## _wp0906

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---

### I. Introduction and scope
- Analyzes magnitude of cross-border financial exposures between Western and emerging countries in Europe and associated risks of regional contagion.
- Provides information on major banking groups active in the CESE region and their exposures to subregions, using country-level data from BIS reporting banks (home–host exposures).
- Focuses on contagion through a “common lender” that may act as a key funding source for multiple countries and thereby transfer a shock from one country to others where the parent bank has direct or indirect operations.

### II. Contribution, methodology, and indices
- Computes indices of exposure to regional contagion based on stylized facts from interlinkages between Western European and CESE countries.
- Explores alternative assumptions about:
  - the common lender (Austria, Italy, Sweden, Germany),
  - trigger countries (the three CESE countries to which a lender has largest exposure),
  - different measures of financial exposure (foreign claims, international claims, international claims on CESE banks only).
- Stylized logic behind indices:
  - High exposure to contagion requires: (1) common lender’s exposure to the trigger country is large; (2) same lender is an important source of funds for other countries; (3) those other countries lack significant additional sources of funding.
- Two indices:
  - Index 1 (AEadI): CL_i_ad / CL_j_AE, using absolute dependence and ex-ante absolute exposure (both in percentage terms).
  - Index 2 (REBAEadI): incorporates rebalancing (CL_i_REB) to capture potential cutbacks in funding after a trigger-country problem.
- Practical deviations noted from Sbracia and Zaghini (2001) in choice of common lender and claims concepts.

### III. Key empirical findings and stylized facts
- Cross-border interlinkages within Europe are economically significant.
- Most CESE countries are highly dependent on Western European banks, directly or through local banking sectors; exposures are fairly concentrated.
- Austria, Germany, and Italy account for the largest share of Western European claims for the CESE region as a whole (for the Baltics, mainly Sweden).
- Non-European reporting banks hold less than 10 percent of the total claims on CESE.
- Outstanding foreign claims in excess of 80 percent of GDP for: Bosnia and Herzegovina, Croatia, Latvia, Estonia, Lithuania, Czech Republic, Hungary, Slovakia.
- Exposures are significant relative to host country banking sector assets for many CESE countries, but much less so for: Russia, Turkey, Ukraine, Albania, Belarus, Moldova, Macedonia.
- The magnitude of Western European bank exposures to CESE is far smaller than CESE exposures to Western banks in most cases; exceptions include Austria and Sweden:
  - Austria: foreign claims of reporting banks on emerging Europe amount to over 70 percent of Austria’s GDP and 26 percent of its banking system assets at end-2007.
  - Belgium and Sweden: exposures relatively high in terms of GDP (25 percent and 20 percent, respectively) but at most 10 percent of banking system assets.
- Composition and concentration matter for vulnerability:
  - Czech Republic, Poland, and, to some extent, Hungary have relatively diversified sources of funds.
  - Bosnia and Herzegovina, Croatia, Romania, Serbia, Slovakia: at least one third of exposure to Austrian banks.
  - Italy accounts for 20-35 percent of foreign claims on Bosnia and Herzegovina, Bulgaria, Croatia, Poland, Slovakia.
  - Baltic countries: at least about 60 percent of total exposures to Sweden at end-2007.
- Lender-country vulnerability by concentration:
  - The three Baltic countries together represent about 73 percent of Sweden’s exposure to all developing countries (about 20 percent and 10 percent of Sweden’s GDP and banking system assets, respectively, at end-2007).
- Shift in composition (end-2005 to end-2007):
  - Share of lending by European reporting banks to banks in CESE fell by 3.9 percentage points (from 27.2 percent to 23.3 percent).
  - Share of lending to nonbank institutions increased by 8.6 percentage points (from 52.9 percent to 61.6 percent).
  - Large country-level increases (exceeding 10 percentage points) observed for: Latvia, Romania, Macedonia, Turkey, Estonia, Croatia.

### IV. Funding structures, liquidity reliance, and risks
- Credit growth and financial deepening:
  - During 2000-07, credit increased by about 23 percent a year on average in real terms across the region.
  - During 2004-07, credit to the private sector increased on average by about 30-50 percent in real terms in nine of the 19 CESE countries.
  - Ratio of private sector credit to GDP rose significantly; cumulative increase exceeded 20 percentage points in seven CESE economies.
- Loan–to–deposit ratios (LTD):
  - LTDs rose in most countries; in the Baltics LTDs roughly doubled since the early 2000s.
  - Ukraine, Hungary, Russia: LTDs ranged from 120–150 percent in 2007.
- Net foreign liabilities (NFL) to private sector credit rose sharply in many countries (notably Baltics, most of South Eastern Europe, Belarus, Russia, Ukraine); by mid-2008 Albania, the Czech Republic, and Macedonia, FYR, had negative ratios of NFL to bank credit.
- Funding risk channels:
  - Heavy dependence on foreign funding: risk of sudden shortfalls or costly access to funds upon reassessment of exposure to a host country.
  - Parents’ willingness/ability to support subsidiaries depends on market conditions; deteriorating home-country funding can force parents to slow lending abroad.
  - Liquidity or solvency problems in parents can transmit to local banks in concentrated, largely foreign-owned banking systems.
  - Curtailment of syndicated lending or deleveraging can impede credit expansion.

### V. Contagion channels and factors determining magnitude
- Two contagion forms analyzed:
  - (i) home-to-host (shock originating in home country of a foreign bank);
  - (ii) common-lender (regional contagion triggered by a problem in another CESE country to which a Western country has significant exposures).
- Common-lender channel logic:
  - A “common lender” (country C) funds private sectors of countries A and B; a shock in A may create liquidity/solvency pressures in banks of C if parent highly exposed to A, transmitting problems to B even without direct A–B links.
  - Parent-to-subsidiary funding reassessment can cause sudden liquidity shortfalls for subsidiaries if parents withdraw deposits, lending, or raise funding costs.
  - Host-to-home contagion: problems in parents can spread to subsidiaries/branches in other countries via confidence effects or direct funding exposures.
- Factors determining magnitude of contagion:
  - (i) Size of exposures of home banks (common lender) to the host country with a problem.
  - (ii) Dependence of the host country on funds from the home country.
  - Three necessary channel conditions reiterated: (1) common lender’s exposure to initially affected country must be large; (2) lender must be an important source of funds for other countries; (3) potentially affected countries must lack other readily available funding sources.

### VI. Exposure indices: selected numeric results (Foreign Claims Concept)
- Tables and selected index values (end-2007):
  - Index without rebalancing (Table 6a) — selected high values:
    - Croatia: 318.8; 278.9; 221.9.
    - Slovakia: 184.2; 161.2; 128.3.
    - Czech Republic: 134.2; 117.4; 93.4.
    - Bosnia and Herzegovina: 226.5; 198.1; 157.7.
    - Estonia: 403.2; 351.9; 315.6.
    - Latvia: 247.0; 215.6; 193.4.
    - Lithuania: 195.3; 170.5; 152.9.
  - Index with rebalancing (Table 6b) — selected values:
    - Croatia: 46.45; 39.59; 30.40.
    - Czech Republic: 28.09; 23.94; 18.39.
    - Slovakia: 22.67; 19.33; 14.84.
    - Estonia: 157.53; 131.00; 113.65.
    - Latvia: 75.55; 62.83; 54.51.
    - Lithuania: 66.61; 55.39; 48.06.
- International claims concept indices (smaller magnitudes but similar ranking patterns):
  - Table 7a (without rebalancing) — selected values:
    - Croatia: 56.7; 116.6; 105.7.
    - Hungary: 22.0; 45.3; 41.1.
    - Romania: 19.3; 39.8; 36.0.
    - Estonia: 251.1; 183.6; 201.1.
    - Latvia: 157.4; 115.1; 126.1.
    - Lithuania: 101.9; 74.5; 81.6.
  - Table 7b (with rebalancing) — selected values:
    - Croatia: 8.77; 19.78; 17.61.
    - Hungary: 3.57; 8.06; 7.18.
    - Romania: 3.30; 7.44; 6.63.
    - Estonia: 100.25; 66.20; 80.28.
    - Latvia: 50.33; 33.23; 40.30.
    - Lithuania: 29.74; 19.64; 23.82.
- Measures of relative dependence and exposure (selected table entries, foreign claims concept, end-2007):
  - Poland relative shares to reporting-country banks (selected): Austria 6.19; Germany 18.10; Italy 20.51; France 7.36; Belgium 8.04; Sweden 2.54; Netherlands 9.94; Switzerland 2.22; UK 1.13; Portugal 4.68; Spain 1.62.
  - Moldova relative shares (selected): Austria 32.49; Germany 19.49; Italy 33.21; France 0.00; Belgium 1.08; Sweden 0.00; Netherlands 4.69; Switzerland 0.00; UK 0.72; Portugal 3.25; Spain 0.72.
  - Home-country exposure to CESE (TOTAL CESE row): Austria 91.607; Germany 48.110; Italy 86.847; France 37.151; Belgium 68.029; Sweden 89.332; Netherlands 30.433; Switzerland 23.127; UK 7.031; Portugal 44.682; Spain 2.524.
- Measures of absolute dependence and exposure (selected entries, foreign claims concept, end-2007):
  - Total foreign claims by country on CESE (selected as share of GDP, percent): Austria 57.3; Germany 3.5; Italy 10.4; France 11.8; Belgium 4.2; Sweden 4.6; Netherlands 1.5; Switzerland 5.7; UK 1.3; Portugal 0.7; Spain 2.7; Poland 0.9.
  - Croatia (total foreign claims, millions of US dollars): 182.8; exposures by country (selected): Austria 66.5; Germany 35.5; Italy 59.5; France 15.0.
  - Home-country absolute exposure as ratio to banking sector assets (Table 5, percent): Austria 25.379; Germany 2.443; Italy 5.692; France 2.261; Belgium 6.762; Sweden 9.602; Netherlands 3.068; Switzerland 2.506; UK 0.364; Portugal 2.362; Spain 0.226.

### VII. Robustness, interpretation, and main conclusions
- Robustness:
  - Although magnitudes vary across scenarios (common lender, trigger country, claims concept), the group of CESE countries most exposed to regional contagion remains broadly similar.
  - Foreign claims produce higher indices than international claims; international claims on CESE banks only produce even smaller indices, but country ranking is broadly similar.
- Interpretation and caveats:
  - Indices gauge susceptibility to contagion originating from another country in the region; they do not represent an assessment of financial or macroeconomic vulnerability and stability of individual countries.
  - Actual vulnerability depends on other factors: capitalization, liquidity, soundness of banking systems and key institutions, macroeconomic fundamentals, maturity structure of claims, and institutional/regulatory arrangements affecting liquidity and rebalancing ability.
  - Indices are a first step to a fuller vulnerability exercise.
- Main conclusions:
  - The larger the dependence of a CESE country on funds from a regional common lender, and the greater that lender’s exposure to a trigger country, the higher the country’s exposure to regional contagion.
  - Contagion indices highest when common lender’s activities are substantially concentrated in the CESE region; indices smaller when lender’s exposure to CESE is small relative to its economic size.
  - Austria, Italy, and Germany as common lenders have the largest effect in propagating shocks across a wide range of CESE countries; Sweden dominates Baltic linkages.
  - Spillovers from Baltic-originated problems to other CESE countries are limited via the common-lender channel because Sweden’s exposure to non-Baltic CESE is immaterial.
  - Even where exposures are well diversified, regional spillovers can materially increase overall impact if one CESE country triggers stress.

### VIII. Policy implications and recommended actions
- Adopt a regional approach to managing vulnerabilities given high financial interlinkages and risk of rapid regional contagion.
- Strengthen supervision and cooperation:
  - Strengthen bank supervision and prudential regulation where warranted.
  - Close cooperation between home and host supervisory authorities, including coordinated inspections and joint risk assessments.
  - Develop cooperative arrangements for crisis management.
- Contingency planning:
  - Develop contingency plans for systemic disturbances associated with regional spillovers, including problems triggered by highly active institutions with concentrated exposures.
  - Conduct crisis simulations for regional spillovers to develop coordinating procedures and test adequacy of internal and international processes; clarify responsibilities and information/data needs.
- Stress testing and regional spillovers:
  - Incorporate regional spillovers in stress tests through both financial institutions’ balance sheets and the “real economy.”
  - Use index information to design crude stress-test scenarios and resilience testing of individual country banking systems.
  - More detailed information on exposures of individual banks would improve assumptions and analyses; further research recommended.
- Use in Fund regional surveillance:
  - Cross-border exposure analysis and contagion channels could be used in Fund regional surveillance.
  - Regular updates of contagion indices could provide warning signals and an operational tool for regional surveillance.

*Source: _wp0906 (IMF Working Paper excerpts provided).*

### References..............................................................................................................

### _wp0906 - References..............................................................................................................

### I. Introduction and scope
- The paper analyzes the magnitude of cross-border financial exposures between Western and emerging countries in Europe, and discusses associated risks in terms of exposure to potential regional contagion.
- It provides information on major banking groups active in the CESE region and their exposures to different subregions, using country-level data from BIS reporting banks to explore home-host exposures.
- The analysis focuses on contagion through a “common lender” that may act as a key funding source for multiple countries and can thereby transfer a shock from one country to others where the parent bank has direct or indirect operations.

### II. Contribution, methodology, and indices
- Contribution:
  - Computes indices of exposure to regional contagion based on stylized facts from interlinkages between Western European and CESE countries.
  - Explores alternative assumptions about the common lender, trigger countries, and different measures of financial exposure to gauge countries’ susceptibility to contagion.
- Stylized logic behind the indices:
  - High exposure to contagion requires that: the common lender’s exposure to the trigger country is large; that the same lender is an important source of funds for other countries; and that those other countries lack significant additional sources of funding.
- Caveat:
  - The contagion exposure indices gauge susceptibility to contagion originating from another country in the region and do not represent an assessment of the financial or macroeconomic vulnerability and stability of individual countries.

### III. Key findings (summary)
- Financial interlinkages within Europe are economically significant.
- Most CESE countries are highly dependent on Western European banks, either directly by their private sector or through local banking sectors, and these exposures are fairly concentrated.
- Austria, Germany, and Italy account for the largest share of Western European claims for the CESE region as a whole (for the Baltics, mainly Sweden), though some CESE economies have relatively more diversified sources of funds.
- The magnitude of Western European bank exposures to CESE is far smaller in most cases, except for Austria and Sweden.
- Where exposures to host countries are economically non-negligible, their concentration raises concerns.
- The larger the dependence of a CESE country on funds from a common lender and the greater that lender’s exposure to a trigger country, the higher the country’s exposure to regional contagion.
- Austria, Italy, and Germany as common lenders have the largest effect in propagating shocks across a wide range of CESE countries.
- Susceptibility to regional contagion is largest when the common lender’s activities are substantially concentrated in the CESE region.
- A broadly similar group of CESE countries appear to be more exposed to regional contagion than other CESE countries under alternative assumptions and measures.

### IV. Background: credit growth and financial deepening in CESE
- Foreign ownership of CESE banking systems brought advanced technology, risk management techniques, increased access to cross-border funding, and contributed to rapid financial deepening.
- Foreign ownership levels are among the highest in the world (see Figure 1: Asset Share of Foreign-Owned Banks, 2000-06).
- Credit growth:
  - During 2000-07, credit increased by about 23 percent a year on average in real terms across the region.
  - During 2004-07, credit to the private sector increased on average by about 30-50 percent in real terms in nine of the 19 CESE countries (Table 1).
  - The ratio of private sector credit to GDP rose significantly, with the cumulative increase exceeding 20 percentage points in seven CESE economies.
- Catch-up effect:
  - CESE countries with low levels of financial intermediation at the end of the 1990s experienced faster credit growth than countries with higher credit-to-GDP ratios (Figure 2).
- Drivers:
  - Rapid convergence in credit ratios was mainly driven by similar and aggressive business strategies of mostly Western European banking groups dominating CESE banking sectors (Figure 3 and Appendix I).

### V. Funding structures, liquidity reliance, and risks
- Loan–to–deposit ratios (LTD):
  - LTDs have been rising in most countries, particularly in the Baltics where LTDs roughly doubled since the early 2000s.
  - In Ukraine, Hungary, and Russia, LTDs ranged from 120–150 percent in 2007.
- Deposit vs credit growth:
  - Except in a few cases (Moldova, Serbia, Macedonia, and Bosnia), changes in bank credit–to–GDP ratios significantly exceeded changes in bank deposits–to–GDP during 2003–2007 (Figure 4).
- Reliance on foreign funding:
  - High and rising LTDs required increasing reliance on foreign funding channeled through the banking sector, reflecting relatively undeveloped domestic capital markets and easy access by mostly foreign-owned banks to cheap parent funding.
  - Net foreign liabilities (NFL) as a ratio to private sector credit have been rising sharply since the beginning of the decade in many countries (most notably in the Baltics, most of South Eastern Europe, and Belarus, Russia, and Ukraine), although the rising trend turned around more recently in a few countries (Croatia, Hungary, Serbia, and Slovakia) (Figure 5).
  - By mid-2008, Albania, the Czech Republic, and Macedonia, FYR, were the only countries with a negative ratio of NFL to bank credit.
- Funding risk channels:
  - Banking systems heavily dependent on foreign funding could face sudden shortfalls or costly access to funds if there were a reassessment of exposure to a host country.
  - Parent banks’ willingness and ability to support subsidiaries depends on market conditions; deteriorating funding conditions in home countries may force parents to slow lending and liquidity provision abroad.
  - Liquidity or solvency problems in a parent can be transmitted to local banks in a concentrated and largely foreign-owned banking system.
  - Curtailment of syndicated lending or deleveraging across markets can similarly impede credit expansion.

### VI. Paper organization (structure)
- Section II: background on credit growth, reliance on foreign funding, and risks of concentrated foreign funding.
- Section III: discussion of possible channels of regional contagion.
- Section IV: stylized facts on cross-border exposures between CESE and Western European countries.
- Section V: computation of indices of exposure to regional contagion.
- Section VI: implications for Fund financial sector surveillance and concluding remarks.

*Source: _wp0906 - References..............................................................................................................*

### 14.      The impact of such a credit crunch would be amplified if funding from other

### The impact of such a credit crunch would be amplified if funding from other (nonbank) sources were also limited

### Credit market developments and amplification risks
- Some emerging European countries that had been turning to international capital markets for funding saw demand for financial sector bonds drying up since the subprime crisis in August 2007 (example: Eurobond issuance by the Russian and Ukrainian financial sectors).
- Some banks in CESE reportedly postponed planned bond issues as a result of higher spreads.
- International bond issuance has been a negligible source of funding for most other countries in the region.
- Direct borrowing from abroad by the nonfinancial private sector is also likely affected by a tightening of credit conditions in international markets.

### Possible propagation channels of regional shocks
- Contagion channels arise from cross-border interlinkages among Western and CESE banking sectors; many Western European banks expanded in CESE with such operations accounting for a substantial share of their profits.
- Adverse developments in CESE banking sectors (and economies) could have adverse implications for home financial systems; problems in home countries can similarly affect host countries, with a high risk of spillover to other countries in the region.

- Common-lender channel:
  - A “common lender” (country C) may be a main funding source for private sectors of two countries A and B.
  - A shock in A (e.g., problem in a foreign-owned bank in A) may create liquidity or solvency pressures in banks of C if the parent bank is highly exposed to A, transmitting problems from A to B even without direct A–B links.
  - Other parent banks exposed to affected host countries could be affected in turn, creating second-round effects.

- Parent-to-subsidiary funding reassessment:
  - A sudden reassessment of a parent bank’s exposure to a host country can expose its daughter to sudden liquidity problems.
  - Banks heavily dependent on parent funding could face a sudden shortfall or costly access to credit if the parent withdraws deposits or lending or charges much higher rates.
  - In concentrated banking systems with substantial interbank linkages, liquidity problems can spread domestically and to other foreign-owned banks, affecting parents of those banks and generating regional second-round effects.

- Host-to-home contagion:
  - Liquidity or solvency problems experienced by a parent can spread to subsidiaries or branches in other countries.
  - Host country banking systems can be affected via deterioration of confidence in daughter banks and/or direct funding exposure to the parent.
  - A change in market risk assessment of a parent bank belonging to a deteriorated banking group can propagate spillovers to other foreign banks exposed to affected host banks, spreading liquidity or solvency pressures further.

- Factors determining magnitude of contagion:
  - (i) Size of exposures of home banks (common lender) to the host country with a problem.
  - (ii) Dependence of the host country on funds from the home country.
  - Three necessary conditions for the channel to operate (Sbracia and Zaghini (2001)): (1) common lender’s exposure to initially affected country must be large; (2) lender must be an important source of funds for other countries; (3) potentially affected countries must lack other readily available funding sources.

### Stylized facts on cross-border exposures and financial linkages
- Data source and scope:
  - Uses consolidated foreign claims of BIS reporting banks on individual CESE countries.
  - BIS foreign claims include outstanding consolidated claims on local banking systems and claims on the nonbank sector (direct lending).
  - In BIS terminology: (a) + (b) = “international claims”; (a) + (b) + (c) = “foreign claims.” Foreign claims include local claims of foreign-owned subsidiaries in local currency.

- Exposures of CESE to Western European banks:
  - Most CESE countries are heavily exposed to Western European banks, directly by their private sector or through local banking sectors.
  - Austria, Germany, and Italy account for the largest share of foreign claims for CESE countries as a whole.
  - Non-European reporting banks hold less than 10 percent of the total claims on CESE.
  - Outstanding foreign claims owed to reporting banks in all western European countries are substantial (in excess of 80 percent of GDP) for Bosnia and Herzegovina, Croatia, Latvia, Estonia, Lithuania, Czech Republic, Hungary, and Slovakia.
  - Exposures significant in terms of host country banking sector assets for many countries, but much less so for Russia, Turkey, Ukraine, Albania, Belarus, Moldova, and Macedonia.
  - Focusing only on international claims on CESE banking systems suggests heavy reliance of CESE banks on external funding to support rapid expansion of lending to the private sector.

- Exposures of Western European banks to CESE:
  - The magnitude of western European bank exposures to CESE is far smaller compared with CESE exposures to western banks, with exceptions.
  - For Austria, the foreign claims of the reporting banks on emerging Europe amount to over 70 percent of Austria’s GDP and 26 percent of its banking system assets at end-2007.
  - Exposures of banks in Belgium and Sweden are relatively high in terms of their GDP (25 percent and 20 percent, respectively), but much less so in terms of banking system assets (at most 10 percent).
  - For the remaining Western countries, exposures are negligible, including for France, Germany, and Italy with active presence in the CESE.

### Concentration, composition, and country-specific patterns
- Composition and concentration matter for vulnerability:
  - Vulnerabilities increase if exposures reflect heavy reliance on foreign funding and if exposures are heavily concentrated.
  - Most CESE countries have concentrated exposures measured by foreign claims, particularly to banks in Austria and Italy, as well as to France and Germany; Baltic countries have large exposures to Sweden.

- Examples of concentration and diversification:
  - Czech Republic, Poland, and, to some extent, Hungary have relatively diversified sources of funds.
  - Bosnia and Herzegovina, Croatia, Romania, Serbia, and Slovakia have at least one third of their exposure to Austrian banks.
  - Italy accounts for 20-35 percent of the foreign claims on Bosnia and Herzegovina, Bulgaria, Croatia, Poland, and Slovakia.
  - The Baltic countries have at least about 60 percent of their total exposures to Sweden at the end of 2007.
  - Such concentration makes many CESE countries heavily exposed to potential adverse developments in Austrian, Italian, and Swedish banks active in the region.

- Lender-country vulnerability from concentration:
  - The three Baltic countries together represent about 73 percent of Sweden’s exposure to all developing countries (about 20 percent and 10 percent of Sweden’s GDP and banking system assets, respectively, at end-2007).
  - Such exposure would make Sweden vulnerable to adverse developments in any one of the Baltic countries, with potential spillovers to the other two economies.
  - Exposures to CESE for other Western European countries are either well-diversified (e.g., Austria, Belgium), and/or the size of the absolute exposure is not economically significant (e.g., France, Germany, Italy, Portugal).

- Diversification can mask regional correlation risks:
  - Even where exposures seem well diversified across countries (example: Austria, which is highly exposed to CESE with exposure to a single country up to 17 percent), regional spillovers can increase ultimate impact because troubles in one country can spill over to others and markets may not initially differentiate countries by vulnerabilities.

*Source: _wp0906 - 14.      The impact of such a credit crunch would be amplified if funding from other (nonbank) sources were also limited*

### 27.      What do these stylized facts on the exposures of Western and CESE countries

### 27.      What do these stylized facts on the exposures of Western and CESE countries say in terms of exposure to contagion risks?

### Contagion channels analyzed
- Two forms of contagion examined:
  - (i) exposure to a shock originating from the home country of a foreign bank (home-to-host channel);
  - (ii) regional contagion triggered by a problem in another CESE country to which a Western European country has significant exposures (common lender channel).
- Measure of absolute dependence: amount of claims owed to a home country as a share of the CESE country’s GDP (Table 4 of Appendix III).
  - Illustration: any potential adverse developments in Austrian (or Italian) banks would be felt most significantly in Croatia, Bosnia and Herzegovina, and Slovakia; similarly, adverse developments in Swedish banks would be felt most strongly in Estonia, Latvia, and Lithuania (see Figure 10).

- Representative bilateral magnitudes (from text footnote examples):
  - Austria makes up 36 percent of Croatia’s exposure to all reporting country banks in end-2007.
  - Croatia constitutes only 12 percent of Austria’s exposure to all developing countries.
  - Austria’s largest exposure is to the Czech Republic: 17 percent.
  - The Czech Republic owes about 30 percent of all its foreign claims to Austria at end-2007.

### Common lender channel: index construction and interpretation
- Two indices computed to evaluate exposure to regional contagion (following and adapting Sbracia and Zaghini (2001)):
  - Index 1 (AEadI): CL_i_ad / CL_j_AE where
    - CL_i_ad = “absolute dependence” of country i on the common lender: foreign claims owed by country i to the common lender’s banks in country i's GDP (Table 4 of Appendix III).
    - CL_j_AE = ex-ante “absolute exposure” of the common lender to the trigger country (the country with which it has the highest exposure); defined as the ratio (in percentage terms) of the common lender’s claims vis-à-vis country j to its own funds (using the common lender’s banking system assets). Both magnitudes expressed in percentage terms.
  - Index 2 (REBAEadI): incorporates rebalancing (CL_i_REB), defined as the amount of claims of the common lender on country i (CL_i_A) in ratio to the total amount of funds lent to all other developing countries, excluding claims on the trigger country. Index 2 captures potential cutbacks in funding (credit line rebalancing) by the common lender after a trigger-country problem.

- Practical choices and deviations from Sbracia and Zaghini (2001):
  - No single unambiguous common lender for CESE; many countries highly dependent on Austria, but also on Italy and Germany; Baltics predominantly dependent on Sweden.
  - Indices computed under different assumptions for the common lender (Austria, Italy, Sweden, Germany).
  - For each common lender, the three CESE countries to which that lender has the largest exposure were chosen as the trigger countries.
  - Indices computed using:
    - foreign claims concept;
    - international claims concept;
    - international claims on CESE banks only.
  - Appendix Tables 6a, 6b (foreign claims), 7a, 7b (international claims), and figures (Figures 11–13) present detailed index values and illustrations.

### Key empirical results and stylized findings
- General properties of the indices:
  - The larger a country’s dependence on home-country banks and the larger the common lender’s exposure to a trigger country, the higher the contagion indices.
  - Accounting for rebalancing (Index 2 vs. Index 1) typically reduces index values significantly; countries with lower absolute dependence drop out of the most exposed group under Index 2.
- Dependence on common lender structure:
  - Contagion indices are highest when the common lender’s activities are substantially concentrated in the region.
  - Indices are smaller when the common lender has a large presence but smaller exposure in economic terms to CESE countries; exposures are then too small to materially affect funds available to others when a trigger problem arises.
  - Austria as common lender would have the highest effect propagating shocks across a wide range of CESE countries.
- Baltic region specifics:
  - Potential contagion between Sweden and the Baltic countries is highly concentrated.
  - Baltic countries exhibit the highest exposure indices for a hypothetical problem triggered in Estonia, Latvia, or Lithuania.
  - Spillovers to other CESE countries through the common lender channel seem contained within the Baltic region because dependence of non-Baltic CESE countries on Sweden is immaterial; hence rebalancing effects are small.
  - Contagion from the Baltics to the rest of CESE seems fairly unlikely based purely on the common lender channel; conversely, other CESE-triggered problems do not seem to impact the Baltic countries except when Germany is the common lender.
- Effect of claims concept:
  - Using the international claims concept produces significantly lower contagion exposure indices (given smaller magnitude of exposures) but the group of countries more exposed to regional contagion remains broadly the same (Figure 12).
  - Foreign claims (which include local currency assets of foreign-owned affiliates) produce much higher indices than international claims (which only include cross-border lending and foreign currency assets of foreign-owned affiliates).
  - Indices based on international claims on CESE banks only are even smaller in magnitude but do not dramatically alter which countries are most exposed (Figure 13).
  - Ranking differences across concepts: ordering of vulnerable countries differs somewhat, particularly for Austria and Italy as common lenders, compared to Germany; this likely reflects a significantly higher share of cross-border claims in foreign claims for Germany than for Austria and Italy, and a widespread and large subsidiary network of Austrian and Italian banks that magnifies vulnerabilities.

### Robustness and common findings across scenarios
- Although magnitudes vary across scenarios (different common lenders, trigger countries, and claims concepts), the group of CESE countries most exposed to regional contagion remains broadly similar.
- Differences in magnitude reflect:
  - international claims and claims on banks being subsets of the foreign claim concept;
  - differing sizes of financial exposures between home and host countries across alternative triggers and common lenders.
- For the analysis’s purposes, the indices’ value lies in identifying the group of countries that appear more exposed under various scenarios; that group remains broadly similar regardless of concept or assumptions.

### Conclusions, caveats, and policy implications (summary)
- Cross-border financial interlinkages within Europe are economically significant.
- Financial sectors of most CESE countries are dominated by institutions belonging to a limited number of financial groups with active regional presence and some with significantly concentrated exposures.
- Most CESE countries are highly exposed to Western European banks, either directly by their private sector or through local banking sectors.
  - Austria, Germany, and Italy account for the largest share of claims for the CESE region as a whole (for the Baltics, mainly Sweden), though some CESE economies have relatively more diversified sources of funds.
- Heavy concentration of Western European exposures matters where host-country exposure is non-negligible in magnitude.
- Even where exposures are well diversified, potential economic and financial contagion within CESE could increase overall exposure materially if one CESE country triggers regional stress.

*Source: IMF staff analysis (excerpt from content unit "_wp0906 - 27.      What do these stylized facts on the exposures of Western and CESE countries").*

### 39.      The contagion analyses offer the following conclusions: The larger the dependence

### 39.      The contagion analyses offer the following conclusions: The larger the dependence

### Contagion analysis conclusions (paragraphs 39–41)
- The larger the dependence of a CESE country on funds from a regional common lender, the higher is its exposure to problems triggered in the common lender’s banks.
- The larger the dependence on a common lender, and the greater the latter’s exposure to a trigger country, the higher is the susceptibility to regional contagion.
- Contagion indices are the highest when the common lender has activities substantially concentrated in the region, and are smaller when the common lender has large presence in, but smaller exposure to, the CESE in terms of its economic size.
- When the common lender’s exposures to any country in the region are economically too small, they are unlikely to affect the funds available to others when problems emerge in a trigger country.
- A potential spillover of Baltic-originated problems to the other CESE countries may be limited, at least based purely on the common lender channel, since Sweden’s small exposure to non-Baltic CESE makes the likelihood of any rebalancing effect small.
- The contagion exposure indices computed here do not represent an assessment of the financial or macroeconomic vulnerability and stability of individual countries studied; they only measure the degree to which shocks from foreign markets can affect a given country and help identify likely pressure points associated with a regional shock originating from a given country.
- Actual vulnerability depends on other factors, including the capitalization, liquidity, and general soundness of individual banking systems and key institutions, as well as macroeconomic fundamentals.
- Actual vulnerability also depends on the “true ability of the common lender to rebalance,” which would depend, among other things, on the maturity structure of the common lender’s claims on the borrower, and the nature of the institutional regulations that affect financial relationships between home/host institutions, and hence the liquidity of funds.
- The exposure indices should therefore be seen as a first step to a full vulnerability exercise.

### Policy implications and recommended actions (paragraphs 42–47)
- Regional approach:
  - The high degree of financial interlinkages in the region and the risk of regional contagion argue strongly for a more regional approach to managing potential vulnerabilities.
- Strengthen supervision and cooperation:
  - In addition to strengthening bank supervision and prudential regulation where warranted, close cooperation between home and host supervisory authorities is needed.
  - At a minimum, this calls for conducting coordinated inspections of internationally active banks and undertaking joint risk assessments.
  - Initiatives are needed to develop cooperative arrangements for crisis management, some of which are already taking place.
- Contingency planning:
  - Given the extent of susceptibility to regional contagion that can spread very quickly, better contingency planning is essential.
  - Develop contingency plans to deal with more systemic disturbances associated with regional spillovers of financial troubles and contagion, including those triggered by individual financial institutions that are highly active with concentrated exposures in the region.
  - Conduct crisis simulations for regional spillovers by monetary and financial supervisory authorities in both domestic and cross-border contexts to develop coordinating procedures in crisis management and to test the adequacy of internal and international processes.
  - Such exercises help test potential weaknesses in communication and coordination channels and procedures, clarify responsibilities within and between countries, and define information and data needs.
- Stress testing and regional spillovers:
  - Stress tests to assess the stability of financial systems should take greater account of regional spillovers through both the balance sheets of financial institutions and through the “real economy,” especially given the growing importance of direct exposures of internationally active financial institutions to the private sectors in host economies.
  - Many recent FSSAs have focused on cross-border exposures of domestic financial systems and regional feedback linkages (examples cited include Austria, Bulgaria, Croatia, Latvia, and Lithuania), but there is a need to carry out such analyses at the regional level in addition to individual country analyses.
- Use in Fund regional surveillance:
  - The analysis of cross-border financial linkages and contagion channels could provide a starting tool the Fund could exploit in its regional surveillance activities.
  - The magnitude of cross-border exposures could help assess susceptibility to regional contagion arising from reliance on foreign banks.
  - Contagion indices can be used to identify likely pressure points, capture potential spillover effects and propagation channels of a regional shock originating from a given country, and evaluate risks a home or host country might face given vulnerabilities building up elsewhere in the region.
  - Regular updates of the indices could provide a warning signal about a likely build-up of pressures and serve as an operational tool to feed into regional surveillance activities.
- Crude stress-test scenarios:
  - Index information could help assess scenarios for resilience testing of individual country banking systems and gauge risks associated with a potential problem in a third country to which significant home country banks are exposed.
  - Such information could provide more realistic scenarios and assumptions in conducting stress tests for liquidity and contagion risks.
  - Availability of more detailed information on exposures of individual banks active in the region would improve the quality of assumptions and analyses; such analysis could be the focus of further research.

### Major banking groups and regional exposures (paragraphs 48–52, Figure 14 notes)
- Definitions used:
  - Asset exposure: absolute exposure (total assets in the region).
  - Relative exposure: ratio of assets in the region to total banking group assets.
- Variation across banking groups:
  - The seven largest institutions each had total assets over €30 billion and an asset share of over five percent in the CESE region in 2007.
  - Several banking groups had large absolute exposures but negligible regional importance in total assets (examples in text: ING, Commerzbank, and Citibank).
  - Some banks have significant relative exposure but low absolute exposure to the whole CESE region; several of these have substantial exposures and concentration in subregions (example: Swedbank in the Baltics; several Greek banks in Southeastern Europe).
- Classification of the seven largest regional banking groups:
  - CESE-focus banking groups (activities concentrated in home countries and CESE): Erste Bank, Raiffeisen, and OTP Bank, each with over 30 percent of total assets in CESE.
  - Large European banking groups with large absolute exposure but smaller relative exposure to CESE: Unicredit, KBC, Societe Generale, and Intesa SanPaolo.
  - For banks with smaller relative presence in the region, vulnerability to home-to-host contagion is more relevant; for truly regional banks, contagion is likely in both directions with potential spillover across subsidiaries.
- Within-region diversification (end-2007 observations):
  - OTP is a purely CESE bank, with all its major subsidiaries located in the region.
  - Raiffeisen maintained 50 percent of its overall asset base in the CESE region.
  - Erste maintained 35 percent of its overall asset base in the CESE region.
  - Unicredit’s presence in 20 countries in the region accounted for about 11 percent of its asset base.
  - Unicredit and Raiffeisen are well-diversified within the region with relatively large subsidiaries in several countries; biggest subsidiaries cited in a footnote: for Unicredit — Poland, the Czech Republic, Croatia, Russia and Kazakhstan; for Raiffeisen — Russia, Hungary, Slovakia and Ukraine.
  - Other banks’ regional activities are more concentrated: Erste (Czech Republic and Romania); OTP (Hungary, Bulgaria and Ukraine); KBC (Czech Republic and Slovenia); Societe Generale (Czech Republic and Russia); Intesa SanPaolo (Slovakia and Hungary).
- Income generation:
  - The region’s very high income generation capacity gives prominence to the region in groups’ business strategies.
  - For the largest seven banking groups (except OTP), the share of the CESE region in income generation is substantially higher than the share of CESE assets in total group assets.
  - In CESE-focus banking groups, over 50 percent of operating income came from the region in 2007.
  - For Unicredit and Societe Generale, the region’s share in operating income and net banking income, respectively, are approximately twice as high as their share in total group assets.
  - Figure 14 caption notes: RAIF = Raiffeisen; ERST = Erste; UNIC = Unicredit; ISP = Intesa SanPaolo; SG = Societe Generale.

### Shift in composition of cross-border lending (Appendix II, paragraphs 53–55)
- Recent shift away from bank-to-bank lending toward lending to nonbank institutions:
  - The share of lending by European reporting banks to banks in CESE economies in their total outstanding claims on the CESE region fell by 3.9 percentage points over the period (from 27.2 percent in end-2005 to 23.3 percent in end-2007).
  - The share of lending to nonbank institutions increased by 8.6 percentage points (from 52.9 percent in 2005 to 61.6 percent in 2007 during the same period).
- Country-level changes:
  - Most CESE economies experienced growing nonbank shares in their outstanding liabilities owed to European reporting banks.
  - For some CESE countries (Latvia, Romania, Macedonia, Turkey, Estonia, and Croatia), the observed increases were large, exceeding 10 percentage points; these increases were broadly offset by a falling share of direct bank-to-bank lending.
  - Other CESE countries with large exposures to reporting banks had similar shifts in the composition of lending.
- Possible drivers:
  - These shifts may in some cases reflect regulatory arbitrage.
  - Concerns about high credit growth in some countries have prompted measures to slow the growth of foreign bank funding, which in turn may have invited growth in direct cross-border lending to nonbank institutions.

*Source: Excerpt from IMF Working Paper content (paragraphs 39–55, Appendices I–II) contained in the provided PDF content.*

### 56.      However, reporting banks with wide regional presence did not observe a shift

### _wp0906 - 56.      However, reporting banks with wide regional presence did not observe a shift

### Bank-to-bank vs. nonbank lending: observed patterns (2005–2007)
- Reporting banks with wide regional presence did not observe a shift away from bank-to-bank lending.
- For Austria, Italy, Germany, and Sweden, the share of bank-to-bank lending increased over the 2005 – 2007 period.
- Individual countries experiencing rapid credit growth saw a notable shift towards nonbank lending.
- Some countries bucked the trend due to lower initial levels of lending. Countries with increasing shares of bank lending (including Ukraine, Moldova, Belarus, Montenegro) typically started from low levels of dependence on foreign funding, and a significant share of lending to the public sector.

### Measures of relative dependence and exposure (end-2007, Foreign Claims Concept)
- Table 2 (Host Country Exposure to Home Country Banks: Measure of Relative Dependence) reports matrices of rd(i; j) (foreign claims owed by a CESE country to a Western European country's banks as a share of total foreign claims owed to all reporting banks, in percent). Example entries:
  - Poland row (selected): Austria 6.19; Germany 18.10; Italy 20.51; France 7.36; Belgium 8.04; Sweden 2.54; Netherlands 9.94; Switzerland 2.22; UK 1.13; Portugal 4.68; Spain 1.62.
  - Moldova row (selected): Austria 32.49; Germany 19.49; Italy 33.21; France 0.00; Belgium 1.08; Sweden 0.00; Netherlands 4.69; Switzerland 0.00; UK 0.72; Portugal 3.25; Spain 0.72.
- Table 3 (Home Country Exposure to Host Countries: Measure of Relative Exposure) reports re(j; i) (foreign claims of a Western European country on a CESE country as a share of its total claims vis-à-vis all developing countries, in percent). Selected entries:
  - TOTAL CESE row: Austria 91.607; Germany 48.110; Italy 86.847; France 37.151; Belgium 68.029; Sweden 89.332; Netherlands 30.433; Switzerland 23.127; UK 7.031; Portugal 44.682; Spain 2.524.

### Measures of absolute dependence and exposure (end-2007, Foreign Claims Concept)
- Table 4 (Host Country Exposure to Home Country Banks: Measure of Absolute Dependence) reports ad(i; j) in millions of US dollars and as a share of CESE country GDP (in percent). Selected entries:
  - Total foreign claims (first row) by country on CESE: Austria 57.3; Germany 3.5; Italy 10.4; France 11.8; Belgium 4.2; Sweden 4.6; Netherlands 1.5; Switzerland 5.7; UK 1.3; Portugal 0.7; Spain 2.7; Poland 0.9.
  - Croatia row (total foreign claims): 182.8; exposures: Austria 66.5; Germany 35.5; Italy 59.5; France 15.0; Belgium 0.8; Sweden 0.0; Netherlands 0.3; Switzerland 0.3; UK 0.3; Portugal 1.0; Spain 0.0; Poland 0.0.
- Table 5 (Home Country Exposure to Host Countries: Measure of Absolute Exposure) reports ae(j; i) (foreign claims of a western European country on a CESE country as a ratio to the Western European country's banking sector assets, in percent). Selected entries:
  - Total row: Austria 25.379; Germany 2.443; Italy 5.692; France 2.261; Belgium 6.762; Sweden 9.602; Netherlands 3.068; Switzerland 2.506; UK 0.364; Portugal 2.362; Spain 0.226.

### Exposure indices to regional contagion (Foreign Claims Concept)
- Index definition (without rebalancing): Exposure index (1) = ad(i, CL) * AE(CL, i).
- Index definition (with rebalancing): Exposure index (2) = ad(i, CL) * AE(CL, i) * REB(CL, i).
- Table 6a (Index without rebalancing, end-2007) — selected high values:
  - Croatia: 318.8; 278.9; 221.9 (across different common-lender trigger configurations).
  - Slovakia: 184.2; 161.2; 128.3.
  - Czech Republic: 134.2; 117.4; 93.4.
  - Bosnia and Herzegovina: 226.5; 198.1; 157.7.
  - Estonia: 403.2; 351.9; 315.6.
  - Latvia: 247.0; 215.6; 193.4.
  - Lithuania: 195.3; 170.5; 152.9.
- Table 6b (Index with rebalancing, end-2007) — selected values:
  - Croatia: 46.45; 39.59; 30.40.
  - Czech Republic: 28.09; 23.94; 18.39.
  - Slovakia: 22.67; 19.33; 14.84.
  - Estonia: 157.53; 131.00; 113.65.
  - Latvia: 75.55; 62.83; 54.51.
  - Lithuania: 66.61; 55.39; 48.06.

### Exposure indices to regional contagion (International Claims Concept)
- Table 7a (Index without rebalancing, end-2007) — selected values:
  - Croatia: 56.7; 116.6; 105.7.
  - Hungary: 22.0; 45.3; 41.1.
  - Romania: 19.3; 39.8; 36.0.
  - Estonia: 251.1; 183.6; 201.1.
  - Latvia: 157.4; 115.1; 126.1.
  - Lithuania: 101.9; 74.5; 81.6.
- Table 7b (Index with rebalancing, end-2007) — selected values:
  - Croatia: 8.77; 19.78; 17.61.
  - Hungary: 3.57; 8.06; 7.18.
  - Romania: 3.30; 7.44; 6.63.
  - Estonia: 100.25; 66.20; 80.28.
  - Latvia: 50.33; 33.23; 40.30.
  - Lithuania: 29.74; 19.64; 23.82.

*Source: Authors' calculations based on BIS Quarterly Review: June 2008, Table 9B: Consolidated foreign claims of reporting banks - immediate borrower basis on individual countries by nationality of reporting banks / Amounts outstanding (end-Dec 2007 data).*

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