Banks’ challenges in Central and Eastern Europe
The banking sector in Central and Eastern Europe (CEE) is facing historical challenges on several fronts. First of all, not only has bankerbashing by politicians become a daily exercise, but fiscal measures such as a banking tax or a financial transactions tax are endangering the basic business model of the entire financial sector. Moreover, these actions have come on top of the constantly increasing regulatory requirements imposed by local and European Union (EU) lawmakers since the outbreak of the recent financial crisis in 2008. Secondly, macroeconomic uncertainties are posing a substantial challenge, especially in countries with traditionally unbalanced growth dynamics reflected in excessive foreign currency borrowing, high levels of public debt or lending booms financed mainly by foreign funding. Therefore, countries with a relatively low inflation rate, low budget deficits and low public spending have not undergone major gross domestic product (GDP) downward adjustments. Thirdly, investors are able to clearly differentiate among the countries of CEE, an expression that today is only a geographical phrase as the countries of this region are more different than ever due to their divergent macroeconomic developments. Last but not least, the honeymoon between the commercial banks and their clients is definitely over as clients have become well-informed, critical and selective when using financial services, and they are conscious of their rights. All of these reasons contributed to fundamentally reshaping the set-up of the banks in all aspects compared to what they used to be before the beginning of the financial crisis:
- • Employee structure: the ratio of people employed in the sales network has decreased substantially compared to the number of staff employed at headquarters; risk-related jobs due to an explosion of non-performing loans have more than doubled or even tripled; the number of employees involved in internal audit, compliance, reporting requirements and dealing with supervisory-related tasks has grown at a disproportionally high rate, making management of operating cost a substantial challenge.
- • Financing: due to substantial deleveraging, the importance of local funding has increased tremendously while intra-group funding has been reduced substantially; the importance of funding provided by international financial institutions such as the EBRD (European Bank for Reconstruction and Development), EIB (European Investment Bank), KfW (Kreditanstalt fur Wiederaufbau - German development bank) group of German promotional banks and the IFC (International Finance Corporation, a member of the World Bank group) has become significant; government guarantee schemes have gained in importance as well; cross-border financing has become reserved to just a limited number of top-rated clients.
- • Activity focuses: rather than continuing to hire and increase the branch network, banks have been cutting staff and closing down banking offices; despite valuations below book value, the interest in acquisition is close to zero; rather than enhancing scope and moving out of core business areas, everybody is going back to basic banking.
- • Profitability: non-performing loans have become main profit drivers; return on equity has been falling also partly due to increased capital requirements; double-digit returns on equity have become a real exception.
While in good times before the collapse of Lehman Brothers even mediocre banks were able to show significant profits, the banking market today is far more competitive. For the move to this new reality, traditional remedies such as efficiency increases, pricing adjustments and scope revision, by the time they have been implemented, are too little and too late. Hoping to grow out of the existing problems is hardly possible either, as in most CEE countries banks’ non-performing loans are reducing the size of interest-bearing assets day by day; the volume of amortized loans is much higher than the volume of newly extended loans; deposit gathering is very competitive and pricy; the repricing of existing loans even due to substantially increasing administrative or funding costs is challenged by supervisors; and non-business-related expenses are increasing continuously. Last but not least it is not only the banks but clients as well that are deleveraging, while GDP growth is in the best case a meagre 1 to 2 per cent per annum. Under such circumstances, which are not expected to change soon, one definitely has to pose a question: what to do next? There is a lot of work to be done by all participants.
Banks need to reinvent themselves and prepare for the new reality in all aspects. Banks need to focus on their core services in which they are the best rather than on areas that might look most profitable or are currently in vogue. Moreover, instead of focusing on transactions, when the pricing of stand-alone transactions can hardly cover costs, they need to focus on relationship banking based on maintaining salary accounts. In order to become a one-stop shop for financial services in general, banks need to offer not only their own products but also services offered by other financial service providers. The previous strategy of offering all services to all clients definitely failed due to lack of exclusive knowledge in all areas and the absence of economies of scale. Efficiency needs to be boosted substantially as well, almost like in car manufacturing during the last decades, in order to be able to deliver services that are customer-tailored and exactly on time.
Supervisors more than ever need daily contact with the industry as their measures can substantially impact upon the banking sector. No mistakes are allowed, as both parties should be fully aware of the responsibilities they have for the entire macroeconomic stability. Supervision has become more costly not only for the institutions that carry out supervisory tasks but also for the objects of supervision, as the number of supervisors has been constantly increasing and as the number of regulations has been growing exponentially in the same way as reporting requirements. The establishment of new regulatory measures and institutions should not be the end of it; if the set-up changes, it should become normal procedure to also remove an institution or regulation in the process.
Governments are also playing a key role in achieving a stable and active banking sector by securing macroeconomic stability and providing a maximal level of medium-term and long-term predictability. Supporting the existing banking sector, even if that is not politically opportunistic, is much more beneficial than trying to build up a new financial sector with more state ownership. The need for some state involvement at the beginning of the financial crisis should not be used today to take away the benefits of strategic owners in the banking sector created in the 1990s and the 2000s in the CEE countries.
International financial institutions also need to readjust their strategy in the region and refocus away from privatization and cross-border lending towards the development of local currency money markets, working out non-performing loans and providing partial guaranties for certain industries. The market must be allowed to clean up the existing banking system by mergers, takeovers or partial sales, soon.
As the set-up of the new supervisory framework in the EU has not been optimal by far, several countries have used it as an excuse to intervene on a local basis, thereby further segmenting the delicately balanced banking sector. In addition to the different macroeconomic perspectives, the ‘me first’ syndrome practised by some countries has also contributed to the fact that in many cases the valuation of subsidiaries on a stand-alone basis is much higher than the value of an entire group. It is entirely opposite to what took place just a couple of years ago.
The banking sector was an engine of the transition process in CEE since its very beginning and if that is fixed soon, it can become a driving force once again. Therefore, instead of replacing the banking sector, one must fine-tune and adjust it as there is neither the time nor the need to build up a new one.