Vienna Initiative: regulatory capture and policy confusion continues

In February 2009 the European Bank for Reconstruction and Development, together with the European Investment Bank and the World Bank Group launched a series of meetings with commercial banks, coordinated with the European Commission and the International Monetary Fund, to shore up a weak link in the financial systems of the European Union. The weak link is in so-called ‘emerging Europe’, the countries of central and eastern Europe that are in the EU, but are outside the European Monetary Union, the Euro-zone. These are mostly ex-Communist countries whose financial systems had remained undeveloped under communism.

This article is from Issue 52 of our quarterly newsletter Bankwatch Mail

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Subsequently, with bank privatisation, their financial systems came to be dominated by large western and northern-European banks, that had expanded aggressively to gain critical mass in the Single European Market for financial services that was inaugurated by the Lisbon Agenda agreed in 2000.

This has distorted banking systems in central and eastern Europe, making them heavily focused on lending to unstable asset markets (real estate, local stock markets), and with weak money markets. In the wake of the financial crisis of 2008, it was feared that the large western and northern European commercial banks would withdraw from lending to central and eastern Europe, creating a ‘credit crunch’, as companies and individuals seeking to roll over their debt find that they are unable to do so, and are forced to reduce spending and sell assets.

The Vienna Initiative resulted in an agreement between the EU, the World Bank, the EBRD, the EIB and commercial bank groups (Italy’s Unicredit, France’s Société Générale, Austria’s Raiffeisen International) under which the commercial banks were given ‘financial support packages’ in return for commitments not to reduce their lending in central and eastern Europe. Close to EUR 33bn in public funds was mobilised, with support for lending supposedly aimed at the real economy (small and medium-sized enterprises in particular) one of the explicit selling points promoted by the initiative's backers.

On March 16 this year, the European Bank Coordination Initiative (the official name for the Vienna Initiative) reconvened in Brussels ostensibly to meet ‘a similar need for collective action to avoid suboptimal outcomes’. The official reason was the publication that month of figures from the Bank for International Settlements (BIS) showing that in the third quarter of 2011 some USD 35bn had been taken out of eastern Europe by western European banks. In the largest market, Poland, foreign credit had shrunk by USD 13bn or 8.6 percent. This aroused fear that the voluntary commitments of the large western European banking groups made in Vienna in 2009, and due in any case to expire in April 2012, had been effectively abandoned. Reuters reported in January that some EUR 24.5bn in lending to which the western banks had committed themselves by April had not been made.

The real reason was the tightening up of bank regulation announced by the BIS Committee on Banking Regulation in 2010. This significantly raised the amount of capital which banks are supposed to hold in relation to their risk-weighted assets. In Europe, the European Banking Authority, that is supposed to coordinate bank regulation in the EU, issued guidelines requiring banks to raise their core Tier 1 capital (effectively their share capital and retained earnings) to nine percent of risk-weighted assets, considerably more than the six percent recommended by the Basel Committee. Moreover, capital markets have been weakened by the financial crisis and European capital markets have been weakened further by the war on government debt that is the unintended consequence of the 1992 Maastricht Treaty.

In this situation banks would have found that the easiest way to comply with these requirements is to reduce their holding of risky assets, simply by refusing to lend any more in eastern Europe, where the risks are relatively high because of weak banking systems and foreign currency exposure. Banks operating in Hungary have already been affected by the fall in the Hungarian forint of around a third against the Euro.

Two particular faults in the web of international banking in Europe have been identified. One is Austria, whose capital is an international banking centre and whose banks Erste Group, Raiffeisen International and Bank Austria (owned by the Italian group Unicredit) have taken a leading role in expanding into eastern Europe. The Austrian government, anxious at what the failure of a large bank would do to the borrowing and the credit rating of the government, had been pressing Austrian banks to disengage from eastern Europe. In November the Austrian banking authorities instructed those banks to reduce their exposure to ‘emerging Europe’, and were especially keen to raise their capital ratios. The other fault is Greece, whose banks hold large quantities of Greek government debt, but also have large lending operations in Bulgaria, Romania and Serbia.

In the end, the banking authorities backed off, and have given the western European banks more time to achieve the target capital ratios. The Brussels meeting agreed that banks should discourage foreign currency lending in eastern Europe and noted the limited capacity of countries in that region to absorb project finance.

In effect the Vienna Initiative revealed the willingness of the bank regulators and international financial institutions such as the EBRD and the EIB to accept the priorities of the big banks in western Europe. In 2009 they received massive financial support in return for lending commitments on which they failed to deliver. In 2012, they got relief from inconvenient capital requirements and the blessing of the European Commission for failure to deliver on lending commitments to eastern Europe, pending the development of local capital markets.

The experience of history suggests that those capital markets will fail to develop as long as the European Commission continues its war on government debt and the proper role of central banks in refinancing it. The most developed financial markets, in western Europe and north America, expanded on the basis of government debt markets in the nineteenth century and the first half of the twentieth century, where the central bank provided crucial refinancing facilities. The sub-prime market crisis hit the American financial system because, as Ben Bernanke has pointed out, there was not enough government paper in the balance sheets of commercial banks and financial institutions, rather than because there was too much. At a time when private sector borrowers are deleveraging, the stability of the banking system depends on the willingness of the public sector to provide good liquid assets for banks to hold.

Jan Toporowski has worked in international banking, fund management and central banking. He is currently Professor of Economics and Finance at the School of Oriental and African Studies, University of London. His most recent book is Why the World Economy Needs a Financial Crash and Other Critical Essays on Finance and Financial Economics (Anthem Press 2010).