By Anoop Singh

European banks play an important role in supplying credit to several Asian economies. What happens if they start reducing their exposure to the region?

The largest borrowers from European banks are Australia, Hong Kong SAR, Korea, Malaysia, New Zealand, Singapore, and Taiwan Province of China, while China, India, and the economies of South East Asia generally have smaller liabilities.

Among European banks, those from the United Kingdom have a particularly significant presence in Asia. For most regional economies, the nonbank private sector—businesses and households—is the main recipient of credit from foreign banks as a whole.

Prominent role

European banks play a prominent role in the areas of trade credit and specialized project financing. In several Asian economies, however, lending by local subsidiaries and branches is funded primarily by local deposits, reducing potential deleveraging pressures.

In Australia, Hong Kong SAR, Korea, New Zealand, Singapore, and Taiwan Province of China, the domestic banking sectors are relatively more reliant on European banks for wholesale funding, increasing their vulnerability to deleveraging through the financial system.

It appears that European banks have already started deleveraging from Asia. So far this has been a gradual process, partially offset by regional banks stepping in. But what would happen if the process gathered pace and became a disorderly rush for the exits?

Hints from the past

One way to shed light on this question is to examine what happened the last time around, in 2008, a year that encompassed both the Bear Stearns sale and the Lehman Brothers bankruptcy. We find that deleveraging by European banks during 2008 led to a large contraction in credit supply in destination countries. But while the credit contraction in Asian economies in response to the deleveraging was substantial, the size of the response was smaller—by about 50 percent—than that for a broad sample of countries.

What explains this smaller credit contraction in Asia?  We explore two possible explanations for a more muted transmission in Asia: a stronger policy response and healthier balance sheets in local Asian banking systems.

More vigorous response

The evidence suggests that the monetary—and to a lesser extent the fiscal—policy response in Asia was more vigorous than in other regions.

In addition, Asian countries also took a number of measures to maintain market confidence and stabilize financial markets. These included instituting liquidity guarantees, negotiating Federal Reserve swap lines, strengthening regional reserve pooling, expanding deposit insurance, and supporting trade finance and SME programs.

Lower debt to equity ratios

The second reason for the more subdued impact of foreign deleveraging could be that Asia’s local banking systems had healthier balance sheets entering the crisis.

This is supported by the fact that Asian financial firms had lower leverage ratios—the ratio of debt to equity—relative to global peers.

How Could Asia Handle a Future Shock?

Going forward, while the space for a macroeconomic policy response is smaller than it was entering the global financial crisis, Asia’s policymakers still have ample room to react appropriately to a sharp deleveraging of foreign banks arising from a euro area shock.

In addition, capital adequacy ratios, which exceed regulatory norms in most economies, and low nonperforming loan ratios, combined with room to offer liquidity support, suggest that relatively healthy local banking systems should also provide a buffer, as they did in the wake of the global financial crisis.