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Vicious Cycle 2.0: European bank interconnectedness and vulnerabilities

Vicious Cycle 2.0: European bank interconnectedness and vulnerabilities

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Guest post by Silvia Merler.

Since the beginning of the crisis – and more so since 2010 – Europeans have been looking at the sovereign-banking “vicious circle”, tying together the dismal fates of States and banks. This has emerged as a characteristic disease of the euro crisis, and one of the stated objectives of the European Banking Union project was to remedy it. 

The idea was to achieve this goal in a twofold way. Ex ante, by strengthening and harmonising supervisory requirements (e.g. on capital) and by empowering a high-quality independent supervisor to oversee their fulfillment, thereby rebuilding trust in supervision and in the financial sector’s health. Ex post, in the event of an unavoidable crisis recourse to taxpayers’ money would be limited as far as possible, thereby preventing worries about the damage that bank rescue would inflict on public finances.

The ex ante principle was translated into practice through the creation of a Single Supervisory Mechanism (SSM) under which, on the 4th of November, the ECB took over supervisory responsibility for major banks in the euro area. The ex post principle was concretised through the introduction of the Bank Recovery and Resolution Directive (BRRD) which gives a framework for resolution of troubled banks, and through the creation of a Single Resolution Mechanism (SRM), which should ensure consistent and homogeneous application of the BRRD. Among other provisions, the BRRD contains a set of rules for bail-in of private creditors in bank resolution, strengthening the private creditor responsibility that de facto is already introduced through the amended State Aid framework.

There has been a remarkable shift in the European mindset about banking crisis, from bail-in being taboo to bail-in being regarded as a welcome new normal. In principle, there is nothing bad about this idea, but the question is whether in rapidly overturning the attitude and approach to private creditor involvement, European policymakers may have overlooked important weaknesses that still exist in the system. This could have serious consequences for the application of these new rules. 

One such point of weakness could be the fact that banks are actually very substantial creditors to other banks, via cross-holdings of shares as well as bank bonds. In its latest Financial Stability and Integration Report (April 2014), the European Commission reported that between 2008 and June 2013, out of an aggregate increase of €630 bn in banks’ capital, €400 bn corresponds to increases in interbank positions and only €230 bn is fresh capital injected from outside the banking system. Despite declining since the pre-crisis peaks, interconnectedness across banks remains high, and as of December 2013 “the counterparty for 24 percent of Euro area banking assets (or €7,400 bn) is another Euro area bank”.

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The chart above - originally published in this Bruegel post - shows how serious the situation is in the case of Italian banks, who appear to be strongly tied together in a network of cross-holdings. The chart below - compiled by the Financial Times in 2013 - shows that the Spanish system was not immune to the problem either, although less striking. In the case of Italian banks, I pointed out that strong cross holding structure (with political interference) could impede necessary post-stress test reform, but this is not the only problem. The resolution of Portugal’s Banco Espirito Santo (BES) in August 2014 brought to light another, potentially serious, implication. The second largest shareholder of BES was in fact another bank, France’s Credit Agricole. Due to the restructuring of BES, Credit Agricole ended up taking a 708 m euro loss from its stake in BES, nearly wiping out its second-quarter net profit, which fell 97.5 percent to 17 m euros.

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Banks’ bond holdings also represent a possible risk to resolution. Almost 40% of securities other than shares issued by banks in the euro area are held by other banks in the euro area at the aggregate level, according to ECB data, and holdings are also affected by home bias.

The charts below show Italian and Portuguese banks’ holdings of bonds issued respectively by domestic government, other domestic banks and other domestic sectors. As a comparison, holdings of bonds issued by the corresponding sectors in other euro area countries (i.e. cross border rather than domestic holdings) are also reported. It is clear (and not new) that holdings by banks of bonds issued by the domestic government have increased a lot during the crisis, in some cases reaching the level of the 1990s. But what is even more noteworthy is the increase in holdings of bonds issued by fellow domestic banks, which seem to have been traditionally very low but are now between 7 and 9% of total assets in these two countries.

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Conversely, French and German banks not only reduced (or at least did not increase significantly) their exposure to the domestic government, but also decreased their holdings of bonds issued by other domestic banks as a percentage of total assets:

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The strong interconnectedness of banks makes the European financial system vulnerable in the context of bank resolution and raises concerns regarding the viability of bail-in. As the BES case showed, the creditors targeted by bail-in would to a large extent include other banks: losses due to bail-in would be likely to cause them serious problems. Bail-in could therefore become very difficult due to the systemic implications. It follows naturally as a conclusion that one of the first priorities for the ECB in its brand new role as supervisor must be to weigh possible measures to mitigate these problems. The ECB in its prudential exercise is including a capital add-on of 1 percent to take into account the systemic relevance of banks. This is in line with CRD IV rules, which include mandatory systemic risk buffer of between 1 and 3.5 percent CET 1 of RWAs for banks that are identified by the relevant authority as globally systemically important and also gives the supervisor an option to set a buffer on 'other' systemically important institutions, including domestically important institutions and EU-important institutions.                                   

On top of imposing a capital buffer to limit the effect of interconnectedness once it has built up, one possible way to go would be to act on its underlying drivers to foster more diversification ex ante. There has been a lot of talk over the last years about the need to change the framework for the risk-weighting of government bonds in banks’ assets, in order to better reflect their actual degree of risk (which certainly was way above zero, during the crisis). Reports suggest that stricter rules on banks’ exposure to single counterparties could trigger a sovereign debt portfolio rebalancing in the order of €1tn across the region. The data presented here suggest that weakening the drivers of bank-to-bank interconnectedness (e.g. by means of risk weights) and fostering portfolio diversification should also rank high on the priorities, in order to foster financial stability in Europe. Otherwise, we might sooner or later discover that by trying to fix the sovereign-bank vicious cycle we have instead fuelled a bank-to-bank one which is no less dangerous.

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Silvia Merler is an economist and an Associate Fellow at Bruegel.org, where the original version of this post can be found.

Image from www.jsculpt.com


















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