S&P Report Examines How Parent Bank Ownership In Emerging Europe Can Mitigate Sovereign Risk
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LONDON June 4, 2008--Foreign direct investment in emerging Europe's financial sectors has expanded dramatically since the mid-1990s, particularly from Western Europe. A new Standard & Poor's report published today, titled "Friends In High Places? Foreign Bank Ownership And Emerging Europe Sovereign Ratings," examines to what extent, in the event of a crisis, foreign bank ownership can mitigate the risk of financial sector contingent liabilities for emerging European sovereigns.
"Rapidly burgeoning stocks of domestic credit, fuelled in a number of countries by subsidiaries of foreign banks, have significantly increased the level of monetization in emerging European economies," Standard & Poor's credit analyst Remy Salters said. "This phenomenon is welcome, but it comes with an increased potential cost of bank bailouts in the event of a financial system crisis."
Although foreign ownership can sometimes restrain credit expansion, as it did in the case of Poland, there is evidence that, in some countries, foreign participation in the banking system has helped fan the flames of already overheating economies and/or exacerbated inappropriate economic policy mixes by funding imbalances. In several sovereigns, related capital account inflows have partly financed large current account deficits. Should these inflows from parent banks slow or reverse, a hard landing for the economy could follow.
"Although we believe the risk of parent bank withdrawal is remote, a worst-case scenario could include balance-of-payment difficulties and sharp currency depreciations," Mr. Salters said. "This, in turn, would lead to multiple second-round costs for the sovereign, including in some countries higher contingent liabilities as unhedged foreign currency borrowing turns bad."
Given emerging Europe's degree of dependence on parent bank ownership, Standard & Poor's has created an aggregate measure that aims to differentiate the extent to which, in the event of a crisis, parent banks' financial strength and commitment to their subsidiaries would moderate a sovereign's contingent liability. This measure, called the "contingent liability moderator", takes into account the likelihood of parent support and the financial strength of parent banks as indicated by their ratings.
The results of the exercise are shown below, where 100% is the best contingent liability moderator attainable:
Estonia 54%
Czech Republic 54%
Lithuania 41%
Slovak Republic 33%
Croatia 26%
Poland 24%
Romania 22%
Latvia 21%
Hungary 20%
Bulgaria 18%
Serbia 7%
Although foreign ownership can sometimes restrain credit expansion, as it did in the case of Poland, there is evidence that, in some countries, foreign participation in the banking system has helped fan the flames of already overheating economies and/or exacerbated inappropriate economic policy mixes by funding imbalances. In several sovereigns, related capital account inflows have partly financed large current account deficits. Should these inflows from parent banks slow or reverse, a hard landing for the economy could follow.
"Although we believe the risk of parent bank withdrawal is remote, a worst-case scenario could include balance-of-payment difficulties and sharp currency depreciations," Mr. Salters said. "This, in turn, would lead to multiple second-round costs for the sovereign, including in some countries higher contingent liabilities as unhedged foreign currency borrowing turns bad."
Given emerging Europe's degree of dependence on parent bank ownership, Standard & Poor's has created an aggregate measure that aims to differentiate the extent to which, in the event of a crisis, parent banks' financial strength and commitment to their subsidiaries would moderate a sovereign's contingent liability. This measure, called the "contingent liability moderator", takes into account the likelihood of parent support and the financial strength of parent banks as indicated by their ratings.
The results of the exercise are shown below, where 100% is the best contingent liability moderator attainable:
Estonia 54%
Czech Republic 54%
Lithuania 41%
Slovak Republic 33%
Croatia 26%
Poland 24%
Romania 22%
Latvia 21%
Hungary 20%
Bulgaria 18%
Serbia 7%
