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
Successful 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
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”?
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...?
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 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
Equity 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 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 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