By Ajai Chopra

Europe’s economic and financial integration has been a tremendous success, but the region is now under great stress. As the global economic crisis has shown, the flipside of Europe’s successful integration has been a synchronized economic downturn and complex financial spillovers between countries.

For those of us involved in providing financing and policy advice to emerging Europe, it quickly became apparent that the official sector would be more effective if it managed to secure the cooperation of private western banks operating in emerging market countries in central, eastern, and southern Europe (CESE).

During the past decade, western banks played an important role in developing the financial sector in emerging Europe, through ownership of banks and through direct cross-border lending to financial institutions and firms. But over time, CESE countries accumulated high levels of debt to western banks. Although these banks have a declared long-term interest in the region, they came under intense pressure to deleverage when the global financial crisis struck because of the weak financial conditions in both home and host countries and the diminishing appetite for risk at the global level. Uncertainty about other banks’ strategies further exacerbated the pressure on individual banks to scale back lending to the region.

Europe’s economic and financial integration has been a tremendous success, but the region is now under great stress (photo: Dimitar Dilkoff/AFP/Getty Images)

Europe’s economic and financial integration has been a tremendous success, but the region is now under great stress (photo: Dimitar Dilkoff/AFP/Getty Images)

These conditions could have given rise to a classic collective action problem where uncertainty about other players’ actions trigger responses at the individual level that lead to inferior outcomes and higher collective costs. Had a sudden retrenchment occurred, the capital outflows from emerging Europe would have undermined financial institutions and the already fragile balance of payments position in many of these countries. The continued support from private banks to the region was therefore critical.

That’s why the IMF and other multilateral and regional organizations took the initiative to facilitate the collective action that was needed to foster financial sector stability in CESE countries and reduce the likelihood of a “sudden stop” in capital flows.

So how has it worked in practice?

Typically, there has been a forum for direct engagement with international banks operating in a specific country. The aim is to secure parent banks’ continued support, including through commitments regarding their future rollover and recapitalization efforts. The forum also provides an opportunity to inform participants of regulatory and supervisory actions by home and host supervisors.

Meetings on specific countries bring together representatives from banks operating in the region, home and host officials (supervisors, central banks, and treasury officials), multilateral institutions—either a subgroup or all of the following depending on circumstances: the IMF, the European Commission, the European Central Bank, the European Bank for Reconstruction and Development, the World Bank, the International Finance Corporation, the European Investment Bank, and the Committee of European Bank Supervisors—and other stakeholders as deemed necessary. Meetings on EU countries have been jointly chaired by the European Commission and the IMF; for countries outside the EU, the meetings have been chaired by the IMF. 

In the context of IMF-supported loan programs, country meetings have been held for Bosnia, Hungary, Romania, and Serbia. These meetings have aimed to secure commitments from banks to maintain exposure to these countries and provide capital support to their subsidiaries as needed. As such, they have provided an avenue for voluntary involvement of the private sector in IMF-supported programs. (A recent paper on the analytic basis for Fund lending has an interesting discussion on private sector involvement in Box 3.) Apart from country-specific meetings, discussions among relevant stakeholders have led to deeper understanding of the problems, the policy actions taken, and the international dimensions of individual strategies.

But we are not yet out of the woods. Although the country-specific meetings have helped keep the private sector engaged, there is a risk that containing deleveraging in some countries will come at the expense of other countries. Parent banks have said they worry that overly rigid country-level commitments could complicate their regional and global strategies. For example, consistent with their long-term commitment to the region, parent banks have noted that the viability of their investments would benefit if capital could shift between CESE countries.

 These concerns are valid and underscore that any bank coordination process needs to be dynamic so that it can adapt to underlying economic conditions. That’s why it will be important for all stakeholders to take stock and discuss ways to bring a stronger regional perspective to bank coordination efforts and deal innovatively with new challenges as they arise.

The global economic crisis has demonstrated just how interconnected the world has become. Regionally coordinated policy solutions have become essential to help strengthen confidence and secure better outcomes, raising the bar for all actors involved.