Depreciation and banking sector vulnerabilities in CEECs

The emerging economies in Central and Eastern European countries (CEECs) have been hit particularly hard by the financial crisis. This is generally viewed as a result of vulnerabilities that have accumulated during the pre-crisis period. The excessive consumption growth was associated with a lending boom, and the credits were provided mainly by foreign banks which invested massively in CEECs.

The depreciations reduced the foreign currency value of credits provided in East European currencies, thus imposing significant losses on foreign banks. As many foreign banks engaged in foreign currency lending, the exchange rate depreciations increased the risk of foreign currency loans with similar negative implications on profits of foreign banks. The financial vulnerability in CEECs was further increased by adverse income shocks of the borrowers.

We show that depreciations have possibly improved the competitiveness of industrial enterprises but increased financial vulnerability especially of foreign banks, which used foreign funds for financing credit expansion in the CEECs. The main objective of the paper is to identify the link between macroeconomic shocks, the institutional environment and the responses of the financial sector in CEECs to the financial crisis. We compare the impact of the depreciation shock with output and inflation shocks. Finally, we provide recommendations for the national and the European regulatory framework of the banking system with respect to the specific conditions in CEECs.

The empirical strategy will reflect possible endogeneity problems and non-linearities. First, the baseline regression will include time and bank fixed (or random) effects, which can cover a large part of the endogeneity bias, which is time or bank invariant. Second, dynamic panel models will include lagged internal instruments. Third, we will apply a difference-in-difference approach for the analysis of the depreciation shock.

While the recent literature is based mainly on aggregate data for individual countries or sectors, we follow micro-econometric approach and provide more precise insights into the determinants of foreign lending. The advantage of our data set is also a comparatively long time dimension after the financial crisis (2008 to 2012).

Keywords: banking industry, devaluation, loans, financial vulnerability, CEECs, Difference-in-Difference