Financial Crisis in Central and Southern Europe: The World Bank’s Instruments and Policies Orsalia Kalantzopoulos, Sr. Advisor Financial and Private Sector Development How did CEE countries get into crisis? While global imbalances played a crucial role, some (but clearly not all) of the countries in ECA accumulated their own sources of vulnerability. • High private sector imbalances (manifesting in large current account deficits) • High private sector credit growth • Both made possible by high global liquidity (as well as little attention to counterbalancing macro policies) Indeed, external financing was uniquely abundant—also fueled by the expectation of rapid EU convergence But the source of funds affects risks Three sources in ECA (and rollover (RO) during East Asia was 65%): • Domestic savings (resident deposits); quite stable • Parent banks; so far stable (RO 90%)—role of Vienna initiative • Wholesale funding—largely dried up! Sources of Funding in ECA Countries Bank funding Parent bank Wholesale Convergent 1/ HUN Credit growth KAZ HRV SRB BGR RUS UKR LVA Excessive 2/ low stability Resident deposits CZE SLK POL TUR MKD ROM LTU EST medium stability lower risk grey area higher risk high stability grey area Source: M itra, Selowsky and Zalduendo, 2009, Turmoil at Twenty (forthcoming). 1/ Countries exp eriencing credit growth rates that could be viewed as in line with those of countries with similar initial ratios of p rivate sector credit to GDP. 2/ Countries exp eriencing credit growth rates that can be considered as above average; that is, their credit growth rates are too high in relation to their initial ratios of credit to GDP. Diagnostics and Issues Identified • Banking exogenous shocks -- withdrawal of international interbank credits to domestic banks; • Banking endogenous problems -- of overly high loan/deposit ratios, high loan/value ratios and over-reliance of foreign exchange borrowing by bank customers (euro, yen, etc.) • Bank supervision: lack of supervisory oversight in part due to overreliance on Basel II internal ratings based models. • Subsidiaries of domestic banks in riskier countries and lack of adequate home/host supervision arrangements. Focus Areas of Multilateral Players -- IMF, EC • Multilateral financial rescue packages involved the IMF, EC (its financial/funding institutions, ECB, EIB, EBRD), and the World Bank. • IMF and EU Financial Support: Largest -- provided critical mass of funding needs. IMF/EU funding served some key purposes: (a) liquidity to central banks and banking system; (b) fiscal support; (c) bank capitalization contingent facilities; and (d) foreign exchange reserves. • IMF Policy Agenda: focused on fiscal/current account deficit adjustment, debt reduction and debt sustainability, monetary and inflationary developments, fiscal reserves, and international reserves. Focus Areas of Multillatral Players -- World Bank • Focus on medium-longer term structural reforms and longer term impacts of crises and needed mitigation measures, including: • (a) preservation of social expenditures and support programs (all); • (b) stronger banking credit regulation and independent well funded supervisors (Romania, Hungary, Serbia); • (c) banking and corporate debt resolution (Latvia, Ukraine); • (d) mechanisms for winding down troubled banks with lowest fiscal cost (Latvia, Ukraine); and • (e) preventive supervisory powers to halt deteriorating trends in individual institutions or systemically (Hungary, Latvia, Serbia). Critical Elements of World Bank Financial Packages • World Bank is focusing on banking sector credit portfolio trends and potential deterioration of loans due to negative GDP growth. Instruments and policies used include: • (a) design of intensive special purpose bank inspections (Hungary, Ukraine); • (b) stress testing of banks’ balance sheets and available capital with implications for capital strengthening (Hungary, Ukraine, Latvia); Critical Elements of World Bank Financial Packages • (c) new preemptive supervisory powers to require additional capital or intervene banks before they reach insolvency stage (Latvia, Hungary, Ukraine); and • (d) bank resolution powers to carve out good assets from a failing bank and transfer to other market participants with matching deposits to keep the maximum number of depositors current and actively serviced (rather than being paid out) (Ukraine, Latvia). Coordination with IMF and EU • IMF and EU (including ECB) have played major resource role in foreign currency liquidity in the interbank market and in ensuring that parent banks of local subsidiaries maintain their funding in domestic country markets (Vienna initiative). • IMF and EU have also provided funds for contingent bank capitalization programs (EU-wide design) to strengthen bank balance sheets and prevent premature insolvencies. • World Bank has focused on quality of the asset side (asset quality) and long term solvency of banks while IMF/EU have focused on bank liabilities and need for funding liquidity for client countries. Critical Elements - World Bank Financial Packages • EU/IMF/Bank have emphasized broader coverage and funding of deposit insurance systems to provide confidence to depositors to maintain their funds in banks and avoid “runs” on banks. • At times, this requires modest increases in premiums for deposit insurance funds but not overly high premiums to avoid stressing bank finances further. EU/IMF funding at times serves as backstop for broader government guarantees of depositors, i.e., another form of liquidity guarantees to banks. Other World Bank Funding and Policy Areas POLICIES TO FIX MICRO/INSTITUTIONAL LEVEL PRACTICES THAT EXACERBATED THE CRISIS: • The World Bank has also focused on improving loan accounting norms and standards to assure higher loss reserves/provisions against possible deterioration of loan portfolios and hence erosion of bank capital. • Has also encouraged increased deposit-based funding (vs. interbank or bank bond funding) of banking loans, for banks to have increased stability via deposits in their funding base. Other World Bank Funding and Policy Areas POLICIES TO FIX MICRO/INSTITUTIONAL LEVEL PRACTICES THAT EXACERBATED THE CRISIS, Continued …. • The World Bank has encouraged less enterprise borrowing in foreign currency if customers only earn local currency. • Coupled with the above issue, it has also helped design out-ofcourt debt restructuring procedures for debtors to maintain loan repayments and allow banks to reduce loan write-offs. • The World Bank has encouraged financial authorities to utilize more flexible methods of bank resolution (vs. laws on outright bankruptcy/receivership of banks) so that failing banks’ assets and liabilities can be transferred to sounder banks, before liquidating residual bad assets, thus saving fiscal funds. Thank you