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

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Presentation on theme: "Credit Growth and Bank Soundness in Emerging Europe Natalia Tamirisa Deniz Igan International Monetary Fund The 13 th Dubrovnik Economic Conference June."— Presentation transcript:

1 Credit Growth and Bank Soundness in Emerging Europe Natalia Tamirisa Deniz Igan International Monetary Fund The 13 th 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 Financial deepening but excesses, credit booms are a risk Schadler et al (2004); Cottarelli et al (2005); Egert (2007); ECB (2007) Schadler et al (2004); Cottarelli et al (2005); Egert (2007); ECB (2007) Credit growth improves bank soundness, unless it is excessive Credit growth improves bank soundness, unless it is excessive Maechler, Mitra, and Worrell (2006) Maechler, Mitra, and Worrell (2006) FSIs are favorable, but backward looking FSIs are favorable, but backward looking Hilbers et al (2005); Iossifov and Khamis (2006) 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... How to manage macroeconomic and prudential risks......and not to kill the goose that lays the golden eggs?...and not to kill the goose that lays the golden eggs?

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

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

14 The sample covers most NMS banks...

15 Distance to defaulta proxy for insolvency risk The number of STD a return realization has to fall for equity to be exhausted~probability of default 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 Bank account data STD deviation for the entire sample period STD deviation for the entire sample period Robustness to alternative ways of measuring volatility of returns; NPL ratios; loan loss reserves 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 Commonly used technique Linear models using panel data Linear models using panel data A relatively short time dimension A relatively short time dimension Lags of dependent variables Lags of dependent variables Advantages vis-à-vis Arellano-Bond Advantages vis-à-vis Arellano-Bond Two-equation estimation Two-equation estimation Subsample analysis Subsample analysis Advantages vis-à-vis 2SLS Advantages vis-à-vis 2SLS Efficiency gains Efficiency gains Unbiased in models with lagged dependent variables Unbiased in models with lagged dependent variables No apparent specification problems No apparent specification problems Unit roots rejected Unit roots rejected Hausman specification tests inconclusive Hausman specification tests inconclusive Residual analysis validates inclusion of lagged dependent variable Residual analysis validates inclusion of lagged dependent variable No multicollinearity No multicollinearity Robustness to single-equation estimation Robustness to single-equation estimation

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

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

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

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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 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 Ensuring sound lending decisions and risk management is much more difficult Higher degree of foreign participation in the Baltics Higher degree of foreign participation in the Baltics Additional comfort that the banking system can withstand shocks Additional comfort that the banking system can withstand shocks More foreign affiliates are branches More foreign affiliates are branches Supervision is more challenging 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) 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 Forward-looking and risk-based supervision Supportive market infrastructure (credit bureaus) Supportive market infrastructure (credit bureaus) Sufficient disclosure of information Sufficient disclosure of information Financial sector surveillance and analysis Financial sector surveillance and analysis Weaker banks expansion is most pronounced in household and foreign currency lending Weaker banks expansion is most pronounced in household and foreign currency lending Closer monitoring of risk exposures and lending practices in these markets Closer monitoring of risk exposures and lending practices in these markets Foreign banks are taking on greater risks, consistent with parent banks strength Foreign banks are taking on greater risks, consistent with parent banks strength Effective cross-border cooperation between supervisors 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 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 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 In Poland and the Slovak Republic, stronger institutions are growing faster Different intensity of risk-based policy instruments (Hilbers et al, 2005) Different intensity of risk-based policy instruments (Hilbers et al, 2005) Country-specific regulatory framework (e.g., supply-side measures) Country-specific regulatory framework (e.g., supply-side measures) Basel II, EU Capital Requirements Directive, IFRS Basel II, EU Capital Requirements Directive, IFRS

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


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