Capital Inflow Reversals, Banking Stability, and Prudential Regulation in Central and Eastern Europe

Abstract

Capital inflows to Central and Eastern Europe (CEE) are particularly vulnerable to reversals. Banking systems in the region are inordinately exposed to such volatility because of their role in channeling inflows and because of the transition-related weaknesses in their institutional environment. Although prudential bank regulations in CEE countries are largely aligned with the European Union`s banking directives, there is a strong case for countries in the region to overshoot those directives, at least until the transition process is completed. Talley, Giugale, and Polastri show that capital inflows into the countries of Central and Eastern Europe (CEE)-inflows that are mainly private, debt-driven, and increasingly supplied by banks on a shortening maturity - are especially vulnerable to reversals. They show that the region's banking systems are disproportionately exposed to those reversals, and absorb the lion's share of bank-supplied inflows. They analyze the main links through which external financial turbulence is transmitted to the domestic banking industry, especially during the transition. Mechanisms for prudential regulation are in place in the region-and largely mimic the standards directed by the European Union-but the authors argue that these standards are insufficient for CEE countries. They base their argument not on actual enforcement (a genuine concern) but on the fact that EU banking directives were designed for more stable economies and for banking systems less vulnerable to reversals in capital inflows. A strong case can be made, they say, for CEE countries to overshoot those directives, at least until the transition is complete. This paper - a product of the Office of the Chief Economist, Europe and Central Asia Region - is part of a larger effort in the region to produce analytical work of policy relevance in the area of macroeconomic and financial stability. The study was funded by the Bank's Research Support Budget under the research project Financing and Stability in Eastern Europe (RPO 682-35). The authors may be contacted at [e-mail] or [e-mail].