Navigating Financial Stability: FinSAC's Response to Persistent Banking Crises

The World Bank’s Financial Sector Advisory Center and the Austrian Government have significantly improved the resilience of banking sectors in FinSAC client countries through extensive reforms and contingency planning, despite persistent bank failures and systemic crises. Ongoing efforts focus on enhancing regulatory frameworks, asset quality, and cross-border cooperation to prevent future banking crises.

The World Bank's Financial Sector Advisory Center (FinSAC) and the Austrian Government have extensively examined the vulnerabilities exposed in the banking systems of FinSAC client countries during the global financial crisis. These countries, which include several in Eastern Europe and Central Asia, faced unrestrained loan growth often fueled by foreign currency funding, leading to unsustainable business models. This crisis resulted in a dramatic increase in nonperforming loans (NPLs) and severe funding problems for banks. To prevent a recurrence, authorities, international financial institutions, and banks initiated the Vienna Initiative. Since then, extensive reforms aligned with international and EU standards have markedly improved the resilience of these banking sectors.

Persistent Bank Failures Amid Reforms

Despite these reforms, bank failures have persisted over the last decade, with notable instances in Azerbaijan, Bosnia and Herzegovina, Moldova, Montenegro, North Macedonia, Serbia, and Ukraine. In some cases, these failures resulted in systemic crises, as seen in Ukraine, Azerbaijan, and Moldova. The financial systems in these countries are typically bank-centric, with limited capital markets and insurance sectors. Most countries operate with a small number of banks, and there is a high level of foreign ownership, with state-owned banks holding significant market shares in some regions.

Significant Strides in Prudential Frameworks

Over the past decade, FinSAC countries have made significant strides in upgrading their prudential frameworks. These reforms include enhanced standards on capital adequacy, liquidity and funding, credit risk classification, and corporate governance. Banks have improved their financial health, with NPL ratios on a consistent downward trend and improved profitability. Both banks and authorities have stepped up contingency planning for crises, with banks preparing regular recovery plans and resolution authorities defining strategies to deal with non-viable banks.

Challenges in Recovery Planning

However, specific challenges remain. Local capital markets are often shallow, limiting options for bond or share issuance, and the financial capacity of shareholders is crucial as recovery plans require their commitment. The recovery prospects for banks integrated into foreign banking groups depend significantly on the support from parent companies. Authorities must carefully calibrate how foreign parent companies may act in case of problems with their subsidiaries. While local subsidiaries have become more self-sufficient, recent history shows that parent banks typically support their subsidiaries. Most FinSAC client countries have updated their frameworks to manage the failure of non-viable banks, adopting the Financial Stability Board's Key Attributes and the EU's Bank Recovery and Resolution Directive. These countries have established independent resolution authorities with broad powers to implement both closed and open bank resolutions.

Testing New Frameworks

The new frameworks were put to the test with the failure of Sberbank Europe's subsidiaries in Bosnia and Herzegovina and Serbia in early 2022. International sanctions led to a liquidity crisis, prompting swift resolution actions that transferred the subsidiaries' shares to other banks, averting financial instability. In managing systemic banking crises, authorities must be prepared to take exceptional actions. Comprehensive assessments like asset quality reviews and viability exercises are essential to estimate losses and systemwide capital needs. Resolution authorities face challenges such as finding suitable buyers in stressed conditions and managing liquidity. Mechanisms like bridge banks can be useful when there is insufficient time to arrange transfers, although setting up such banks requires careful planning.

Open Bank Resolutions and Future Preparedness

Open bank resolutions using bail-in powers are still limited in the region, and few banks have the necessary liability structures to support these measures. Public support might be necessary in some scenarios, despite the aim to minimize taxpayer involvement. Effective management of asset quality and ensuring funding availability are crucial during crises. Cross-border coordination and cooperation are also vital, given the systemic importance of local subsidiaries within larger banking groups. The ongoing financial sector reforms in FinSAC countries reflect a commitment to preventing future banking crises and ensuring the stability and resilience of the financial system. By continuing to enhance regulatory frameworks, improve asset quality, and strengthen contingency planning, these countries are better equipped to manage and mitigate the impacts of potential banking failures. The collaborative efforts of FinSAC, the World Bank, and the Austrian Government provide a robust foundation for these improvements, offering technical expertise and support to help these countries navigate the complexities of financial sector reform. The journey towards a more resilient banking sector is ongoing, and continuous adaptation and improvement are necessary to address the evolving challenges and risks in the global financial landscape.