Macedonian Banks are Safer than West Europe's Banks

By Sam Vaknin

Editor in Chief of Global Politician

Even under the best case scenario (in which banks take a 50% haircut on the credits they have extended to profligate Greece, but there is no default) French, Italian, German, and Austrian banks run a collective capital shortfall of c. 40 billion euros. Add to this the EU's new banking capital adequacy regulations and the figure doubles. Imagine a contagion spreading to Portugal and Spain and we are talking 200 billion euros. Add a crumbling Italy and literally all the major banks in western Europe are insolvent. The EFSF - the euro's emergency kitty - is supposed to recapitalize these tottering financial institutions, but hitherto it has remained largely bereft of the minimal resources required.

Frankly, I'd rather put my money in a Macedonian bank than in any west-European bank. Macedonia's banks have acted far more prudently than their brethren abroad, partly because they derive handsome profits from arbitrage between government bonds and deposits and partly because, accustomed as they are to bad borrowers and defaults, they are hypervigilant and laudably cautious. Macedonian bankers are, thankfully, not sophisticated and so avoided the pitfalls of derivatives, securitization, swaps, and other miracles of western financial engineering.

Ironically, the main risk to the Macedonian banking system stems from the fact that more than 80% of the sector is owned by foreign banks. Contagion from abroad - not the quality of their portfolios - is what keeps Macedonia's bankers awake at night.

In June 2008 , the Austrian Erste Bank has just published a report about the state of the banking system in Central and Eastern Europe. Macedonia was not even mentioned. The banking sectors of Bulgaria, Romania, Russia and Ukraine are poised to grow the fastest, as these countries catch up with the West, said Erste. With the exception of the scandal-ridden French Societe Generale, no prime foreign bank was represented in Macedonia in 2008. Even Societe Generale had merely purchased a local bank rather than open its own branch. Erste Bank itself declined to buy Stopanska Banka in 1997.

How things have changed!

Erste and other major foreign banks are now fully present in Macedonia.

But is foreign banking such a good thing?

Research demonstrates that foreign banks tend to lend to foreign direct investors and foreign clients. They rarely extend credit to local firms, let alone individuals in the host country. True, they bring with them management know-how, access to financial networks and markets, and fresh capital. Their entry fosters competition and improves the overall performance of the banking sector, as well as the terms and conditions offered to domestic clients by domestic banks.

But not all is rosy. Foreign banks bring with them systemic risks. Macedonia was spared the worst of the global credit crunch precisely because it was not exposed to the global financial system. It had no subprime mortgage market, no crazy credit derivatives, no mysterious hedge funds. Its backwardness turned out to be a blessing as it avoided the excesses perpetrated by foreign banks in the USA, in Europe, and in some parts of Asia.

Erste Bank's report was very clear about it: the existence of foreign banks in Bulgaria, Romania, Russia and Ukraine is precisely why the meltdown of the global credit markets has wreaked collateral damage on the banking sectors in these countries.

Greece aside, there is a greater threat looming on the horizon: Basel III.

In the wake of the Great Recession (2007-8) – a crisis largely of the financial system – the multinational Basel Committee and the Group of Central Bank Governors and Heads of Supervision, comprised of central bankers, banking supervisors, and regulators more than doubled the amount of equity (Tier 1) capital banks must have to 4.5%.

Another 2.5% of their assets must be held as an equity “conservation buffer” to be amortized and deployed in case of emergency. Banks which resort to the buffer must, however augment their capital by any (legal) means possible (for instance, by not distributing dividends, by divesting non-core assets, or by issuing new stock). Yet another 1.5% of the balance sheet must be held in “less-than-equity” quality investment vehicles and the total leverage ratio must never go below 3% in equity (admittedly, a liberal number).

Moreover: regulators can impose the equivalent of yet another 2.5% in risk-weighted assets (including off-balance-sheet assets, such as derivatives) in the form of a “countercyclical buffer”. This is intended to counter the pro-cyclical nature of most capital requirements and reserves regimes: the more assets’ prices rise (and commensurate risks increase), the less the capital set aside as loans are deemed “safer” by greedy bankers whose compensation is often tied to their institution’s short-term performance.

The Basel III regime has to be fully implemented by 2019, a concession to under-capitalized banking sectors in various EU members (notably Germany). Ironically, the Basel Committee was created in 1974, following the failure of a German bank and an ensuing near-collapse of the currency markets. Indeed, the Basel regime is as strong as its weakest link: multilateralism has its price. This in-built frailty forces the Committee to remain vague on what constitutes capital; on disclosure regarding derivatives; and on the loaded issue of subordinated debt vs. corporate bonds (subordinated debt would force banks to become a lot more transparent and is likely to foster shareholder activism).