When ratings agency Fitch downgraded UniCredit group to A from A+ in mid-April 2009, citing "increasing vulnerability to potential severe stresses in central and eastern Europe (CEE) and the Commonwealth of Independent States (CIS)", it was the latest in a line of statements from ratings agencies and equity research teams suggesting that the bank's presence in emerging Europe was a source of weakness. Standard & Poor's had placed the outlook on Intesa Sanpaolo on "negative" a month earlier, noting "we expect loan losses to accelerate" on the bank's €28bn CEE loan book.
 And as both banks began negotiating with the Italian government on cash injections to boost capital adequacy, speculation was rife that they would be asked to concentrate on their domestic markets. This speculation appeared to be confirmed as UniCredit announced job cuts totalling 1400 in its Ukrainian and Kazakh subsidiaries in late 2008 and early 2009, respectively.
 Not so, says Federico Ghizzoni, who runs UniCredit's Poland markets division and shares responsibility for CEE as a whole. The bank has at least three home markets, thanks to its acquisition over the past decade of HypoVereinsbank (HVB) in Germany and Bank Austria. Mr Ghizzoni is the board member responsible for the CEE region at Bank Austria, which had a large CEE presence even before UniCredit took control, and the group may draw some of its recapitalisation from the Austrian government.
 "We are not changing our strategy because of the crisis. In the medium term, investment in the region is still core for the group," says Mr Ghizzoni. "We are unique because our franchise is pan-European, with 4000 branches in CEE out of 10,000, so it is difficult to say what is the core market."
 Nor is the macroeconomic picture uniformly negative across the CEE region. Ukraine is a troubling market for both UniCredit, which completed the purchase of Ukrsotsbank in late 2007, and Intesa, which took over Pravex Bank in 2008. But this is partly because the Ukrainian authorities have struggled to formulate a policy response to the impact of the credit squeeze on high levels of private sector external debt and an under-capitalised banking sector. In Hungary, high levels of household debt were compounded by the government's poor fiscal position even before the financial crisis unfolded.
Recovery forecast
 By contrast, UniCredit's head of emerging Europe research, Martin Blum, forecasts solid recoveries for many countries in the region, including Poland, the Czech Republic, Slovakia, Romania and Turkey, to begin in 2010.
 According to Mr Ghizzoni, UniCredit's subsidiaries in many of these countries are sources of stability for the group. "Countries such as Poland and Turkey are not dependent on the group for new capital or funding, the loan-to-deposit ratio is less than 100% or in equilibrium," says Mr Ghizzoni.
 At the other end of the scale, the Russian or Kazakh subsidiaries are less well funded. But he emphasises that, even though the Kazakh authorities made state capital available to the country's banking sector, including UniCredit's unit ATF Bank, ATF will not need the funds after its parent increased the bank's capital by €150m.
 However, liquidity transfers around pan-regional banking groups may not be so easy, as local regulators are focused on ensuring the units of global banks based in their jurisdiction are well funded and well capitalised. "Rather than regulation, there is more moral suasion from regulators asking the shareholder of subsidiaries to retain the dividend and invest liquidity locally, but this pressure is not substantial," says Mr Ghizzoni.
 "The division made about €2bn of net profit in 2008, which made it possible for us to maintain or increase the subsidiary banks' capital, and we have also transferred some dividends to the holding level without any problem. What is important is to keep the capital of each bank at a level that makes sense for its situation," he adds.
 Demand for new loans has been low since the start of 2009, and neither bank is intending to raise significant wholesale financing for the CEE subsidiaries at a local level. "In recent years, we were primarily relying on funding from Milan, although I would not exclude the opportunity of subsidiary banks tapping the market individually," says Dr Gyorgy Suranyi, head of Intesa's CEE operations.
Turkish exception
 UniCredit's Turkish subsidiary, Yapi Kredi, is such an exception, raising a syndicated loan for $500m in April 2009. "Other than that, we are talking to the multilaterals, or the funding will come from the group. We expect the rouble market in Russia might reopen later this year," says Mr Ghizzoni. Ukrsotsbank was reported in March 2009 to be one of the first batch of five chosen by the European Bank of Reconstructiona nd Development to receive special funding to support Ukraine through its banking crisis, most likely in the form of subordinated debt. No one is denying that, as growth reverses and unemployment rises, loan quality will deteriorate and the cost of risk and credit provisions will continue to rise. UniCredit moved more than a year ago to begin preparing for the downturn in the CEE region.
 "We set up a special team in each bank to identify all corporate customers one by one, to monitor them and propose active restructuring - not debt workouts, but the restructuring of performing clients to give them the possibility of going through this period of crisis by better planning of their liquidity and borrowing," says Mr Ghizzoni.
 In fact, he believes the active approach the bank has taken to helping its clients manager their balance sheets, along with closer integration between commercial and investment banking activities, could help to increase market share - the bank added about 1 million retail and corporate customers across the region in 2008. And he stresses: "The trend is continuing whether competitors are pulling back or not."
 Naturally, efficiency will also be part of the process of consolidation next year. "In terms of IT, we are making efforts to reduce complexity, and we aim to have a maximum of three systems across the whole group within three years, while the back offices are also integrating more," says Mr Ghizzoni.
 "Profit and loss accounts are still the responsibility of local subsidiaries, but we completed the integration of 17 banks in 2006 to 2007, and finally we are starting to see the results. And the crisis helps, as being part of an international group is now perceived as valuable by staff and customers alike," says Mr Ghizzoni.
Foreign currency dilemma
 One aspect of the loan portfolio causing particular concern is the extent of retail lending in foreign currencies, mainly Swiss francs and euros. As Swiss and eurozone interest rates were significantly lower than local rates in countries such as Hungary, Ukraine and Romania, there was strong demand for these products. But the one-way bet on emerging currencies broke down sharply in the fourth quarter of 2008, with the Hungarian forint sliding about 40% and the Ukranian hryvnia almost halving in value.
 Opinion had always been divided on the wisdom of leaving less sophisticated borrowers exposed to exchange rate risks. UniCredit's Polish subsidiary, Bank Pekao, had refused to issue foreign currency mortgages for this reason. But the bank lost market share as a result, and Mr Ghizzoni says a balanced approach is necessary. "Lending in Swiss francs may be dead, but we have to live with reality, and the reality is that demand for lending in euros will be there, even after the risks have been explained to customers, as long as local rates are substantially higher than those in the eurozone. So the question is how to manage that demand," he says.
 UniCredit has launched a standard restructuring package for foreign currency retail borrowers in countries where exchange rates were hit, which may involve bringing instalments back toward pre-devaluation levels and deferring principal payments for one to two years.
 "This won't solve the problem, but I am confident that it will give us the possibility to have lower provisions for non-performing loans," says Mr Ghizzoni.
 Mr Suranyi brings to bear his substantial experience as governor of the Hungarian central bank in discussing the dilemma.
 "Foreign exchange rate-based lending in small, open economies where central banks have opted for inflation targeting is definitely not riskless. But in a small, open economy, the exchange rate is the real economic anchor. So if the exchange rate drops, it is unimaginable that the central bank would not respond by raising the interest rate, so there is a mirror risk for local currency lending," says Mr Suranyi.
 This point was demonstrated in October 2008, when the Hungarian central bank hiked local interest rates by 300 basis points in one day, in a bid to slow the forint's devaluation and limit the pass-through to inflation.
 Mr Suranyi emphasises the rigorous risk management of foreign currency mortgage lending at Intesa's subsidiaries. "Across the 10 to 15-year life of an average mortgage, the risk on this timescale can be contained by following conservative policies - the loan-to-value ratio is not generally exceeding 70%, and the debt service ratio on proven income is not greater than 30% of income," he says.
 Both banks are likely to continue lending in euros in emerging Europe, especially for front-runner countries that will probably join the eurozone, as this will remove the exchange-rate risk for clients.
Unicredit Central and Eastern Europe net loan write-downs and provisions (2008)
