Wait: What About Europe's Other Banking Crisis?!

10/18/2013 06:10 pm ET | Updated Jan 23, 2014

The European Banking crisis is old news. False. The Western European Banking crisis is old news. The crisis in "the banks of Europe" has not been fully covered. Last Thursday, the Institute of International Finance (IIF) produced a report highlighting the sharp contrast in borrowing rates for SME's in peripheral Europe compared to those in countries like Germany. Shortly after, the Financial Times pointed to the crippling effects this could have on the economy. Today, I make a plea for shifting the focus before we determine the course of action. It would be a mistake to perceive this as an isolated event. Understanding the dislocated interdependence between the banks in the core and the periphery of Europe is vital to resolving the issue. The relationship they crafted is a tale of naiveté: overemphasizing opportunities and underappreciating risks.

Under Communism, Eastern Europe had its own banks. These were traditionally large state banks and a few specialized banks. There was no incentive to conduct proper risk management and the banks were left to cope with a lot of bad loans as a result. Cleaning up banks' balance sheets after the fall of communism was a tricky problem. While their post-Soviet economies needed new businesses, their banks often did not have sufficient funds to generate the necessary loans.

Meanwhile on the other side of Europe, European integration had reshaped the banking landscape of Western Europe. The integration of EC markets led to a massive increase in non-domestic claims as banks were now also able to set up branches in other parts of the union. From 1999 on, the lion's share of the member states' liabilities originated outside their borders. Further, the legal requirement for the functional separation of banks was omitted. Both of these European banking directives led to an entirely new concept of banking in the West. Banks were not only altered in size and regional scope, they were also broadened functionally.

As a consequence of this fairly radical deregulation, western banks generated an incredible flow of funds. These funds needed to be invested somewhere but Western Europe did not offer very interesting projects. The new Eastern banking market did, and had a need for a capital that it could not generate on its own. Supply and demand successfully met and so Western European banking deregulation created the opportunity to fund the transition of post-communist Eastern European banking sectors.

A new banking model emerged. The financial sector in Eastern Europe became ever more detached from state intervention and boomed with the inflow of Western credit. Western banks opened branches in the East which fed local economic growth. Eastern subsidiaries were largely the result of large scale mergers and acquisitions rather than gradual emergence of a banking sector, as had been the case for their Western counterparts. Neighboring Western countries such as Austria were the first to acquire foreign assets from Central and Eastern Europe. Soon Italian, Belgian and French banks also held large shares.

There was reason to celebrate. Banking in Eastern Europe developed exponentially. Local banks are benefiting from the same favorable market conditions, but they often have a better knowledge of their still relatively immature markets. Poland is the prime example of East European countries that meanwhile have sufficient funds and a flourishing economy to fall back on so that their lending machine is not dependent on the presence of foreign banks. Their debt levels have decreased and their labor markets remain more flexible than they are in the West. Successful regional banks have even started to expand across borders.

The prospect of Eastern cross-country banks' expansions must have been ominously familiar for the West where this risky model led to banking collapses and near-collapses in 2008, but the mix in the East was even more interesting. Besides the cross-border banking component, the entire existence of banking in the East was reliant on funding from the West. The dream of a 'Polish road to financial independence' soon vaporized for many countries in Eastern Europe as the side effect of the Western sovereign debt crisis.

Western parent banks were struggling to clean up their balance sheets, which required them to fix their eroding basis structure during ongoing calls for recapitalization, at the expense of their foreign commitments. The direct result was a clear reversal of Western banks' medium and long term objectives in Central- and Eastern Europe. The regions' rising share of non-performing loans could potentially create an additional threat to their already fragile West-European home bases.

So far a total credit crunch has been avoided. Under the non-binding Vienna initiative, Western European banks promised to refrain from excessive de-leveraging in their central European subsidiaries. Although this commitment managed to stop some of the bleeding, such decisions are decreasingly under the control of the banks themselves. Belgian bank KBC, for instance, was forced to cut back on their commitments in its Eastern 'second home market' after receiving an EU rescue package.

Only Poland, perhaps, could shrug off the withdrawal of Western funds. Meanwhile, investors are getting anxious in less politically stable countries like Hungary. The Economist reports an exodus of the country's only hope of recovery, as almost half of young Hungarians plan to emigrate. Hungary's foreign debt is now woven into the Western banks' balance sheets, although Hungary is situated outside of the Eurozone. Meanwhile Hungary is still standing in the rain next to the EMU umbrella that is still trying to shelter Greece.

Attempts to resolve either side of the problem should highlight this interdependence. While the air is being squeezed out of the lungs of the East, the already-patched-up Western economy takes another punch to its vital organs. Crippled Europe could now, really, crack down.