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Bank of Greece Workshop The Euro Area Sovereign Debt Crisis and Its Implications for the Economies of SEE The implications for the financial sector and ECB policy initiatives to alleviate the consequences of the crisis

Frank Moss (European Central Bank)

Athens, 18 May 2012

The vicious cycle between fiscal/banking/growth developments

• A shock to the fiscal outlook • Will add to financial volatility/increased interest rates in the sovereign debt market • Will reduce the foreign investor base for sovereign debt (and increase the sovereign CDS) • Will necessitate more domestic bank funding for the sovereign • Will reduce the appetite for wholesale investors in bank debt (and increase bank CDS) • Will lead to higher bank funding costs and a reduction in access to interbank markets • Will reduce the capacity for banks to extend credit • Will reduce economic growth • Will create a new shock to the fiscal outlook and will increase the NPLs for banks 2

The ECB’s crisis response – non-standard monetary policy action to address malfunctioning financial market segments

I. Bank funding • Fixed-rate full allotment mode in all refinancing operations (since October 2008) • Lengthening the maturity of the refinancing operations (1, 3, 6, 12 and 36 months) • Extending the list of eligible collateral (and not fully relying on rating agencies) • Extending liquidity directly in foreign currencies (USD and CHF) • Reducing reserve requirements II. Covered bond market • Covered Bond Purchase Programme 1 (CBPP1) EUR 60 bn purchased from July 2009-July 2010; CBPP 2 under way for EUR 40 bn (until November 2012) III. Sovereign bond market • Securities Markets Programme (launched in May 2010); EUR 241 bn purchased so far (but no QE !) 2

The 2 VLTROs made a distinct improvement in banks’ funding conditions

Historical volatility of DE, FR, IT and ES 10-year government bond prices (1 June 2011 – 16 April 2012 in ppt.) 100 90 80 70 60 50 40 30 20 10 0 Jun 11 German 10-year bond French 10-year bond Italian 10-year bond Spanish 10-year bond

SMP2

Aug 11 Oct 11

EU Summit 26/27 October 3-year LTRO 3-year LTRO

Dec 11 Feb 12 Apr 12 Euribor-OIS spread and the EUR/USD basis swap (Jan. 2008 – Mar. 2012 in basis points 200 EUR/USD FX basis swap EURIBOR/OIS spread 150 100 50 0 -50 2008 2009 2010 2011 2012 3

… and had a beneficial effect on sovereigns, even outside the euro area Sovereign spreads

(basis points) 1200 1000 800 Croatia Turkey former Yugoslav Republic of Macedonia 600 400 200 0 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

Sources: Bloomberg, Datastream, ECB and national sources.

Notes: CDS spreads for Croatia and Turkey, bonds spread for the FYR of Macedonia.

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Using the window of opportunity to address the real challenges

• Repairing the banking sector – Adequately provisioning for the sovereign risk exposures (EBA exercise) – Capitalising the banks adequately (Basel III) – Orderly deleveraging (national supervisors and ESRB) • Addressing the fiscal consolidation needs – Reinforcing the euro area fiscal frameworks – Enhancing fiscal sustainability through growth-promoting structural reforms – Strengthening the euro area/international financial support channels 6

Bank deleveraging as a medium-term global trend

• Return to more sustainable business models is a

global trend

which can contribute to financial stability

– less reliance on volatile funding sources – lower leverage • Euro area banks

may need earlier and more deleveraging than their international peers

– Comparatively high leverage ratios – High reliance on wholesale funding – Regulatory changes requiring larger capital and liquidity buffers (EBA re-capitalisation exercise, Basel III) – On-going subdued economic activity 7

Cross-border deleveraging in SEE countries

• Concern about

‘home bias’

of euro area banks

• Mitigating factors – Geographic proximity – Prospect of EU accession and euro adoption – Relatively bright medium-term growth prospects (catching-up) – Banks mainly funded by local deposits • Risk factors – Lack of economic growth in some countries – External and internal imbalances – Pockets of financial sector weaknesses – Volatile political environment in some countries 8

SEE countries mainly funded by local deposits

Funding structure of banks in EU candidate countries

(in percent of total bank liabilities) Capital External liabilities Deposits and other 100 90 80 70 60 50 40 30 20 10 0 Croatia former Yugoslav Republic of Macedonia Montenegro Turkey

Sources: National sources.

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No firm evidence of ‘home bias’ during crises periods

Breakdown of EU banks’ value-adjusted divestments by location

Domestic sale EU non-domestic sale Non-EU sale 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: CapitalIQ

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Policy Initiatives aimed at mitigating cross-border deleveraging risks

• European Banking Authority (EBA) – Assessment of deleveraging plans in the EU – Co-ordination of cross-border discussions in the Supervisory colleges • European Systemic Risk Board (ESRB) – Focus on systemic risk dimension of deleveraging at the level of the EU • Vienna 2.0 Initiative – Joint public/private initiative including non-EU countries in Central, Eastern and Southeast Europe 11

No dramatic recent cross-border deleveraging …

Change in bank liabilities

(Contributions to change in total bank liabilities in percentage points)

Q4 2011 versus Q3 2008 Q4 2011 versus Q3 2011

Capital External liabilities Deposits and other Capital External liabilities Deposits and other 80 60 40 20 0 -20 20 10 0 -10 50 40 30 80 70 60 -40 Croatia former Yugoslav Republic of Macedonia Montenegro Turkey Croatia former Yugoslav Republic of Macedonia Montenegro

Sources: National authorities, Haver Analytics and ECB calculations. Notes: Data for Montenegro refer to Q3 2011 in the left panel chart as no data for Q4 2011 (and thus for the right panel) are available.

Turkey 12

Domestic deleveraging in some countries due to unsustainable lending booms

Real credit growth

(annual percentage changes) 200 150 100 50 0 -50 Croatia former Yugoslav Republic of Macedonia Montenegro Turkey

Sources: IMF, Haver Analytics and national sources.

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Summary and conclusions

• A process of disorderly deleveraging by euro area banks was avoided through the ECB’s VLTROs and other policy measures • Especially European (but also other globally active) banks have good reasons to orderly deleverage over the medium-term • Weak credit growth in some countries may reflect demand factors at least as much as supply constraints • The SEE financial sectors should be increasingly based on local savings (‘new growth model’) • SEE countries face similar challenges as the euro area to maintain conditions for sustainable growth of which a sound financial sector is part 14