Viv Davies  interviews Harry Huizinga for Vox

October 2011

Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/7293]

Viv Davies:  Hello. Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies, from the Centre for Economic Policy Research. It's the 17th of November 2011. I'm speaking with Professor Harry Huizinga of Tilburg University, about his recent paper titled "Does the European Financial Stability Facility bail out sovereigns or banks?"

Using event-study methodology and statistical analysis, Huizinga concludes in his recent paper that the creation of the EFSF has resulted in the bailout of both banks and countries, and that the increased credit worthiness of the heavily indebted countries comes at the expense of a lower quality of debt of the non‑heavily indebted Eurozone countries.

He also concludes that the use of EFSF funds has been expensive and inefficient and that there is a limit to the extent to which the EFSF can be scaled up. Nevertheless, he suggests that this may indeed be a blessing in disguise.

I began the interview by asking Harry to briefly explain what the EFSF is and what it was designed to do.

Prof. Harry Huizinga:  The EFSF, that's the European Financial Stability Facility, it was set up on May 9th 2010 by announcement of the Eurozone governments. It is supposed to provide loans to Eurozone governments that are experiencing debt difficulties. The EFSF itself gets it funding from the capital markets. It uses guarantees from the Northern European countries.

Viv Davies:  The basis of your recent paper is to question whether the EFSF actually bails out sovereigns or banks. Firstly, how are banks affected by the EFSF? Secondly, how did you go about answering that initial question in your paper?

Prof. Huizinga:  Well, the banks, they do not get funding from EFSF directly, but indirectly they certainly are affected. First, they are affected because they hold a lot of government debt on their books. If the indebted countries in the South – if the credit worthiness of these countries improves – then the evaluation of these debts rises and that helps the banks. Secondly, what's important is that if the indebted countries are made more creditworthy, they also will be able to have a more creditable financial safety net. This helps the banks in indebted countries.

How did we go about looking at all this? Well, we look at the changes in market prices around the announcement date of May 9th 2010 of the EFSF and we look at the free prices particularly. First what we do is we look at the bank stock prices around this date.

We look at whether bank equity holders are affected by change in equity prices. Secondly, what we do is we look at the CDS spreads, which are available on bank liabilities. We see whether the cost of insuring bank liabilities, bank bonds, actually is affected by this. A third thing we have to look at is country CDS spreads. We look at whether the insurance necessary to insure government debts of indebted countries is affected by this announcement.

What you find, if you look at just the prices themselves, you find that the bank stock prices actually fall. Perhaps because bank equity investors expected an even bigger EFSF to come about. Perhaps they were disappointed by what they saw.

But on the other hand we find that the CDS spreads for both bank debts and for country debts, they fell. That's evidence that the market values of bank debt and government debt rose. You can say there's been some bailout of countries and also of at least the bank liability holders.

Secondly, what we do in this study is an event-study using event-study methodology, where we look in more detail at how these prices are affected, also by the exposures that banks have to sovereign debt. For that we use detailed information on the exposures that are available from stress tests that were conducted by a committee of European bank supervisors in 2010.

Secondly, we use information on the fiscal position of the countries by using information on the indebtedness and deficits of the country involved. From that you can get a bigger picture of exactly which banks and banking systems and countries, how they did, and how that depends on the exposure and on the fiscal situation of the countries.

Viv: What are the main results of your analysis?

Prof. Huizinga:  Well, the main results are, if we first look at the bank equity holders, they benefited to the extent that the banks held debt to the PIIGS countries. Those are Portugal, Ireland, Italy, Greece and Spain. But they were hurt to the extent the banks held other Eurozone debt. Then if you move to the bank liability holders, if you look at the CDS spreads there you find that the bank liability holders equally gained to the extent that banks held PIIGS debt, and they were hurt to the extent that the bank held the non‑PIIGS debt.

Also we see that the bank liability holders they gained if the bank is located in a country which has some strained public finances as indicated by a high debt or a high deficit.

Interestingly enough the countries, they saw their CDS spreads fall. So therefore the countries became more creditworthy. If the countries had banking systems with a little exposure to PIIGS debt, and, in contrast, if the bank systems had a lot of debt to non‑PIIGS Eurozone countries, then we saw actually that the CDS spreads rose.

Also, the CDS spreads fell to the extent that the country has a lot of government debt.

Viv:  OK. What can you say about the size or the magnitude of the effects on banks?

Professor Huizinga:  Well, when you look at the magnitudes, you can first look at what happens directly to the valuation of the sovereign‑debt portfolios that banks have. There we found that the announcement increased the valuation of these portfolios of sovereign debts of the banks in the study by about 10 billion. Then, looking at what happens to bank equity prices and to bank liabilities, you find that bank liabilities increase in value by about 29 billion, while bank equities fell in value by about four billion. If you add up the effect on bank liability holders and bank equity holders, you get to a positive amount of 25 billion, while, in fact, the increase in the valuation of the sovereign portfolio was only 10 billion. Banks, as a whole, if you add up the effect of bank liability holders and bank equity holders, it's much larger than the direct effect or the exposure they have to these countries. It seems to indicate that the banks benefited a lot because the financial safety nets in the country involved were made more creditable. If the countries are more creditable, they can more credibly provide support to the banks.

Viv:  What general conclusions can be drawn from your study? What would you say the implications of the study might be for how the EFSF is currently perceived by policymakers in terms of its role in helping solve the Eurozone crisis?

Professor Huizinga:  Well, one implication is the fact that both the banks and the countries were bailed out, and there are some related effects. If banks were located in countries with strained public finances, they were gaining more. On the other hand, if countries have banking systems more heavily exposed to the PIIGS countries, then the countries gained more. Now, the second thing is that we do see that it's bad for banks to have exposure during this episode to the non‑PIIGS Eurozone countries. That suggests that the creditworthiness of the non‑PIIGS countries has actually declined. That suggests that there is no free lunch. On one hand, you can increase the creditworthiness of the PIIGS countries, but it comes at a cost of reducing the creditworthiness of the non‑PIIGS countries.

That will also suggest that there is a limit to how much you can actually scale up the EFSF. While our study does not indicate clearly how far you can go in scaling it up, there is some cost to scaling it up. If you look at more recent experiences, if you look at what's happening in the last several weeks particularly, you see that there, indeed, is a lot of difficulty in scaling up the EFSF. While policymakers have said that, in principle, now the EFSF should be able to scale up to more than about a trillion's worth of lending capacity, you see, in practice, this is very difficult. I think this is consistent with the results we find, where you see the fact that there is no free lunch. You can try to scale it up, but only at a cost, and therefore you can only go so far.

Viv:  What about these discussions recently about turning the EFSF into a bank?

Professor Huizinga:  That's one way to try to scale it up. Then you would use the moneys that are guaranteed by the Eurozone countries as equity to the bank. Then you can try to attract additional funding from other sources, such as from sovereign‑wealth funds. For instance, China is mentioned as a possible provider of money. Then, if you do that, in principle, you could increase the lending capacity of the EFSF to more than a trillion euros. But it's been quite difficult to attract funding this way. It's to be seen whether this is going to be possible. Our study suggests that it would come at a cost of creditworthiness to the north, so perhaps it is not as easy as anticipated by policymakers.

Viv:  Another conclusion from your study is that the EFSF has benefited banks holding PIIGS debt, regardless of whether they are distressed and where they are located.

Professor Huizinga:  Yes. This is one of the, I think, lessons to be learned, that given that the EFSF cannot be too big, given that there is a scarcity of public money available, you should try to use it very well. What has been happening so far is that if you indiscriminately guarantee countries, and therefore also banks that hold this debt, then you do not just benefit the banks which are located in the Eurozone and are distressed, but also banks that are located elsewhere and are not distressed. You can say that this would be an inefficient way of using money. I think one lesson is that if the money is limited, you should use it very efficiently.

Viv:  What would be your key message now for policymakers dealing with the Eurozone crisis, Harry?

Professor Huizinga:  The key message is that if you have little money available, try to make the best of it. Try to use it well. The banks, it would mean that if you're going to bail out the banks, try to do it at low public cost. On one hand, try to have arrangements where the equity holders, they're gaining not too much. One way to do that is to make sure that the countries, or the EFSF, if they bail out banks, they get, say, warrants, which would provide some of the upside potential on equity prices to the providers of public moneys. On the other hand, it's also important that perhaps the bank liability holders provide some of the money necessary to do the bailouts. That would be paramount to a "bail‑in," where some of the money is cut from the bank liability holders. Try to bail out the banks as cheaply as possible.

The same goes for the countries. If you have little money available, in the EFSF, as we've seen, you may not be completely credible – and we've also seen that – while, as a result, you might see very high yields on countries' debts, such as Italy's debts. One benefit of that is that you actually get more leverage on the policymaking, and actually, perhaps you have more influence if you want to get countries to reform, so that you can promote growth. That's exactly what you have seen in Italy, where you've seen it changed. Now there is the government by Monti, and in fact you have more growth‑promoting policies. My message to policymakers would be, try to see their limited resources as a blessing in disguise.

Viv:  Harry Huizinga, thank you very much for taking the time to talk to us today.

Professor Huizinga:  OK, thank you.