8 Macroeconomic and financial conditions have been supportive... DisinflationImproved economic prospectsEU accessionPent-up demand for creditEasy global monetary conditionsAmple global liquiditySuccessful disinflation, improved economic prospects and declining risk premia, pent-up demand for credit, lower interest rates, expectations of long-term appreciation, ample global liquidity
9 ...as are supply-side factors PrivatizationEntry of foreign banksStrategic expansionHigh 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 lookingHilbers et al (2005); Iossifov and Khamis (2006)Foreign banks are more efficient, but loan growth is similarAydin (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”?financial deepening and economic growth
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...?CountriesBanks (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, updated217 banks during in 8 NMS7 observations per bank, on averageUnconsolidated data, where availableCommercial banks and leasing companiesBreakdowns of loans by currency and purpose (supervisory data)6 NMS (except Hungary and Latvia)
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 defaultDD ≡(equity capital+average return)/STD of return,Bank account dataSTD deviation for the entire sample periodRobustness to alternative ways of measuring volatility of returns; NPL ratios; loan loss reservesEquity capital and average return in percent of assets; bank account data because any banks are unlisted and NMS stock markets are not very liquid; STD for the entire sample period to obtain a sufficiently long-term view of the risks faced by a bank
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 techniqueLinear models using panel dataA relatively short time dimensionLags of dependent variablesAdvantages vis-à-vis Arellano-BondTwo-equation estimationSubsample analysisAdvantages vis-à-vis 2SLSEfficiency gainsUnbiased in models with lagged dependent variablesNo apparent specification problemsUnit roots rejectedHausman specification tests inconclusiveResidual analysis validates inclusion of lagged dependent variableNo multicollinearityRobustness to single-equation estimation
22 Is the glass half empty or half full? No evidence that credit growth has weakened banksConsistent with FSI analysisNot surprising in an upward stage of the credit cycleDuring weaker banks started to expand just as fast as sounder banksNew result, not detectable in aggregate dataSome weaker banks are weak in the absolute sense
23 These results are robust to... Including additional macro and bank-level variablesControlling for year- and country-specific factorsUsing alternative measures of bank ownershipUsing alternative measures of bank soundnessControlling for nonlinear effectsAssuming faster feedback effectsSingle 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 CEECsEnsuring sound lending decisions and risk management is much more difficultHigher degree of foreign participation in the BalticsAdditional comfort that the banking system can withstand shocksMore foreign affiliates are branchesSupervision 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 supervisionSupportive market infrastructure (credit bureaus)Sufficient disclosure of informationFinancial sector surveillance and analysisWeaker banks’ expansion is most pronounced in household and foreign currency lendingCloser monitoring of risk exposures and lending practices in these marketsForeign banks are taking on greater risks, consistent with parent banks’ strengthEffective 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 banksIn Poland and the Slovak Republic, stronger institutions are growing fasterDifferent 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 managementMacroeconomic conditionsCross-country econometric analysis using publicly available dataNot a substitute for country-specific stress tests using supervisory dataA complement because it draws on a regional set of information in a systematic manner
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