27

**34. Some illustrative computations provide a sense of the potentially significant magnitude by which European bank deleveraging could affect EMDE credit.** Subject to a number of assumptions and caveats associated with the limited availability of granular data, the computations attempt to get a suggestive estimate of the effects of the deleveraging, using the regional credit distribution of European banks under various scenarios. Starting from the situation where European banks collectively have €1.64 billion of EMDE credit, or about 7.3 percent of their total loan portfolio (table 1, figure 21),<sup>18</sup> we consider two deleveraging objectives: (i) a short-term objective, to comply with the EBA recapitalization requirements by June 2012; and (ii) a longer-term objective, to reduce the assets/equity ratio to a desirable level. We account for the following drivers: (a) the ability of banks to raise capital (through rights issues, retained earnings, and the like); (b) the extent to which deleveraging is necessary through asset reduction; and (c) the extent to which necessary asset reduction occurs through the loan book. Simplifying assumptions are discussed in box 3.<sup>19</sup>

# **Box 3. Simplifying Assumptions Underlying the Simulations of the Credit Impact of Deleveraging**

- All factors mentioned above are taken equally across European countries. For example, it might be assumed that all countries are able to raise their capital levels by 20 percent. However, banks in core European countries are likely better positioned to raise capital than their peers in the periphery.

- Any reductions in credit occur proportionately across regions. This assumption ignores the possibility that emerging markets might be hit disproportionately due to home biases. On the other hand, foreign bank branches and subsidiaries of European banks that are funded in local markets might be able to better absorb loan deleveraging pressures.

- Assets are 2.8 times RWAs. This figure is based on the median in a recent sample of internationally operating banks.

- The relative regional credit distribution of some countries is equal to the distribution average of all other countries, given the lack of information on regional distributions of emerging market credit for some countries.

**35. In the short term, banks need to adjust their balance sheets to comply with EBA**

**requirements. A worst-case scenario implies a €245 billion reduction in EMDE credit** . Banks that were identified as having a capital shortfall in EBA stress tests in 2011 have €1.35 trillion outstanding in EMDE credit (about 8.3 percent of their total loans). In a worst-case scenario (Scenario 1), if banks need to meet the full €114.7 billion capital shortfall fully through deleveraging and if the deleveraging occurs fully through the loan book, the estimated decline in EMDE credit could be as much as €245 billion, or 19 percent of the outstanding EMDE credit (figure 22). If banks are able to raise capital to cover half the shortfall (Scenario 2), the estimated short-term impact on EMDE credit would be lower, at €131 billion (10 percent of their

> 18 These figures are taken from IMF Financial Soundness Indicators.

> 19 Given the simplifying assumptions used in the simulations (box 3), the results should be interpreted as suggestive.