The recession in emerging Europe will be more severe than elsewhere due to large imbalances, and will put the financial strength ratings of local banks and their western parents under pressure, Moody's said on Tuesday.

The combination of higher provisions for bad debt, the rise in banks' borrowing costs and falling currencies will weigh down banks' profitability and help erode their capital base, the ratings agency said in a special comment on the region's banking sector released overnight.

The warning alarmed markets on Tuesday, sending the euro, emerging European currencies and bank stocks lower on concerns the region's crisis may become a vicious circle.

Deteriorating financial strength of East European subsidiaries has a negative spillover effect on their West(ern) European parents, Moody's said in the note.

A widespread deterioration in the economic health of core markets in Eastern Europe is exerting negative rating pressure on subsidiaries and eventually may also lead to a weakening of the parent bank's ratings, it said.

Western European banks led by UniCredit, Erste Group Bank, Raiffeisen International and Societe Generale have bought most of emerging Europe's banking sector in past years to tap into the rampant credit growth that fueled the region's boom.

Their eastern franchise has in the past boosted parents' profits and helped them resist the temptation of structured debt products, but this boon has turned into risk now that economic crisis has the region firmly under control.

The euro hit its lowest in more than two months against the dollar on Tuesday as the report added to investors' worries over the region. The Polish zloty, Hungarian forint and Czech crown all fell to new lows.

Shares in the western lenders that control emerging Europe's banking market also slumped, with Austria's Erste Group Bank, Belgium's KBC and Societe Generale all among the top losers in the FTSEurofirst.

There is no doubt that markets have decided that emerging Europe is the subprime of Europe and now everybody is running for the door, said Lars Christensen, an economist at Danske Bank.

YOUNG BANKS

Modern banks in the region are still young, which means that relatively low confidence may trigger bank runs more quickly then in the West, and that banks' loan books are so far largely untested by a severe economic downturn, Moody's said.

Most of the western banks active in the region have assets in a number of countries and may become more selective in funding their subsidiaries, heightening the risk for weaker countries.

Banks allocate capital to their subsidiaries depending on expected risk-adjusted returns, the agency said. Thus, risks are particularly skewed to the downside in countries that have been identified as more vulnerable.

However, the agency notes that there are motives for banks to continue funding emerging European units. Parent banks abandoning one country may destroy clients' trust in another country, creating negative effects of its own, Moody's said.

With a relatively small number of banks concentrated in a handful of countries, some very exposed western European sovereigns have come under pressure for fears of a knock-on effect of potential emerging European bank failures.

Austria is by far the most exposed to the region, as its banks have lent the equivalent of 75 percent of its GDP to clients in emerging Europe. Belgium's, Sweden's and Greece's exposure is also substantial.

The spread of Austrian and Greek 10-year bonds over German bunds widened to a lifetime high of 124 basis points and 300.8 basis points, respectively, on Tuesday.

The whole path of development in eastern Europe has been to borrow from abroad to fund consumption and investment, and clearly that has become unsustainable, said Neil Shearing, economist at Capital Economics.

(Editing by Patrick Graham)

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