Fitch Ratings-London-28 May 2012: Fitch Ratings says is a newly-published special report on bank funding risks in Central Eastern Europe, that developments in the euro zone are driving a re-examination of foreign parent banks' policy towards their subsidiaries in CEE. However, the agency believes that this re-positioning heralds a retrenchment rather than any wholesale reversal of foreign parent banks' commitment to the region.

Fitch recognises that the risk of 'home bias' - where parent banks choose retrenchment overseas rather than downsizing their domestic balance sheets - is rising. However, the growth in deposit volume throughout 2011 suggests that part of the decline in cross-border funding has been mitigated by domestic financing sources. Furthermore, although parent banks in some of the more troubled eurozone member states have sold assets in CEE, other banks in the core eurozone have instead injected new capital into CEE subsidiaries.

"The eurozone crisis has moved the banking model in Central and Eastern European countries into a transition phase, with domestic subsidiaries having to fund new lending through deposits rather than relying on foreign parent banks' funding" says Michele Napolitano, Associate Director in Fitch's Sovereign team.

Foreign ownership of local banks has been a rating strength in CEE. Foreign parent banks stood by their subsidiaries through the height of the global financial crisis in 2008-09, providing funding and maintaining exposures. However, given the systemic importance of eurozone banks' subsidiaries in CEE and the funding risks faced by parent banks, Fitch says contagion effects from further turbulence in the eurozone could present a significant tail risk for CEE.

Fitch believes that the biggest risk arising from a deepening in the eurozone crisis could be a reduction in funding availability for CEE subsidiaries, which could force them to become increasingly self-sufficient. Although eurozone banks' subsidiaries would be able sustain some reduction in funding, they could be forced to cut credit provision and shrink their balance sheets further, with adverse effects on CEE growth.

Fitch's analysis suggests that lending from eurozone headquartered banks to countries in the CEE region declined in H211 as macroeconomic rebalancing and deleveraging constrained the demand for credit. However, the size and pace of deleveraging have been limited for the most part. Moreover, deposit growth appears to have mitigated the decline in cross-border funding, highlighting the growing importance of domestic financing sources.

A key issue for the future will be the potential for deposit growth. Most countries in CEE already have a significant deposit base relative to GDP, while demographics and tight immigration policies across the region point to limited potential in future deposit growth. As a result, the impact of external deleveraging on credit growth may become more severe in 2013-14, although the impact will vary across the region depending on loan to deposit ratios.

Fitch notes that in contrast to 2008-09, when host CEE countries faced external financing challenges, this time the shock emanates from parent banks that are facing dual pressures from home regulators and unreceptive financial markets. Viewed against this background, the compulsion to maintain a strong overseas presence has diminished and attempts to slow this process may be less susceptible to a renewed Vienna Initiative.

The Vienna Initiative 2, adopted in March 2012, does not change Fitch's base case expectation that CEE will continue to experience weak, or marginally negative, credit growth in the near future. However, the new initiative (if properly implemented) might reduce the risk of a more negative downside that would result from a disorderly regional deleveraging along with aggressive repatriation of parent bank funding and capital.