Decomposing Financial Risks and Vulnerabilities in Emerging Europe

Abstract

This paper assesses how various types of financial risk such as credit risk, market risk, and liquidity risk affect banking stability in emerging Europe. It also examines how the quality of supervisory standards may have mitigated the vulnerabilities arising from these risk factors. Using panel data, the paper finds that (1) credit quality is of general concern especially in circumstances where credit growth is accelerating; (2) although higher provisioning could adversely affect profits and returns volatility, good supervisory policies on provisioning mitigate such adverse effects; and (3) highly liquid banks are not necessarily more stable because they might be pursuing activities with more volatile returns, but a well-functioning payments system helps to lower the adverse impact on stability. The paper also corroborates earlier evidence of the positive (negative) effect of financial depth (foreign ownership) on stability.[JEL E44, D53] IMF Staff Papers (2010) 57, 25-60.

Credit Growth, Bank Soundness and Financial Fragility

“…The majority of the studies in this area have primarily dealt with developed markets, such as the US banks (Contessi andFrancis, 2009), transition (Coricelli andMasten, 2004) and EU countries (Collarelli et al, 2005;Egert et al, 2006;Maechler et al, 2007) and to a lesser extent, the Latin American (Barajas et al, 2005;Breuer et al, 2009) banking sector. Using quarterly (and monthly) data on banks from eight Latin American countries for 1992-2001, Barajas and Steiner (2002) finds that the evolution of deposits to be a key factor explaining credit expansion.…”

“…These variables reflect the supply-side determinants of credit growth, the importance of which was emphasized by Dell'Ariccia et al (2008), Nier and Zicchino (2006). In line with recent studies of bank soundness (De Nicolo, 2007;Maechler et al, 2007), measures of bank profitability (proxied by the net interest margin), liquidity (proxied by the liquidity ratio) and efficiency (proxied by cost to income ratio) are included as explanatory variables. We also control for income diversification in the soundness equation: using crosscountry data on 288 banks for 1995-2000, Laeven and Levine (2008) find that well-diversified banks are less prone to taking risks.…”

Credit booms and busts in emerging markets

“…We use the ratio of the end‐stock of non‐performing loans (NPL) to gross loans as well as the ratio of annual loan loss provisions (LLP) to gross loans as measures of credit losses. Previous studies show that rapid credit growth is an early indicator of build‐up of credit risk (Maechler et al ., ). Results by Foos et al .…”

“…We use the ratio of the end-stock of non-performing loans (NPL) to gross loans as well as the ratio of annual loan loss provisions (LLP) to gross loans as measures of credit losses. Previous studies show that rapid credit growth is an early indicator of build-up of credit risk (Maechler et al, 2010). Results by Foos et al (2010) suggest that excessive loan growth represents an important driver of the riskiness of banks, and Dell'Ariccia et al (2012) present evidence that fast credit growth can be linked to a decline in lending standards.…”

Bank Credit to the Private Sector Before, During and After the Crisis – Evidence From Cesee Countries

“…(2015) The deterioration of the economic ambience also boosted non-performing loans, and thus, banks started to respond with tighter criteria and a narrowing of credit supply. Previous studies show that rapid credit growth is an early indicator of credit risk formation (Maechler, Mitra & Worrell, 2010). Results by Foos, Norden and Weber (2010) suggested that credit growth represents a significant growth of banking risk, and Dell'Ariccia, Igan and Laeven (2012) presented evidence that rapid credit growth may be associated with a decline in credit standards and loan performance problems.…”