**Important policy progress has recently been made to address these factors.** To remove break up risk premia from sovereign yields, the ECB announced its OMT program. To date, the effect of the OMT program appears to have been successful and sovereign market stress indicators have improved significantly. Also, concrete steps have been made towards a banking union. However, key differences remain on pan-European deposit insurance and bank resolution. Moreover, as markets have recently rallied in the wake of the OMT program and sovereign yields fall, the incentive to address structural weaknesses may have diminished.

# **V. Transmission Channels and Emerging Market Credit Conditions**<sup>31</sup>

**Banks are often the dominant source of funding in EMDEs. International banks in general and European banks in particular play an important role in financial systems of EMDEs.**<sup>**32**</sup> **As such, the impact of European bank deleveraging and tighter credit conditions is being directly transmitted to the rest of the world through various channels** , including: (i) reduced cross-border claims of European banks on the public, private, and banking sectors of emerging market and developing economies; (ii) sales or downscaling of noncore, nondomestic businesses in host economies; (iii) deleveraging by subsidiaries and branches of foreign banks faced with reduced funding flows from parents, or parent attempts to transfer dividends, capital, or liquidity to headquarters; and (iv) increased cost of borrowing for subsidiaries, either as a result of a general worsening of funding conditions or as investor concerns about parents generate anxiety about the overall health of banking groups. Indirectly, European financial stress is transmitted via lower economic growth, macro, and trade channels.

**Accordingly, a country’s immediate vulnerability to European bank deleveraging depends**

**on a combination of factors.** These include: (i) the size of cross-border claims of European banks relative to the recipient’s economy, particularly where local affiliates play a key role in the provision of credit to the private sector but are not systemic to the overall banking group; (ii) the maturity (hence reversibility) of cross-border claims; (iii) whether the local affiliates rely on a wholesale (cross-border) funding model; (iv) the capacity and willingness of other financial institutions—both from developed and developing countries—and markets to step in. European (parent) bank retrenchment could destabilize the local financial system and affect economic activity, especially where host countries lack well-developed capital markets and alternative sources of non-bank financing; and (v) to insulate their financial system, some local supervisors have resorted to “ring-fencing” capital and liquidity of local affiliates of foreign banks or requiring them to invest additional equity in stand-alone subsidiaries. Although these measures will protect the domestic financial system they could ultimately prove harmful for financial integration and stability.

> 31 The first two paragraphs of this section are largely drawn from Feyen, Kibuuka, and Otker-Robe (2012) which also includes more details on the role of international banks in EMDEs.

> 32 For example, the share of bank assets owned by foreign banks is on average about 10 percent in developing countries. However, large variation between countries and regions exist. For example, representing over 50 percent of total assets, foreign bank ownership is particularly prevalent in sub-Saharan Africa and emerging Europe.

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