/27/08 12/14/08 01/31/09 03/20/09 05/07/09

Raiffeisen (Austria) Erste Bank (Austria)Banca Intesa (Italy) UniCredit (Italy)

ING Bank (Netherlands) Soc Generale (France)KBC Bank (Belgium)

Yes, ECA is at risk of sharp economic decline and poverty increase

Re-pricing of risks by financial institutions is likely to reduce financing for firms and households

Massive inflows of liquidity by central banks to safeguard the financial system is likely to generate inflation

Hence, countries are likely to enter into a period of stagflation

Tensions on exchange rates and interest rates could lead to significant losses for households with debts in foreign currency at floating rates

Declines in securities markets will impact the investment portfolios of insurance companies, investment funds, and pension funds in addition to banks

Declines in pension funds’ returns will affect retirement incomes

Real GDP Growth in ECA (annual % change)

-4-202468

1012

Russia

KazakhstanUkraine

TurkeyEstonia

LatviaLithuania

BulgariaRomania

Czech RepublicPoland

Hungary

Slovak Republic Croatia

2007 2008 2009

Consumer Prices in ECA (annual percent change)

0

5

10

15

20

25

30

2007 2008 2009

The global credit crunch is likely to lead to a significant slow down in growth

Source: IMF, World Economic Report 2008

Ukraine, Kazkhstan, and the Baltics are at particular risk; a crisis there could contaminate other ECA countries

These countries are particularly exposed to the credit crunch due to: Their high current

account deficits, High external debt, High dependency on

external capital inflows

In case of a deeper crisis in these countries, other ECA countries could be affected as market sentiment for the region deteriorates

Current Account Balance (% of GDP)

-25-20-15-10-505

10

ECA

Bulgari

a

Croati

a

Czech

Rep

ublic

Estonia

Georg

ia

Hunga

ry

Kazak

hstan

Latvi

a

Lithu

ania

Poland

Roman

ia

Russia

Serbia

Slovakia

Slovenia

Turkey

Ukraine

2007

2008

Gross and Net External Debt (% of GDP), 2008

-40-20

020406080

100120140

ECA

Bulgar

ia

Croatia

Czech

Rep

ublic

Estonia

Georgi

a

Hunga

ry

Kazak

hstan

Latvi

a

Lithu

ania

Poland

Roman

ia

Russia

Serbia

Slovakia

Slovenia

Turkey

Ukraine

Gross external debt (% of GDP) Net external debt (% of GDP)

Source: Fitch, September 2008

Thus, the challenges ahead are substantial

Main objective: restore the global financial system to full functionality, at the least possible cost to taxpayers: i.e. Restore adequate liquidity Strengthen impaired balance sheets Rebuild capital where needed Restore trust in the global financial system Allow credit to resume

Challenges: Consolidation of financial systems in many countries Adequate use of public balance sheets to contain systemic financial

risks Avoiding excessive moral hazard Regaining investors and depositors confidence Significant additional risks could materialize (e.g. counterparty risk in

$55 trillion CDS market)

What Needs to be Done ? Action Plans (1)

Policy Makers: Improve quality of financial

information; Understand group/

conglomerate structures “Get out of the Dark” –

understand your banks and risks;

Crises must be managed; Align incentives of all players; Reduce the Unknowns- Provide

policy certainty

Putting in place a credible (big) package at once, but preferably only once!

Political consensus or consultation for major decisions;

Inter-Agency coordination crucial (crisis mgmt. team);

Communication & Leadership key;

Prepare to manage bad assets (AMC)- Insolvency Solvency Regime

What Needs to be Done ? Action Plans (2)

Policy Makers: Check your “tool box” to be sure

you have: Adequate legal, regulatory

and organizational arrangements to deal effectively and quickly with the crisis.

Are all “the players on the same page”?

Adequate Diagnostics? Adequate Bank Resolution System

Adequate liquidity (LOLR). : market liquidity vs. ELA (emergency liquidity assistance). Quality and scope of eligible collateral.

Adequate Deposit Insurance System (funded and able to return insured deposits fast)?

Adequate loss-absorption mechanisms (fiscal/external)?

Adequate crisis communication strategy?

What Needs to be Done ? How can we help?

World Bank: Encourage Contingency

Planning and Crisis Preparedness;

Mobilize expertise- Inside & Outside Bank;

Crisis response teams must have diverse skills: legal advice (instruments for bank resolution), asset valuation, financial analysis, central and commercial banking, macroeconomists,..

Cross-Border Issues are likely to be important in ECA, particularly if a major European bank were to fail;

Consolidation and failures will happen;

Pre-design Loan types.

1 31

Main regulatory failures Policy RecommendationsWeaknesses in on-site supervision

Political support and resources for Supervisors to do their job. IFIs must forcefully send this message in FSAPs and other interactions with country authorities;Strenghten on-site activities particularly in periods of rapid economic growth and fast credit expansion. During the upward phase of the business cycle automatic anti-cyclical measures are necessary, as well as an intensification of on site activities to verify the quality of loan underwriting standards. How can we achieve this?

Weaknesses in understanding and confronting the financial reality and risks posed by complex financial, industrial/commercial and mixed conglomerates

Implement group-wide consolidated supervision

Supervisory Weaknessess and Recommendations

1 32

Supervisory Weaknessess and Recommendations (2)

Lack of response from senior supervision authorities to the accumulation of risks, both on a solo basis (ex.; individual bank), at the consolidated group level (ex., financial and mix conglomerates), as well as at the overall system level (ex., banking system)

Give the same protection and status as Central Banks to supervisory agencies i.e independence, protection of personnel from beeing fired or prosecuted while discharging their duties, competitive salaries, etc…“Need to be feared” (as put by Lord Turner about supervisors) i.e by an enhancement of their enforcement actions in response to banks taking higher risks or hiding risks in un-transparent ways (ex., SIV, conduits)

Weaknesses in Central Bank’s macro/prudential powers (as stressed in the de Larosiere Report)

Strenghten Central Bank’s macro/prudential powers Monitor liquidity at an aggregate level i.e liquidity of securities at a systemic level and “marking-to-maturity’ funding risks taken by banks

The Bank can play a key role in four main areas

Advice on diagnostics & crisis management, in collaboration with other IFIs, including: Methods of bank monitoring and viability assessment (triage

& recapitalization strategies) Methods for restructuring failed banks, cleaning up balance

sheets, orderly resolution & Exit, etc.Provision of budget support for bank recaps/carve outs, in

coordination with IMF Emergency Facility, through FS DPLs and transaction-based lending (ex. Mexican crisis).

Support to the Real Sector via Lines of Credit (examples Turkey & Ukraine)

TA to further strengthen banking and securities market prudential regulation and supervision.

=> Speed is important

Immediate

Short-term