## Austria — Financial System Stability Assessment (FSSA) Update (_cr08190)

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---

### Background and scope
- Prepared by the Monetary and Capital Markets and European Departments; Approved by Jaime Caruana and Alessandro Leipold.
- Date: May 22, 2008.
- Based on the FSAP Update team’s visit in November-December 2007 and discussions during the Article IV consultation mission in March 2008.
- FSAP Update team members: Daniel Hardy (Mission Chief), Li Lian Ong, Alexander Tieman (all MCM); Erik Lundback (EUR); Richard Britton and Fernand Naert (consultants).
- Price of print copies: $18.00 a copy.

### Major findings — systemic soundness and exposures
- Overall assessment:
  - The Austrian financial system is generally robust and has strengthened since the 2003 FSAP.
  - Aggregate financial soundness indicators for banks are at satisfactory levels; most banks recorded strong results in 2007.
  - Insurance sector indicators are satisfactory; corporate leverage is decreasing; households are not heavily indebted by industrial country standards.
- Cross-border expansion:
  - Rapid expansion into Central, Eastern and Southeastern Europe (CESE) and the Commonwealth of Independent States (CIS) produced higher profits and diversification but also larger vulnerabilities.
  - CESE and CIS exposures are large relative to the domestic economy and bank capital and relative to host-country economies; currently they are contributing to earnings and growth.
- Market turmoil and liquidity:
  - Recent global securitized and interbank market turbulence has had a limited direct effect on Austrian banks to date.
  - Banks mainly pursue an “originate-and-hold” strategy with a solid base of deposits and limited exposure to affected securitized markets.
  - Turbulence has increased funding costs and could slow growth, potentially affecting credit quality.

### Key risks and vulnerabilities
- Credit risk concentrated in CESE/CIS:
  - Rapid lending growth in CESE/CIS (including substantial foreign currency lending) and macroeconomic imbalances could correct abruptly, leading to deteriorating loan quality.
  - Contagion across the region is possible through trade, investment linkages, and investor behavior treating the region as a single asset class.
- Indirect foreign exchange risk:
  - Sizable indirect FX risk exists through foreign currency lending both domestically and abroad.
- Funding and growth dynamics:
  - Higher funding costs may produce a “soft landing” by slowing credit expansion, but could be followed by a sharper cycle of lower investment and deteriorating portfolio quality.
- Operational, governance, and legal risks:
  - Significant strains arose from a few local institutions where internal controls failed, highlighting corporate governance weaknesses.
  - Operational risks and risks related to political instability and/or unpredictable judiciaries persist in some host countries.
- Supervisory and systemic preparedness:
  - Effective implementation of amended bank supervisory framework requires close cooperation between OeNB and FMA.
  - Need for intensified international supervisory cooperation and for resources to support enhanced on-site inspection and off-site analysis.

### Supervisory and regulatory developments
- Institutional changes:
  - Bank regulatory framework amended to assign banking inspection and analysis wholly to OeNB; FMA retains overall responsibility (including regulation and enforcement) and nonbank responsibilities.
  - OeNB given sole responsibility for on-site supervision from January 2008.
- Supervisory practice enhancements:
  - More sophisticated supervisory practices introduced, including stress testing and verification of risk management systems and models.
- Governance of the safety net and legal clarity:
  - Greater clarity needed on government institutional liability for possible supervisory negligence; current broad liability creates moral hazard and fiscal/taxpayer burdens.
  - A more formalized system of early remedial action for troubled institutions would be useful; deposit insurance schemes could be reviewed to minimize resolution costs.
- Resourcing and institutions:
  - Steps taken to ensure adequate, well-qualified supervisory staff and more frequent on-site inspections.
  - System of state commissioners at larger banks appears inconsistent with modern supervisory practice and should be phased out.
- International cooperation:
  - Recommend crisis management drills and joint inspections/joint supervisory plans for groups active abroad.

### Policy recommendations — summary with priorities
- Priority All Sectors
  - High: Continue to develop cooperation with foreign home and host supervisors.
  - High: Define government institutional liability for financial sector supervision more narrowly.
  - High: Intensify the on-site inspection program and complementary off-site analysis and monitoring.
  - High: Enhance supervisory staff resources and expertise.
  - Medium: Raise administrative fines to European standards.
  - Medium: Define the responsibilities of external auditors in line with supervisory priorities.
  - Medium: Promote the periodic rotation of external audit firms.
- Banking (selected High/Medium priorities)
  - High: Have the FMA and the OeNB publicly acknowledge and enshrine in operating procedures their common commitment to cooperate very closely in bank regulation and supervision, and corrective action and enforcement.
  - High: Intensify coordinated or joint inspections with foreign supervisors, and joint risk assessments of groups, followed by joint supervisory plans.
  - High: Follow up the planned crisis management exercise with peers in CESE countries with an exercise involving countries farther afield where Austrian banks are active.
  - High: Ensure that banks continue to manage indirect credit risk stemming from foreign currency loans, both domestically and abroad, and promote borrowers’ awareness of the risks.
  - High: Set up a system mandating early remedial action when warning signs are detected.
  - High: Further develop stress testing, focusing especially on links between credit quality and macroeconomic performance in all markets where Austrian banks operate.
  - Medium: Give the FMA greater authority to object to group structures that impede effective supervision and corporate governance.
  - Medium: Reconsider current exemptions of small banks from some corporate governance regulations.
  - Medium: Phase out the appointment of state commissioners to banks.
- Insurance, Pensions, and Securities (selected)
  - High: Abolish the current restriction that 40 percent of contributions in Zukunftsvorsorge funds must be invested in European Economic Area stock markets with low market capitalization.
  - High: Become a full signatory to the International Organization of Securities Commission (IOSCO) Multilateral Memorandum of Understanding.
  - Medium: Ensure that tax and regulatory policies are neutral across otherwise comparable savings vehicles to support competition.
  - Medium: Support the expansion of the supply of well-trained actuaries.
  - Medium: Extend stress testing of insurance companies’ and pension funds’ liabilities and investigate the use of market-based soundness indicators.

### Stress testing and scenario analysis — coverage and methodology
- Coverage:
  - Stress tests center on the six largest Austrian banks: Erste, Bank Austria Creditanstalt (BA-Ca), Raiffeisen Zentralbank Österreich (RZB), Österreichische Volksbank (OeVAG), Bawag/Postsparkasse (Bawag), and Hypo Alpe-Adria-Bank International (HAA).
  - These banks together have a domestic market share of 68 percent at mid-2007 (consolidated data).
  - Top-down (TD) and bottom-up (BU) approaches used; TD uses OeNB supervisory data, BU uses banks’ internal models.
- Scenario specifications (as presented):
  - CESE confidence crisis: roughly a halving of current account deficits in the countries involved over one year; severe real effects including up to a nine percent decrease in GDP in 2008 in Romania and Bulgaria.
  - Global economic downturn: domestic GDP growth declining to 2.8, -0.4, and -0.1 percent for the years 2007–2009.
  - Market shocks: (Euro) interest rate curve +/- 200 basis points, 200 basis points steepening; foreign and domestic equity indices -35 percent; Euro exchange rates +/- 15 percent; implied volatilities +200 basis points, -100 basis points.
  - Indirect credit risk: -10 percent CHF/EUR rate, -15 percent performance of repayment vehicles.
  - Liquidity tests: quantitative scenarios after 30, 60, and 90 days; BU three-month scenario with 80 bps secured-unsecured spread widening and 30 percent reduction in collateral pool.
- Modeling notes and caveats:
  - TD assumes conservative LGDs (100 percent LGD in some cases); BU uses banks’ LGD estimates or 45 percent standard.
  - PDs increased by up to 71 percent in the global downturn scenario; LLPs increased by up to 145 percent in the CESE scenario (as translated by logistic regressions).
  - Profits net of credit losses decline by up to 17 percent in both scenarios (profile estimated from Asian banks’ profit developments during the Asia crisis).
  - Tests used mid-2007 data; results subject to model risk and potential underestimation of risks given favorable historical data.

### Stress testing — results and quantitative impacts
- CESE scenario (three-year horizon for the six largest banks):
  - Total losses:
    - TD results: €10 billion.
    - BU results: €6.3 billion.
  - Total regulatory capital: €41.4 billion.
  - Quarterly profits at mid-2007: €1.6 billion (projected profits before credit losses would amount to about €17 billion over three years).
  - TD estimates suggest banks lose about a year and a half’s worth of profit, equivalent to some 2.8 percentage points in terms of regulatory (tier I + tier II) capital.
  - TD RoE impact: average RoE declines to 4 percent in the second year of the scenario (pre-stress mid-2007 average RoE: 22 percent).
  - A number of smaller banks would fall short of minimum capital requirements under the macroeconomic scenarios; these banks represent only a small percentage of total banking assets.
- Global downturn scenario (three-year horizon for the six largest banks):
  - Total losses:
    - TD results: €4.9 billion.
    - BU results: €1.6 billion.
  - TD RoE impact: average RoE declines to 13 percent in year 2 and 9 percent in year 3 (pre-stress mid-2007 average RoE: 22 percent).
  - In year 3 of the global downturn scenario four out of six large banks have RoE below 5 percent; one bank exhibits a loss in year 3.
- TD versus BU:
  - TD generally presents a larger impact than BU due to conservative TD assumptions (LGD, treatment of subsidiaries, rating bases).
  - Replacing conservative TD assumptions with BU-like PDs (but keeping higher LGDs) reduces TD global downturn losses to € 2.7 billion versus € 1.6 billion in BU.
- Indirect credit risk (exchange rate + repayment vehicle shock):
  - CHF/EUR rate shocked downward by 10 percent and repayment vehicle performs 15 percent worse: impact on LLPs is some 300 percent, amounting to an impact of 1.4 percent of capital of the banking system.
  - Asset-weighted average impact for large banks: 0.7 percent of capital; ranges from 0.1 percent to 1.4 percent for individual large banks.

### Market, liquidity, and systemwide implications
- Market risks:
  - Market risks are generally modest; interest rate risk dominates but remains limited.
  - Instantaneous 200 bps increase across the Euro yield curve leads to average losses equivalent to 0.2 percentage points of capital against an average capital ratio of 11.5 percent before the shock.
- Liquidity:
  - Austrian banking system exhibits ample liquidity; large banks have varied but generally adequate liquidity management systems.
  - Liquidity stress tests (BU and TD) indicated all banks remained liquid under severe withdrawal and market-value shock scenarios.
  - Recent credit market turmoil did not threaten liquidity at large Austrian banks; impact confined to higher funding costs to date.
- Systemic and supervisory implications:
  - Both CESE and global scenarios produce substantial additional credit losses but do not wipe out aggregate capital given existing profit buffers and regulatory capital levels.
  - Significant downward pressure on profitability and RoE could prompt banks to improve performance or face capital constraints in expanding credit, particularly in CESE countries, potentially generating negative feedback effects.
  - Supervisors should intensify cross-border cooperation in stress testing and monitoring concentrated CESE/CIS exposures.

### Structure, exposures, and selected statistics (as presented)
- Financial system structure:
  - Bank-dominated system with about 850 banks organized into sub-sectors; six institutions hold about half of total assets, three of which are foreign-owned.
  - Total area 83,850 square kilometers.
  - Total population (2006) 8.3 million.
  - GDP per capita (2007) US$ 44,966 (€ 32,800).
- Banking sector metrics (selected table figures as presented):
  - Total financial system assets 788.7 (EUR billion) in 2003; 1,047 (EUR billion) in 2007.
  - Banking sector: number of banks 896 (2003) and 870 (2007); assets 605.1 and 900.0 (EUR billion); percent of total assets 76.7 and 77.0; percent of GDP 267.5 and 331.3 (as presented).
  - Total foreign currency-denominated loans/total loans table values: 24.4, 25.9, 24.8, 23.6, 2.4, 7.9, 15.0 (as presented).
  - Regulatory capital/risk-weighted assets 12.4, 11.8, 11.8, 12.7, 11.9, 14.9, 19.3 (2004–2007 and quartiles shown).
- Foreign expansion and CESE contribution:
  - In 2006, total assets of the six largest Austrian banks in the CESE region were equivalent to over 60 percent of GDP (a fifth of total banking assets or 3 times regulatory capital), and generated about 40 percent of banks’ profits.
  - Composition of consolidated foreign claims (September 2007): Emerging Europe: 52%; Developed countries: 48%; Other emerging market regions: 3%.
  - Country shares (as presented): Croatia: 6%; Czech Republic: 10%; Hungary: 6%; Poland: 2%; Romania: 7%; Russia: 3%; Slovenia: 2%; Slovak Republic: 5%; Other emerging Europe: 8%.
- Foreign currency lending to domestic customers:
  - As of June, 2007: Foreign currency loans to domestic nonbanks accounted for about 17 percent of total loans; this corresponds to about 18 percent of GDP.

### Governance, AML/CFT, and enforcement issues
- Governance and fraud:
  - Managerial failings and/or fraud led to several episodes of difficulties in certain institutions (e.g., Bawag); common features included failure to reveal material information to auditors or boards and conflicts of interest.
- AML/CFT:
  - Banks face reputation risk from exposure to money laundering/financing of terrorism in domestic and international activities.
  - Compliance with the FATF 40+9 Recommendations may be uneven across the region; an IMF assessment of Austria’s compliance will be conducted in September 2008.
- Enforcement and corrective action:
  - Authorities have contingency plans and have generally acted expeditiously once severe strain was clear.
  - Recommendation to establish expectations and periodic rotation of audit firms (with footnote context preserved: allow longer retention if good reason and effective rotation of key auditors).
  - The separation of supervision and enforcement powers requires close cooperation between FMA and OeNB, with public acknowledgment of joint responsibility and predetermined procedures for dealing with problem cases.
  - Crisis management exercises with CESE and more distant partners recommended and should involve scenarios with difficult choices on dealing with insolvent bank(s).
- Government institutional liability (“Amtshaftung”):
  - Very wide interpretation of government institutional liability for supervision impairs effectiveness; authorities may be sued for even slight negligence.
  - Consequences include moral hazard, shifting commercial risk to authorities, direct fiscal costs, and significant administrative burden.
  - Recommendation: define government institutional liability more narrowly; clarify that regulation and supervision are undertaken primarily in the general public interest and that a bad outcome is not in itself evidence of negligence by the supervisor.

### Safety net arrangements, deposit insurance, and liquidity provision
- Deposit insurance (as presented):
  - Compulsory and organized by five separate sub-sector schemes meeting EU minimum standards; a sixth scheme established for credit institutions licensed or changing “sectors” after June 30, 2006.
  - Funding is ex post; member banks contribute when a guarantee event occurs; payouts in excess of ceilings can spill over or be financed by bonds the federal government has the legal right, but not the obligation, to guarantee.
  - No occasion to date where second or third layers of the deposit insurance framework were accessed.
  - Recommendation: improve IT and legal provisions to identify insured deposits and enable rapid payouts or transfer of insured deposits and corresponding assets to a sound bank.
- Systemic liquidity:
  - Liquidity management through the Eurosystem; OeNB lends to banks only against collateral and retains flexibility in acceptable collateral.
  - Authorities consider it inappropriate to predetermine detailed public rules for temporary liquidity provision in a systemic crisis because of moral hazard concerns and varying circumstances.

*International Monetary Fund — Financial System Stability Assessment—Update (Austria), May 22, 2008.*

### 2008. The views expressed in this document are those of the staff team and do not necessarily reflect

### Austria — Financial System Stability Assessment (FSSA) Update

### Background and scope
- Prepared by the Monetary and Capital Markets and European Departments; Approved by Jaime Caruana and Alessandro Leipold.  
- Date: May 22, 2008.  
- Based on the FSAP Update team’s visit in November-December 2007 and discussions during the Article IV consultation mission in March 2008.  
- FSAP Update team members: Daniel Hardy (Mission Chief), Li Lian Ong, Alexander Tieman (all MCM); Erik Lundback (EUR); Richard Britton and Fernand Naert (consultants).  
- Price of print copies: $18.00 a copy.

### Major findings — systemic soundness and exposures
- Overall assessment:
  - The Austrian financial system is generally robust and has strengthened since the 2003 FSAP.
  - Aggregate financial soundness indicators for banks are at satisfactory levels; most banks recorded strong results in 2007.
  - Insurance sector indicators are satisfactory; corporate leverage is decreasing; households are not heavily indebted by industrial country standards.
- Cross-border expansion:
  - Austrian financial institutions rapidly expanded into Central, Eastern and Southeastern Europe (CESE) and the Commonwealth of Independent States (CIS), generating higher profits and diversification but also greater vulnerabilities.
  - CESE and CIS exposures are large relative to the domestic economy and bank capital and relative to host-country economies; currently they are contributing to earnings and growth.
- Market turmoil and liquidity:
  - Recent global securitized and interbank market turbulence has had a limited direct effect on Austrian banks to date.
  - Banks have a solid base of deposits and mainly pursue an “originate-and-hold” strategy, with limited exposure to affected securitized markets.
  - The turbulence has increased funding costs and could slow growth, potentially affecting credit quality.

### Key risks and vulnerabilities
- Credit risk concentrated in CESE/CIS:
  - Rapid lending growth in CESE/CIS (including substantial foreign currency lending) and macroeconomic imbalances could correct abruptly, leading to deteriorating loan quality.
  - Contagion across the region is possible through trade, investment linkages, and investor behavior treating the region as a single asset class.
- Indirect foreign exchange risk:
  - Sizable indirect FX risk exists through foreign currency lending both domestically and abroad; this is a particular concern.
- Funding and growth dynamics:
  - Higher funding costs associated with global turmoil may produce a “soft landing” by slowing credit expansion, but could be followed by a sharper cycle of lower investment and deteriorating portfolio quality.
- Operational, governance, and legal risks:
  - Recent significant strains have arisen from a few local institutions where internal controls failed, highlighting corporate governance weaknesses.
  - Operational risks and risks related to political instability and/or unpredictable judiciaries persist in some host countries.
- Supervisory and systemic preparedness:
  - Effective implementation of amended bank supervisory framework requires close cooperation between OeNB and FMA.
  - The need for intensified international supervisory cooperation and for resources to support enhanced on-site inspection and off-site analysis.

### Supervisory and regulatory developments
- Institutional changes:
  - The bank regulatory framework was amended to assign banking inspection and analysis wholly to OeNB; FMA retains overall responsibility (including regulation and enforcement) and nonbank responsibilities.
  - Authorities are enhancing coordination of bank oversight between OeNB and FMA.
- Supervisory practice enhancements:
  - Supervisory practices have become more sophisticated, including stress testing and verification of risk management systems and models.
- Governance of the safety net and legal clarity:
  - Greater clarity is needed on government institutional liability for possible supervisory negligence; current broad liability creates moral hazard and fiscal/taxpayer burdens.
  - A more formalized system of early remedial action for troubled institutions would be useful; deposit insurance schemes could be reviewed to minimize resolution costs.
- Resourcing and institutions:
  - Authorities are taking steps to ensure adequate, well-qualified supervisory staff and more frequent on-site inspections.
  - The system of state commissioners at larger banks appears inconsistent with modern supervisory practice and should be phased out.
- International cooperation:
  - International cooperation should be further strengthened; recommendations include crisis management drills and joint inspections/joint supervisory plans for groups active abroad.

### Policy recommendations — summary with priorities
Priority All Sectors
- High: Continue to develop cooperation with foreign home and host supervisors.
- High: Define government institutional liability for financial sector supervision more narrowly.
- High: Intensify the on-site inspection program and complementary off-site analysis and monitoring.
- High: Enhance supervisory staff resources and expertise.
- Medium: Raise administrative fines to European standards.
- Medium: Define the responsibilities of external auditors in line with supervisory priorities.
- Medium: Promote the periodic rotation of external audit firms.

Banking
- High: Have the FMA and the OeNB publicly acknowledge and enshrine in operating procedures their common commitment to cooperate very closely in bank regulation and supervision, and corrective action and enforcement.
- High: Intensify coordinated or joint inspections with foreign supervisors, and joint risk assessments of groups, followed by joint supervisory plans.
- High: Follow up the planned crisis management exercise with peers in CESE countries with an exercise involving countries farther afield where Austrian banks are active.
- High: Ensure that banks continue to manage indirect credit risk stemming from foreign currency loans, both domestically and abroad, and promote borrowers’ awareness of the risks.
- High: Set up a system mandating early remedial action when warning signs are detected.
- High: Further develop stress testing, focusing especially on links between credit quality and macroeconomic performance in all markets where Austrian banks operate.
- Medium: Give the FMA greater authority to object to group structures that impede effective supervision and corporate governance.
- Medium: Reconsider current exemptions of small banks from some corporate governance regulations.
- Medium: Phase out the appointment of state commissioners to banks.

Insurance, Pensions, and Securities
- High: Abolish the current restriction that 40 percent of contributions in Zukunftsvorsorge funds must be invested in European Economic Area stock markets with low market capitalization.
- High: Become a full signatory to the International Organization of Securities Commission (IOSCO) Multilateral Memorandum of Understanding.
- Medium: Ensure that tax and regulatory policies are neutral across otherwise comparable savings vehicles to support competition.
- Medium: Support the expansion of the supply of well-trained actuaries.
- Medium: Extend stress testing of insurance companies’ and pension funds’ liabilities and investigate the use of market-based soundness indicators.

### Stress testing and scenario analysis (summary)
- Stress tests conducted as part of the update indicate:
  - Market risks are generally well contained.
  - Liquidity is at comfortable levels.
  - Credit risk in Austria and in CESE/CIS markets is the principal challenge; stress scenarios show material additional credit losses under macroeconomic stress, underscoring the need to manage credit quality and foreign currency exposures carefully.

*International Monetary Fund — Financial System Stability Assessment—Update (Austria), May 22, 2008.*

### 1.      This report updates and extends the findings of the 2003 FSAP, which found the

### _cr08190 - 1.      This report updates and extends the findings of the 2003 FSAP, which found the

### Overview and main findings
- The 2003 FSAP found the Austrian banking sector to be generally sound.
- Expansion into CESE countries and some CIS countries boosted banking sector performance, offsetting low profitability in the home market.
- Supervision was based on strong institutions and a comprehensive and modern legal framework, consistent with European Union (EU) directives.
- Integration within the euro zone and large and growing exposure to the CESE region gave rise to certain vulnerabilities.

### Follow-up on 2003 FSAP recommendations
- Key recommendations from 2003 included:
  - support the bank consolidation process;
  - continue to strengthen governance;
  - address special challenges created by foreign currency borrowing by residents and the state-sponsored pension scheme, the Zukunftsvorsorge;
  - reform the deposit insurance scheme;
  - upgrade arrangements for dealing with systemic problems, including formulation of contingency plans.
- Many recommendations were broadly implemented (Appendix I referenced).

### Macroeconomic context and outlook
- The soundness of the financial system was helped by generally satisfactory macroeconomic performance (Table 1).
- Economy closely integrated with Western Europe; corporations benefited from exports to, and direct investment in, CESE countries.
- Going forward, a slowdown is likely in the context of current downside risks to the global economy.

### Structure of the financial system (summary points from Tables 1–3)
- The Austrian financial system remains bank-dominated.
- There are still about 850 banks organized into various sub-sectors and tiers, but six institutions hold about half of total assets, three of which are foreign-owned.
- An unusual characteristic is strong demand for foreign currency loans. As interest differentials narrowed, the ratio of foreign currency to total loans started to decline and are now almost all denominated in Swiss francs; levels remain high, especially for mortgage loans (Table 3).
- Selected exact statistics (as presented):
  - Total area 83,850 square kilometers
  - Total population (2006) 8.3 million
  - GDP per capita (2007) US$ 44,966 (€ 32,800)
  - Example GDP growth series (2002–2009 Proj.): 0.9, 1.2, 2.3, 2.0, 3.3, 3.4, 2.1, 1.7 (Percentage changes at constant prices)
  - Registered unemployment rate (percent): 6.9, 7.0, 7.1, 7.3, 6.8, 6.2, 6.1, 6.2 (periods shown)
  - General government gross debt (end of period) 65.9, 64.7, 63.8, 63.5, 61.8, 59.1, 57.8, 56.7 (Percent of GDP)
  - Banking sector assets (December 2003 / December 2007 examples): total financial system assets 788.7 (EUR billion) in 2003; 1,047 (EUR billion) in 2007 (as presented)
  - Banking sector: number of banks 896 (2003) and 870 (2007), assets 605.1 and 900.0 (EUR billion), percent of total assets 76.7 and 77.0, percent of GDP 267.5 and 331.3 (as presented)
  - Banking sector financial soundness indicators (selected): Regulatory capital/risk-weighted assets 12.4, 11.8, 11.8, 12.7, 11.9, 14.9, 19.3 (2004–2007 and quartiles shown); Total foreign currency-denominated loans/total loans 24.4, 25.9, 24.8, 23.6, 2.4, 7.9, 15.0 (table values as presented)
  - Return on assets: 0.6, 0.6, 0.7, 0.7/0.3, 0.6, 0.8/2/ (table values as presented)
  - Liquid assets/total assets 28.9, 27.4, 27.6, 26.8 (table values)

### Cross-border exposures and CESE/CIS presence
- Almost all large Austrian banking groups now have major subsidiaries in several CESE countries and some CIS countries; these subsidiaries are often large relative to host countries’ financial systems.
- In 2006, the total assets of the six largest Austrian banks in the CESE region were equivalent to over 60 percent of GDP (a fifth of total banking assets or 3 times regulatory capital), and generated about 40 percent of banks’ profits.
- This total is roughly evenly divided between the CESE countries that joined the EU in 2004, and the remainder.

### Nonbank financial sector developments
- Significant growth in some nonbank segments: occupational pension fund assets, non-term life insurance, and Zukunftsvorsorge pension accounts have grown.
- Austrians still rely substantially on state-provided pensions.
- Austrian insurers are active in the CESE region, partly due to slow domestic non-life growth.
- Austria’s investment funds market has expanded rapidly and is ranked eighth in Europe in terms of assets under management.
- Stock of bonds outstanding and equity market capitalization have increased substantially since 2003, partly due to expansion into CESE markets.
- Vienna Stock Exchange (VSE) has cooperation agreements with exchanges in CESE countries.

### Governance, fraud, and institutional weaknesses
- Managerial failings and/or fraud led to several episodes of difficulties in certain financial institutions.
  - Common features: failure to reveal relevant material to internal auditors or supervisory boards, conflicts of interest, withholding of information from supervisors and the public.
  - Cases did not appear to have persistently weakened systemic confidence, but in one case authorities provided a guarantee to creditors (not called upon).
- The most prominent case referenced was Bawag, Austria’s fourth-largest bank; discovery of a fraud and subsequent U.S. lawsuit triggered a deposit run in early May 2006, which was successfully stemmed.

### Reform of supervisory architecture
- The FMA is the integrated regulator and supervisor for the financial system (created in 2002). The OeNB until now undertook most on-site and some off-site bank supervision. The Federal Finance Ministry (BMF) retains responsibility for certain legislative matters.
- Recent legal changes shifted more responsibility for banking supervision to the OeNB: OeNB given sole responsibility for on-site supervision from January 2008.
- FMA and OeNB jointly determine inspection schedules (major banks annually; medium-sized banks every two years); both agencies and the BMF can request follow-up or ad hoc inspections.
- For off-site supervision, a joint OeNB-FMA database is being established; OeNB tasked with analysis. FMA retains licensing and enforcement powers and all responsibilities for NBFIs.
- Measures enacted to strengthen governance and internal controls in financial institutions (examples: “fit and proper” rules for supervisory board chairmen; supervisory boards mandated to include individuals with financial expertise). Some provisions exclude small banks.

### Practical supervisory cooperation issues and recommendations
- The OeNB and the FMA need full and public commitment to intense cooperation; acknowledge joint responsibility for effectiveness beyond legal responsibilities.
- Authorities are establishing joint teams to conduct oversight of individual banks; planned common database is important.
- Consider eventual abolition of the state commissioner function: now appointed for banks with assets over €1 billion (previous threshold €375 million); practice may create perception of government responsibility and can be circumvented by management.
- Heavy reliance on external auditors remains; effectiveness may be diminishing. Auditors may not report problems promptly and may lack capacity to verify complex credit risk models.
- Supervisory priorities and recommendations:
  - Keep monitoring and analysis up to date, refine macro-scenario analysis for exposures to CESE and CIS, and increase use of market-based indicators.
  - Further intensify on-site inspection, prioritizing large banks but not neglecting smaller banks, especially those outside group structures.
  - Address staff resource constraints: compete with private sector for specialized expertise; ensure attractive compensation and career prospects.
  - Develop ongoing cooperation with supervisors in countries where Austrian banks are active; pursue coordinated or joint inspections and joint risk assessment followed by joint supervisory plans.
  - Assist counterparts abroad with consumer financial education and guidelines on foreign currency borrowing.
  - Consider additional governance reforms: extend certain “fit and proper” requirements to more supervisory board members while calibrating to bank complexity; strengthen governance mechanisms for small cooperative banks.
  - Encourage banks to rotate external audit firms (not just individual auditors) to limit auditor capture.
  - Consider reviewing regulations governing financial groups, particularly bank–nonbank connections where nonbanks are domiciled outside the EU; give FMA authority to object to or unwind group structures that impede supervision and governance.
  - Periodically repeat surveys of on- and off-balance sheet exposures to financial vehicles affected by strains to quantify exposures and ensure risks are managed.

*Source: _cr08190 (IMF).*

### 15. Banks (and other financial institutions) face a reputation risk arising from

### 15. Banks (and other financial institutions) face a reputation risk arising from

### AML/CFT and reputation risk
- Banks face reputation risk from exposure to money laundering/financing of terrorism risk in both domestic and international activities.
- Compliance with the international anti-money laundering/combating the financing of terrorism (AML/CFT) standard may be uneven across the region.
- Efficient implementation of sound preventive measures in Austria is needed to prevent foreign entities being used to channel illegal funds into the domestic financial system.
- An assessment of Austria compliance with the Financial Action Task Force FATF 40+9 Recommendations will be conducted by an IMF team in September 2008.
- Following finalization of the assessment report, an AML/CFT Report on Observance of Standards and Codes (ROSC) will be prepared and circulated to the Board for information.

### Enforcement, corrective action, and intervention
- Even with the best supervisory system, individual financial institutions may get into difficulties and fail.
- The regulatory and supervisory framework should, inter alia, facilitate orderly exit and the smooth management of stress situations.
- Suggested supervisory practice: establish an expectation that audit firms will be rotated periodically, while allowing a bank to keep a firm longer if it can provide good reason and the audit firm concerned is large enough that rotation of key auditors is effective. (Footnote context retained exactly as in source.)
- Authorities have elaborated contingency plans for dealing with bank failures and other problem cases; in recent episodes in Austria, authorities generally acted expeditiously once it became fully clear that an institution was under severe strain.
- As a member of the European System of Central Banks, the OeNB has mechanisms in place to monitor banking sector liquidity and provide extra liquidity if needed.
- The FMA and the OeNB will need to cooperate especially closely in the enforcement of regulations and intervention, and they should publicly acknowledge their common commitment.
  - The separation of supervision and enforcement powers can be cumbersome and is potentially dangerous.
  - Both institutions should explicitly acknowledge and explain that they are working for the seamless integration of all aspects of regulation, supervision and enforcement, and that any criticism should be directed at them jointly.
  - They will need to review procedures for dealing with problem cases to predetermine procedures and specific responsibilities (for example, for communication with the public).
- Crisis management exercises:
  - Authorities’ plans to conduct a crisis management exercise with partners in CESE countries are commendable, and should be extended.
  - The first exercise is to be conducted with neighboring countries, but that could be followed by an exercise involving those further afield, including perhaps non-EU members.
  - Exercises should be based on scenarios involving difficult choices in dealing with an insolvent bank(s).
- Early remedial action:
  - It can be valuable to set up a system that mandates a decision on required remedial action promptly after warning signs are detected.
  - Authorities (and banking associations) monitor early warning indicators and have a history of taking enforcement action.
  - Next step: establish a series of explicit, and perhaps published, quantitative and qualitative triggers for remedial action.
  - While flexibility is needed in the range of actions, such a commitment can help prevent undue forbearance and reinforce good incentives for financial institutions.
  - Progress on early remedial action could help accelerate EU-level initiatives in this area.
- Deposit insurance:
  - The current deposit insurance schemes is adequate and in line with EU standards, but could be improved.
  - Presently, separate deposit insurance schemes are operated by each sub-sector of the banking system, and payouts are made in due course after a depositor of an affected bank applies for compensation.
  - If a bank needs to be resolved, making insured deposits rapidly available would reduce liquidity costs to bank depositors and support confidence in the overall banking system.
  - Deposit insurance schemes should develop the necessary information technology systems and legal provisions to identify insured deposits, so that payouts could be immediate in case of need.
  - Consideration should be given to establishing procedures to transfer insured deposits and corresponding assets from an intervened bank to a sound bank, which, however, may require revision to the legal framework for bank resolution.

### Government institutional liability for financial sector supervision (“Amtshaftung”)
- Current situation:
  - Effectiveness of financial sector regulations and enforcement is being impaired by a very wide interpretation of government institutional liability for financial sector supervision.
  - Authorities may be sued for even slight negligence in supervision and enforcement.
  - There is a public perception that regulatory authorities should be able to prevent any bad outcome, such as instances of fraud or mismanagement.
  - Many law suits for large sums have been filed against the authorities, and in some cases substantial payouts were mandated by the courts; individual officials have been threatened with suits.
  - International standards require a higher level of legal protection of supervisors.
- Consequences:
  - Resulting moral hazard: investors will be less careful if they expect they can get compensation by suing the government should the investment go bad.
  - Legal provisions appear to shift much commercial risk from economic agents to the authorities.
  - Direct cost borne by the Austrian taxpayer; indirect cost in terms of overall efficiency of the financial system.
  - Administrative cost of dealing with these cases, especially supervisors’ time, has been significant.
  - Costs may rise and vulnerability to legal action may increase as supervision becomes more risk-based, because the role of expert judgment will increase.
  - Although authorities have a history of taking enforcement measures despite threat of legal action, a “chilling effect” on willingness to take action cannot be excluded.
- Recommendation:
  - Government institutional liability for financial sector supervision should be defined more narrowly.
  - Some steps have been taken (notably the 2005 Act that required that any suit be brought against the Federal government and not individual agencies), but more is needed.
  - One possibility: amend laws to clarify that regulation and supervision are undertaken primarily in the general public interest.
  - There should be explicit recognition that investors—most importantly shareholders, but also other creditors—bear the risks of their investment, including operational risks and counterparty risks.
  - There needs to be general recognition that a bad outcome is not in itself evidence of negligence by the supervisor.

### B. Stability — performance and stability indicators
- Profitability and margins:
  - Banks have enjoyed rising profitability.
  - Level of domestic bank profitability has risen, mainly because banks have improved performance through greater cost efficiency and successful pursuit of fee income.
  - Domestic interest margins continue to be squeezed by intense competition.
  - Profitability has held up in many CESE markets; as some sectors have matured, new, highly profitable activities such as retail lending have grown in importance.
- Capital, leverage, and asset quality:
  - Capital and leverage ratios have remained stable despite a rapid expansion in balance sheet size.
  - Non-performing loan ratios are falling.
  - Expansion into CESE and CIS markets has diversified risk away from Austria for the system as a whole.
  - Those countries are themselves diverse in both macroeconomic and microeconomic risk factors.
  - Certain markets are important to individual banks; risk that investors perceive CESE and much of the CIS as one investment class, making countries—and Austrian banks—vulnerable to contagion.
- Liquidity:
  - Banking sector as a whole exhibits adequate liquidity.
  - Liquidity indicators have been broadly stable at least through end-2007.
  - Large banks either have a broad retail base themselves or have access to the retail base of the lower tiers of their sub-sectors, and expansion in CESE countries is not heavily dependent on short-term market funding.
  - Reportedly, the mortgage banks also have secured longer-term financing.
- Distribution of performance across banks:
  - Quartile distribution is dominated by numerous smaller banks, while sectoral aggregates reflect weight of large banks.
  - Many small banks have much higher capital relative to assets, and correspondingly low return on equity.
  - While not an immediate prudential concern, these banks would find it difficult to attract outside capital.
  - There are a large number of smaller banks with relatively concentrated loan portfolios.

### Box 1 — Financing Sources and Exposures to CESE Countries (key points)
- Funding structure of Austrian banks appears to be stable (Figure 1).
- Funding for foreign subsidiaries shows rising share of local deposits, especially local currency funding (Figure 2).
- Interbank loans from parents account for 10 percent of total funding, with other types of lending from parents representing another 10 percent; the balance comprises mainly equity and debt issuances by the foreign subsidiary.
- Parents’ exposure to CESE countries, via lending to their foreign subsidiaries and direct loans into those countries, has remained relatively flat in absolute terms since 2005. Given the continuing rise in parents’ total assets, exposure has declined as a proportion of their assets.
- Strong growth in local lending to nonbanks by foreign subsidiaries has driven up the banking groups’ total exposure to emerging European countries.
- Subsidiaries’ rising investment in securities has also increased group exposures.
- Rising local deposits represent the main source of funding in most markets.
- OeNB data suggest that direct lending by Austrian parents to non-subsidiaries in emerging Europe have remained relatively stable in aggregate, although there has reportedly been an increase in direct lending to larger corporates in some markets, in part in response to administrative measures taken by those countries authorities to slow credit growth.

### Non-Financial Soundness Indicators (Table 4: Austria)
- Corporate sector (In percent)
  - Total debt as a percentage of equity 1/2: 51.0 206.5 119.1 114.4 112.9
  - Total debt as a percentage of GDP: 84.1 81.2 82.9 83.7 ...
  - Profitability (return on equity) 1/2: 4.8 23.3 14.6 14.7 15.0
  - Number of applications for protection from creditors (number): 2,957 2,972 3,203 3,084 3,023
- Household sector (In percent)
  - Total debt as a percentage of GDP: 48.4 50.6 54.2 53.4 53.1
  - Financial saving ratio as a percentage of GDP: 6.6 7.2 7.8 7.2 7.3
  - Savings rate: 8.7 8.9 9.3 9.7 ...
- Real estate sector (In percent)
  - House price inflation: 0.4 -2.7 4.8 3.1 5.1
- Source noted in table: OeNB.
- Table footnotes preserved:
  - 1/ Break in series in 2005.
  - 2/ 2007Q3.

### Recent market turbulence and market-based indicators
- Recent financial markets turmoil does not appear to have had a major impact on Austrian banks.
  - FMA and OeNB compiled information on banks’ exposures to affected asset classes and off-balance sheet risks (including special investment vehicles, asset-backed commercial paper and sub-prime mortgages), which turned out to be modest.
  - Write-downs reported to date were easily absorbed in strong 2007 profits.
  - Banks have not made extra use of central bank financing.
  - One major bank was recently able to raise additional capital to support its expansion in CESE.
  - Demand for private placement of securities and Pfandbriefe has reportedly held up relatively well.
  - Impact of higher funding costs will be phased in, and currently does not appear to be more severe than what was seen in past tightening cycles.
- Market-based indicators:
  - Exposure of Austrian banks to CESE and CIS countries is perceived as generating higher returns but also higher risks; broader exposure brings diversification benefits.
  - Major Austrian banks have posted strong positive stock price performances in recent years, although affected by recent turmoil in global financial markets.
  - On a risk-adjusted basis—using the Sharpe ratio—the stock price returns have been in line with those of other European banks.
  - Series for different banks display periods of low correlation, suggesting investors distinguish among different domestic and CESE country exposures.
  - The credit default swap (CDS) spreads of Austrian banks are normally somewhat wider than those of large diversified European banks, indicating greater perceived credit risk.
  - Since the beginning of 2008, Austrian banks’ CDS spreads have widened further, as have those of major European comparator banks, but there have been no high spikes.

### Stress test results
- A battery of stress tests was undertaken by the authorities and major banks in cooperation with the FSAP team (Appendix III).
- Two macroeconomic stress scenarios center around shocks coming from CESE and a global downturn that causes a prolonged domestic recession.
- The scenarios are more severe than anything witnessed in the post-transition period in CESE and CIS countries, or in Austria’s post-war economic history.
- The assumed realization of market risks and liquidity shocks would represent extreme events in mature markets, and are comparable to those undertaken in FSAPs for other European countries.

*Source: _cr08190 - 15. Banks (and other financial institutions) face a reputation risk arising from (IMF staff report content).*

### 34. Stress tests show that the main sources of risks for Austrian banks are credit

### 34. Stress tests show that the main sources of risks for Austrian banks are credit

### Stress-test findings: credit risks and capital impact
- Main sources of risk identified:
  - Credit risk stemming from exposures to CESE and CIS countries.
  - Indirect credit risk associated with foreign currency lending.
  - Other credit risk from domestic lending.
- Scenario outcomes:
  - Scenarios generated substantial strain on the banks, resulting in very low, or in some cases, negative return on equity, although capital buffers generally remained intact (Figure 9).
  - The largest impact followed from losses in CESE and the CIS, but only in a few cases would the losses affect capital given the baseline level of profitability.
  - All of the large banks stayed well above the 8 percent minimum capital requirements under stress.
  - A number of smaller banks would fall short of the minimum capital requirements under the macroeconomic scenarios; these banks represent only a small percentage of total banking assets.
  - Many of the smaller banks would likely benefit from support within their sub-sector of the banking system, forestalling systemic effects.
- Indirect credit risk:
  - Estimated indirect credit risk related to exchange rate movements confirms the resilience of the system, although the overall impact and that on some of the large banks is considerable.
- Data vintage:
  - The tests were run using mid-2007 data, which were the most recent available at the time of the December 2007 mission.

### Quantitative illustration (as presented)
- Figure 9: Austria: Estimated Credit Losses under Macroeconomic Stress
  - Quarterly impact averaged across the six largest banks in percentage point of capital (chart timeline: Q3 2007 to Q2 2010).
  - Two scenarios shown: CESE scenario; Global downturn scenario.
  - Source: OeNB and banks' calculations.
  - Note: Loss estimates based on "top-down" methodology.

### Market and liquidity risks
- Market risks:
  - Additional stress tests suggested that market risks are generally modest, with the banks taking only small active positions.
- Liquidity risks:
  - Liquidity stress tests indicate that the large banks would likely not see major strains in the event of a general squeeze on sources of liquidity, over and above the effect on profits of generally higher market price for liquidity in the unsecured market.

### Caveats, model risk, and scenario interactions
- Model- and data-related caveats:
  - Stress test results are subject to model risk and other caveats.
  - Given favorable macroeconomic developments over the last years in Austria, CESE countries, and the CIS, credit risk indicators based on data from this period are likely to underestimate risks.
- Potential for sharper shocks than modeled:
  - For certain countries one cannot exclude a sharper adjustment in current account deficits, possibly accompanied by large swings in CESE currencies versus the Euro and major balance sheet effects.
  - A severe downturn might result in contagion among the countries in CESE and the CIS, and consequently a larger spillover to Austria than seen historically.
  - The global downturn and CESE scenarios may be related and could occur simultaneously.
- Counterbalancing measures in tests:
  - The stress tests used a number of conservative assumptions (for example, on loss given default rates) to help counterbalance these caveats.
  - Sensitivity analyses around the baseline stress scenarios were undertaken; the results appear to be robust.

### Policy recommendations and supervisory priorities
- Enhancing bank modeling capacity:
  - The authorities need to monitor and promote the development of modeling capacity in the large banks, especially with respect to the linkages between macroeconomic scenarios and microeconomic behavior, such as probabilities of default.
- Strengthening authorities' stress-testing capacity:
  - The authorities should continue to develop their own stress testing capacity, focusing on the links between credit quality and macroeconomic performance in the markets where Austrian banks are active, second-round feedback effects on Austria, noninterest income, and funding costs.
- Refining indirect-credit-risk estimates:
  - The authorities (and banks) need to continue to refine estimates of indirect credit risk stemming from exchange rate movements in assessing exposures.
- Cross-border supervision and concentration monitoring:
  - Supervisors should remain alert to banks’ concentrated exposure to the CESE and CIS region, and intensify further cross-border cooperation in stress testing and supervision generally.

---

*Source: _cr08190 - 34. Stress tests show that the main sources of risks for Austrian banks are credit*

### 50. Further structural evolution and probably consolidation of exchanges can be

### _cr08190 - 50. Further structural evolution and probably consolidation of exchanges can be expected; regulators will need to adapt to these market-driven changes.

### Exchanges, market fragmentation, and regulatory cooperation
- Since 2006, the majority of trading on the VSE by value has been executed by foreign members, including remote members.
- A London-based MTF has announced that it will include Austrian stocks on its trading platform in 2008, and others will almost certainly follow.
- Potential fragmentation of trading in Austrian stocks will increase the importance of cooperation and information exchange among national regulators through mechanisms developed by the Committee of European Securities Regulators, and bilaterally.
- The fees from the VSE’s index and data businesses make up 20 percent of revenue.
- Almost all the other 80 percent derived from trading activities (including listing fees of 2–3 percent of the total revenue). This is high compared with some other exchanges.

### Implementation of 2003 FSAP recommendations — selected supervisory, prudential, and institutional measures (Appendix I)
- Resolve the issue of institutional liability of supervisors.
  - The tasks of the FMA and those of the external auditor have been defined more specifically in law, and state liability for the external auditor has been restricted. Only the Federal Republic, and not the FMA, may be taken to court in cases where losses or damages are incurred in the performance of supervisory duties.
- Complete development of the process for supervision of conglomerates.
  - Austria transposed the EU-Directive on Financial Conglomerates into Austrian law in 2004; the provisions entered into force on January 1, 2005. The necessary organization for supervision of financial conglomerates within the FMA was set up in 2004. Supervisory teams responsible for the analysis of conglomerate activity have been set up. The reporting systems regarding own funds and risk management have been defined, taking into account the structure of individual conglomerates. Reports were received in the second quarter of 2007, and the system is expected to be fully in place by 2008.
- Increase the frequency of on-site inspections, especially for the largest institutions.
  - The FMA and the OeNB have strengthened their on-site supervision capacity by increasing the number of on-site inspections, mostly conducted by the OeNB. The FMA categorizes institutions according to size and type, and bases the number of regular on-site inspections according to the category. Special purpose inspections are also conducted.
  - The FMA has enhanced cooperation with host supervisory authorities in CESE. Since 2004, it has conducted four joint-examinations with local authorities in four different countries; in 2006, the FMA and OeNB launched a coordinated cross-border on-site examination of a banking group, in co-operation with eight host supervisors.
- Review possible need for a broad provision in the banking law allowing FMA to issue regulations.
  - The supervisory instruments of the FMA include the ability to enact regulations, although enactment is subject to various limitations, for constitutional reasons.
- Strengthen the contingency planning framework to deal with systemic problems, should one occur.
  - The Financial Market Committee (FMK) has established a Crisis Management Sub-Committee for the exchange of information between its member institutions and the preparation of recommendations in the event of a crisis. The OeNB introduced a Crisis Management Manual in 2005 that sets forth procedures for crisis management.
- Provide banks with more detailed guidelines for managing risks.
  - Two main initiatives: (1) The FMA minimum standards in areas where additional guidance is deemed necessary (standards not legally binding; considered during on- and off-site analyses). (2) The FMA/OeNB guideline series on risk-related topics providing examples of best practice.

- Continue to closely monitor foreign currency lending by banks to unhedged domestic customers, especially by the small banks most heavily involved in these loans, and ensure that appropriate risk management is followed for these loans.
  - In 2003, the FMA published minimum standards on the granting and management of foreign currency loans.
  - The FMA and OeNB have introduced an initiative designed to raise the risk awareness of borrowers and have instituted enhanced regulatory reporting with regards to foreign currency lending. Foreign currency loans are a regular part of the OeNB’s stress testing exercise and coverage in the Financial Stability Report.
  - Regulatory reporting regarding foreign currency lending has been extended and now covers information on both the repayment structure of loans as well as the use of repayment vehicles. A detailed questionnaire on foreign currency exposures of Austrian banks’ subsidiaries in the CESE has been sent out to the major Austrian banks active in the region. A similar review was also conducted in 2006.

- Deposit insurance consolidation considerations.
  - The deposit guarantee schemes are organized by the five separate “sectors” within the banking industry. A sixth scheme was established for credit institutions licensed or changing “sectors” after June 30, 2006, representing the establishment of an Austrian-wide deposit guarantee scheme whereby all Austrian banks have to contribute towards the refunding of secured deposits in the event of a bankruptcy. Membership of the sixth scheme was extended from five to 10 years in 2005.

- Securities market regulation fines.
  - In 2006, the Act on Amending Financial Market Supervision substantially increased the maximum level of administrative fines in all areas of supervision to 50,000 euro.

- Insurance and pension supervision.
  - The FMA requires insurance companies to implement appropriate risk management and has set additional qualitative requirements in the guidelines on financial instruments, derivative instruments, risk management and fair-value reporting. Profit and loss figures have to be reported quarterly, and one-year forecasts must be included. Stress testing has been improved, and the FMA’s analytical tools have been further developed.
  - The FMA issued a circular on the professional and personal qualifications of actuaries in 2004. A regulation on actuaries’ reports was introduced in 2005. The Austrian Actuarial Association strengthened standards for chartered actuaries in 2005.
  - Insurance undertakings are required to set up an internal audit unit for the entire business, which report directly to the management board or the managing directors, as well as appropriate internal controls. Guidance on minimum standards for internal audit was introduced in 2005 to supplement these measures. Since 2005, companies are required to rotate external auditors every five years.

- Pension product oversight.
  - Legislation on investment by pension funds was passed in 2005, and implementing regulations took effect in 2006. Investments must either be guided by procedures in compliance with risk management regulations with a few caps on certain types of investment, or abide by simpler but more restrictive quantitative restrictions.
  - The Regulation of the FMA sets out the minimum standards for the risk management of Pensionskassen, and the Regulation on Additional Provisions of the FMA for Zukunftsvorsorge. A company providing Zukunftsvorsorge products must have its internal models of asset allocation assessed by an outside expert, and its actuary also needs to validate and explain the model.

- Corporate governance reforms.
  - Planned amendments to the Banking Act will require a “fit and proper” test for the chairman of the supervisory board, and for members of management boards of certain types of financial firms.
  - Parts of the voluntary Code of Corporate Governance are to be transformed into statutory obligations. A project to implement an EU Directive (2006/46/EC) requiring all listed companies to produce and disclose a Corporate Governance report has been presented. This Directive is to be implemented in June 2008.
  - Under Article 42 of the Banking Act, the internal auditor has to report directly to the directors. The internal auditor has to report the main findings to the chairman of the supervisory board and the audit committee on a quarterly basis.

### Structure of the financial system and banking sector metrics (Appendix II)
- The financial system is characterized by the dominant position of the banking sector.
- At over 300 percent of GDP, total banking sector assets are far larger than those of insurance companies and pension funds, and account for more than about ¾ of total financial sector assets (Table 2).
- Banks also own the collective investment scheme providers and other financial institutions.
- Investments in these financial institutions (mainly in the form of mutual funds) have grown rapidly, but are still a relatively small share of GDP.
- Stock market capitalization is about 60 percent of GDP.
- Insurance sector: density and penetration for life-insurance is well below the EU-15 average, while non-life insurance density and penetration are in line with the EU-15.

- Banking sector structure:
  - Seven sub-sectors: joint stock and private banks or commercial banks (Aktienbanken); savings banks (Sparkassen); rural credit cooperatives (Raiffeisenbanken); industrial credit cooperatives (Volksbanken); provincial or state mortgage banks (Landeshypothekenbanken); building societies or savings and loans associations (Bausparkassen); and special purpose banks (Sonderbanken).
  - Vast majority operate as universal banks, but significant differences remain across sub-sectors in organization and ownership.
  - Three sub-sectors—savings banks, Raiffeisen banks and Volksbanken—have tiered structures with apex or central institutions providing centralized services.

- Consolidation and density:
  - Trend towards integration of banks, primarily within sub-sectors. Formalization of cross-guarantees has reinforced this trend.
  - Austria still has about 850 banks and about one bank branch for each 2,000 people.
  - Bank and branch densities remain among the highest in Europe and comparable to Germany and Italy.
  - A system-wide shared ATM network enhances customers' ability to use banks outside their geographic region, increasing competition.

- Profitability and efficiency:
  - Notwithstanding narrowing interest rate margins, profitability has gradually improved and return on assets was among the highest in the EU-15 in 2006.
  - Cost-to-income ratios have decreased, reflecting major improvements in efficiency, but remain somewhat above the average of Austria’s European peers.

### Foreign expansion, CESE exposures, and contribution to profitability
- Austrian banks expanded early into CESE markets beginning in the early 1990s.
- In 2006, total assets in CESE accounted for about 20 percent of Austrian banks’ consolidated assets and activities there contributed almost 40 percent of their total profits.
- Return on assets has been much higher for operations in the CESE than in the domestic market.
- Measured as share of GDP, Austrian exposures to the CESE are far larger than those of its European peers.
- Composition of consolidated foreign claims (September 2007):
  - Emerging Europe: 52%
  - Developed countries: 48%
  - Other emerging market regions: 3%
  - Croatia: 6%
  - Czech Republic: 10%
  - Hungary: 6%
  - Poland: 2%
  - Romania: 7%
  - Russia: 3%
  - Slovenia: 2%
  - Slovak Republic: 5%
  - Other emerging Europe: 8%

### Foreign currency lending to domestic customers
- The high level of foreign currency denominated loans made by Austrian banks to domestic customers is unique in Western Europe.
- Expansion primarily through tiered banking sectors; originated in some banks in the western region.
- After rapid growth, the share of outstanding foreign currency loans as a share of total loans has recently started to fall, although the level remains high.
- As of June, 2007:
  - Foreign currency loans to domestic nonbanks accounted for about 17 percent of total loans.
  - This corresponds to about 18 percent of GDP.

_Italicized source: IMF staff report content provided in the supplied PDF excerpt._

### 58. Safety net arrangements include a deposit insurance framework and systemic

### 58. Safety net arrangements include a deposit insurance framework and systemic liquidity arrangements that have been agreed for Eurosystem members (Box 3)

### Safety net arrangements — Deposit insurance and systemic liquidity
- Deposit insurance:
  - Compulsory and organized by sub-sector with five separate schemes, each meeting minimum EU standards.
  - Each scheme is administered by the respective trade association in the sector and operates shared early warning systems.
  - Funding of the compulsory schemes is ex post; member banks from the affected sector contribute only when a guarantee event occurs.
  - Contributions are based on the proportion of the covered deposits in each sector, subject to an annual ceiling depending on the risk-weighted assets of the contributing bank.
  - Payouts in excess of the ceiling spill over to the other sectors; if the shortfall persists, the originally affected sector can issue bonds to raise external funds.
  - The federal government has the legal right, but not the obligation, to guarantee such bonds.
  - To date, there has been no occasion on which the second or third layers of the deposit insurance framework have been accessed.
  - Deposit insurance payouts would be triggered only after the sub-sectoral support arrangements have been exhausted.
- Systemic liquidity arrangements:
  - Liquidity management is carried out through the Eurosystem, to which the OeNB belongs.
  - Emergency lender of last resort (LOLR) assistance can be provided to an illiquid but solvent institution when necessary.
  - Eurosystem principles for LOLR assistance:
    - Provision of such assistance is primarily a national responsibility.
    - Any potential liquidity impact from providing emergency liquidity assistance must be managed consistently with maintaining the unified monetary policy stance.
  - OeNB lends to banks only against collateral, with flexibility in acceptable collateral.
  - Austrian authorities consider it inappropriate to predetermine and publicly announce detailed rules for temporary liquidity provision in a systemic crisis because of moral hazard concerns and varying circumstances.

### Investment funds and insurance sector structure
- Investment funds:
  - Austria is ranked eighth in Europe in assets under management (AUM) in the investment funds market as at end-June, 2007.
  - Assets under management in Austria reached €172 billion as at the end of October 2007; the size of the sector has more than doubled since 2000.
  - There are 24 investment management companies managing these assets, with the top 3 companies accounting for 57 percent of the market share as at end-October 2007.
- Insurance sector:
  - At end-2006, there were 52 companies, of which 33 engaged wholly or mainly in life business, and around 60 small mutual associations.
  - No independent reinsurance companies presently.
  - Many companies are members of groups associated with a bank; two are linked to major insurers from another European country.
  - Foreign companies have branches in Austria; Austrian companies have subsidiaries abroad, notably in CESE countries.
  - Number of subsidiaries rose from 58 in 2004 to 95 in 2007; these subsidiaries contributed about 24 percent of the premia written in 2006 for the relevant groups.
  - Total insurance sector assets amounted to €82 billion as at end-2006.
  - Solvency ratios have trended slowly upwards; profitability has been adequate (helped by dividends from subsidiaries in CESE countries); operational efficiency has improved.
  - Austria is prone to idiosyncratic natural events (e.g., building damage from heavy snowfall); no natural catastrophe as severe as the 2002 flood has occurred recently.

### Pension system and retirement saving arrangements
- Current pension benefits:
  - Social security pensions account for over 90 percent of current pension benefits in Austria.
- Reforms and pillars:
  - System reformed in 2003 and 2005 to create stronger incentives to remain economically active and save in second and third pillar schemes.
  - Second pillar occupational pension funds introduced in the early 1990s; assets under administration by these funds have grown sharply since then.
  - Mandatory employee severance funds (Mitarbeitervorsorgekassen) can be seen as part of the second pillar but are still quite small and not designed for mainly long-term saving.
- Third pillar:
  - Life insurance products are the most important savings vehicle with an increasing share in unit-linked products.
  - State-sponsored pension scheme (Zukunftsvorsorge) introduced in 2003; offered through life insurance and investment fund companies.
  - Zukunftsvorsorge features include: (i) a government subsidy in the form of a premium; (ii) a guarantee of invested capital plus the premium; and (iii) tax exempt capital gains, income, inheritance and pension benefits.
  - The scheme has been popular and growth has been rapid, although the total amount of assets is still low.
  - Special pension investment retail funds with some tax advantages have not gained traction, possibly because accumulated assets must be paid out as annuities rather than lump sums.

### Stress testing — Coverage and methodology
- Coverage:
  - Stress tests center on the six largest Austrian banks: Erste Bank der oesterreichischen Sparkassen (Erste), Bank Austria Creditanstalt (BA-Ca), Raiffeisen Zentralbank Österreich (RZB), Österreichische Volksbank (OeVAG), Bawag/Postsparkasse (Bawag), and Hypo Alpe-Adria-Bank International (HAA).
  - These banks together have a domestic market share of 68 percent at mid-2007 (consolidated data).
  - Top-down stress tests performed on supervisory data of all Austrian banks.
  - Insurance companies are not included.
  - Stress tests cover trading and banking books and are performed on a group level, i.e., including CESE and CIS subsidiaries, for the relevant macroeconomic scenario and market risk tests.
- Specification of scenarios and shocks:
  - Two three-year macroeconomic scenarios:
    - A confidence crisis in CESE: roughly a halving of current account deficits in the countries involved over one year (currency pegs remain intact); severe real effects of up to a nine percent decrease in the level of GDP in 2008 in Romania and Bulgaria.
    - A global economic downturn: domestic GDP growth declining to 2.8, -0.4, and -0.1 percent for the years 2007–2009.
  - Market risk shocks:
    - (Euro) interest rate curve: +/- 200 basis points, 200 basis points steepening.
    - Foreign and domestic equity indices: both -35 percent.
    - Euro exchange rates: +/- 15 percent.
    - Implied volatilities: +200 basis points, -100 basis points.
  - Indirect credit risk analysis:
    - Exchange rate movements and shortfall in performance of loan repayment vehicles: -10 percent CHF/EUR rate, -15 percent performance of repayment vehicles.
  - Liquidity stress testing:
    - Qualitative assessment of compliance with BIS principles for the Assessment of Liquidity Management in Banking Organizations, and a quantitative scenario focusing on effects after 30, 60, and 90 days.
  - Credit spread risk and operational risk are not assessed.
- Methodology:
  - Bottom-up (BU) exercise:
    - Uses banks’ internal risk models for credit and market risks.
    - OeNB provided estimates for relative changes in PDs and LLPs under the macro scenarios.
    - Banks used these changes to estimate portfolio impacts; OeNB provided a profile for decline in profits before credit losses.
    - Banks reported results in millions of euro additional losses.
  - Top-down (TD) exercise:
    - Depends solely on OeNB modeling of supervisory data.
    - Tests market and credit portfolios and allows analysis of the entire Austrian banking system.
    - Contagion analysis performed TD for the global downturn scenario using a model of the Austrian interbank market.
    - Results reported in millions of Euro.
  - Modeling notes:
    - Adverse macro environment translated into PDs and LLPs using logistic regressions: PDs increased by up to 71 percent in the global downturn scenario, LLPs increased by up to 145 percent in the CESE scenario.
    - Profits net of credit losses decline by up to 17 percent in both scenarios (profile estimated from Asian banks’ profit developments during the Asia crisis).
  - Caveats:
    - Favorable starting conditions may deteriorate over time as cycle turns and CESE markets mature.
    - Models lack interaction/feedback components among financial institutions.
    - Modeling capacity differs across banks, introducing model risk.
    - TD tests face data limitations; conservative assumptions on LGD, incorporation of subsidiaries, and corporate ratings tend to produce larger impacts in TD than BU.

### Stress testing — Results and implications
- CESE scenario results (three-year horizon for the six largest banks):
  - Total losses:
    - TD results: €10 billion.
    - BU results: €6.3 billion.
  - Regulatory and profitability context:
    - Total regulatory capital: €41.4 billion.
    - Quarterly profits at mid-2007: €1.6 billion (projected profits before credit losses would amount to about €17 billion over three years).
  - Return on Equity (RoE) impact:
    - Average TD estimate of RoE declines to 4 percent in the second year of the scenario.
    - In the second year under TD: three of the major banks exhibit losses, one makes a small profit, two maintain RoEs of around 10 percent.
    - Pre-stress mid-2007 average RoE: 22 percent; large six banks exhibited RoEs between 9 and 28 percent.
  - Profit-equivalent and capital impact:
    - TD estimates suggest banks lose about a year and a half’s worth of profit, equivalent to some 2.8 percentage points in terms of regulatory (tier I + tier II) capital.
  - Table 7 highlights (reported as presented):
    - BU - average TOTAL (three-year presentation across quarters): 649 567 910 3130 1371 2911 489 665 547 471 1,052
    - TD - average TOTAL (three-year presentation across quarters): 710 741 061 3617 7189 1831 731 491 301 201 151 171,668
    - BU - RoE: 26.4
    - TD - RoE: 22.4
    - BU - average as percentage point of capital 2/: 1.1 2.0 .1 0.1 0.2 0.2 0.2 0.2 0.1 0.1 0.1 0.1 1.7
    - TD - average as percentage point of capital 2/: 1.1 2.0 .1 0.2 0.2 0.3 0.3 0.3 0.3 0.2 0.2 0.2 0.2 2.8
    - Scenario Year summaries: Year 1 = 10.8; Year 2 = 4.2; Year 3 = 8.4 (additional specific table formatting preserved in source).
- Global downturn scenario results (three-year horizon for the six largest banks):
  - Total losses:
    - TD results: €4.9 billion.
    - BU results: €1.6 billion.
  - RoE impact:
    - Average TD-estimated RoE declines to 13 percent in year 2 and 9 percent in year 3.
    - Half of the large six banks see RoE decline below 10 percent in year 2; in year 3 four out of six have RoE below 5 percent; one bank exhibits a loss in year 3.
    - Pre-stress mid-2007 average RoE: 22 percent; large six banks estimated RoEs between 9 and 28 percent.
  - Table 8 highlights (reported as presented):
    - BU - average TOTAL (three-year presentation across quarters): 309  91011141618232630323638  261
    - TD - average TOTAL (three-year presentation across quarters): 678272934434757698193102111117811
    - BU - RoE: 26.4
    - TD - RoE: 22.3
    - BU - average as percentage point of capital 2/: 1.1 2.0 0.0 1.0 0.0 2.0 0.0 2.0 0.0 2.0 0.0 6.0 0.4
    - TD - average as percentage point of capital 2/: 1.1 2.0 0.05 0.05 0.06 0.07 0.08 0.10 0.11 0.14 0.15 0.17 0.19 1.3
    - Scenario Year summaries: Year 1 = 19.1; Year 2 = 20.8; Year 3 = 23.8 (additional specific table formatting preserved in source).
- Overall implications:
  - Both scenarios produce substantial additional credit losses but do not wipe out aggregate capital given existing profit buffers and regulatory capital levels.
  - Significant downward pressure on profitability and RoE would arise, potentially prompting banks to improve performance or face capital constraints in expanding credit, particularly in CESE countries, which could generate negative feedback effects.
  - TD results generally show larger impacts than BU results due to conservative assumptions in TD modeling (LGD, subsidiaries, ratings).

*Source: IMF staff report section and Appendix III on Austria FSAP Update (content as provided).*

### 76. The top-down analysis generally presents a larger impact than the bottom up

### 76. The top-down analysis generally presents a larger impact than the bottom up

### Differences between top-down (TD) and bottom-up (BU) analyses
- TD assumes a 100 percent LGD with zero collateral in the CESE scenario and a 100 percent LGD for the uncollateralized part of the credit portfolio in the global downturn scenario; banks use either their internal estimates for LGD or the standard 45 percent figure.
- Some banks filed loans to the public sector under the industry category ‘services’, producing a relatively low baseline PD for that industry category (to which the changes in PDs provided by the OeNB were applied); the OeNB uses a higher estimate based on loans to corporates only.
- Portfolios covered in TD and BU analyses are not identical: TD uses the same reported data for all banks, whereas banks include and exclude different categories of assets in their BU estimations.
- Data used in TD estimates of PDs may be different and might cover a longer period than the data included by the banks in their BU estimates; recent favorable macroeconomic developments mean estimation using this period can produce lower, possibly overoptimistic, PDs.

### Global downturn scenario — additional factors and reconciliation
- For individual Austrian customers with loans at more than one bank, the TD model assumes the lowest (most risky) rating applies; banks use their own internal rating.
- Larger banks often produce less conservative ratings than smaller banks, biasing TD losses upwards.
- Replacing conservative TD assumptions with assumptions on defaulted loans and PDs close to those used in the BU model (but keeping the higher LGDs) reduces the TD estimate of total losses in the global downturn scenario to € 2.7 billion, compared to € 1.6 billion in the BU analysis.

### Top-down analysis for the entire Austrian banking system (systemic impact)
- Approximately 4.6 percent of the banks would fall below the 8 percent capital ratio in year 3 under lower domestic growth and increased domestic PDs.
- An additional 0.6 percent of banks would see their regulatory capital fall below 4 percent.
- In terms of assets:
  - 1.4 percent of banks fall below the 8 percent capital requirement.
  - Banks representing an additional 0.1 percent of assets fall below the 4 percent capital level.
- Footnote: banks representing 91 percent of assets maintain a capital adequacy ratio above 10 percent.
- Most small banks under strain are expected to benefit from a resolution within their tier of the Austrian banking system, preventing actual defaults; assuming conservatively no such resolution, problems in small banks result in a limited number of contagious defaults, but the systemic impact would be limited.

### Market risks
- Market risks are not a major source of risk for large Austrian banks; interest rate risk dominates but remains limited.
- An instantaneous 200 bps increase across the entire Euro yield curve leads to banks’ losses equivalent to 0.2 percentage points of capital on average, against an average capital ratio of 11.5 percent before the shock.
- Dispersion across banks is large, driven by some banks gaining from an interest rate increase and others losing from a parallel downward shift.
- Instantaneous market risk shocks assume profits remain positive but, in contrast to the three-year macro scenarios, profits are not taken into account for these shocks.

### Table 9: Market Risk Scenarios — selected average impacts and dispersion (as presented)
- Interest Rates
  - BU -0.16 0.20
  - TD -0.34 0.31
  - BU 0.13 0.20
  - TD 0.39 0.36
  - BU -0.08 0.10
  - TD -0.23 0.23
- Equity Prices
  - BU -0.04 0.05
  - TD -0.09 0.05
  - BU -0.08 0.15
  - TD -0.08 0.05
- Exchange Rates
  - BU -0.14 0.33
  - TD 0.08 0.19
  - BU 0.19 0.31
  - TD -0.08 0.19
- Implied Volatility
  - Increase of implied volatility by 200bps BU 0.00 0.01
  - Decrease of implied volatility by 100bps BU 0.00 0.00
- Scenario descriptions (as presented)
  - Appreciation of Euro by 15%
  - Decrease in non-domestic equity prices by 35%
  - Parallel downward shift of Euro yield curve by 200 bps
  - Steepening of Euro yield curve through 200 bps increase of 10 year rate
  - Decrease in domestic equity prices by 35%
  - Depreciation of Euro by 15%
  - Parallel upward shift of Euro yield curve by 200 bps
- Source note in table: OeNB and banks’ calculations.

### Indirect credit risk induced by exchange rate risk
- Stress test: simultaneous negative shocks to exchange rates and performance of repayment vehicles associated with many foreign currency loans.
- Scenario: CHF/EUR rate shocked downward by 10 percent and repayment vehicle performs 15 percent worse than baseline.
  - Impact on LLPs is some 300 percent, amounting to an impact of 1.4 percent of capital of the banking system.
  - Roughly half of this impact is due to foreign currency movements, the other half due to underperformance of the RPV.
- For large banks:
  - Impact ranges from the equivalent of 0.1 percent of capital to 1.4 percent.
  - Asset-weighted average impact of 0.7 percent of capital.
- Impact of movements in the EUR/JPY exchange rate is minor, reflecting low volume of JPY loans.
- Factors explaining large impact:
  - Conservative modeling assumptions (total impact of exchange rate movements assumed to occur within a year, despite long durations for many mortgages).
  - Many repayment vehicles are life insurance products, often with guaranteed minimum returns.
- Risk has diminished compared to some years ago due to a shift of currency composition of domestic foreign currency loans from JPY to CHF, which has historically exhibited lower volatility vis-à-vis the Euro.
- Authorities have taken measures: publications, information campaigns, and introduction of minimum standards for granting and managing foreign currency loans and loan repayment vehicles.
- Conclusion: foreign currency loans remain an area for continued vigilance by banks, supervisors, and the financial stability authority.

### Liquidity
- The Austrian banking system as a whole exhibits ample liquidity.
- Many banks have a stable source of funding in deposits, aided by a tiered banking system where small banks contribute to the liquidity of the apex institution of their sector.
- Large banks have liquidity management systems of various levels of sophistication.
- Liquidity stress tests and recent credit market turmoil did not threaten liquidity at any of the large Austrian banks, illustrating a prudent approach towards liquidity.
- Liquidity stress test design:
  - Bottom-up three-month liquidity crunch scenario: increase in spread between secured and unsecured Euro money market rates of 80 bps, and simultaneous reduction in the pool of collateral by 30 percent.
  - Top-down single-factor shocks: (i) decrease in market value of liquid bonds of 25 percent; (ii) decrease in market value of equity portfolio of 35 percent; (iii) withdrawal of 40 percent of all short-term funding; (iv) withdrawal of 50 percent of short-term deposits of nonbank customers.
- Result: All banks remained liquid under these circumstances.
- Forward-looking considerations:
  - Banks indicate liquidity management is likely to gain prominence given prolonged market turmoil.
  - Given funding structures, business models, and group setups, none of the large banks see major strains beyond generally higher market price for liquidity in the unsecured market.
  - If CESE and CIS economies suffer a severe recession, major Austrian banks operating in this region might experience difficulties securing funding, adding strain on liquidity.

*Source: _cr08190 - 76. The top-down analysis generally presents a larger impact than the bottom up*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08190.pdf_