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Financial Spillovers and Deleveraging: The Case of Romania

This blog looks at foreign bank deleveraging and examines how Romania’s asset prices have been impacted from European crisis spillovers.[1] Foreign bank deleveraging has been orderly and moderate so far in Romania unlike in some peer countries. Findings from the spillover analysis suggests that Romania’s asset markets tend to co-move more closely with its regional peers but have been also strongly impacted by the Euro area financial crisis. Romania’s bank capitalization has remained strong at 14.7 percent at end-June while prudential provisions covered 98 percent of non-performing loans. In addition, the National Bank of Romania takes a pro-active stance in intensively supervising the financial system.

Context

Beyond financial spillovers, Romania’s growth trajectory and domestic credit performance is strongly influenced by developments in Western Europe. According to the IMF 2012 Spillover Report, a one percent growth shock in Western Europe gives rise to a shock of about equal size in CESEE. Banking linkages are an important separate conduit for spillovers. The cross-border banking model used in the Spillover Report finds that a 1 USD change in cross-border exposure of western banks vis-à-vis CESEE banks translates over time into a 0.8 USD change in domestic credit. And each extra percentage drop in real credit growth leads to about 0.3 percentage point reduction to real GDP growth. So any intensification of the Euro area crisis that would cause disorderly deleveraging of parent banks could significantly impact private sector credit growth in Romania.[2]

The risk of disruptive parent funding withdrawals by European banks from CESEE has been a longstanding concern. Some orderly deleveraging is unavoidable given past excessive FX driven credit booms and European banks’ desire to shrink non-core assets over time. Disorderly foreign bank deleveraging can risk a credit crunch, balance of payment stress and loss of reserves, a sharp depreciation, increases in risk premia as well as spillovers to the real economy. Excessive deleveraging in CESEE countries has been prevented thus far, partly thanks to the EBCI which encouraged parent banks to maintain exposure to their subsidiaries.[3] The ECB’s LTROs have also provided some funding relief to parent banks but the LTRO effect is diminishing. Compared to other emerging market regions, the CESEE has seen larger foreign bank deleveraging since the Lehman Brothers collapse in September 2008, with the exposure to Asia & Pacific and Latin America & Caribbean by far exceeding the level in September 2008.

 

Romania has been strongly impacted by the financial crisis in 2008/09 but also recently from the intensification of the euro area crisis. Both CDS and Emerging Markets Bond Index Global (EMBIG) spreads have been steadily increasing again to levels that remain lower than Hungary but higher than Bulgaria or Poland. Domestic political tensions in Romania have also contributed to the weak performance of Romanian asset prices as well as the depreciation of the exchange rate.

 

The Romanian banking sector remains vulnerable to spillovers from the euro area and domestic developments, and deleveraging remains a risk. The banking system is 80 percent foreign owned with Austrian banks dominating the market with 38 percent of system assets. Subsidiaries of Greek banks hold about 12.1 percent of system assets and 9.6 percent of deposits at the end of June. In particular, Greek banks have orderly deleveraged to cope with a more limited funding availability. While overall bank capitalization remains strong with 14.7 percent, the liquidity situation is quite heterogeneous among banks. Credit growth has significantly slowed and nonperforming loans continued to rise to 16.8 percent in June, mainly due to the weak economic activity and the vulnerability of the large legacy of foreign-currency loans. Prudential provisions almost fully cover nonperforming loans with 98 percent. But profitability is poor, mainly because of the persistent need for higher provisioning, lower interest rate margins and still high overhead costs (despite banks’ recent trend to cut personnel costs).

Financial Spillover Analysis

Findings from a Dynamic Conditional Correlation (DCC) GARCH equity market model suggest that Romania’s implied equity market co-movement with a GIIPS equity market average and the Euro Stoxx appears lower than of Poland but higher than Bulgaria.[4] Romania hovers around 0.4–0.5 in terms of the implied correlation with an occasional correlation jump, corresponding to volatile episodes.[5]

 

In terms of CDS spread co-movements, Romania shows the highest implied correlation with Bulgaria followed by Hungary/ Poland and then an average of the GIIPS CDS spreads. The average implied correlation between Romania and the GIIPS CDS average stood at around 0.2–0.3 and sporadic volatility jumps up to 0.4 compared to co-movements of Romania with Bulgaria, Hungary and Poland of around 0.5–0.8. The CDS model with Italy confirms the results.

 

The EMBIG spread model finds that Romania’s spread moves closer to Hungary’s and Poland’s EMBIG spreads than the GIIPS 10-year bond yields over Germany’s 10-year (GIIPS10y) as well as the Emerging Market Europe EMBIG spread. Comparing Romania, Hungary and Poland against GIIPS10y indicates that Romania’s EMBIG spread tends to exhibit a lower DCC GARCH implied correlation to the GIIPS10y for the most part of the sample period. Results do suggest that Romania as Hungary and Poland have not been immune to volatility in the GIIPS bond spread over Germany with correlation jumps up to 0.5-0.6. Overall, an intensification of the Euro zone crisis would likely lead to heightened financial spillovers to Romania with an increase in risk premia (as measured by CDS and EMBIG spreads) as well as adverse developments on the domestic equity market.

High estimated correlations of Romania’s asset prices and spreads mean that Romania is vulnerable from an intensification of the euro area crisis. Continuing domestic political tensions would bring in an idiosyncratic and adverse component into Romania’s asset prices, a risk on top of the European common factor. Vulnerabilities especially to financial spillovers from Europe call for safeguarding sufficient public and financial sector buffers and implementation of prudent contingency planning, given the negative effect sharp increases in Romania’s CDS and EMBIG spreads or declines in equity prices would have on Romania’s financing costs and capital inflows, exchange rate, market sentiment as well as credit and liquidity risk of the banking sector.

Foreign Bank Deleveraging

Unlike some regional peers, foreign bank deleveraging in Romania has been moderate so far, partly due to the European Bank Coordination Initiative (EBCI). In July, the total exposure to Romania of the nine largest foreign banks that participated in the EBCI fell to 94 percent (against March 2009 exposure) from 101.3 percent at end-2011, notably due to reduced exposure to non-financial institutions. Exposure of parent banks to their subsidiaries has remained at a similar level between March 2009 and July 2012.

 

Overall bank system parent funding has been orderly, declining moderately since end-2011. At end-July, it stood at 89.2 percent of the end-2011 level. The decline in overall sector exposure of BIS reporting banks to Romania has been in the average for the CESEE (excl. Russia and Turkey) with a 20 percent deleveraging ($13.4bn) between 2008:Q3 and 2012:Q1, much less than in Ukraine (52.8 percent), Latvia (38.3 percent) or Hungary (38 percent). Relative to GDP, the 7.2 percentage points decline also compares favorably against many other CESEE countries. Part of the reduction in exposure can be explained by the reabsorption of loans by subsidiaries that during the credit boom period had been outsourced to SPVs and parent-related affiliates abroad. Furthermore, the majority of banks’ parent funding (close to 70 percent) has a maturity of over one year, preventing an abrupt withdrawal.

Deleveraging has been driven by different factors. Some causes for the orderly foreign bank deleveraging in Romania were weak parent banks (especially Greek banks), changes in parent funding strategy (e.g., some French banks) or some loss in domestic funding (e.g., Greek subsidiaries). If the overall financial sector environment were to further deteriorate, including with further rising NPLs and continued poor profitability, some parents could scale back long-term support for their subsidiaries, thus making them more reliant on domestic funding.

Conclusion

Vulnerabilities to financial spillovers from Europe to Romania call for safeguarding sufficient public and financial sector buffers and implementation of prudent contingency planning given the negative effect that sharp increases in Romania’s CDS and EMBIG spreads or declines in equity prices will have on Romania’s financing costs and capital inflows, exchange rate, market sentiment as well as credit and liquidity risk of the banking sector. According to the DCC GARCH analysis, Romania’s asset markets and spreads tend to co-move more closely with its regional peers but have been strongly impacted by the financial crisis in 2008/09 and also recently from the intensification of the euro area crisis. Results indicate that Romania’s asset prices significantly co-move with the euro area periphery and European risk premia with related correlation jumps up to 0.5–0.6. But Romania’s bank capitalization has remained strong at 14.7 percent at end-June while prudential provisions covered 98 percent of non-performing loans.

In light of the uncertain environment and spillover risks from the euro area such as an acceleration of foreign bank deleveraging, it is important that the NBR continues to take a pro-active stance in intensively supervising the financial system. Any necessary measures should be taken to ensure that banks have sufficient capital and liquidity especially from shareholders. With system deposits limited to fully replace any parent bank deleveraging, the continuing support of parents will be crucial given, in particular, the large currency mismatch in the banking system. It is equally important that the NBR, in coordination with other relevant authorities, stands ready to implement its crisis management framework and updates detailed contingency plans on an ongoing basis.

The views expressed in this article are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. Any errors and omissions are the sole responsibility of the authors.


[1] This blog is drawn from IMF (2012) “Romania: Selected Issues Paper,” IMF Country Report 12/291.

[2]The usual caveats of directly translating the average cross-country effect (to the CESEE) onto Romania should be considered in the above estimates given some country-specific heterogeneities.

[3] EBCI (2012) provides an analysis of deleveraging in the CESEE: EBCI (2012) “CESEE Deleveraging Monitor,” Report prepared for the Steering Committee Meeting on July 18, 2012, in Warsaw, Poland.

[4] See IMF (2012) for more technical details.

[5] A possible caveat is that any low liquidity in e.g. Romania’s equity market would possibly distort and amplify the results somewhat.

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