Corporate banking in Eastern Europe, like many other financial businesses, grew very rapidly over the past several years, far faster than it did in the more mature markets of Western Europe. As this growth continued, many expected that the ways these two regions conduct this business—lending to companies and providing them with cash management, treasury, foreign exchange, and other services—would become increasingly similar. As the Eastern European business grew, the argument ran, the level of service, quality of products, risk sophistication, and especially profit margins would parallel those that characterized corporate banking in France, Germany, and other established Western European markets.
But the credit crisis and ensuing market turmoil have exposed the error of that argument. Corporate banking in Eastern Europe is on a different path, one fraught with difficulties for the unwary and unprepared. The region’s currencies are plunging, and its economic outlook is gloomy. Analysts have expressed fears that the corporate sector in some Eastern European countries may well be on the verge of widespread default. The banks that serve these companies are also at risk. The crisis has brought into focus the substantial differences in corporate banking—size, stability, skills, and others—that persist between the East and West.
These enduring differences cannot be ignored as corporate bankers attempt to shepherd their clients through this crisis and position themselves for growth in the hoped-for recovery. Corporate bankers must realign their management agenda to take on five important, crisis-specific tasks: rethinking the way they lend, improving their risk- and loss-mitigation skills, expanding their range of products and services, adjusting their cost base to the new reality, and finally, putting in place a newly assertive style of account management.
The current crisis is comparable in scale to that of the early 1990s after the fall of Communism, with the notable difference that today, Eastern Europe’s troubles are part of a worldwide economic crisis. Few believe that it will be over soon; at this point, almost any kind of economic disaster seems plausible. But taking a long-term, optimistic view, we believe that Eastern Europe can again be an important source of growth in corporate banking, a region of significant strategic and economic value both to domestic banks and to the Western European banks that have invested there. We believe that the winners of the post-crisis phase are shaping their fates right now by diligently pursuing one of the few viable strategic options open to them. Those that have clear strategic aspirations, that are willing to challenge conventional wisdom about how corporate banking should be done, and that can align a rigorous crisis-response program behind their strategy will be best placed to benefit when market conditions improve.
The situation today
After several consecutive years of rapid development—as instanced by 20 percent or more annual revenue growth from 2000 to 2007—it seemed common wisdom that Eastern Europe was on a clear path toward matching Western European performance. Broadly speaking, analysts and bankers expected that the pursuit of growth would continue. Margins would decline as the flow of capital from Western European finance continued to expand. The cost of risk would eventually fall to levels more typical of those in Western European countries as Eastern European corporates became stronger, better capitalized enterprises. The range and sophistication of products that bankers in Moscow or Prague offered to their clients would soon look no different from those on offer in London or Paris.
With credit evaporating, it is abundantly clear that Eastern European banks are overexposed. Indeed, the situation is so dire for many that survival, not growth, is now the top priority. We see four ways that the crisis has upended conventional wisdom and altered the evolution of corporate banking in this part of the world.
Scarce capital, narrowing margins
The era of cheap money is over, and funding costs are rising. Broadly speaking, the economic boom in many Eastern European countries has been supported by the influx of foreign capital through lending or investment. Both these sources of capital have evaporated, and where capital can be found, it comes at a much higher cost.
Over the short term, this will reduce margins. Over the longer term, however, a reemphasis on careful pricing, brought about by a higher cost of capital and liquidity, will actually help reinflate margins. We expect that banks will successfully pass on to customers their higher cost of funds; margins correlate well with funding costs (Exhibit 1). Banks’ ability to do this will only be enhanced by a lower level of competition if, as many expect, some banks withdraw from selected markets in the next year or two. Higher margins are of course an opportunity for corporate banks—but not many banks have the skills and tools to capture it.
Generally speaking, the higher the cost of lending, the higher the margin the bank receives.
Growth in Eastern Europe has come mainly through a reactive kind of banking, in which customers ask and banks lend. With credit shriveling, an overreliance on asset products is a clear problem and will not be enough to steer corporate portfolios successfully through the crisis. One stark difference between Western and Eastern European corporate banking is seen in revenues per client (Exhibit 2).
Eastern European companies generate less revenue and smaller profits than those in Western Europe.
In our view, this difference stems from the fact that at many Eastern European banks, relationship managers (RMs) and managers believe that client demand is limited to simple lending products. As a consequence, structured reviews of corporate accounts are uncommon, and clients’ transaction and capital markets businesses are often not managed actively. Eastern European banks are missing out on a significant portion of their clients’ potential spending on these services. The narrow product focus and limited cross-selling exacerbates the structural difference between banks in the two regions (companies in Eastern Europe are smaller than their counterparts in Western Europe).
Still emerging markets, after all
After a period of strong economic growth, Eastern European economies appeared to achieve the kind of economic stability that is more characteristic of their Western neighbors. Alas, the crisis has shown that Eastern European economies remain vulnerable and much more exposed to external shocks than Western European economies are, as seen in the recent spike in credit-default-swap (CDS) rates and in currency volatility (Exhibit 3). Companies (and households) that earn their income in local (and now weaker) currencies may not be able to repay loans taken out in foreign currencies. These loans will also be very difficult to roll over, hurting borrowers as well as the balance sheets and profits of banks.
Investors have grown worried about the health of Eastern European economies.
In light of this, banks will need to be much more circumspect in extending credit to some companies and sectors, and all concerned will need to manage their currency exposure much more carefully. But prudent risk management will only take banks so far. Many expect corporate default rates to soar.
Only the biggest Eastern European companies are sophisticated users of capital markets products (sales and trading products such as interest rate, foreign exchange, and commodity derivatives and investment banking services such as debt and equity securitization and M&A advice). Usage of these products lags behind that in Western Europe (Exhibit 4). In some cases, such as at certain Polish banks, risk-hedging products have been used poorly, with some companies appearing to use foreign-exchange products in a speculative manner aimed at augmenting their underlying businesses rather than hedging their exposure.
Eastern European companies trail their counterparts in the West in the use of sophisticated products.
Worse, in the wake of the crisis, even those big customers that have taken up these products have cut back tremendously on their use. Midsize corporates could benefit from these products, especially as hedges, but many companies have an inadequate understanding of their customers’ needs and the products available. Corporate banks are not ready to step into the breach; few have the kind of advisory model that might help guide customers to these relatively simple hedging products. Corporate customers everywhere can benefit from hedging their interest-rate risk; many, especially those outside the eurozone, can also benefit from some standard foreign-exchange products (typically spot trading, forwards, and foreign-currency lending, often in combination).
The new management agenda
The sense of stability and prosperity that was so evident in Budapest, Warsaw, and Bucharest has turned out to be evanescent. But similarly, the current dire business climate in Eastern European markets is unlikely to be permanent. The situation remains fluid; banks’ clients urgently require guidance to anticipate and take advantage of changes in this dynamic environment. Corporate banks should consider five focused initiatives to respond to the exigencies of the crisis (Exhibit 5).
The new management agenda
With capital scarce and lending hazardous, Eastern European banks will need to improve both the efficiency of their risk-weighted assets (RWAs), especially loans, and of their pricing. Moving to a lean capital business model (including such steps as expanding into better collateralized, RWA-efficient products such as factoring) will help ensure that banks are fully exploiting the power of their balance sheets. Incentives for lending should measure contribution after risk costs, rather than volume. Shifting incentives for frontline bankers from lending products to deposits and fee-generating products will help avoid lending for lending’s sake.
To reflect the higher cost of funding and the risk their clients face, banks must adopt a new pricing discipline, both for new business and as they renew or extend credits to top-tier clients. Many have already begun efforts to improve pricing but are stumbling because they lack capabilities. Specifically, they need flexible internal transfer-pricing mechanisms to react quickly to market changes in funding costs. They will need the ability to calculate, in real time, a target credit margin for each customer, taking into account the up-to-the-minute cost of financing, the client’s business climate (its size, macroeconomic conditions prevalent in its geography and industry, and so on), and its risk exposure.
Also crucial is a set of reference prices to set expectations for the target credit margin on loans and for other products and services. If the reference prices are to have meaning, then banks will also need a strict discounting policy that includes a clear statement of decision-making authority.
Finally, RMs will need a pricing tool that provides them with a full understanding of the profitability achieved with each client. Standardized templates in the tool will help them document their agreements. A clear set of pricing key performance indicators (for example, average level of discounts expressed as a percentage of base price; average return on equity) will guide their pricing discussions and credit proposals, helping them to monitor customer profitability. Regular reports from the tool will help banks track margin developments.
Improve restructuring and risk-mitigation skills
To no one’s surprise, Eastern European banks—like those in virtually every part of the globe—have seen their risk management strategies come up short. In Eastern Europe, the problems are, if anything, worse. Not since the fall of Communism—a time when many of today’s bankers were still in school—has the region seen such complex problems, requiring skilled use of early- and late-stage credit workout and loan-loss mitigation.
Many banks are unprepared; their workout groups consist mainly of lawyers that can dispose of corporate remains. Those lawyers may yet be needed. But before that, banks must work quickly to develop the skills and programs needed to do 50 or 100 workouts a year in some segments, instead of the customary 3 or 4.
Banks should focus on early detection and turnaround skills to help customers through the down cycle. For example, they should introduce early-warning indicators, such as unusually large draws on credit lines or big customers closing their accounts, and respond appropriately when these alarms go off. They should conduct crash programs—focused efforts to improve an entire portfolio of loans through intensive workout and recovery—and in some cases a division of assets between a “good” and “bad” bank to avoid contagion. And they should improve collection capabilities.
Apart from these initiatives, many banks will benefit from a clear separation between the risk office and the frontline sellers to avoid conflicts between risk and business interests. The establishment and timely involvement of an intensive-care task force is essential for the bank to react effectively to changes in different risk exposures. Clear guidelines for foreign-currency lending are required to control borrowers’ exchange-rate risks.
At most banks, credit processes are still cumbersome and lengthy, and they unduly use critical risk resources. Although throughput time has become less of a priority in the crisis, most banks can still benefit from optimizing the use of risk resources to provide better-quality risk decisions. Introducing a semistandardized credit decision-making tool kit (especially for midmarket customers), which enables shorter throughput times and higher cost efficiency, can pay off.
Capture hedging potential
As noted, the opportunity to serve Eastern European companies on their hedging needs is substantial. Exchange rates are volatile, putting many companies in need of simple foreign-exchange products and, in some cases, of a more sophisticated combination of hedges and foreign-currency lending. To capture these opportunities, banks can consider two intiatives. First, they can divide their trading desks into two groups, one responsible for simple and the other complex transactions. One team can assist customers with daily transactions—typically, foreign-exchange spot and forward trades, and also government bonds and other products. This customer desk should have a clear mandate to increase the bank’s share of customers’ business. A second, usually smaller trading desk can manage the more sophisticated and structured products.
Second, banks can assign customers to customer-desk traders and product specialists, and encourage them to collaborate with RMs in serving customers. RMs know their customers’ needs for capital markets products. And dealers and product specialists, through this “secondary portfolio,” can supply their execution expertise and specialized knowledge to ensure that clients receive the best the bank has to offer.
Adjust to the new reality
A generation of Eastern European bankers has grown up in a prolonged economic boom, building sales teams and processing centers in one city after another in a rush to keep up with demand. It will not be simple to change that mind-set, or to start dismantling the work of a lifetime. Nonetheless, change they must. Banks must adjust their cost base, especially staffing, to the lower level of business activity.
This adjustment should take several forms. Banks are used to plying talented RMs with more money to lure them from the competition. That game is changing. Obviously, talent is in greater supply than before, shifting the advantage to banks. Benchmarks from banks in more mature economies can help determine the right level of staffing. But demand is falling faster for generalists than for certain specialists. Well-trained risk managers and others with special skills may indeed continue to name their price.
Banks with a presence in several countries will have to think hard about ways to develop skilled people—perhaps in a centralized training program—who can then be distributed across the network to the places where they are most needed. These banks must also consider ways to speed knowledge around their network so that even at the height of the crisis, bankers can learn from their colleagues’ experience.
Finally, to retain these bankers and attract others, banks will need to reinforce performance-based incentive systems. Banks that cut costs not simply arbitrarily but rather as a result of a thoughtful talent strategy will build the muscle needed now and over the coming few years.
Get assertive on account management
To execute all the changes described above, banks need to place a new emphasis on active account management. Corporate bankers must cease to think of themselves as simple lenders and instead seek to know their customers and deliver the products and services that meet their needs. Lending will not disappear, of course; it will persist, especially if banks improve the way they do it, but other products and services are just as important. Active account management can be the agency through which banks derive the benefits of improved lending, stronger risk management, better trained staff, and a suite of products that meet client needs.
As a first step, banks will have to be much more selective about their lending clients, as deleveraging will force banks to reduce their total exposure. We have found that a simplified segmentation approach, based on objective measures, is helpful to the front line in clarifying the bank’s objectives:
Core clients. These are customers with whom the bank enjoys a “house bank” status; they are typically served with a full range of products, including loans, of course, as well as transaction, deposit, and capital markets products. For this client group, the bank’s strategy should be both to raise prices sufficiently to cover increased funding costs and, more important, to demonstrate commitment and support through the crisis—for example, by renewing credit lines whenever possible. By making commitments now, banks can retain these core customers after the crisis has passed.
Restructuring cases. These are companies that have already been affected by the crisis or continue to have significant exposure to it. Intensive care can limit credit losses and can even help turn around some customers. These may well prove to be long-term clients that will be fiercely loyal to the bank that stood by them during difficult times.
RWA-inefficient borrowers. This group consists of companies that take advantage of the bank: they typically use only lending products and turn to competitors for transactions, cash management, and other products. These opportunistic customers are not profitable for the bank, and worse, they use up scarce funding. This group should be cautiously served; current exposures should be reduced where possible—for example, by not renewing credit lines—and new loans should be priced assertively to reflect true capital costs.
With the customer base reduced, banks can then deploy a proactive account-management approach. RMs should review accounts at least twice a year against a set of criteria, including client profitability, RWA consumption, product usage, and hidden opportunities for cross-selling products other than loans. At many Eastern European banks, this will require a substantial cultural shift (in itself no trivial matter, and a topic worthy of substantial discussion beyond the scope of this article).
Further, the successful introduction of proactive account planning will require two investments. First, banks will require greater customer transparency to provide concise and comprehensive information to RMs. This could include a detailed analysis of all of a customer’s transactions with the bank to reveal cross-selling opportunities. Managers, too, will need regular reports if they are to monitor progress against account plans and coverage models.
Second, banks must establish capabilities to cross-sell products more effectively, especially without further extension of credit. To boost deposits, banks should devise cross-selling campaigns, develop customized “sticky” products, and adjust incentives to promote deposit gathering. For more complex products, such as capital markets hedging, cash management, factoring, leasing, and government-subsidized lending, banks should develop training to upgrade the sales skills of RMs, upgrade coverage teams, and establish dedicated sales teams of product experts.
Constrained by the crisis
So far, we have discussed the broad effects of the crisis on the entire region. But not all countries have been affected the same way; some will likely fare better than others (see sidebar, “The uneven effects of the crisis”). It is fair to say, though, that in every country, the crisis has diminished the attractiveness of corporate banking and that in most, the business will take some time to recover.
Given this state, many banks are reconsidering their high-level strategies. Those with a presence in several countries have a few options. They can choose, for instance, to lessen their exposure in a given country (by reducing or even freezing RWA limits there, for example, gradually reducing the country’s weight in the portfolio). But banks must be careful, as reducing lending in a country could contribute to a higher default rate. Banks might also concentrate resources in their larger operations through asset swaps with their smaller entities. Such a consolidation makes sense, given that after the crisis many banks in Eastern Europe may find themselves subscale, even relatively.
Banks with particularly troubled franchises have, we believe, only one good option. Liquidating positions is too costly, as buyers are scarce at the prices that banks deem appropriate. Moreover, potential buyers do not have the funding resources needed to operate these entities. For some banks in high-risk countries, running down the bank appears to be an option, but this, too, could be costly and time consuming, entailing significant write-offs. We believe that for many banks, the option value associated with continuing operations—and with the adoption of an agenda like the one we have outlined above—is higher than any of the alternatives.
Given these constraints, strategic choices in many markets are limited to shifting resources between businesses (such as between retail and corporate banking) or between customer segments or products (between large corporates and small and medium enterprises, for example, or between leasing and lending). One consideration in the retail versus corporate decision is that corporate customers are much more difficult to re-sign after they have left; their memory of good (and bad) treatment lasts much longer than that of retail customers. Further, the retail business will be easier to accelerate once bankers can safely say that the crisis has passed.
We have referred several times to the passing of the crisis. But that moment will not be reached without at least some restructuring of the market. The nature and extent of that restructuring will depend most obviously on the duration of the crisis. If recovery comes soon, the industry structure in many places will stay the same. If, however, the crisis is deep and long, regional corporate-banking networks will have to restructure significantly, and some consolidation is likely. A second factor is the vulnerability of many national economies. Even in the most affected countries, many banks believe they can weather the crisis. But should further shocks come—currency devaluations, corporate defaults—experience suggests that the financial impact could be rapid and severe. Finally, the strategies of foreign global banks will also affect restructuring. For many of these banks, their Eastern European group is a small part of their portfolio. Nonetheless, decisions made at headquarters may have big effects on Eastern Europe. We maintain that because of its long-term prospects and the short-term constraints, the region is unlikely to see a mass exodus.