Prisoners’ Dilemma: Will Western European Banks Continue To Support Their CEE Subsidiaries?

Will Western European parent banks continue to support their Central and Eastern European (CEE) offspring? This issue has been getting a lot of play in the media in recent months and for good reason. Foreign parent banks, via their subsidiaries, hold 60-90% market share (as a % of assets) in CEE countries, and these parent banks are currently facing a mountain of challenges: 1) Their own difficult funding conditions; 2) Expected spike in non-performing loans (NPLs) in Eastern Europe due to deteriorating economic conditions; 3) Deteriorating economic conditions in parent banks’ home markets; 4) Exposure to depreciating CEE currencies due to high levels of foreign currency lending, particularly in Hungary and Romania.

The concern is that in a worst-case scenario, one or more parent banks could pull the plug on support for their Eastern European subsidiaries. In what I view as a very positive sign for the CEE region, groups of foreign banks operating in Hungary, Romania and Serbia have in recent months collectively pledged to support their subsidiaries as needed. While such announcements have not been seen as big news, an examination of this issue through the lens of a prisoners’ dilemma shows why such pledges are of paramount importance.

The general idea is that these parent banks (as well as the CEE economies in which they operate) are likely to be collectively better off if they all continue to support their Eastern European subsidiaries. The problem, however, is they may not be individually incentivized to do so. So the key in preventing a foreign bank retrenchment from the CEE region is promoting policies, such as the pledges mentioned above.

How Is Western European Banks’ Decision To Support Their Eastern Offspring Similar To A Prisoners’ Dilemma?

The basic idea of the prisoners’ dilemma is that police arrest two suspects, who would collectively be better off cooperating with each other – that is, remaining silent. However, each is individually incentivized to ‘defect’ and confess. (See Dixit and Nalebuff, The Concise Encyclopedia of Economics for a more detailed description/definition of a prisoners’ dilemma)

Parent Banks Collectively Better Off Staying The Course

Foreign parent banks, operating in Eastern Europe via subsidiaries, are likely to be collectively better off if they continue to support their subsidiaries and stay the course in the region. That is, the region’s economic contraction is likely to be less severe (meaning the spike in non-performing loans is likely to be less sharp) and the chance of a banking crisis will be significantly reduced if foreign parent banks maintain their balance sheets in the region and recapitalize their CEE subsidiaries as necessary. The IMF agrees. In its Europe Regional Outlook, the IMF acknowledges that “a sharp cutback in cross-border funds and failure of private owners of parent banks to respond to the recapitalization needs of the emerging European subsidiaries could have a serious impact on the broader economy.”

Worryingly, the IMF says there is already some evidence of banks’ reluctance to lend (as Senior Loan Officer’s Lending Surveys in some countries indicate for the first quarter of 2009). Looking at the issue through the lens of a prisoners’ dilemma sheds some light on why parent banks are not necessarily acting in a way that promotes their collective best interest.

Those Who Stay The Course Risk The Suckers’ Payoff

The problem in a traditional prisoners’ dilemma is that it becomes a challenge to enforce coordination. Each player has an incentive to defect. In this case, parent banks may have an incentive not to pour additional capital into their subsidiaries if they are unsure other banks will do the same. If one parent bank chooses to recapitalize its subsidiary while the others don’t, bank lending will likely still dry up and the overall economy will likely deteriorate significantly, leading to an even bigger spike in NPLs than that already expected in the region. Consequently, the bank that chose to recapitalize could essentially be throwing good money after bad – the equivalent of the so-called ‘suckers’ payoff’ (the worst individual outcome in the prisoners’ dilemma which occurs when one player chooses to cooperate – ‘the sucker’ – while the other chooses to defect).

In fact, even if one bank expects the others to ‘cooperate’, the bank may still feel that it’s better off not investing additional capital into its own subsidiary since it may be able to ride other banks’ coattails – in the sense that the other banks’ actions may be enough to ensure financial stability.

Cooperators Worse Off If One or More Defects

Fitch Ratings does a good job of explaining the potential fallout from just one parent bank pulling up stakes in the region: “Should a foreign‐owned subsidiary be allowed to default in this region, this would pose a real threat of deposit flight away from foreign‐owned banks in the same country or may even trigger contagion across the region, which would affect financial stability.” The basic idea is that if parent banks are unsure about their counterparts’ commitment to supporting their subsidiaries, then individually, they could very well decide to cut their losses and not recapitalize their subsidiaries to avoid throwing good money after bad.

Asymmetric Prisoners’ Dilemma Potentially Makes Cooperation More Difficult

Applying the prisoners’ dilemma – a two-p layer game – to the issue of whether foreign parent banks will stay the course in the CEE region involves a fair amount of simplification. In reality, this is a multi-player, asymmetric prisoners’ dilemma, which makes it much more complex. The problem is that studies have shown that coordination is less likely in an asymmetric prisoners’ dilemma.

The situation is asymmetric in the sense that the parent banks involved have different amounts of ‘skin in the game’ – that is, different amounts of exposure to the CEE region – so their incentives to support their CEE subsidiaries vs. pulling out are not quite the same. Fitch Ratings recently issued a great report that details how different parent banks might fare, in terms of capital deterioration, under four different stress test scenarios, and the analysis shows that some banks are in a much more precarious situation than others.

Because asymmetry tends to decrease cooperation rates, policymakers have their hands full in overcoming this particular prisoners’ dilemma.

IMF/European Commission Act As Enforcers

An outside enforcer can help overcome the collective action problem in a prisoners’ dilemma. In what I see as a positive sign, the IMF and the European Commission are attempting to play this role by bringing the foreign banks – in Hungary, Romania and Serbia - together in a series of coordination meetings, in which the banks have pledged to maintain their exposure and support their subsidiaries as needed.

On May 19, banks in Romania went so far as to commit to a precautionary increase in the minimum capital adequacy ratio for each subsidiary from 8 to 10% for the duration of the country’s IMF program. (See related spotlight issue for more information on these coordination meetings: Western European Banks Pledge Continued Support To Hungarian, Romanian, Serbian Subsidiaries)

Even in the absence of true enforcement power (the IMF can’t really impose serious punishment on a ‘defector’ bank), there’s still significant value in getting parent banks to signal to each other that they’re willing to ‘cooperate’ and support their subsidiaries. As parent banks’ continued support is a key ingredient in preventing crises in the CEE region, further policy action should be aimed at encouraging banks to act in their collective best interest and stay the course in the region.