Thomas Mirow, EBRD: a whole new business model is needed, where subsidiary funding will be more reliant on local deposits

Autor: Bancherul.ro
2012-01-14 12:25

In his speech to the Campus for Finance at WHU Otto Beisheim School of Management, Thomas Mirow looks at the shortcomings that have produced a financial crisis that has resulted in huge economic and political costs, said the bank in a press release.

He refers specifically to ineffective regulation and supervision of the financial markets, unsustainable public and private leverage, credit-led growth, lack of policy coordination in the eurozone and regional macroeconomic imbalances.

The President highlights the problems in emerging Europe, referring to excessively rapid financial development and its consequences in some cases. He points out that, now, banking in Europe is undergoing its most profound change since the start of the deregulation process 30 years ago and new national and international regulatory frameworks are being reshaped or created in order to pay more attention to systemic or macro prudential risks.

The President believes that in the long run a whole new business model is needed, where subsidiary funding will be more reliant on local deposits and – where they have been developed – local bond markets, and notes that the EBRD can play a role in building local capital markets in emerging countries and generally supporting financial sectors.

He concludes that “The banking sector is at a crossroads”.

Speech to the Campus for Finance at WHU Otto Beisheim School of Management by EBRD President Thomas Mirow

Thomas Mirow, President of the European Bank for Reconstruction and Development, Campus for Finance on “Sustainable Finance”, WHU Vallendar, 13 January 2012

Ladies and Gentlemen,

Good morning. It is a great pleasure to stand today before this diverse audience of enthusiastic students and young professionals. The daily media reports are full of the fire and fury of the battle over the current economic challenges. Sometimes, though, you need to leave the battlefield to get a better understanding of the underlying issues. This forum, today, provides a valuable opportunity, beyond the pressing needs of crisis management, to take a step back and debate on the foundations of our financial system. I am sure that we will have the chance of a fruitful exchange after my address, which I will try to keep short.

The global financial crisis has been a powerful reminder that an ill-designed financial system can entail huge social, economic and political costs. It resulted from shortcomings in a wide range of issues: ineffective regulation and supervision of the financial markets, unsustainable public and private leverage, credit-led growth, lack of policy coordination within the eurozone, persistent global and regional macroeconomic imbalances – to name but the most obvious ones.

To focus our discussion, I will look today in more details at the banking sector in the “emerging” Europe – central and eastern Europe – where my organisation, the European Bank for Reconstruction and Development, has operations. Central Europe has plenty of experience both in the excesses of financial development, and now in the attempts to guide financial markets towards a more sustainable future. It is a good case study to try and cautiously draw a few conclusions on what went wrong in the past decade – but also on what can be done to make our banking system more stable.

A few words on the EBRD

Let me start, if you allow, with a few words on the EBRD. The Bank was created in 1991, shortly after the fall of the Iron Curtain, to accompany the countries of the former soviet block on their thorny path towards democracy and market economics. Our goal is to promote private initiative and entrepreneurship in 29 countries, from Baltics to Turkey and from Poland to Mongolia. We invest today around EUR 9bn annually in both debt and equity, and engage in policy dialogue with governments on a wide range of policy issues.

And now, against the background of the Arab Spring, the international community has asked us last year to expand our mandate to the countries of the southern and eastern Mediterranean, where the challenges bear some similarities to those of central Europe twenty years ago. This process is ongoing, but we should be able to start investing in Morocco, Tunisia, Egypt and Jordan in the course of this year – technical cooperation projects have started already.

Roughly a third of our portfolio is in the financial sector. Nine of our countries of operation are members of the European Union; most of them are largely dependant on funding from parent banks in the eurozone. Needless to say that we keep a close eye on the ongoing crisis and, to some extent, contribute to containing it. I will get back to this later, but let me start with briefly outlining what happened in the banking sector in central Europe in the past twenty years.

What happened?

After a series of local banking crises following the fall of the Berlin Wall, central Europe opened itself up very rapidly to foreign banks through privatisations, which in several countries placed 70-90 per cent of bank assets under the control of foreign-owned bank subsidiaries. We continue to believe that this has protected a number of countries against deep home-grown financial crises, and allowed them to import skills and technology into underdeveloped financial sectors.

Foreign capital flows into the region increased swiftly, mainly from European parent banks to their newly acquired subsidiaries. Rapid credit growth fuelled GDP growth, which in turn called for more funding. These inflows took external deficits and debts well beyond what was considered sustainable in the context of other emerging markets, and persistent trade imbalances developed.

As is a common experience throughout financial history, capital inflows fuelled lending booms in several sectors, gradually eroding lending standards and credit quality. Lending in foreign currencies developed, in particular for mortgages and consumer finance – not only in Euro, for which an economic rationale could be made, but also in cheap funding currencies such as the Swiss Franc. This turned particularly virulent in the liquidity crisis of 2008-09, when many central European countries saw sharp currency realignments.

What went wrong?

What went wrong? A number of countries in emerging Europe succumbed to the typical pitfalls of overly rapid financial development – although some, Poland for instance, managed to engage on a more sustainable path. To a large extent, the causes of instability were the same that led to the crisis in developed markets, in the US or in the eurozone.

First, most governments connived in, if not actively encouraged, progressively riskier lending. This is now well understood for the housing boom in the U.S., but also in Europe, where banks have accumulated large amounts of sovereign debt holdings, which they then use to get liquidity from the ECB.

Second, authorities at national and European levels made the false assumption that free capital flows between countries can always be smoothly absorbed by the domestic financial system, and do not require additional scrutiny under prudential rules. When trying to better manage these capital flows, several countries in emerging Europe had difficulties to make the case that they did not violate the rules of the single capital market.

Finally, regulators allowed financial market integration to run well ahead of the integration of regulatory efforts. The so-called ‘colleges’ of supervisors overseeing international bank groups are still in their early days. A recent agreement between Scandinavian and Baltic countries to coordinate on the resolution and burden sharing in financial crises is exemplary, but still very much the exception.

What is being done?

Banking in Europe is undergoing probably its most profound change since the start of its deregulation process thirty years ago. This is driven in part by regulation, but also by investors and bank executives themselves, who realised that a new, more stable business model was needed.

A new set of regulations

First, national and international regulatory frameworks are being reshaped – or created – to pay much more attention to systemic or “macroprudential” risks. In the EU, four new European supervisory agencies and bodies have been established, although more needs to be done to make these new institutions fully effective – staffing to start with.

Within emerging Europe itself, national regulators have tightened lending standards considerably, and not just with regard to foreign exchange-based lending. Standards of disclosure and consumer protection have been raised, belatedly recognizing that there has been considerable mis-selling of risky products, and often poor ‘financial literacy’.

Second, extensive work has gone globally into strengthening capital and introducing liquidity buffers, as well as limiting overall leverage. Basel III must now make its way into EU and national legislations. A notable progress, in our view, will be the introduction of countercyclical capital buffers.

These new capital requirements, however, have to be implemented cautiously. In an effort to restore confidence and pre-empt a second credit crunch, European leaders adopted much more demanding prudential ratios. The risks of accelerated deleveraging and of increasing home bias are high. No region would be more vulnerable to this than emerging Europe, with its deep banking linkages to western Europe.

A new business model

In the longer run, a whole new business model is needed. Subsidiary funding will be more reliant on local deposits and, where they have developed, local bond markets. A new model of ‘network banking’ is starting to emerge, where each subsidiary benefits from the group’s technology and credit assessment standards, and the common franchise inspires confidence among depositors. Less dependant on international wholesale markets and parent banks liquidity, credit growth will be more muted, but less prone to abrupt reversals.

Local savings pools are slowly growing, in line with more prudent macroeconomic policies and household behaviours, but also with the emergence of institutional investors – importantly pension funds and insurance companies. Much remains to be done to further deepen local capital markets. Incidentally, broadening local bond markets is an objective not just in emerging markets. Equally, here in Germany many Mittelstand firms have recognized that excessive reliance on bank funding can be limiting, and a small specialist bond market for SMEs is beginning to develop.

What is the EBRD doing?

Building local capital markets in emerging countries requires the capacity to provide long term capital amidst risky environments, and often poor and rapidly evolving regulation. Multilateral institutions such as the EBRD have a key role to play in this regard.

First, our involvement in the banking sector has been central in strengthening institutional capacity, for instance for prudent SME lending. We are also active in selectively building up private equity and venture capital funds, demonstrating best industry practices. This is particularly important in harnessing emerging Europe’s rich endowment in skilled labour, which could be better deployed in risky small businesses.

Second, we are deeply involved in advising on reforms that underpin capital market development, and support this through our own local currency issuance and lending activities.

Finally, we leverage our good access to both private and official sectors to foster regional supervision and coordination efforts. Within Europe there is a grave danger that financial integration – which reaches well beyond the borders of the single market – is undermined by national agendas. Deleveraging is doubtless unavoidable, but will need to be measured and balanced.

Concluding words

Ladies and Gentlemen,

The banking sector is at a crossroad. Banks in emerging Europe will need to fund themselves through a more balanced mix of international wholesale markets, intra-group liquidity, domestic deposits and local capital markets – thus limiting foreign exchange mismatches and the impact of capital reversals. These are the basic features, which to a large extent apply to developed economies as well.

But a number of other acute – and widely discussed – issues need to be swiftly addressed, which we have not discussed as they are not, at least not yet, of major concern for central Europe, for instance:

(i) the development of a large and largely unregulated shadow banking sector;
(ii) the spiralling growth of derivative products, probably well beyond the needs of hedging, which may make the case for a tax on financial transactions;
(iii) the question of ‘bonuses’ and how to reward – and measure – performance without encouraging excessive risk-taking.

‘Never waste a crisis’, as the saying goes among policy makers these days. Indeed, every crisis offers opportunity for positive change. It is my firm belief that from the ruins of misdirected lending and poor regulation, more sustainable business models can emerge.

I look forward to discussing this with you now.

Thank you for your attention.

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