Despite emergency summits and last-minute reforms, there is still a large question mark hanging over the euro. This column argues that a chief cause of this is the management of Europe’s banks. It epitomises many of the contradictions at the heart of the Eurozone and unless resolved could be the cause of a slow and painful death of the single currency.
The Eurozone crisis keeps evolving along multiple dimensions. On the sovereign debt front, no deal is yet in sight on Greece’s debt restructuring, and Italy and Spain face major refinancing needs in early 2012. On the institutional reform front, the summit on 8-9 December fell short of delivering a true fiscal union (O’Rourke 2011), and tensions between the Eurozone and the UK have been brought to boiling point. On the growth front, a possible deep and prolonged recession looms.
Vincent O'Sullivan, Stephen Kinsella17 December 2011
The capital shortfall at EU banks is 8% higher than originally thought, according to the latest assessment from the European Banking Authority. This column examines the evolution of loan-to-deposit ratios in big European banks. It says banks have been buying back their debt securities, hoarding profits, limiting bonuses, and deleveraging. However, write-downs of sovereign debt have largely offset these efforts.
The capital shortfall at EU banks is 8% higher than originally thought, according to the latest assessment from the European Banking Authority (EBA 2011) released on 8 December. In the aggregate, European banks need to raise €114.7 billion as an exceptional, temporary capital buffer against sovereign debt exposures and to ensure their individual Core Tier 1 capital ratio reaches 9% of risk-weighted assets by the end of June 2012.
The financial system is like an organ in the body of the economy. But is it the heart or the appendix? This column, part of the Vox Debate on whether we need a financial sector, argues that we should measure the value banks create through their management of risk, not simply their bearing of risk. Under this measure, banks may well be less valuable to the economy.
Like an organ of the human body, the financial system calls most attention to itself when it malfunctions. But in normal times, is the financial system like the human heart, circulating essential capital throughout the economy? Or is it like the appendix, doing little when healthy but devastating when ill? Since the truth is probably somewhere in between, how can we calculate the contribution of finance to a modern economy?
The interplay of sovereign spreads and banks’ fragility in the Eurozone
Damiano Sandri, Ashoka Mody23 November 2011
European policymakers are confronting a heightened crisis characterised by a perverse and seemingly intractable interplay between sovereign debt pressures and financial-sector fragilities. This column argues that the payoffs from strengthening banks’ balance-sheets can still be large and, therefore, fiscal support is merited. But a more resolute strategy for winding down banks is also needed.
European policymakers are confronting a heightened crisis characterised by a perverse and seemingly intractable interplay between sovereign debt pressures and financial-sector fragilities (Wolff 2011). Three questions arise:
How much capital do European banks need? Some estimates
Viral Acharya, Dirk Schoenmaker, Sascha Steffen22 November 2011
The lack of market confidence in European banks is fed by the uncertainty about Eurozone sovereign debt. This column argues governments and banking supervisors should agree a recapitalisation package well before Christmas. It adds that the required amount to be raised by each bank should be presented as a euro amount and not as a ratio so as not to tempt banks to cut down assets instead of raising capital.
The European banking system is freezing up. Several banks are not able to fund themselves in the market. The lack of market confidence in European banks is fed by the ongoing uncertainty about Eurozone sovereign debt (as well as real estate) to which these banks are exposed.
Nobody thinks that utility-operating companies – whether in transport, such as railways, in energy, such as electricity, or telephone or water – are too big to fail. If they lose enough money and go bust, then, if another company cannot be found to take over the franchise, the government steps in to take over the operations. They keep the capital and (most of) the workers to continue running the utility. No one would think that it would make any sense to rip up the railway lines, electricity pylons, or water pipes, to sell them for scrap, and to push the skilled workers into unemployment.
A debate is raging on capital adequacy requirements for banks. The UK wants to be allowed to “top up” the agreed levels, i.e. to impose stricter capital standards than the EU minimum. This column argues the UK is right, and that the German and French opposition might be motivated by weaknesses in their banking systems.
Bank capital has emerged as a key element in the post-crisis financial regulatory reforms. Basel III is now likely to include a 7% equity-to-risk-weighted-assets capital requirement.
7% was a compromise. Some countries wanting more capital now intend to implement stricter standards unilaterally. This is making some of the others unhappy, and a bitter debate has erupted within the EU on whether individual EU member countries should be allowed to require more capital than the Basel III, and hence EU, minimums.
Ruediger Fahlenbrach, Robert Prilmeier, René M Stulz27 May 2011
Crises are a regular event in financial markets. But do banks that have been hit particularly hard in one crisis learn from the experience and suffer less in future crises? This column suggests not. It shows that banks particularly hard hit by the 1998 financial crisis were also badly affected by the recent financial crisis. It blames the high-risk business models on which these banks rely.
On 17 August 1998, Russia defaulted on its debt. This event started a dramatic chain reaction. As one observer put it, “the entire global economic system as we know it almost went into meltdown, beginning with Russia's default” (Friedman 1999). As Russia defaulted, a number of investors, including banks, made large losses. For example, the market capitalisation of both CitiGroup and Chase Manhattan fell by approximately 50% in the two months following the Russian default.
From financial crisis to Great Recession: Evidence on the transmission role of banks
Shekhar Aiyar12 May 2011
It is widely believed that banks played a central role in the Great Recession, but where is the smoking gun? This column presents evidence from the UK confirming the conventional wisdom. It finds that banks transmitted the unprecedented external funding shock by cutting back on domestic lending.
How did problems originating in one asset class in one country propagate internationally, sparking the Great Recession? A standard stylised explanation relies on the globalisation of the banking system, and has two parts.
The authors of CEPR DP8333 assess the optimal level of equity for banks to hold, taking into account costs and benefits both private and social. After considering these overall economic (or social) costs, the authors conclude that desirable equity levels for banks are far higher than actual levels or even target levels under Basel III.