Banks cope with heavy weather in eastern Europe

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As the financial crisis abates, Austrian banks are looking with cautious optimism towards 2010. As the economies in central and eastern Europe have begun to stabilize and even recover, the banks – big players in the CEE region – see a good chance to limit their losses from bad consumer and commercial loans and to slowly rebuild their depleted capital base.

But there are still significant risks ahead, analysts warn. Even if growth resumes in the CEE countries sometime next year, bankruptcies are expected to continue rising. And if there is another downturn and another financial panic, it would expose the Austrian banking sector to devastating losses.

Still, the mood is quite different to earlier this year, when the IMF and other international observers pointed to the huge exposure of Erste Group, Raiffeisen Zentralbank and Bank Austria, a Unicredit subsidiary, to eastern Europe of €200bn ($300bn) or nearly 70 per cent of Austrian gross domestic product. It warned that the growing economic storm in the region could sink the banks and threaten the stability of Austria’s public finances.

The stock prices for the once high-flying financial stocks tumbled on the Vienna bourse and for several months, Austria faced a spike in the yields on its public debt that cost the government around €200m in additional interest payments.

Austrian bankers and public officials repeatedly argued that the fears in the financial markets were exaggerated. They pointed to the fact that the banks’s largest exposures were in countries like the Czech Republic, Slovakia and Poland that weathered the crisis relatively well. Moreover, in the unlikely case of a meltdown, Austria could count on support from other EU member states, the European Commission and the IMF.

Starting in early summer, the situation calmed down, thanks to massive international loans to CEE countries, an injection of fresh state capital into the banks and the general improvement in the European business climate. The three major banks reported first-half results where loan-loss reserves for CEE were sharply higher, but these costs were offset by improved operating profits. Overall, the results exceeded analysts’ expectations and contributed to a recovery of Erste and RI share prices.

The gains in operating earnings were driven by strong trading profits and cost-saving measures in CEE markets. But despite some worries expressed in the regions, none of the banks significantly curtailed their exposure.

Herbert Stepic, chief executive of Raiffeisen International, says he is convinced that his bank’s strong presence in CEE will start to pay off again. “Economic indicators are much more positive than a couple of months ago,” he says. “2010 will be another challenging year for the banking industry and CEE shall see only a slight real growth of its economy. But it remains a highly attractive market in the long term due to the convergence process and the low penetration of banking products.”

A stress test conducted by the Austrian National Bank in July showed that the banks have enough capital to survive even a drastic recession in Eastern Europe and a grave worsening of the global financial crisis. The worst-case scenario assumed €30bn in loan-loss charges against earnings for the whole sector, an amount that Ewald Nowotny, National Bank governor, called manageable.

The government injected a total of €7bn of hybrid participation capital into five of the country’s largest banks, using up about half of the funds that it pledged to the banking sector as part of a total €100bn package of state aid. Bank Austria, the largest bank, was in talks with the government about capital injection but ultimately refused any state aid as it was able to tap the capital markets again.

Only one bank, Kommunalkredit, was nationalised after the institute that had specialised in the financing of communal infrastructure projects failed due to the drying up of the credit markets last autumn. Including guarantees, the government’s exposure to the banking sector is currently estimated at €30bn.

The conditions in eastern Europe are improving but they are still not stable, economists warn. While Austrian banks have very little exposure to troubled Latvia and the Baltic region, the crisis in these countries could still spill over. Romania, where Erste Group is active through its BCR subsidiary, and Ukraine, where Raiffeisen owns Bank Aval, are particularly vulnerable. Russia is also a potential trouble spot for Raiffeisen.

During the preceding boom, a large part of consumer and commercial bank loans were denominated in euros or Swiss francs. So when local currencies went into a slide, bank customers suddenly faced sharply higher payment obligations. Even though the exchange rates stabilised and western banks stopped offering foreign currency loans once the financial crisis began, it will take several years for this risky exposure to be wound down.

Accounting rules allowed the banks to take their time in writing down troubled and non-performing loans, which helped to limit the immediate impact on their balance sheets. But that means that the loan-loss reserves at the three banks that stood at around €3bn in the summer are bound to rise further, which will keep earnings growth down for the foreseeable future. But as confidence returns to the financial markets, the banks are expected to tap the capital markets through secondary share offerings rather than ask for more state aid.

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