Thematic Blogspot - Tackling current and future financial crisis with regulations: the Euro Zone gam
European banks suffered heavily from the 2007 crisis and are recovering laboriously. Acharya and Steffen highlighted that banking systems in Eurozone were under-capitalized since the financial crisis, and turned to risky sovereign debt assets as a result. With the emergence of the European debt crisis, banks faced severe liquidity and solvency issues. Even more worrying is the “dislocation between financial markets and the real economy” as pointed out by the EBA. Access to credit became extremely tight as shown by Kay et al. Loan acceptances fell up to 30% in some EU countries.
Percentage change in bank loan acceptances
Source: ESRI analysis of Eurostat access to finance data.
The decline in bank profitability magnifies those issues: banks with a Return on Equity lower than 4% represent 39% of the banking system in assets and EuroIntelligence fears that combined with low growth outlook, more risks could arise.
The Euro zone is vulnerable because it is an imperfect monetary union. Nicolas Véron specifically identifies a mismatch between market integration in the Eurozone and the preservation of national banking sector policies, including constraints against non-banking financial sector development to protect national “champions.” This happens despite the fact that national supervisory capacities were overwhelmed by banks size and growth, according to Dell’Ariccia et al.
This combination of vulnerabilities suggests that the euro zone needs more regulation. However, Dell’Ariccia et al note that, in times of financial instability, implementing more regulations and supervision could be quite costly. Wolf Wagner warned that a monetary union without a complementing banking union exacerbates systemic risk, but dealing with asymmetric shocks in a monetary union is complex, and the Banking Union will need to be well orchestrated.
A large regulations package to prevent future crisis
New institutions, new rules: Following the recommendations of the Larosière report, the European Systemic Risk Board was created in 2011 and is in charge of overseeing the build-up of financial risks at the macroprudential level, and the harmonization of financial stability policies between the European Supervisory Authorities (EBA, ESMA, EIOPA) and national supervisors. The ECB took over the surveillance of the 128 largest banks and will host a single crisis resolution mechanism and a deposit guarantee fund.
European-level directives reinforce the framework. The CRD IV package is designed to implement the Basel III rules in Europe. By reinforcing previous norms (capital requirements, liquidity ratios) and introducing new tools (leverage ratio, counter-cyclical buffers), it aims at strengthening banking institutions, and preventing the formation of bubbles in periods of excessive credit-growth. But, as pointed out by Karel Lanoo, excessive reliance on core tier-one ratio can give a misguided view of a bank’s health (Dexia had a core tier ratio above 9%), while the inadequate risk weighting of sovereign and real-estate assets is not addressed. Finance Watch also criticizes the lack of risk-weighting reform, too reliant on rating agencies and internal models. Similarly, Danièle Nouy highlighted the need for better supervisory practices and fewer “incentives for the purchase of sovereign debt.”
Will a supra-national supervisor be enough? According to Marius Zoican, given large and asymmetric cross-exposures, transnational European banks cannot be left under the responsibility of national supervisors—providing a rationale for a single supervisor in the monetary union. Moreover, the Single Supervisory Mechanism could enhance cross-border lending and address macroeconomic imbalances in the euro area, according to Thorsten Beck. Guillaume Arnould adds that the SSM will improve the harmonization of regulatory directives and information sharing and break the vicious circle between banking and sovereign default risk—a key point, for Thorsten Beck, to address the lack of internalization of cross-border spillovers, if properly complemented by a resolution mechanism.
The current solution, the SSM, is not exempt from criticisms:
On the scope of supervision—Guillaume Arnould argues that supervising only the largest banks is questionable as banking crises also spread through small local banks, often more exposed to NPLs
On the resources for resolution—funds allocated to the domestic resolution and deposit guarantee mechanisms appear too small to deal with a crisis occurs. According to Marius Zoican and Lucyna Gornicka in a Tinbergen Institute paper, the current architecture of the Banking Union could create an illusion of soundness, and enhance risk-taking and moral hazard.
As noted by Nicolas Veron (Peterson Institute), given the asymmetric concentration of small banks in a few countries, partial supervision could lead to political tension and regulatory arbitrage.
The potential adverse impacts of over-regulation
Higher capital requirements might damage the banks’ capacity to lend. In the Euro Area, policymakers try to revitalize the economy while the banking sector undergoes a process of deleveraging. The Modigliani-Miller theorem (1958) suggests that changing capital requirements would not affect bank lending. In practice, if all studies concur on the regulations long-term benefits, a range of possible frictions exists on the short-term run. Aiyar et al (2013) show that a half of banks’ short-term response to an increase in capital requirements occurs through a contraction of lending. Jonathan Bridges et al add that the largest effects arise for commercial real estate lending, followed by lending to other corporates and then secured lending to households. On the other hand, Avinash Persaud advocates that the main reason for reduced lending is the weak demand because many borrowers are still repairing their balance sheets or are not creditworthy.
What matters is how deleveraging is conducted:
Jean-Pierre Landau calls for a more “flexible capital targeting” to find the optimal equilibrium path between the credibility risk of waiting too long and the cost of going too fast. He points out the contradiction between accommodative monetary policy and tightened prudential standards. Accelerated deleveraging by banks impairs the monetary transmission mechanism. The conjunction of low interest rates and credit constraints distorts portfolio choices and asset prices. Interest rate risk is piling up in balance sheets while bank credit is impaired, especially for small and medium enterprises.
Lev Ratnovski suggests that banks should backload their equity increase to the time when growth revives. Ratnovski calls for higher capital ratio requirement (18% risk-weighted capital rather than the 12% demanded by the Basel III regulation) but admits that his analysis is limited by the fact that “safe levels of leverage are subject to change over time” (Eggertson and Krugman 2010).
Steeve Ceccheetti criticized the Eurozone authorities for allowing banks to meet capital ratio by shedding assets instead of raising additional capital. To limit this temptation, Viral Acharya, Dirk Schoenmaker and Sascha Steffen argue that the required amount to be raised by each bank should be presented as a euro amount and not as a ratio. A potential exception to the additional capital requirements could be applied to new net exposures, as the UK Financial Services Authority has been doing since 2012, to avoid further drag on lending (VoxEU).
Finally, Luc Laeven highlights that regulatory reforms target banks’ risk-taking behaviors without considering their governance—he finds that greater capital requirements increase risk-taking in banks with powerful owners.
Where do we stand with sovereign risks? Close ties between government and bank solvency has been a common thread for countries involved into the Eurozone crisis, as argued by Thorsten Beck, though this has been mitigated by the implementation of the ECB’s OMT program in September 2012 (Mainly Macro and the November 2014 ECB’s financial stability review). Regulatory measures may have produced counter-productive results on that front.
For Wolf Wagner, the key concern is that banks had over-accumulated governments bonds of their own countries, which calls for the diversification of sovereign exposures or, alternatively, the introduction of synthetic Eurobonds.
Viral Acharya argues that “a fuller solution to the problem of entanglement of sovereign and banking sectors requires not just a banking union:” it rests on directly addressing the sovereign excess in the borrowing markets by adjusting the capital charges for sovereign bonds and imposing the highest quality bucket for the government bonds eligibility for liquidity holdings. Claudia Buch and Benjamin Weigert claim that banking and sovereign distress have to be tacked at the same time. They call for the establishment of a European Redemption Pact (based on a proposal of the German Council of Economic Experts) to strengthen the fiscal discipline in the Euro Area.
Will regulations tackle the current crisis?
Banking union as a tool to solve the crisis? Views are mixed on whether the banking union will provide a lasting solution to the crisis. For Dell'Ariccia et al, it will support financial intermediation: resources deployed through the ESM should help banks to recapitalize, and supervision by the ECB will guide them towards more proper governance. Ian Begg is more doubtful on the effectiveness of the banking union, which relies too much on the consent of European governments, and hence on compromises to the expense of efficiency.
Recapitalization first? Thorsten Beck argues that the banking union only responds to medium-term issues. In another VoxEU article, Beck compares the implementation of the SSM to the introduction of insurance after the insurance case has occurred. Instead he proposes a European Recapitalization Agency to sort out fragile banks across Europe. Recapitalization also is the key for Benink and Huizinga as they compare the US and European situations—the former immediately recognizing losses and resolving their banks while the latter gambled on economic recovery to lift the profitability of financial institutions.
Recognizing losses is important, and some doubt the 2014 stress tests were sufficient. The stress tests, conducted in 2014, provided a source for comfort but also called for caution: while Gretchen Morgenson reveals that one quarter of the banks did not respect the ECB classification of non-performing loans, Thorsten Beck highlights the fact that the stress tests scenario did not include important aspects like the possibility of a sovereign default in the Eurozone and the risk of adverse deflation. Acharya and Steffen criticize the unrealistic ratio-weighted system applied by the ECB. Further, the banking sector in the Eurozone still carries €800bn of non-performing loans (4% of total Eurozone assets), and is considered as “non-compliant” with the Basel III rules (Bruegel). Benink and Huizinga conclude that without any recapitalization, economic stagnation will continue towards Japanese-style inertia and zombie banks proliferation.
What to expect next? Thorsten Beck blames political inaction and “half-baked approaches and unsustainable policies,” leaving it to the ECB to deal with the crisis, while protecting national bank banking systems. As highlighted by Jean-Pierre Landau, this is especially damaging in the Eurozone where banks account for more than 80% of credit. Developing market intermediation could be a solution—keeping in mind the risks associated with shadow banking (see for example EuroIntelligence and the IMF GFSR). Moreira and Savov propose to balance the need for a more developed shadow banking sector in the Eurozone with a more encompassing regulatory and supervisory regime.
