Banking in Central/Eastern Europe: Austrians

UNCLAS SECTION 01 OF 04 VIENNA 001848

SENSITIVE
SIPDIS

TREASURY FOR FTAT, OCC/SIEGEL, AND OASIA/ICB/ATUKORALA
TREASURY PASS FEDERAL RESERVE, FINCEN, AND SEC/JACOBS

E.O. 12958: N/A
TAGS: EFIN AU XH
SUBJECT: Banking in Central/Eastern Europe: Austrians
to Stay the Course, But Say Risks Abound

REF: VIENNA 1751 and previous

Sensitive but Unclassified - Entire Cable.


1. SUMMARY. The financial crisis has triggered
concerns about Austrian banks' huge exposure -- over
EUR 250 billion -- to markets in Central, Eastern, and
Southeastern Europe (CESEE) and the former Soviet
Union (FSU). Austrian banks (and the GOA) argue they
can manage the increased risks, because they have a
solid base of deposits and equity, including GoA
equity injections, sufficient to weather problems in
CESEE/FSU subsidiaries. Despite the global economic
downturn, the CESEE/FSU outlook is generally better
than for Western Europe and a region-wide recession is
not expected. Austrian banks are determined to remain
in eastern markets, which they say are still under-
banked and offer growth potential. An IMF "stress
test" showed considerable resilience of the Austrian
banks against shocks. All Austrian banks active in
CESEE/FSU are "system-relevant" in Austria meaning the
GoA will not let them collapse. Still, banks here do
not rule out 1997/98-style crises, particularly in
Ukraine, Hungary, Bulgaria, Romania, Croatia, and
Kazakhstan. END SUMMARY.


2. This cable is based on meetings of Embassy
officers with representatives of several large
Austrian banks with CESEE/FSU operations, information
from the Austrian National Bank/OeNB, new CESEE/FSU
reports of commercial banks, and other sources.

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Position of Austrian Banks in CESEE/FSU
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3. According to the OeNB's Financial Stability Report
(released December 15),Austrian banks' Tier 1 capital
ratio in June 2008 was 7.4%, the consolidated capital
adequacy ratio 10.8%. Twelve Austrian banks operate
73 fully consolidated subsidiaries in CESEE/FSU, of
which 37 are in the 12 new EU member states, 23 in
other SEE countries and 13 in FSU. Austrian banks
have a 15.2% share of the entire CESEE/FSU banking
market (21.8% excluding Russia). CESEE/FSU accounts
for 28.5% of Austrian banks' total consolidated
assets, but reaches 40% and more for the five large
Austrian banks active in CESEE/FSU (listed below).
NOTE: Unconsolidated bank assets of banks
headquartered in Austria were EUR 972 billion in June
2008; total consolidated assets (i.e. including
CESEE/FSU subsidiaries) were EUR 1,162 billion, of
which the five largest Austrian banks accounted for
63.3%. END NOTE.


4. Five of Austria's six largest banks are major
players in the region:
-- Bank Austria/BA
-- Erste Bank/EB
-- Raiffeisen Zentralbank (through its consolidated
subsidiary Raiffeisen International/RI which handles
the Raiffeisen group's CESEE/FSU business)
-- Volksbanken, and
-- Hypo Alpe Adria/HAA
Examples of Austrian dominance in CESEE/FSU:
-- BA is the largest bank in Bosnia-Herzegovina,
Bulgaria and Croatia, number three in Kazakhstan and
four in Czech Republic and Ukraine
-- EB is number one in Romania and Slovakia, two in
Czech Republic and three in Croatia
-- RI is number one in Albania, two in Kosovo, Serbia
and Ukraine, three in Belarus, Bosnia-Herzegovina,
Romania and Slovakia, and four in Bulgaria and
Croatia.
NOTE: BAWAG, Austria's number five bank, has
subsidiaries only in Hungary and Slovenia.

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Subprime Versus CESEE/FSU Risks
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5. The subprime crisis had limited impact on Austrian
banks. Total write-downs were about EUR 2 billion
until mid-2008 and actual losses so far have been only
about EUR 200 million, according to the OeNB. Banks
were spared immediate fallout due to their strong

VIENNA 00001848 002 OF 004


CESEE/FSU focus, an "originate and hold" business
model, and a focus on retail deposit business along
with trade financing. Austrian banks have solid
deposit cover of their CESEE/FSU assets (i.e. loans)
according to the OeNB. On average, CESEE/FSU
receivables are 112% of deposits -- versus 128% in
Austria -- but the ratio is over 150% In Hungary,
Latvia, Montenegro, Slovenia and Ukraine. The
"deposit" deficit is 61% in FSU, 27% in Bulgaria and
Romania, 5% in the other CEE countries, and 7% in SEE.
Austrian banks are suffering indirect effects of the
subprime crisis, i.e., higher refinancing costs,
declining revenues from trading and commissions,
credit scarcity, and investor risk aversion.


6. In the first half of 2008 Austrian banks'
unconsolidated -- i.e. domestic -- operating results
were down 11.2% compared to the same period in 2007,
stemming from lower revenues (down 1.8%) and higher
operating expenses (up 4.0%),according to the OeNB's
Financial Stability Report. On a consolidated basis,
the decline was less strong because of continued
strong CESEE/FSU business. So far, Austrian banks
have been able to cover write-offs from current
revenues and have benefited from their retail banking
business focus. An increase in deposits since the
beginning of the international financial market crisis
strengthens their liquidity position and reflects
customer confidence in them. However, strong profits
in the region -- for some banks 50-80% of overall
profits -- are over for the time being. According to
the OeNB, Austrian banks' consolidated profits in 2008
will drop 25% from the 2007 level (which was an
exceptionally good year) but still match the levels of
2005/2006.

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Bankers See CESEE/FSU Risks as Manageable
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7. Since the Iceland collapse -- unforeseen by rating
agencies, Austrian banks complain -- CESEE/FSU
countries with high external deficits have come into
critical focus. All Austrian banks active in
CESEE/FSU feel that CESEE/FSU risks are limited and
that they can continue supporting their subsidiaries,
particularly given their strong deposit basis (with
the possible exception of Ukraine). However, the
region remains under-banked and continues to offer
long-term potential to increase financial
intermediation. Austrian bankers recognize that the
boom days are over and economic growth will slow
markedly through 2010 (see para 14 below),but say the
region does not now face a recession and retains a
strong medium/long-term growth potential based on
competitive advantage and a catch-up demand for
infrastructure. Austrian bankers like to point to
resiliency in emerging Europe ("this is not the first
crisis these countries have faced") and express
confidence that the EU, and European strategic
investors, exert a positive stabilizing influence over
most of the region.


8. Bankers here recognize the risk inherent in
CESEE/FSU markets' dependency on capital inflows to
finance economic growth. Foreign banks played a role
in that dependency with their strong lending growth.
Rising costs of external financing and tighter
conditions will now inhibit, rather than fuel, those
economies. Austrian bankers point to countries with a
greater dependency on foreign funding (and thus higher
risk) including Kazakhstan, Latvia, Estonia, and
Bulgaria, followed after some distance by Romania,
Lithuania and Croatia. Another risk factor is the
high share of foreign exchange lending (mostly in
Euros) -- which helps Austrian banks manage currency
risk but might call into question the credit-
worthiness of local borrowers if a local currency
depreciates sharply. Countries with exchange-rate
pegs are under special pressure: devaluation would
lead to payment difficulties because of the private
sector's large foreign debts, so any expectation of
such a development could trigger capital flight.
Austrian banks are concerned but opine that no
government in the region has an interest in letting
its currency fall sharply, since all (except Russia)

VIENNA 00001848 003 OF 004


must finance current account deficits and tend to
borrow in Euros. (NOTE: Hungary is a partial
exception with its forint-denominated floatings, but
has other reasons to support the forint, say Austrian
financial analysts - END NOTE). Austrian banks are
concerned about countries with high public debt
including Hungary and much of southeast Europe.


9. The biggest concern is Ukraine, particularly if
the currency volatility continues, followed by
Hungary, Bulgaria and Romania. For most bankers
Russia is not a concern: they view it as a special
case of a country rich in natural resources. On the
Russian bank market, they say the worst seems to be
over. Since all system-relevant banks in Russia are
owned by the government, state-owned companies or
municipalities, the Russian government seems committed
to help them -- and the failure of other banks would
help promote consolidation. For HAA, its huge
exposure in Croatia is a problem. In any case,
Austrian bans remain committed to those countries and
none i considering pulling out (though they may scale
own in one or more countries).


10. Bankers expess confidence that the IMF seems
prepared to hep any CESEE/FSU country in crisis and
the EU willlikely help at least the candidate
countries. Te good news includes reforms and
instittional deepening; moreover, the public in many
CESEE/FSU markets now has more confidence in banks
than in governments and political leadership.
However, some Austrian banks says CESEE/FSU
governments are not reacting appropriately to the
crisis and that the banks have had to send strong
messages that they will NOT bail out those markets
("they're on their own" as an interlocutor put it).


11. Austrian regulators express strong confidence in
their banks' ability to weather any CESEE/FSU storms
on the horizon. OeNB Governor Ewald Nowotny has said
publicly that Austria will outperform other markets
during the current crisis because of their strong
presence in CESEE/FSU and has repeatedly predicted
that the GOA will not have to cover losses at large
Austrian banks. Most bankers -- including at RI and
EB -- echo this confident sentiment. UniCredit CEO
Allessandro Profumo (head of BA's parent group) has
however expressed concern about risk -- which may
reflect the fact that BA expanded in CESEE/FSU just
before the crisis and may now be confronted with
write-downs. For example, in 2007 BA bought 95% of
Ukrainian bank Ukrotsbank for EUR 1.5 billion: the
other 5% is listed on the stock exchange, where the
share price has fallen 80% since the beginning of

2008. Also in 2007, BA bought ATF-Bank (the third
largest bank in Kazakhstan) for EUR 1.45 billion -- in
a market that bankers say is now quite shaky.

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IMF Stress Test: Banks Resilient Against Shocks
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13. Even though the situation has deteriorated
considerably since the summer, a June 13 IMF stress
test of the Austrian banking system (as part of its
Financial Sector Assessment Program - FSAP) remains
relevant. (NOTE: full text available at
www.imf.org/external/pubs/ft/scr/2008/cr08204 .pdf).
Key messages of the IMF report are:

-- The Austrian banking system shows considerable
resilience against shocks. Banks are well-
capitalized, have a moderate attitude toward market
risks, follow an "originate and hold" strategy in
lending, and have a stable funding source in deposits.

-- The main risk for the Austrian banks stems from the
credit risks in CESEE/FSU -- but Austrian banks still
have most assets (i.e. loans) in their domestic
market.

-- Test results of substantial strain on the banks
showed very low or in some cases even negative return
on equity, but capital buffers generally remained
intact. Severe shocks originating in CESEE and a
global downturn causing a prolonged domestic recession

VIENNA 00001848 004 OF 004


would lead to substantial credit losses of banks and
severely affect their return on equity. Only in a few
cases would the losses affect base capital, but
capital would still remain above 8%.

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New Economic Forecast for CESEE/FSU: No Recession
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14. The boom is over, there will be a marked slowdown
through 2010, but no recession in the region - these
are the key messages of a closely-watched November 27
forecast by the Vienna Institute for International
Economic Studies (an independent economic research
institute specialized in CESEE/FSU economies). In
individual countries -- Hungary, Estonia and Latvia --
a recession is likely but overall growth in the new
EU-10 CEE member states will decline from a 6.3%
average in 2007 to 5.0% in 2008 and 2.7% in 2009. A
more optimistic scenario puts growth at 3.5% in 2010.
The study predicts 2009 growth of 3% in southeast
Europe 5.2% in Russia. However, forecasters say their
prognosis is especially uncertain at this turning
point in the global economy.

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Comment/Assessment
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15. While individual CESEE/FSU markets appear quite
shaky -- and none is as broad and deep as even Austria
-- Austrian banks still say they can manage the risks
and potential losses, and no bank is considering a
retreat. The economic crisis will lead to markedly
lower economic growth in the region, but not/not a
region-wide recession and performance will still beat
Western Europe, say forecasters here. The size of the
GoA banking rescue package gives some reassurance
because it takes into account the Austrian banks'
CESEE/FSU exposure. Since all five Austrian banks
with noteworthy CESEE/FSU subsidiaries are "system-
relevant" in Austria -- "too big to fail" -- the GoA
will intervene if any starts to teeter. OeNB Governor
Nowotny and others remain convinced that relatively
small Kommunalkredit bank (reftels) will remain the
only bank troubled enough to warrant GoA takeover.

GIRARD-DICARLO