Wide Angle Shot: CEE Banks Riding through turning cycles & geopolitics

We are in for a record-year in CEE banking, the Return on Equity (RoE) across all markets may surpass the 20% level. Such profitability readings had been last seen 2005/06. We must admit that the performance will exceed our most positive expectations, notwithstanding the multitude of challenges, be it geopolitical instability, external shocks or rates/FX market volatility. However, aggregated earnings for the whole region include special effects in very Eastern markets (Russia & Ukraine) that make such a comparison obsolete and not commercially comparable nowadays. To clarify: the RoE in the EE region is seen at 30% in 2023 compared to more moderate RoE readings of 16-19% in CE/SEE. That said, banks active in CE/SEE could enjoy an extended momentum to their profitability, stemming from wider net interest margins (NIM) and (still) contained risk costs. However, the slow burning stagflation recession, which did not develop into a shock, seems to be manageable for banks - although some credit risks may still materialize at a later stage. Solid results can certainly be attributed in part to the supportive rates environment. Nevertheless, they also reflect optimization and efficiency efforts of recent years, which are now providing a tailwind.

To certain extent, the boost to core banking revenues is a systemic factor in the global high-rate environment. However, CE/SEE markets have had an edge over the euro area where the average RoE picked up to a lower 10%. The relative outperformance of CE/SEE banking markets vis-à-vis euro area banking exceeds long-term averages and currently stands at 6-7 percentage points. More strikingly, for the first time since 2005 we are recording double-digit RoE readings in all major (12) CE/SEE banking sectors we cover. We have never seen such broad-based and solid profitability. Even during the “CEE bonanza times” pre-GFC (2005-2006) “only” 10 out of 12 regional banking sectors posted a double-digit RoE. On an interesting note, for the first time over the last decades SEE banking sectors are slightly outperforming CE (or CE-3 markets) in terms of profitability (average regional RoE of close to 19% in SEE vs 16 % in CE). This is positive news, although one has to ask the question whether SEE profitability must not be well above CE levels due to (geo-political) risk considerations and mostly subscale market sizes.

As of 2024 CE/SEE banking assets are approaching EUR 2,000 bn. Previously such readings had been only possible with the inclusion of the sizeable Russian market into regional business strategies (incl. Russia CEE banking assets currently stands at EUR 3,600 bn). Therefore, we see CE/SEE profit pools as sufficient to remain an attractive niche for dedicated cross-border CEE players, i.e. current results are especially remarkable when converted to “cash” terms. As of 2023 the CE/SEE profit pool has approached EUR 19-20 bn, the highest score in the last decade. Czechia remains the profit engine (~25% of CE/SEE profit pool), but Poland and Hungary have been closing in (18% & 13%, respectively). Record banking profitability has aroused the politicians' thirst - which is not just a phenomenon in CE/SEE. The practice of windfall taxes is embracing more CEE jurisdictions, with Ukraine, Romania, Slovenia and Slovakia to follow in the footsteps of Hungary and Czechia where such levies were introduced in 2022. Special taxation co-exists with policy support measures for borrowers (loan moratoria, interest rate caps), which by and large see a rollover into 2024, albeit possibly in a refined format. Currently such measures are in place in Poland, Hungary, Bosnia and Serbia. For banks the measures typically lead to negative adjustments to net interest income, while the latter is also sapped by central banks’ tweaks to remuneration of minimum reserves made in the course of 2023 (in Czechia, the euro area, a new tiering system in Hungary).

Nevertheless, generated core banking income proved strong enough to compensate for additional bank taxation, inflationary pressures on operating costs and transformation of the funding side toward a more expensive mix (growing share term deposits, costly MREL borrowings).

In the Eastern European (EE) banking sectors, we are in for a discomposing record. In war times the RoE is likely to reach an amazing record high of 27% in 2023, higher than in the period 2005/06. Record profitability in EE comes on the back of a solid profit rebound in Russia – despite some fundamental concerns about its durability within a policy-assited lending cycle. More than solid local banking market trends show that extensive Western sanctions cannot put Russia into substantial macro-financial calamities short and medium term. Moreover, record earnings in the war-driven interest and FX environment (plus massive macro-financial assistance) are supporting the banking sector profitability in Ukraine, where the RoE may exceed the 50% level in 2023. This makes the Ukrainian banking sector the "earnings pearl" in CEE banking this year in unfortunate circumstances.

It almost goes without saying that regional business activities of Western banks in CEE shifted further towards CE/SEE markets in 2023. This group of countries now accounts for almost 94% (!) of balance sheet totals of Western banks in CEE. This is an all-time high in the long-term observation and since we have been observing CEE banking trends. The shift in the relative weighting in favor of CE/SEE is of course related to geopolitics. From 2003/04 onwards (i.e. after expansion of Western banks into the "new" East of EU), regional CEE exposures of Western banks shifted in favor of "more juicy" business in Eastern Europe (EE: Russia, Ukraine, Belarus) plus SEE markets. This trend continued up until 2013/2014 (Crimea Annexation). Since then, the trend has reversed again, with CE/SEE expansion taking place as brisk as it did in the early 2000s. Moreover, the exposure of Western banks in CE/SEE is increasingly concentrated in EU markets. This is a function of EU enlargement and a deliberate focus. Currently, or almost constantly since Croatia joined the EU, Western banks have almost 96% of their CE/SEE exposures in EU countries, compared with only 88% in 2004. Indirectly, these figures also confirm the "value" of EU membership in terms of anchoring banking and investor confidence. For the CE/SEE region as a whole, the positive developments of recent years mean that total exposure of Western banks to the region has exceeded the record level of before the GFC (local exposure plus cross-border business).

Overall, the geopolitically driven reorientation of Western banks' business strategies in CEE in recent years has led to a noticeable increase in business activity in Central Europe (CE). This region now accounts for well over 70% of regional bank exposures, the highest ratio since 2002 and even higher than 2022. However, a differentiated view is also necessary here. Over the last 10 years, there are "only" 3 CE/SEE markets with a higher share of Western banks' regional exposures than back then, namely Czechia, Hungary and Slovakia. The long-term winners in regional banking are therefore the CE-3 markets. There has been no clear exposure expansion trend towards Southeastern Europe (SEE) in recent years; i.e. SEE exposures of Western banks have remained constant at 20% of the total exposure of Western banks in CEE for long. The current market consolidation in Romania plus the increased attractiveness of the Croatian market could inject a little more dynamism here. Especially as the SEE banking markets even offer slightly higher earnings prospects than the CE markets for the first time in 2023. However, the development in the Western Balkans is rather disappointing, where the exposure share of Western banks continues to stagnate below 4% (of total CEE exposures). In light of the aforementioned current developments, we see a certain potential in SEE banking, as the strong focus on the CE markets naturally limits their earnings potential (not to mention the rather less prominent role of Western banks in Poland and Hungary). In the medium term, however, the Polish banking market could become more attractive again for foreign banks - including in cross-border business. A more constructive attitude towards the EU could lead to the absorption of EU funds, with positive effects for corporate banking.

High involvement of the Russian government in the economic transformation (incl. a focus on military production) makes natural a consolidation of the banking sector around state-related players. This trend had been taking shape already since some years but entered a new stage in 2022/23. With few sizable M&A deals closed recently we see the market share of state-related banks (total assets) approaching 75%; before 2021 the market share of state-owned lenders remained below 70%. Albeit supportive to the sector stability, this structural shift further aggravates the challenge of correspondent relationships in “unfriendly” currencies due to the broad-based sanctioning of most state-owned lenders. Notably, despite a mass trade diversion with a migration into RUB and CNY (9M 2023: ~60% in exports & imports), the trade turnover with euro area countries is still sizable (9M 2023: ~EUR 53 bn) and of importance for Russian imports. In fact, EUR-based net exports from Russia have been on average negative in 2023 EUR 1-2 bn per month, hence contributing to imbalances on the partly restricted local FX market.

Along these lines, the deliberate expansion of asset-blocking (SDN) sanctions on Russian second-tier lenders, which had been long off the (sanction) radar, slowly but surely narrows down available USD and EUR payment channels to a limited number of foreign banks. Moreover, among Western groups still locally present in Russia there prevails a downsizing strategy, while they also turn much more selective in payment transfers due to internal compliance policies and risks of secondary sanctions. That said, the maintenance of certain volumes of customer and interbank accounts that cater essential minimum of the Russia-West (or EU) trade basically keeps the balance sheet size of these Western subsidiary banks intact, although their local lending business is contracting (market share in loans heavily down, no participation in strong double-digit local loan market growth). In principle, only few smallish Western lenders could leave the Russian market since end-2022, whereas orderly exits for larger names remain generally blocked by a special law (the reported waiver for Intesa still needs to be clarified). Probably in recognition of the Western banks’ importance to the financial system, the Russian government slightly opened the spigot for possible dividend payments recently (e.g. OTP said it secured necessary approvals in 2023). However, these are conditioned on certain investment commitments. As of Q3 2023 we count at least 15 subsidiaries of major Western universal banks still formally present in Russia with a ~3.5% combined market share in assets. That said, the market share of Top-4 Western lenders still present on the Russian market decreased to close to 1%, down from some 3% in 2021, in terms of total loans (reflecting the local downsizing in lending business).

Against this backdrop, one should not underestimate the "quiet" rise of Chinese banks on the Russian market, which comes along with Russia's economic pivot to the East. Looking at the “Big Four” Chinese lenders with local operations – BOC, ICBC, China Construction Bank and Agricultural Bank of China – there has been impressive 4x growth of their combined local assets since end-2021. In Q3 2023, the value stood at ~EUR 10.6 bn, and BOC and ICBC have shoehorned themselves into the Russian top-30 list. Although this might be still a relatively small asset base (around 0.7% combined market share), it also reveals a growing role in transactional business. Thus, while still trailing with regards to corporate accounts and deposits, Chinese banks are already a hair’s breadth away from larger local subsidiaries of Western banks in terms of their interbank balances. Clearly, this reflects the "new normal" for Russia’s foreign trade profile which pictures a 34% share of settlements in CNY (Sep 2023), and the same is echoed by FX market trading patterns on the local currenty market MOEX, where 50% of trading volumes are in CNY-related currency pairs. We note that Russian state and larger private banks are likewise active in this niche, but in the end, it also plays in favor of Chinese authorities promoting the role of China and Chinese banks as players in international finance (e.g. when it comes to currency and infrastructure). As one might say: “When two quarrel, the third one rejoices”. Going forward we expect that Chinese banks are likely to play at least a similar role like Western banks before the Ukraine conflict as an anchor of stability and facilitator of foreign trade (especially to the East and to countries not sanctioning Russia), while Western banks will have to be even more selective with further declining foreign trade volumes with the Western world.

Overall, exposures of Western banks to Russia decreased further by around 12% in 2023 (down by 36% in 2022). In absolute terms (USD 60-70 bn), Russia-related exposures of Western CEE banks are therefore on a par with a country like Croatia. Apart from certain payment transaction functions, Western banks no longer play a de facto (systemic) role in Russia. From a longer-term perspective, Russia-related exposures of Western banks are 70% below the level of 2013 (i.e. the year before the first geopolitical escalation in the region). However, current developments on the Russian market also show that a further reduction in exposure (market exit) is difficult in a phase of geopolitical escalation and in the face of blockades that are entirely intentional in terms of political/sanction economic policy. Where the "new normal" of Russian exposures lies - at or below the level of the links with the Soviet Union - is currently not foreseeable. At just under USD 60 bn, Western exposures to Russia are currently close to the level with the Soviet Union (end of 1980s, around USD 40 bn). In this respect, it is important to note that in the early 1980s, Western banking exposures to the Soviet Union amounted to only USD 10 bn. And it will probably go in this direction for the time being. However, this also makes it clear that, to a certain extent, the West may not be able to act completely without any financial/banking sector ties to Russia in the coming years. It should be noted, however, that the Soviet Union in the 1980s was presumably a more rational actor than Putin's Russia is today.

We note that foreign CEE banks stay generally committed to Ukraine having around 1% of their regional credit exposures (or ~USD 12 bn) allocated to the country. The National Bank of Ukraine (NBU) does its job to maintain financial sector stability, while the high interest rate environment lends significant support to commercial banks' earnings, translating into record high net profits in 2023. The real economy shows high ability to adapt, which is reflected in the recovering GDP growth this year, though asset quality should remain among major topics to digest further. We see signs of a tenuous revival in the lending activity in the last months (inter alia, thanks to government program lending), however the prospects for a full-scale rebound are still constrained by high security risks.

We should stress that extra-high profitability of the banking system would not be possible without respective policies of the government, the National Bank of Ukraine (NBU) and bold Western financial assistance ensuring macroeconomic stability and the solvency of financial market participants. Thus, the idea of the government to impose an additional windfall tax (i.e. 36% on banks’ profit received in 2024-2025) looks rational considering that a good portion of interest income for banks came from investment of their excessive liquidity into NBU deposit certificates and government bonds (income from these investments represents about 70% of interest revenues and close to 50% of banks’ total revenues over 9M 2023).

During the first wave of regional geopolitical escalation (annexation of Crimea) 2014/2015, Western banks' exposures to Ukraine fell even more drastically than during the current full-scale war. In this respect, we would speak of slightly positive developments at present, or rather, only players with a more constant and risk-conscious approach to the Ukrainian market are still represented locally. However, it should also be noted that exposures of Western banks to and in Ukraine are still many miles away from what they once were in times of a higher degree of integration of Ukraine with Western banks and in regional business strategies of Western banks. In 2007/08, the Ukrainian banking market accounted for almost 4% of regional CEE exposures of Western banks. In absolute figures, this means that Western banks currently have an exposure of just over USD 11 bn towards Ukraine compared to over USD 50 bn in 2007/08. Since December 2013, Western banks have reduced their Ukraine exposures by just under 50% compared to over 70% in the case of Russia. In this respect, the following applies: in the short term, Ukraine is experiencing less of a reduction in international financial ties in terms of foreign bank exposure - which is positive; in the long term, however, the country is suffering almost as much as Russia from the tense geopolitical situation. A comparison with Belarus is also exemplary here, where the involvement of Western banks (from somewhat lower levels) has also fallen by around 50% since 2013.

More details are to be found in the new edition of our Raiffeisen Research 2023 CEE Banking Sector Report. The CEE Banking Sector Report (available for registered users) is a well-established co-creation and annual flagship study of Raiffeisen Research. Once a year the entire Raiffeisen Research teams in CEE and Vienna analyze banking sector dynamics in the CEE region in detail. In addition to a granular country coverage with local flavor, plus a focus on the Croatian market this time, we once again documented market shares, balance sheet totals and financials of the leading (Western) cross-border CEE banks. The same holds true for cross-country trends for market shares, business dynamics, asset quality and profitability.