Otilia Dhand of Teneo Intelligence -

The global financial crisis put conventional wisdom on models of financial system ownership in Central and Eastern Europe (CEE) under the microscope. The debate on the merits of foreign- vs. domestic-ownership of banking has since polarized opinion, but is it possible that the whole dispute is misplaced?

The foreign-owned banking system not only helped transmit the crisis to CEE, but it has also played a negative role in the recovery, slowing the region's climb back to growth. However, recent troubles in Slovenia and Bulgaria highlight that the risks of domestic ownership, whether state or private, remain palpable. 

So what's the right choice? The evidence suggests neither is free of dangers, so perhaps rather than focus on a false argument, we should look for ways to manage the shortfalls of both.

False prophets

In the post-communist transition from planned to market economies, privatisation of large state owned banks to foreign investors was the mantra of reformers. That saw most CEE countries privatise their dominant state-owned banks by the early 2000s. 

With domestic capital of the necessary volume largely non-existent, those sales targeted foreign investors. Indeed, one of the stated aims of privatization was that large foreign banks would bring both new financial resources and know-how into the banking sector. 

The second major objective was for the large international financial houses to offer greater stability during times of domestic economic turbulence and to insulate the financial sector from the impact of volatile transition-period politics. The 1997 Bulgarian banking sector collapse, which wiped out half of the country's household savings, serves as a reminder as to why stability was as high on the list of priorities as the perceived need to divorce political and business decision-making in the financial sector. 

Since this form of privatization seemed to address many of the woes of CEE's underdeveloped financial markets, most countries - with the glaring exception of Slovenia - chose this route. Post-privatization, the percentage of foreign ownership across CEE in the banking sector varied from 65% to almost 100%. 

The supporters of privatization did not have to wait long for evidence to support their stance. CEE experienced a foreign-funded credit boom between 2003 and 2008, which drove both domestic consumption and economic growth to new highs. Thus, foreign investment proved its merit.

However, the idyll would soon crumble. The global financial crisis brought a profound challenge to the cosy picture of stability provided by large international financial houses. Rather than safeguarding CEE, those very banks became the main channel of contagion for the worst financial crisis since the Great Depression. 

Funding flows from foreign parents to local units reversed, and CEE fell into deep recession. The recovery was slow as international banks battled to clean their balance sheets or resorted to state bailouts. Vienna Initiatives I and II were the joint response to stem the outflows from CEE and ward off the looming capital starvation. 

Cure-all?

Six years on, banks as well as regulators are still mopping up the spillover. Looking back, it now seems that the opponents of foreign investor focused privatization had a point - far from being a guarantor of stability, majority foreign-owned banks meant credit booms in the good times and sharp reversals in the bad. Not only pro-cyclical, but beyond the control of domestic authorities. 

Calls for greater domestic ownership appear a logical conclusion. Hungary has taken the "repatriation" drive most seriously. Prime Minister Viktor Orban recently announced domestic ownership of banks has reached 50% again. 

However, just ahead of Orban's celebration came a reminder that domestic ownership of banks is not necessarily the cure-all either. In late June, Corporate Commercial Bank (KTB) became the first Bulgarian bank to collapse since the 1990s, raising the spectre of the 1997 financial crisis. 

The avalanche of events that led to the collapse of KTB started with political rather than economic shifts. Bulgaria is notorious for dubious links between politicians and businessmen and earlier this year business interests started to realign in anticipation of a change in power at elections set for October.

The two main actors in the early summer drama were Delyan Peevski, a media mogul and one of the foremost leaders of centrist parliamentary party Movement for Rights and Freedoms (DPS), and Tsvetan Vassilev, the majority shareholder of KTB. Following a fall-out - rumoured to be over Vassilev's support for political newcomer and former TV presenter Nikolay Barekov - the pair traded accusations of plotting each other's assassination, which triggered investigations with cross-border jurisdiction. 

Moreover, Peevski accused Vassilev of treating deposits in KTB as his personal funds. In early June, authorities raided the bank and later the same month, media (largely controlled by Peevski) published a letter, which alleged that a deputy governor at the central bank was under investigation for shortfalls in supervision of a bank "that has recently come into a public spotlight". 

Panic ensued. More than 20% of deposits were withdrawn within a week, leading to KTB's collapse. Large corporate clients, some of them linked to the state or Peevski's business empire, were among those to transfer funds. This cash was speculated to have jumped to another domestically-owned financial house: First Investment Bank (FIBank). 

Within a week, FIBank faced an anonymous campaign alleging lack of liquidity. A bank run followed almost immediately. Bulgaria's two prominent domestically-owned banks faced potential ruin over one political spat. 

FIBank pulled through in the end, but the Bulgarian government was forced to place KTB under special supervision. Sofia has now also resorted to giving up its regulatory independence in favour of the EU's Single Supervisory Mechanism in order to restore trust in the system. 

Tangled

The lesson is clear. The thesis on the systemic risk of political entanglement of domestically-owned banks is still valid. It does not mean all domestic banks are necessarily politicised, just that if they are, they present a systemic risk.

Events in Slovenia, the country that avoided privatization in the first place, are equally instructive. Last year, Ljubljana narrowly avoided a troika bailout as it struggled to meet the costs of non-performing loans piling up in its state-controlled banks. The problems were blamed on the prioritizing of politicised decision making over business merit at the lenders involved. 

Although Ljubljana avoided the need for a rescue, the eventual clean up carried out in December cost the government an equivalent of 7% of GDP. The country's second largest bank, NKBM, is now among the SOEs earmarked for privatisation, and two more banks may follow. 

Maybe it's time to abandon the ideologically tainted bickering on whether foreign or domestic ownership is better. The lesson to be learned here is that both models have their inherent risks and merits, and it would be more prudent to look for ways to mitigate weaknesses and capitalise on strengths. Perhaps the Single Supervisory Mechanism could go some way to disconnect banking supervision from the crux of domestic politics (as Bulgaria has now suggested) and keep an eye on multinational banks at the same time. But as ever, let us see what the implementation brings and where the loopholes lie.