In Q2 2012, the withdrawal of funding by western banks from subsidiaries in Bulgaria continued, reaching about BGN 5 B, or 6,5-7% of GDP, in the period October 2011- July 2012.

In Hungary, Slovenia, and Croatia, the situation is even more serious, according to the CESEE Deleveraging Monitor.

This confirms a trend of parent banks tightening lending to their subsidiaries in the region, as a result of which local banks find it more expensive to rely on funding from their western owners, as well as a trend of decreased demand for loans from local businesses and citizens.

The conclusions are part of a survey carried out by the European Investment Bank (EIB) for the Vienna Initiative – a framework for coordinated crisis management between EU-based cross-border bank groups in emerging Europe.

The European Bank for Reconstruction and Development (ERBRD), the EIB, the European Commission, the International Monetary Fund (IMF), and the World Bank had a key role in the preparation of the report.

The report is aimed at preventing a shock withdrawal of funding by western banks from central, eastern, and southeastern Europe (CESEE), which would leave local bank systems with insufficient resources.

The EIB report notes that the withdrawal of funding by western banks from CESEE continued at a moderate pace in the second quarter of 2012—somewhat higher than in the first quarter but much lower than the worrisome levels seen in the second half of 2011.

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Nonetheless, the cumulative funding withdrawal from the region excluding Russia and Turkey since mid-2011 has been a material 4%of GDP, with several countries hit significantly harder.

In Q2, 2012, the external position of BIS-reporting banks fell by a

moderate 0.8% of GDP vis-?-vis CESEE excluding Russia and Turkey.

At the same time, credit growth has ground to a halt.

Sharply deteriorating financial market conditions from mid-2011 made funding of western parent banks for their CESEE subsidiaries more expensive. Deleveraging resumed when western banks themselves came under intense funding pressure.

Their CDS spreads rose sharply, as did those of CESEE sovereigns. The scarcity of funding might not only have prompted western banks to recall funding from CESEE, it also made parent bank funding for their CESEE subsidiaries much more expensive.

Intergroup funding is typically priced at the cost of funding of the parent plus the CDS spread of the sovereign where the subsidiary is located. With both elements sharply up, subsidiaries ended up strongly incentivized to pay down debt owed to parents.

Between Q3, 2011 and Q2, 2012, in Bulgaria foreign funding in local banks fell by about 5% and the gains from deposits of Bulgarian natural and legal persons increased by around 6%.

The principal sources for banks to fund credit growth—domestic deposits and foreign banks—show a stable contribution from domestic deposits of about 3 percent of GDP in the twelve months to June as well as in the previous twelve-month period.

What changed was foreign bank funding, which went from making a small positive contribution to making a sizable negative contribution. In effect, funding gains from domestic deposits were fully offset by losses in foreign bank financing in the 12 months to June 2012. Overall funding remained essentially flat and so did private sector credit.

Weak CESEE credit growth could be driven by the withdrawal of funding by western banks or by feeble credit demand.

Demand factors certainly explain a good part of the weak CESEE credit growth, according to the report.

Nonetheless, supply factors should not be discounted.

Interest rate developments point to a strong role of demand factors in recent credit

weakness, while credit supply might well have tightened primarily through means other than price.

Meanwhile, a new survey of banks sheds additional light on the role of demand and supply conditions in credit growth, the domestic and international determinants influencing these conditions, and future deleveraging prospects as seen by banks.

According to the EIB's CESEE Bank Lending Survey, cross-border banking groups remain committed to CESEE in general, but they are becoming more selective in their strategies at the country level according to the survey.

All surveyed groups signal their continued commitment to their operations in the CESEE. However, they are clearly taking a more selective approach toward different local markets, in particular with a view to rebalancing toward a more self-sustained local banking model.

This implies a larger adjustment for those countries where market and local funding opportunities are relatively weak and reliance on parent-bank funding is currently relatively high.

Banks report that, in addition to subdued credit demand, domestic and international

supply-side factors are also responsible for sluggish credit growth at the moment.

Going forward, banks expect a pickup of credit demand, continued tight international

supply conditions, and somewhat easier access to domestic funding. On the demand side,

expectations are improving and progressively more subsidiaries expect some rebound in demand for credit across different products and maturities over the next six months.

On the supply side, continued tightness seems generally in store. However, the picture is far from homogeneous across banks. Most of those reporting a tightening over the past six months report a neutral stance for the outlook over the next six months. International factors will continue to contribute to credit standard tightening, as well as domestic features, like local regulation or local NPLs, whereas subsidiaries' access to domestic funding is expected to contribute positively.

Supply side constraints could thus become selectively more binding, depending on whether improvements in local funding conditions provide enough room to accommodate the prospective pickup of credit demand.

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