It has been little more than a decade since the Iron Curtain came tumbling down, and retail banking in Eastern Europe’s most advanced markets has developed at a startling pace. Drab state-run branch offices, with their long lines of people waiting to deposit or withdraw cash, have largely disappeared. In just a few years, the region’s best banks have matched the service revolution—retail brokerage, mutual funds, ATMs, call centers, and Internet and mobile banking—that took five decades to mature in the West. Now, as these former Soviet bloc countries line up to join the European Union and embrace its more predictable economic regime, Western-owned banks are competing with streamlined incumbents in retail-banking markets that have far higher revenue and profit growth than do those in Western Europe or the United States.

Yet Eastern European markets are maturing. Overall investment has fallen from its peak, and while some foreign-owned banks continue to expand, others are leaving as intensified competition and convergence toward Western European market conditions begin to separate the winners from the also-rans. Western bankers will be familiar with the challenges—notably an ever-tougher battle for the all-important affluent-customer segment and a growing need to counter pressure on margins by reducing credit losses and improving cost efficiency.

Nonetheless, Eastern Europe will retain its particular challenges, and it will be essential to master them. The region’s affluent customers, for instance, tend to be young, entrepreneurial, and in need of loans. But banks are grappling with loan loss provisions four times higher than those in Western Europe—a task made no easier by a lack of the type of credit information taken for granted in Western countries. And though the population of Eastern Europe (including Russia and the other former Soviet republics) is almost as big as the European Union’s, overall banking revenues and profits are not only smaller but also divided among more heterogeneous banking markets. Thus it is harder to increase cost efficiency through economies of scale.

A diverse landscape

Banks capable of parsing the opportunity in Eastern Europe can look forward to growth comparable to the heady rates of the 1990s. We expect the retail-banking revenue pool to increase by an average of 14 percent a year, to €16.4 billion ($16.8 billion) by 2010. Profits over the same period will increase fivefold, to €6.8 billion—a 19 percent compound annual growth rate (Exhibit 1). Retail banking’s share of the overall banking market—currently 36 percent,¹ compared with 55 percent in Western Europe—will exceed 50 percent by 2010, at the expense of corporate banking. Although retail-banking profits are expected to grow two or three times faster in the region than they will in leading EU markets over the next decade, the profit pool, currently no bigger than Spain’s, will remain small for the foreseeable future. And while revenues and profits are set to grow quickly, so too is competition, which will make it harder to maintain strong returns.

It all adds up to a critical moment for institutions pondering whether to get further into these markets or to get out. Banks setting their strategies should first consider the diverse nature of Eastern European markets, since some of them have been almost completely restructured, whereas others still have a long way to go (Exhibit 2). At first, investors targeted primarily the Czech Republic, Estonia, Hungary, Poland, and Slovenia. All of these countries, which are scheduled to join the European Union on May 1, 2004, have enacted clear banking regulations, and in all of them private ownership of banks is widespread.² Although the markets are small, they are among the few realistic growth options for European banks. Moreover, geographical proximity and trade flows make Eastern Europe an extension of the home market for some institutions.

Strategies vary widely, from niches to universal banking. Raiffeisen Zentralbank of Austria builds, from scratch, branch networks whose offerings are tailored to small and midsize enterprises and their affluent owners. Citibank has cornered the credit card market in Hungary and Poland through greenfield investments. Italy’s UniCredito, Germany’s HVB, Austria’s Erste Bank, and Belgium’s KBC Bank and Insurance have all built a presence in the region by acquiring local universal banks vying with high-performing incumbents such as OTP of Hungary. Competition is set to heat up in these still relatively fragmented banking markets, and further consolidation is expected soon.

Besides the leaders, Eastern Europe includes a more diverse group of countries, such as Latvia, Lithuania, and Slovakia (also scheduled to join the European Union in 2004), Bulgaria and Romania (slated to join in 2007), and Croatia. Privatization and regulatory reform started later there but are now largely complete except in Bulgaria and Romania. Western banks are beginning to set up shop in these rapidly developing markets, and competition is picking up.

A third, more populous group comprises Russia and several other former Soviet republics—countries with no defined aspirations to join the European Union and with lower levels of GDP per head as well as unstable economies. Privatization of the banking sector and the reform of banking regulations have proceeded unevenly at best in this subregion. Western banks have done little more than establish the occasional branch office there.

The coming profit squeeze

In the region overall, personal financial liabilities are likely to grow faster than personal financial assets. As consumers strive to raise their standard of living to the levels of the West, banks will be busy making loans for houses, cars, and durables such as furniture and white goods. During the next five years, mortgage loans and credit card offers will therefore have by far the largest growth potential, followed—when customers turn their attention to financial savings—by mutual funds.

But growth will be unevenly spread across this varied region. Competition will intensify; meanwhile, interest rates will fall as convergence toward EU conditions increases economic stability, steadies local currencies, and reduces inflation. The process will culminate not when a country is accepted as a member of the European Union but, rather, some years down the road, when it adopts the euro and the European Central Bank sets its reference interest rates.

While such developments should be good news for Eastern Europe, the downside for retail bankers is that lower volatility tends to mean lower deposit and lending margins. In some countries, for example, interest rates on point-of-sale (POS) loans (such as installment loans for durables) now range from 25 to 45 percent. These levels provide a lending net margin of around 10 percent, which amply covers the higher cost of credit risk. In the future, competition and convergence will put pressure on net margins as growth in the volume of loans outpaces growth in net revenues from interest and fees. Thus we expect net margins to drop from an Eastern European average of 2.7 percent in 2000 to about 1.7 percent (close to current EU levels) in 2010.

In a tougher environment, only the best banks will grow profitably. Indeed, this trend might already be apparent. A comparison of the cost-to-income ratios of Eastern European banks indicates a gap of 76 percent between the top and bottom 20 percent of performers—a gap that is likely to widen further—compared with 50 percent in Western Europe.

Local challenges

To thrive in Eastern Europe, banks must at the very least sustain the baseline transformation they have been pursuing since the region first opened up. That means continuing to adopt international best practices, such as raising volumes by expanding product portfolios and service channels, as well as making organizations more cost-efficient by reducing head counts, refining branch processes, and applying centralized IT solutions. But to be truly successful, banks will have to achieve three crucial strategic goals: capturing a substantial share of the affluent market, improving their management of credit risk, and building national and regional scale. To do all this, they must master specific local challenges.

Enticing the newly affluent

All over the world, affluent customers³ provide a disproportionate share of bank profits. In Eastern Europe, it will be crucial to capture this segment because its contribution is expected to grow rapidly. Currently, the top 10 percent of Eastern European bank customers account for 40 percent of retail-banking profits, compared with 70 percent in Western Europe. And the wealth gap is increasing: in Poland the difference in income between the top and bottom 20 percent of the population widened by 21 percent from 1995 to 2000.

Eastern Europe’s newly affluent people are younger, better educated, more familiar with technology, and likelier to be entrepreneurs than are their counterparts in the West (Exhibit 3). Since the Easterners are relatively young and, frequently, owners of fledgling small or midsize businesses, they have fewer financial assets and greater interest in loans than in asset management. As in the West, the young and the educated switch banks frequently and adopt new products and service models quickly. For basic transactions, tech-savvy people want access to direct channels like the Internet and mobile banking. Moreover, the large borrowing needs—both personal and business—of these customers make them demand a high standard of personalized service and efficient loan processing. To attract and retain such exacting men and women, a bank must rapidly develop dynamic sales and service models tailored to their needs and peculiarities.

The battle for the affluent segment is just getting under way. Most of these customers still patronize large incumbent retail banks that are starting to target them with offerings such as personal advisers and branches, tailored current-account packages (sometimes including credit cards), and direct-channel offerings. In Poland, at least 40 percent of all affluent customers own their own businesses. Last year, the country’s largest bank—Bank Pekao, owned by UniCredito—launched a new branch-service model for owners of small and midsize companies, who can now choose to have a personal adviser as a single point of contact with the bank for their private and business needs.

In targeting affluent people, the universal banks could learn a thing or two from niche banks, such as Raiffeisen, that cater exclusively to them. For one thing, it pays to serve them through special units. In Hungary, Raiffeisen offers what it calls "premium" services to customers who have more than €20,000 in assets and an even higher level of "private-banking" services to those worth twice that amount. It acquires prospects through references and offers a personal adviser to ensure that loans are processed smoothly. Each of the bank’s segments has its own call center as well as Internet facilities that enable customers to make current-account, mutual-fund, and brokerage transactions. Tailored products include brokerage services, proprietary and third-party mutual funds, and legal and real-estate advisory services.

Capturing the affluent is a challenge—most banks go after the same customers. It is equally difficult to ensure that the growth they generate is profitable. The solution is the careful management of credit risk, which is amplified by the large proportion of owners of small and midsize businesses among the affluent people in this region: if such an enterprise goes bust, any bank that lends money to its owner risks default not only on business but also on personal loans. Moreover, in Poland, among other countries, entrepreneurs often use personal loans for potentially risky business ventures—a problem that is difficult for banks to control.

Handling credit risk

Lending money is easier than getting it back—a truism of particular relevance in Eastern Europe: in 2000, loan loss provisions there amounted to a startling 17.9 percent of the overall volume of loans, compared with a Western European average of 4.3 percent. The disparity is partly explained by bad loans granted to the old state-owned conglomerates in Communist days, though in the region’s more advanced banking markets government bailouts have reduced the legacy problem to varying degrees.

Still, nonperforming loans weigh heavily on modern Eastern European retail banks. Most of them have a long way to go in tackling credit risk. Besides implementing strict best-practice risk-management and loan approval processes, they should learn from specialized nonbanking operators such as POS credit companies—including Lukas, owned by Crédit Agricole of France, and GE Capital—which have adeptly handled the region’s special challenges in the field of credit underwriting. These companies compensate for the absence of central credit bureaus⁴ by building their own credit history databases, lending small amounts, and then increasing the size of loans after timely repayment.

Credit workout is another area fraught with difficulty. A court system so inefficient that proceedings can take years hinders the effective repossession of collateral, while partially illiquid markets for real estate and durables such as white goods sometimes make it hard to establish realistic recovery prices. Although workout specialists have emerged, most of the successful operations are internal because external collection services command high fees. POS companies stand out in this area, but some banks too have tasted success. OTP, for instance, has reorganized its workout operations into an independent subsidiary that processes and monitors the recovery of small debts in a structured way that has succeeded in raising recovery rates by 10 percentage points.

Building regional scale

So far, high lending and deposit margins have helped Eastern European banks compensate for their lack of scale. That will become more difficult in coming years, and banks will therefore need to achieve greater scale if they are to spread the cost of IT investments and product development over bigger volumes.

Currently, the average cost-to-income ratio of Czech, Hungarian, and Polish retail banks almost matches that of a large sample of Western European universal banks with mainly retail customer bases. But the similar ratios conceal two important differences. On the income side, the average ratio of income (net revenues) to volumes (customer loans and deposits) is twice as high as in Western Europe. The reason is higher margins on lending and deposits and higher fees—attributable to higher interest rates, greater interest volatility, and lower levels of competition. But the average ratio of costs (operating costs excluding loan provisions and extraordinary items) to volumes is also twice as high, largely because Eastern European customers generate less business than do Western European ones (Exhibit 4).

Economies can be won primarily by trimming the workforce and improving branch processes

As the income of banks comes under pressure, preserving the parity of cost-to-income ratios will require substantial cost savings. Economies can be achieved primarily by trimming the workforce and improving branch processes. In Poland, for instance, Pekao lowered its cost-to-income ratio by almost 20 percentage points from 1999 to 2001 by focusing its employees on sales and by introducing central cost controls. OTP, over a five-year period, reduced its staff by half and tripled the number of retail accounts that each employee handled. But without economies of scale, such measures probably won’t fully offset deterioration on the income side.

Improving efficiency through the consolidation of the banking sector, both within individual markets and at the regional level, could go some way toward bridging the gap. Regional players, for instance, are well placed to develop groupwide procurement, card-transaction-processing, and IT platforms that would limit their maintenance and customization costs. It will be a challenge, however, to implement synergies cost-efficiently across disparate markets. In IT, where the biggest opportunity lies, differences in regulations and national languages make it necessary to modify, for each market, any common IT platform—a costly proposition.

A regional strategy has particular importance for big Western-owned banks because it could increase Eastern Europe’s weight in the organization—probably the only way to ensure that senior executives and talented managers take an interest in the region. In addition, Western banks looking to exploit their leadership in products or operations will want to spread their advantage over an area larger than each national market.

But the building of regional scale in diverse Eastern Europe is full of traps, and success will require deep knowledge of specific markets and excellent timing. The advantage is likely to sit with banks that have done business in the region for some time. Institutions such as Citibank, Erste, HVB, KBC, Raiffeisen, and UniCredito can build on their firsthand experience in the more advanced Eastern European markets and anticipate economic developments in the less developed ones.

The scope for expansion varies. In the most advanced markets, the privatization of leading banks is complete, and the only remaining opportunities lie in the purchase of foreign-owned institutions that entered these markets early without a long-term strategy. This shakeout, which is likely to include a wave of mergers among subscale banks, is well under way as competition increases; ABN AMRO, for example, sold its Hungarian retail franchise to KBC, while ING’s retail operations in Hungary were divested to Citibank.

In second- and third-tier markets, notably Bulgaria and Romania, there is still a chance to acquire large banks that are being privatized. Russia—particularly the Moscow area, where the average GDP per capita is estimated to approach that of the most advanced Eastern European countries—could soon be ripe for foreign players as well if the government maintains its stabilization policies. Some Eastern European markets are uncertain politically and economically, but an early presence offers a chance to create value before they mature.

The transformation of Eastern Europe has been remarkable. Yet its maturing banking markets will offer no easy ride in the decade to come. The winners will have a long-term commitment to building a sizable presence in this fragmented region. Many banks will have to consider whether they are truly in it to stay or could better use their energy and resources elsewhere.