Austrian Banking System

Too Big to Save

The banking system has preserved stability throughout the post-2008 crisis, which is not to say that there were no major problems. Clearly, adjustments had to be made, some in the wake of major bank failures. Initially, there were worries that Austria will end up with a banking crisis similar to the one in Iceland and Ireland. This turned out to be overly pessimistic. In part, the assessment was based on the misperception of the salience of the Austrian banks’ subsidiaries in the Central, Eastern, and South-Eastern Europe (CESEE). There were additional worries that panic might break out and run on the banks would lead to public finance problems. Eventually, a problem of that kind emerged on the regional level, with the collapse of Hypo Alpe Adria bank. Overall, the banking sector remained stable due to international initiative, e.g. The Vienna Initiative which dealt with the possible cross-border panic, the support from public funds, and the actions of the central bank. Finally, relatively favorable macroeconomic development, compared to other EU economies in any case, helped support financial stability.

Searching for Risks

Austrian banks are quite exposed to CESEE countries. The reasons are two. One is that profitability of the Austrian market for loans is relatively low. This is hardly surprising in a small, highly developed economy. As a consequence, risks are sought in the neighboring markets of faster growing less developed countries in transition. The other is that Austrian banks are used as a vehicle for investments in these countries by banks and financial institutions from outside of Austria. This strategy offers high returns, but also exposes the banks to double risk of a sudden stop type of crisis. Demand can decline in target countries and supply of funds can also dry up in the investor countries. Both risks were contained by the so-called Vienna Initiative which solicited commitment to slow process of deleveraging from the CESEE region. In addition, in search for risk, there was a shift from Southeast European countries to the markets in Turkey, Russia, and Ukraine. Graph 1 shows the relationship between the level of non-performing loans in a selection of CESEE countries and the growth of loans to private sectors in 2014.

Clearly, the better performers in the post- crisis period, i.e. Russia, Turkey and even Ukraine, became high risk countries during the last year, especially after the introduction of sanctions preventing doing business with Russia, and due to sharp decline in oil prices in the second half of 2014. Those events have eaten into the profits of the Austrian banks. In addition, countries with high shares of non-performing loans in their banking sectors, e.g. in South-Eastern Europe, continue to deleverage and contribute to poor performance of banking profits.

These characteristics point to a structural feature of the Austrian banks. In the integrated European financial market, they search for risk in less developed countries which promise higher returns to invested capital compared to those that can be made either in Austria or in other developed countries, but those also expose the Austrian banking sector as well as the country’s public finances to risks that threaten to be systemic. Table 1 gives some indication on the magnitude of this systemic risk.

Moral Hazard

Recent nationalization and disinvestment of the Hypo Alpe Adria points to an interesting aspect to the developing banking union in the EU. Clearly, for countries like Austria that have a banking sector that is both too big to fail and too big to save, banking union within EU is a welcome development. It offers new ways to share risks within the financial sector and with the budgets of the member states of the EU. One particular element of that which was implemented in the bailout of the failing bank is the provision on bail-in of the subordinated creditors in troubled banks. This has led to phased downgrading of Austrian banks by rating agencies. Clearly, those have judged that risks to investors in Austrian banks have increased due to more restricted state commitment to bailing them out in bad times. In this case, the Austrian authorities have chosen to implement the new bail-in clause of the emerging EU Banking Union early. Similar actions by other countries in similar circumstances will become a rule from January 1, 2016.

What this means is that moral hazard will be somewhat contained with this new bail-in clause. That, however, will increase the risks in the financial sector, which is the intended consequence of the new EU regulation and should contribute to more realistic pricing of risks. However, it will also increase the risk of financial intermediation, which will have an effect on supply of funds and on the ability to search for risk, which has been rather important for the Austrian banks.

Conclusion

So far, the banks have weathered the systemic risks and the authorities have been able to preserve financial stability. Austrian above-average economic performance has also helped its banks and has improved performance of Central European countries where Austrian banks are particularly active (with some major exceptions however). Going forward, it is unclear whether the exiting banking model can be saved, given the changing financial environment and regulations in the EU.