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Gundars Ostrovskis

28 September 2012
This Occasional Paper reviews financial stability challenges in countries preparing for EU membership with a candidate country status, i.e. Croatia (planned to accede to the EU on 1 July 2013), Iceland, the former Yugoslav Republic of Macedonia, Montenegro and Turkey. It follows a macro-prudential approach, emphasising systemic risks of financial systems as a whole. After recalling that some EU candidate countries went through a pronounced boom-and-bust credit cycle in recent years, the paper identifies current challenges for the bank-based financial sectors as mainly stemming from: (i) high or rising domestic credit risk; (ii) unhedged borrowing in foreign currencies; and (iii) strains related to the euro area debt crisis, which is impacting the EU candidate countries via a number of channels. The main channels of transmission of the euro area debt crisis to the EU candidate countries operate via: (i) trade and foreign direct investment; (ii) an increased market focus on sovereign risk; and (iii) "deleveraging", e.g. via a decline of external funding to local subsidiaries of EU parent banks. A macro-stress-test exercise performed by the national authorities of the EU candidate countries in February 2012 suggests that large capital buffers can absorb a shock to credit quality stemming from a drop in economic activity in the EU and renewed strains from the euro area debt crisis. With respect to supervisory practices, the paper finds that the EU candidate countries have made good progress, but some gaps with respect to international and EU standards remain.
JEL Code
F32 : International Economics→International Finance→Current Account Adjustment, Short-Term Capital Movements
F41 : International Economics→Macroeconomic Aspects of International Trade and Finance→Open Economy Macroeconomics
G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation