Lessons from the European financial crisis

Abstract

This paper distils three lessons for bank regulation from the experience of the 2009-12 euro-area financial crisis. First, it highlights the key role that sovereign debt exposures of banks have played in the feedback loop between bank and fiscal distress, and inquires how the regulation of banks' sovereign exposures in the euro area should be changed to mitigate this feedback loop in the future. Second, it explores the relationship between the forbearance of non-performing loans by European banks and the tendency of EU regulators to rescue rather than resolving distressed banks, and asks to what extent the new regulatory framework of the euro-area "banking union" can be expected to mitigate excessive forbearance and facilitate resolution of insolvent banks. Finally, the paper highlights that capital requirements based on the ratio of Tier-1 capital to banks' risk-weighted assets were massively gamed by large banks, which engaged in various forms of regulatory arbitrage to minimize their capital charges while expanding leverage. This argues in favor of relying on a set of simpler and more robust indicators to determine banks' capital shortfall, such as book and market leverage ratios.JEL classification: G01, G21, G28, G33.

Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty

“…When government and bank balance sheets become closely intertwined, their default probabilities become highly correlated too. Our focus on bailouts as an important linkage between banks and sovereigns is supported by Pagano (), who provides evidence that European governments have shown a greater willingness to provide assistance to financial institutions compared to the United States and the United Kingdom…”

“…Pagano () examines the difference in banks' “stand‐alone” credit ratings with the ratings they receive when potential government support is taken into account. He shows that government support reduces banks' funding costs by 60 basis points (bps) in the EU as compared to 10–20 bps for the United States and the United Kingdom.…”

What drives the greater or lesser usage of forbearance measures by banks?

“…The main starting point of the first wave of studies was the subprime crisis which began in 2007 in the USA and had many long lasting effects on the financial and economic environment all over the world. One of these effects was the tremendous worsening of the credit quality of banks' lending portfolios and the consequent increase in the stock of non-performing exposures across Europe [22,23]. The phenomenon clearly worried the Supervisory Authorities and pushed them to analyze the issue attentively, in order to better evaluate the dimension of the problem and devise potential solutions.…”

Banking union: Mind the gaps

“…The lack of any form of fiscal federalism through the establishment of common deposit insurance, combined with the lack of any active policy to reduce entry barriers on de facto local banking markets creates an environment that maintains the existence of segmented banking markets. Pagano (2014) argues that the refusal to create an equivalent federal institution for monitoring banks -a European System of Banking Supervisors -was likely linked to the desire to create country-level banking champions. A federal supervisor of banks will likely ring-fence banks from local political lobbying to finance pet projects, and will then impose checks on the growth of national champions and apply brakes to their potentially unsustainable credit growth.…”