Credit Growth and Bank Soundness in Emerging Europe

1. Credit Growth and Bank Soundness in Emerging Europe Natalia Tamirisa Deniz Igan International Monetary Fund The 13th Dubrovnik Economic Conference June 29, 2007

2. Rapid credit growth in the region...

3. ...increasingly funded through capital inflows

4. ...concentrated in the household sector

5. Rising euroisation of domestic credit

6. Rapid credit growth reflects financial deepening...

7. ...and rising financial integration

8. Macroeconomic and financial conditions have been supportive... • Disinflation • Improved economic prospects • EU accession • Pent-up demand for credit • Easy global monetary conditions • Ample global liquidity

9. ...as are supply-side factors • Privatization • Entry of foreign banks • Strategic expansion • High profitability + subsidies and tax policies

10. Literature • Financial deepening but “excesses,” credit booms are a risk • Schadler et al (2004); Cottarelli et al (2005); Egert (2007); ECB (2007) • Credit growth improves bank soundness, unless it is “excessive” • Maechler, Mitra, and Worrell (2006) • FSIs are favorable, but backward looking • Hilbers et al (2005); Iossifov and Khamis (2006) • Foreign banks are more efficient, but loan growth is similar • Aydin (2006); de Haas and van Lelyveld (2005)

11. Policy Debate • How to manage macroeconomic and prudential risks... • ...and “not to kill the goose that lays the golden eggs”?

12. Focus of This Study • How significant are prudential risks in the NMS? • Has credit growth affected bank soundness? • Are weaker banks expanding faster? • Do prudential risks differ across...? • Countries • Banks (foreign/domestically owned) • Purpose of credit (household/corporate) • Currency of denomination/indexation (foreign/ domestic)

13. Bank-level Analysis • Bank balance sheet data (Bankscope) • Ugo Panizza’s (IDB) data set, updated • 217 banks during 1995-2004 in 8 NMS • 7 observations per bank, on average • Unconsolidated data, where available • Commercial banks and leasing companies • Breakdowns of loans by currency and purpose (supervisory data) • 6 NMS (except Hungary and Latvia)

14. The sample covers most NMS banks...

15. Distance to default—a proxy for insolvency risk • The number of STD a return realization has to fall for equity to be exhausted~probability of default DD ≡(equity capital+average return)/STD of return, • Bank account data • STD deviation for the entire sample period • Robustness to alternative ways of measuring volatility of returns; NPL ratios; loan loss reserves

16. Uniformly higher credit growth; stronger, but more heterogeneous Baltic banks

17. Baseline empirical specification controls for macroeconomic and bank-specific variables...

18. Three-stage Least Squares • Commonly used technique • Linear models using panel data • A relatively short time dimension • Lags of dependent variables • Advantages vis-à-vis Arellano-Bond • Two-equation estimation • Subsample analysis • Advantages vis-à-vis 2SLS • Efficiency gains • Unbiased in models with lagged dependent variables • No apparent specification problems • Unit roots rejected • Hausman specification tests inconclusive • Residual analysis validates inclusion of lagged dependent variable • No multicollinearity • Robustness to single-equation estimation

20. Credit growth in the NMS has been largely demand-driven...

22. Is the glass half empty or half full? • No evidence that credit growth has weakened banks • Consistent with FSI analysis • Not surprising in an upward stage of the credit cycle • During 2001-04 weaker banks started to expand just as fast as sounder banks • New result, not detectable in aggregate data • Some weaker banks are weak in the absolute sense

23. These results are robust to... • Including additional macro and bank-level variables • Controlling for year- and country-specific factors • Using alternative measures of bank ownership • Using alternative measures of bank soundness • Controlling for nonlinear effects • Assuming faster feedback effects • Single equation estimation

26. Weaker Baltic banks are expanding faster than other banks...

27. Possible explanations • Real credit growth in the Baltics is several times higher than in the CEECs • Ensuring sound lending decisions and risk management is much more difficult • Higher degree of foreign participation in the Baltics • Additional comfort that the banking system can withstand shocks • More foreign affiliates are branches • Supervision is more challenging

28. Foreign banks are taking greater risks than domestic banks... ...but commensurate with the strength of parent banks

29. Lending through Nordic banks seems the least related to bank soundness

30. Weaker banks with large foreign currency exposures are expanding faster

31. Weaker banks with large household exposures are expanding faster

32. The negative correlation between bank soundness and credit growth is the highest in household credit

33. Regional Policy Implications • Weaker banks in the NMS have recently started to expand at least as fast as sounder banks (but credit growth per se has not weakened banks) • Forward-looking and risk-based supervision • Supportive market infrastructure (credit bureaus) • Sufficient disclosure of information • Financial sector surveillance and analysis • Weaker banks’ expansion is most pronounced in household and foreign currency lending • Closer monitoring of risk exposures and lending practices in these markets • Foreign banks are taking on greater risks, consistent with parent banks’ strength • Effective cross-border cooperation between supervisors

34. Calibrating Policy Response to Country-Specific Circumstances • In the Baltics, weaker banks are expanding faster (Latvia, Lithuania) or credit growth has weakened banks (Estonia) • In the Czech Republic, Hungary, and Slovenia, weaker banks are expanding as fast as sounder banks • In Poland and the Slovak Republic, stronger institutions are growing faster • Different intensity of risk-based policy instruments (Hilbers et al, 2005) • Country-specific regulatory framework (e.g., supply-side measures) • Basel II, EU Capital Requirements Directive, IFRS

35. Concluding Remarks • Probabilistic conclusions • Quality of banks’ lending decisions and risk management • Macroeconomic conditions • Cross-country econometric analysis using publicly available data • Not a substitute for country-specific stress tests using supervisory data • A complement because it draws on a regional set of information in a systematic manner