CHAPTER 8
have not benefited equally from enlargement. Europe’s southern economies in particular have failed to make their companies fit for a larger Europe due to poor business regulation. Easy finance masked these shortcomings for a while, but the crisis exposed the risks of a three-speed Europe. European integration needs to be crisis-proofed.
Crisis-proof financial flows in Europe A unique feature of European integration is the large volume of financial flows from parent banks in Western Europe to subsidiaries in Central and Eastern Europe—a phenomenon we called “financial FDI.”6 As chapter 3 shows, financial integration is an enviable opportunity for Europe, but with tail risks. Countries that benefit from this opportunity adopt robust macroprudential regulations to moderate the credit booms that large foreign capital inflows induce. The policy arsenal includes capital and liquidity requirements, well-calibrated risk weights, and constraints on lending growth or forex lending. Regulations can also enhance credit quality by tightening eligibility criteria or loan-to-value and debtservice-to-income ratios. But chapter 3 also highlights the limits of such policies in an integrated financial market, and recommends advancing supranational coordination: supervising financial institutions operating across borders, managing liquidity risks during crises, and setting appropriate prudential regulations tailored to country-specific risks. Poland, among the European Union, and Croatia, among non-EU countries, show the benefits of a well-managed financial foreign direct investment (FDI). As the result of integration into the international and regional economy, Croatia and Poland experienced large inflows of financial FDI. Poland shows how good regulations and sound macroeconomic management can work with informal ways of keeping currency mismatches in bank lending manageable. Croatia shows the pros and cons of a more rules-based macroprudential regime (box 8.3).
Box 8.3: Managing financial foreign direct investment: Poland and Croatia Poland As with any type of capital inflow, governments must balance encouraging financial foreign direct investment and managing macroprudential risks. After joining the European Union in 2004, Poland succeeded in striking this balance. Several factors helped. First, good macroeconomic performance: output has grown for 20 consecutive years, and growth has averaged more than 4 percent since 1991. Inflation was brought down gradually and kept low for more than a decade. Second, Poland’s prudential banking sector regulations were relatively sound: capital adequacy trigger ratios are higher than the Basel Accord minimum, and banks must comply with binding liquidity standards. Moreover, Poland was among the region’s first to regulate foreign currency lending through Recommendation S in 2006. Third, an informal
yet effective approach to regulation by the central bank: much of the macroprudential regime, such as Recommendation S, was enforced through moral suasion, without automatic punishment mechanisms for noncompliance. This informal approach may have worked because of Poland’s generally sound macroeconomic policies. Croatia The foreign ownership of banks jumped from 7 percent in 1998 to 90 percent in 2002, remaining around this level since. Credit grew, especially for households. Between 2000 and 2008 household loans grew at an annual average of 23 percent. But with rulesbased macroprudential measures, Croatia managed the boom and subsequent crisis of 2008 relatively well. Between 2008 and 2010 banks enjoyed the highest average bank
regulatory capital to risk-weighted assets in the region. The ratio of nonperforming loans to total loans is around 7 percent. What lies behind this performance? Croatia successfully implemented rules-based macroprudential policies. The exchange rate regime largely ruled out the use of monetary policy. Large structural budget deficits reduced the potential for fiscal policy. Croatia’s formal prudential policy framework may have made up for weaknesses in macroeconomic management. This approach is not without drawbacks. It is difficult to limit credit expansion effectively and tailor policies to different sectors without creating distortions in the market. Restrictions on bank credit, for example, hampered the expansion of small banks. Source: Iwulska (2011), available at www. worldbank.org/goldengrowth
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