Decomposing Financial Risks and Vulnerabilities in Emerging Europe

Abstract

This paper assesses how various types of financial risk such as credit risk, market risk, and liquidity risk affect banking stability in emerging Europe. It also examines how the quality of supervisory standards may have mitigated the vulnerabilities arising from these risk factors. Using panel data, the paper finds that (1) credit quality is of general concern especially in circumstances where credit growth is accelerating; (2) although higher provisioning could adversely affect profits and returns volatility, good supervisory policies on provisioning mitigate such adverse effects; and (3) highly liquid banks are not necessarily more stable because they might be pursuing activities with more volatile returns, but a well-functioning payments system helps to lower the adverse impact on stability. The paper also corroborates earlier evidence of the positive (negative) effect of financial depth (foreign ownership) on stability.