Revisiting Banking Union in a Single Currency Area (Part 1)

Evidence suggests that financial integration in the Euro area is retrenching at a quicker pace than outside the union. Home bias persists. Meanwhile, governments continue to compete on their funding costs via interventions to support ‘their’ banks, avoiding spill over effects on costs of public debt but so distorting the level playing field with massive state aids. Fears of being too exposed to country risk and to a lack of incentives for a proper management of legacy losses is feeding banks’ cross-border risk aversion loop. Bank restructuring is instead gradually taking place where intervention in the banking system was financed by a common Euro area intervention (through ESM or previous programmes).

Financial disintegration and consumers’ welfare

As the Euro area tries to emerge from the ashes of the financial crisis, financial disintegration continues to burden economic recovery and the restructuring of the banking system. Foreign claims (excluding derivative contracts and shares) of EMU banks versus intra-EMU counterparties are retrenching at a faster pace than claims versus non-EMU counterparties. This situation points at idiosyncratic factors within the EMU that are speeding up financial retrenchment.

Figure 1. Intra-EMU MFIs Euro area holdings (€mn), 2006-2013

Source: ECB. Note: Up to November 2013.

Figure 2. Intra versus Extra-EMU (EU) and other extra EMU (selected) outstanding loans and securities other than shares or foreign claims (€mn), ∆ Q2-2010/Q3-2013

Source: ECB and BIS. Note: loans and securities holdings of EMU MFIs versus MFIs and non-MFIs counterparties.  ‘Selected’ extra EMU countries are foreign claims of domestic banks in France, Germany, Italy and Spain versus Australia, Brazil, Canada, China, Hong Kong SAR, Japan, New Zealand, Singapore, United Kingdom, United States.[1]

A more detailed breakdown of cross-border securities holdings show that holdings continue to drop led by a strong home bias, possibly driven by fear of capital flights in the currency union.

Figures 3a and 3b. Securities other than shares, non-domestic (a) versus domestic (b) holdings (€mn), 2007- 2013

Source: ECB. Note: Up to November 2013.

Since 2010, as suggested above, a more than €200 billion drop in holdings of securities issued by non-domestic governments has been offset by holdings of securities issued by the domestic government, with an increase of roughly €500 billion, on top of an increase of other domestic assets. There are no signs that this trend will be reverting soon.

The moral hazard of governments in the Euro area

With the introduction of the common currency, capital (savings) across euro-area countries can move freely, and investors can quickly exchange cross-border investments in the same asset class, for instance, from Spanish government bonds to German ones when risk aversion increases (Kopf, 2011). Because fiscal policies and backstops are national, governments behave strategically to avoid instability in the banking system that would result in capital shifting toward safer banking systems within the same currency area, causing a sharp increase in their own borrowing costs. This fear is, however, typical of a currency union while less significant for countries that do not share a common currency for at least two reasons: the intrinsic legal and economic barriers raised by a different currency, and the financial backstop that the domestic central bank can offer in case the government runs out of money.

Therefore, the use of Eurozone member states’ fiscal power to prop up domestic banking systems has served the purpose of ring-fencing liquidity at national level and ultimately to delay a much needed restructuring of the sector. In effect, a massive intervention of governments to support the financial sector via guarantees, recapitalisation and asset relief took place between 2008 and 2012 and is still ongoing. Interventions were allowed in the EU under the exemption granted by article 107.3(b) TFEU, with very limited conditions for guarantees in particular. Almost €4 trillion in total state aids (of which €413 billion for recapitalisation) flooded the domestic banking systems in the European Union from 2008 to 2012, with Ireland, UK and Germany at the top three in absolute value. Over 75% of these state aids (around €3 trillion) have been used by Euro area countries. Conditions have been tightened only last July 2013, with the request in case of guarantees of a restructuring plan if they are higher than 5% of total liabilities (or €500 million).[2]

Are these actions slowing down bank restructuring in the EMU?

Interventions may have slowed down the restructuring of the banking sector, as many banks remain undercapitalised (Acharya & Steffen 2014). Most notably, in countries where the banking system has been subsidised by the local government intervention, the propping-up of local banks through capital increases (equity dilution) has been fairly slow, despite a different national definition of capital and loans provisions (see also De Grauwe & Ji 2013). This divergence becomes more evident in looking at the annual marginal increase in capital and reserves as a proportion of total capital and reserves vis-à-vis the euro-area average, a calculation that partially neutralises the differences in the definition of capital among countries. Spain and Ireland, driven by the strict conditions imposed by EU intervention, have been the only two countries that had an increase of equity above the euro-area average in five out of the past seven years. While the UK has experienced a marginal increase higher than the euro-area average in four out of seven years, as illustrated by Figure 9, countries where direct or indirect government intervention took place have performed worse in the recapitalisation of banks, in particular, Germany, France and Italy (just slightly above average for three years out of seven) or Belgium and the Netherlands (only two years above the euro-area average, with high volatility in the flow of funds toward recapitalisation).

Banks in the Euro area that have been able to use the credit status of the local government have experienced a slowdown in equity dilution, delaying restructuring and recapitalisation of the banking system and so a proper management of losses on legacy assets. Postponing costs of bank restructuring to future governments (moral hazard), as a fiscal issue, is also hampering the transmission channels of monetary policy. Failure to deal with legacy assets would intensify welfare losses and magnify frictions in credit markets, which may only accelerate the deflationary spiral that may drag Europe into another ‘lost decade’.

For more details, please see Valiante (2014)

References

Acharya V. V. & Sascha Steffen (2014), “Falling Short of Expectations? Stress-Testing the European Banking System”, Forthcoming CEPS Report

De Grauwe, P., & Ji, Y. (2013), “Strong Governments, Weak Banks”, CEPS Policy Brief, n. 305.

Kopf C. (2011), “Restoring Financial Stability in the Euro Area”, CEPS Policy Brief, n. 237, March 15th.

Valiante, Diego (2012), “Last Call for a Banking Union in the Euro Area”, Applied Economics Quarterly, Vol. 58, No. 2, pp. 153-170.

–          (2014), “Framing Banking Union in the Euro Area: Some Empirical Evidence”, CEPS Working Document, N. 389, February.

 



[1] See Commission Communication 2013/C 216/01, entered into force on August 1st, 2013.

 

[2] BIS data converted to Euros with a simple average of yearly exchange rates from 2010 to 2013 calculated by http://www.oanda.com/currency/average. For a definition of ‘foreign claims’, please see BIS Glossary, available at http://www.bis.org/statistics/bankstatsguide_glossary.pdf.