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FM AMEMBASSY LONDON
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RUEHBL/AMCONSUL BELFAST PRIORITY 1345
RUEHED/AMCONSUL EDINBURGH PRIORITY 1152
RUEATRS/DEPT OF TREASURY WASHDC PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHDC PRIORITY
RHEHNSC/NSC WASHDC PRIORITY

UNCLAS SECTION 01 OF 04 LONDON 001369 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: EFIN ECON EINV XG UK
SUBJECT: UK ANALYSTS ASSERT CENTRAL AND EASTERN EUROPEAN 
BANKING SYSTEM FACES PROBLEMS BUT NOT COLLAPSE 
 
REF: LONDON 1321 
 
LONDON 00001369  001.2 OF 004 
 
 
¶1. (U) SUMMARY: Compared to the acutely fragile economic 
climate in Central and Eastern Europe from November 2008 to 
February 2009, UK-based market watchers now feel the worst is 
behind them.  Their views are spurred in part by positive 
news on U.S. and UK banks in recent weeks and assumptions 
that European banks will be fine as well.  Though the risk of 
a slow recovery still looms, analysts generally felt 
confident the largely foreign-owned Central and Eastern 
European banking sector, backed by commitments from foreign 
parent banks and IMF/EC financing, had the tools needed to 
cope with the ongoing economic crisis.  End Summary. 
 
The Banking Sector May Be Out of Acute Danger 
---------------------------------------- 
 
 
¶2. (SBU) Market analysts from Royal Bank of Scotland, Credit 
Suisse, and HSBC told us recently they felt Central and 
Eastern European banks had gotten past the worst of the 
credit crunch.  Troubles in this region's banking sector now 
center around liquidity--not solvency--for emerging Europe, 
said RBS' Head of Central and Eastern Europe Middle East and 
Africa Research, Timothy Ash during a May 14 meeting.  He saw 
positive indicators, namely that Eastern European banks were 
not highly leveraged and governments had maintained lower 
levels of public sector debt.  Compared to Western Europe, 
public sector debt to GDP in Eastern Europe is only 40 
percent vice 70 percent.  Moreover, even in case of a bank 
failure and the need for recapitalization, Ash pointed out 
Eastern European banks are small relative to Western European 
institutions, with bank assets to GDP reaching 100 compared 
to 215 and higher in some Western European countries.  Ash 
implied, consequently, they are not too big to fail or too 
problematic to rescue. 
 
Central European Banks on Solid Ground 
--------------------------------------- 
 
¶3. (SBU) Contrary to worrying Central Europe's banks could 
fail, the key for Central Europe is whether foreign-owned 
parent banks will drag down their Central European 
subsidiaries, HSBC and Credit Suisse analysts told us on May 
22 and June 2, respectively.  Jacqueline Madu, Emerging 
Markets Analyst at Credit Suisse asserted Czech subsidiaries 
are in fact net creditors to their foreign parent banks.  She 
also pointed out that some of the journalists who used Bank 
of International Settlement (BIS) data on liabilities used 
the wrong table, exaggerating the exposure of Austria's Erste 
bank's exposure to the Czech banking sector.  On Poland, Madu 
said only a severe contraction could lead to deterioration in 
portfolios of Polish banks, and this seemed unlikely as the 
crisis bottoms out in Western Europe.  In addition, despite 
the exposure of Polish banks to foreign exchange mortgage 
loans (denominated in Swiss francs), Maciej Baranski, Central 
Europe Analyst in HSBC's EMEA Equities division, told us he 
sees no major deterioration in the quality of those loans 
because the decline in Swiss interest rates. 
 
 
Non Performing Loans Bound to Rise but Not Alarming 
--------------------------------------------- ------ 
 
¶4. (SBU) Rising non-performing loans (NPLs) represent one 
challenge for the banking system but the cleansing needs to 
happen, according to RBS analysts.  RBS estimates Ukraine's 
NPLs at above 20 percent and Lithuania at 8 percent, with 
Latvia and Kazakhstan also at high levels. Turkey,s NPLs of 
around 5 percent are less of a risk.  Russia falls in the 
middle of the extremes, but bankers are nervous, says RBS. 
Economists who use a baseline scenario of a two percent 
contraction in GDP in 2009 predict Russia will see NPLs 
reaching ten percent. If, however, the Russian economy 
contracts 6 to 7 percent this year (as expected from first 
quarter 2009 figures), NPLs will likely rise to 15 percent or 
more and banks will need to recapitalize, according to Ash. 
 
¶5. (SBU) NPLs in Poland, Hungary and Czech Republic have been 
rising and are likely to increase further as economic growth 
slows and unemployment rises, but they are lower than NPL 
rates in 2007 and analysts do not foresee markets reacting 
badly.  In Poland, Jacqueline Madu from Credit Suisse 
stressed to us NPLs have reached 5.5 percent this year but 
are still lower than the 8 percent level two years ago when 
 
LONDON 00001369  002.2 OF 004 
 
 
unemployment hovered around 13 percent.  She said NPLs in the 
three central European countries will likely peak in the 
third quarter of this year, eroding profitability, but will 
not instigate bank insolvency.  Maciej Baranksi from HSBC 
projected nine percent NPLs and single digit loan growth in 
Poland this year, but he saw Polish banks as generally 
stable. 
 
Foreign Banks and Multilateral Institutions Remain Committed 
--------------------------------------------- --------------- 
 
¶6. (SBU) The banking sector in Eastern and Central Europe is 
largely foreign-owned, mainly by Nordic, Austrian, Greek, and 
Italian banks.  The consensus among the analysts is parent 
banks will not allow subsidiaries to fail. (Comment: As an 
example, on May 19, the parent banks of nine large 
foreign-owned banks in Romania reaffirmed their commitment to 
subsidiaries and agreed to increase capital ration from 8 to 
10 percent in conjunction with IMF/EU financial support. End 
Comment.)  Madu told us Hungary's central bank and 
supervisory authority ran stress tests with a very severe 
10.5 percent contraction scenario, and the results suggested 
banks need 1 billion euros, which corresponds to the amount 
received from the IMF/EU. Baranski also agreed and told us 
Western European banks will not let Polish subsidiaries fails 
as this would gravely impact pension funds invested by 
Western banks in Polish subsidiaries. The parent banks may 
force Polish banks to find other sources of funding such as 
local deposits; the ensuing competition for local deposits 
will kill profitability as net interest margins decline. 
 
¶7. (SBU) Foreign banks will remain active in the region 
because of the competitive tax advantage Eastern Europe 
provides compared to Western Europe, labor market 
flexibility, and home market sentiment, analysts said.  RBS' 
Ash acknowledged his bank was cutting operations from 70 to 
56 units in the region, some of which were inherited from its 
merger with ABN Amro.  RBS is looking to reduce risk in the 
region but maintain presence.  Analysts expect some sell offs 
in Kazakhstan Czech Republic, Azerbaijan, and Uzbekistan, but 
RBS is committed to the big emerging markets in the region, 
namely Russia, Turkey, and Poland. HSBC's Baranski, citing 
AIG as an example, told us sell offs of Central European 
subsidiaries will be strategic in nature with financial 
institutions looking for buyers to pay a decent price vice a 
fire sale.  Juliet Sampson, HSBC Chief Economist, Emerging 
Europe, Middle East and Africa Economics and Investment 
Strategy told us May 20 the only "pulling out" scenario she 
can envision is if the parent banks are going out of 
business.  Austrian and Swedish banks, in Central Europe and 
the Baltics respectively, consider the region as home 
territory so they cannot pull out without "shooting 
themselves in the foot."  These parent banks are playing a 
long game and not willing to concede territory to 
competitors, she said, and commented the banks may be less 
committed to investments further afield, such as those in 
Ukraine and Kazakhstan. 
 
¶8. (U) Multilateral institutions will continue to support 
small and medium-sized enterprises (SMEs) through local bank 
lending.  Sampson points to the European Investment Bank's 
(EIB) 440 million euros agreement with Erste Group Bank and 
the EBRD's 432 million euros loan to Unicredit in early May. 
(Comment: EIB will grant loans to four local Erste 
branches--including Ceska Sporitelna, Erste Hungary, and 
Immorent--to provide funding for SMEs projects in the Czech 
Republic, Hungary, Slovakia, Poland, Romania, Bulgaria, 
Slovenia, and Austria.  The Unicredit loan is part of a joint 
effort of EBRD, the World Bank, and EIB to provide over 24 
billion euros in support of banks in the region and to fund 
lending to companies hit by the crisis.) 
 
 
 
The Need to Recapitalize Banks May Be Easing in Some Parts 
--------------------------------------------- ------------- 
 
¶9. (SBU) Baranski asserts the capital position of Central 
European banks is good, thus alleviating the need for bank 
recapitalization in Central Europe, even for Hungary's OTP 
Bank.  Earlier this year, Poland's financial regulator 
requested banks not pay out dividends from 2008 profits. 
Such actions combined with continued, albeit reduced, 
profitability and slower loan growth give Baranski confidence 
that Polish banks' capital positions are strong enough to 
 
LONDON 00001369  003.2 OF 004 
 
 
withstand rising NPLs.  In addition, a greater weighting of 
government securities in their balance sheets may further 
help the capital ratios.  Nonetheless, in his May 5 report on 
Polish banks, Baranski points out a number of banks--namely 
PKO and BRE--are seeking to use various forms of funding to 
boost their capital positions; these capital raisings are 
more to maintain lending in Poland vice solvency concerns. 
He views Russia as a different "kettle of fish" than Central 
Europe.  Most of the liquidity in the banking system is 
focused on the largest banks.  Foreign exchange reserves have 
been used to protect the ruble.  Russian banks lack 
alternative resources such as raising funds overseas, so the 
government will have to recapitalize if NPLs rise or banks 
will have to sell assets said Baranski. (Comment: Earlier 
this year, the Russian government put forth a 900 billion 
ruble bank recapitalization plan for commercial banks, with 
state-controlled banks receiving the largest share.  Russia 
also dipped into its sovereign wealth funds putting 400 
billion rubles of the National Wealth Fund's money on 
deposits at state bank Vneshekonomobank (VEB) as part of 
Moscow's crisis rescue package and a further 225 billion 
rubles to be given to VEB for subordinated loans to banks. 
Nonetheless, President Medvedev announced last month that the 
government will no longer offer large bailouts to businesses 
and state-owned companies.) 
 
 
Potential Knock-on Effects from Troubles in the Baltics 
--------------------------------------------- ---------- 
 
¶10. (SBU) Despite gaining IMF/EU loans, Lativia remains a 
weak link in Eastern Europe. A Latvian devaluation could put 
pressure on other fixed exchange rate regimes in the region, 
particularly Estonia and Lithuania (Ref London 1321).  A 
renewed crisis in the Baltics potentially brings heavy losses 
to Western European banks, especially Swedish ones, and 
dampens some of resilience shown in recent months. Following 
Latvia's failed debt auction on June 3, Sweden's Finance 
Minister attempted to reassure the market that Swedish banks 
could ride through the crisis with a public statement that 
the government of Sweden is prepared to take stakes in 
Swedish banks if they fail to manage mounting losses.  In his 
June 3 markets report, RBS' Ash suggested the lack of vocal 
EU, IMF and Swedish officials' support of Latvia's peg 
implies an underestimation of the size of the problem and a 
failure to realize the extent of the potential regional 
currency corrections making the adjustment in Latvia more 
brutal.  Ash, however, argues Latvia's 7.5 billion euros 
IMF/EU program -- while maybe not the right mix of policies 
to bring Latvia out of the crisis -- allowed other economies 
in the region and foreign banks to build up defenses.  Ash 
does not believe a Latvian devaluation will necessitate 
immediate devaluation of other fixed exchange rate regimes in 
the region.  The key risk will be capital flight vis-a-vis 
local currency deposits.  Overnight deposit rates which 
doubled to 24 percent on June 3 rose to 25 percent June 4 
amid fears of capital flight. During our May 20 meeting, 
Sampson said the mounting troubles in Latvia could be handled 
in a "controlled explosion" and maintained this view in her 
June 4 HSBC Global Research Flashnote.  Sampson argues a 
devaluation before April would have produced more devastating 
fallout.  With the banking sector "on the mend" and risk 
appetite improving, the threat of an extra-regional collapse 
is limited.  Like Ash, Sampson asserts banks with exposure in 
the region have had ample time to assess their risks and 
prepare for such an event. 
 
¶11. (SBU) Also, if Latvia devalues and region-wide currency 
sell-offs ensue, Poland may have to tap the IMF's Flexible 
Credit Line (FCL), according to Madu and Baranski.  Poland's 
fiscal deficit has widened significantly, already reaching 
3.8 percent and likely to increase to 4.8 percent by year 
end.  RBS' Ash, however, views the FCL as free money since 
the there is no conditionality attached and consequently 
believes there's a greater likelihood officials may take the 
money to address budget financing problems.  IMF money 
technically is not meant for fiscal support; however, the IMF 
cannot do anything if Warsaw uses it for the budget.  He told 
us IMF officials have privately commented they do not really 
care if Poland uses the money for fiscal support.  As for 
investors, Ash does not believe the market will react 
negatively if Poland taps the FCL money.  The money will go 
into central bank reserves, the central bank will issue local 
currency and reserves stay the same.  This type of scenario 
allows Poland to cover its budget deficit cheaply if needed. 
 
LONDON 00001369  004.2 OF 004 
 
 
 
¶12.  (U) Comment: Central and Eastern Europe,s banking 
sectors generally appear more resilient than several month 
ago and market confidence has held -- so far -- even under 
pressure of Latvian devaluation. It remains to be seen 
whether the Latvian problem can be contained, with IMF 
officials and European Commission representatives demanding 
meaningful fiscal reform prior to handing out more 
assistance.  While London analysts generally do not see 
spill-over effects, uncertainty remains as demonstrated by 
the cost of insuring sovereign debt in Eastern Europe. 
Moreover, with no clear and transparent Europe-wide bank 
stress tests, it is uncertain which individual foreign parent 
banks are poised to withstand further market strain. 
 
 
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