From Fragmentation to Financial Integration in Europe

Chapter 5. Crisis Management

Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Luc Everaert, Heiko Hesse and Nadege Jassaud 

Managing a financial crisis is a challenge even if the crisis has no cross-border dimensions. By its very nature, a financial crisis is unexpected and an indication that prevention failed. Diagnosis and a viable solution need to be arrived at in real time, under limited information, and with suboptimal policy coordination frameworks. Often, multiple combinations of interventions are possible and resolving a financial crisis involves public guarantees or funding, the approval of which is subject to a democratic process. Consequently, crisis management is seldom smooth, mistakes are made that need to be corrected along the way, and adverse consequences for the real economy are rarely avoided.

Global financial integration, the single market in financial services in the European Union (EU), and the economic and monetary union (EMU) add increasing layers of cross-border complexity to managing a financial crisis in various parts of Europe. The global financial crisis may have been triggered by the subprime mortgage problem in the United States, but it quickly exposed homegrown weaknesses in Europe, in particular the excessive leverage of different sectors of the economy in a number of countries. Tied through cross-border exposure, cross-border ownership, international wholesale funding, or a common currency, most countries in Europe became engulfed in the financial crisis in one way or another. Unfortunately, when the crisis hit, the cross-border framework for crisis management was still in its infancy.

To draw lessons for the design of a robust crisis management framework in the EU, it is useful to briefly review how the global financial crisis turned into a full-fledged crisis in the EU and in EMU more particularly, how the cross-border dimension played out, and how policymakers responded in the various defining moments of the crisis.

From California to Cyprus

Initially, from Europe’s perspective the financial crisis had a foreign label and a degree of remoteness to it. Derivatives involving mortgages in the United States, with California being among the most affected, turned out to be illiquid, causing difficulties for highly leveraged financing vehicles. Some of these products were held in Europe, and BNP Paribas was one of the first firms to suspend payouts of three of its investment funds in August 2007, citing (in a press statement) that it had “no way of valuing the collaterized debt obligations (CDOs)” that were in them. But the crisis quickly took hold in Europe. A few months after BNP Paribas’ decision, it turned out that Northern Rock’s business model, based on securitization of its mortgage portfolios, could no longer be funded. The market for securitized products had dried up.

At this early stage, the financial crisis was treated essentially with national measures, and coordination was limited to central banks providing foreign currency swaps and ensuring interbank liquidity. In 2008, Northern Rock was “temporarily nationalized” and HBOS rescued in the United Kingdom, while in the United States Bear Stearns was taken over by JP Morgan Chase, Fannie Mae and Freddie Mac were bailed out by the government, and in mid-September, Lehman Brothers was allowed to file for bankruptcy. A few weeks later, the Irish government decided to underwrite the entire liability side of its banking system, while Iceland’s biggest banks collapsed, leaving foreign depositors adrift. In the United Kingdom, the rescue package was extended to cover Lloyds TSB. In the Benelux, Fortis was partly nationalized and broken up along national lines while Dexia was bailed out. The common denominators underlying problems in these banks were high leverage, wholesale funding, and exposure to impaired or difficult-to-value assets.

As the financial crisis took a broader economic toll and plunged the global economy into recession, it spread well beyond the financial sector in several countries. In emerging Europe, the Baltics, which were highly overleveraged, were very hard hit, while Hungary and Romania experienced difficulties as a result of the global crisis. For Hungary, Latvia, and Romania, external financial assistance became necessary in 2008 to support their adjustment.

The crisis next headed south and west. Greece, revealing a massive hole in its public finances, had to be bailed out in May 2010, followed by Ireland in November 2010, when contingent liabilities from its banking sector bailout became too heavy for the government to carry. Portugal followed in April 2011 as its economic recession revealed competitiveness problems and markets doubted the sovereign’s ability to continue to finance large deficits and rollover public debt. Finally, Cyprus succumbed to the turmoil, partly as a result of its close links to Greece—which entered into a large sovereign debt restructuring—but also because of a home-grown real estate bubble and an oversized banking system which the sovereign would not be able to support. Italy and Spain suffered severely from contagion, in the case of Spain exacerbated by a deflating real estate bubble, requiring the European Central Bank (ECB) to take extraordinary measures—Long-Term Refinancing Operations (LTROs) and Outright Monetary Transactions (OMT)—to preserve liquidity for banks and sovereigns.

Crossing Borders

While one could argue that policy mistakes by national authorities were the root cause of the financial crisis, such an argument ignores the limitations of national policy action in an interconnected world. Global integration of trade and finance are generally accepted as beneficial to global growth and development. However, together with the benefits, risks also travel across borders and policy actions in any given country have implications abroad.

In the EU, the setting up of the single market in financial services promoted financial integration. The single market concept postulates that within the EU and even the European Economic Area, the financial system is fully unified, as if it were a single domestic system. All financial services are free to cross borders without obstacles and banks can set up branches anywhere they like under the so-called single passport regime: a bank licensed in any EU country is allowed to operate throughout the entire EU. This even applies to banks that are originally from outside the EU: so a Chinese bank incorporated and licensed in Luxembourg can establish a branch in Poland and sell mortgages to residents of Italy out of that branch. As a result of these institutional arrangements, cross-border exposure rapidly grew through 2007 (Figure 5.1) and cross-border ownership of banking institutions took on significant proportions, especially in emerging Europe (Figure 5.2).

Figure 5.1Total Intra-European Union Foreign Exposure

Source: Bank for International Settlements, consolidated banking statistics, immediate risk basis.

Note: Ireland and Finland not included due to breaks in data reporting.

Figure 5.2Market Shares of Foreign Banks in EU Member States, 2011

(In percent)

Source: European Central Bank, Structural Financial database and Monetary Financial Institution (MFI) database.

The strong integration of capital markets and the existence of financial centers further tied the region together. Equity markets operated seamlessly across borders, linking the liability side of the banking and insurance companies closely together. Many transactions went through financial centers, with London providing a diversity of services to the continent, and Dublin and Luxembourg becoming hubs for investment funds.

In the EMU, financial integration went even further because of the use of the single currency. Here, financial institutions across borders became connected through the euro interbank market, while sovereigns and corporate funded themselves in euro area capital markets in which there was very limited national distinction. Indeed, from a regulatory perspective, sovereigns were considered risk-free with zero risk weights for bank capital, while the Stability and Growth Pact and the no bailout clause of the Maastricht treaty were meant to secure fiscal discipline. The resulting interest rate convergence was associated with very large cross-border flows of capital inside the euro area, to a large extent intermediated through the banking system and involving the buildup of sizeable current account imbalances in the euro area (Figure 5.3).

Figure 5.3EU: Current Account Balances

(In percent of GDP for each subgroup)

Sources: World Economic Outlook, IMF (2012).

1 Countries with current account deficits before the crisis: Cyprus, Estonia, France, Greece, Ireland, Italy, Malta, Portugal, Slovakia, Slovenia, and Spain.

2 Austria, Belgium, Finland, Germany, Luxembourg, and the Netherlands.

3 Bulgaria, Czech Republic, Hungary, Latvia, Lithuania, Poland, and Romania.

4 Denmark, Sweden, and the United Kingdom.

The prospective adoption of the euro by emerging European economies that are members of the EU lead to an important convergence play. When eastern European countries joined the EU, western European banks invested massively in those countries and provided funding to their subsidiaries and branches there. Conversely, profits from rapid expansion in emerging Europe underpinned the profitability of the parent groups. With expectation of euro adoption, a lot of borrowing took place in foreign exchange, leading to credit booms, especially in countries which were already pegged to the euro (Figure 5.4 on credit in emerging Europe).

Figure 5.4Selected Emerging European Countries

(Real Private Credit Index)

Source: IMF, International Financial Statistics database, and staff calculations.

Hence, on the eve of the financial crisis, the financial systems of EU countries were closely intertwined, but their supervision was not and the institutional framework to deal with a systemic crisis was virtually inexistent. Despite unbridled cross-border banking and EU and euro area-wide capital markets, countries had adopted their own supervisory approaches, leading to large divergences in the size and structure of national financial systems. Cross-border coordination was largely limited to the encouragement to jointly supervise cross-border banking groups by means of Memoranda of Understanding and the beginnings of harmonization of regulation and supervision through the various EU-wide committees (e.g., the Committee of European Banking Supervisors).

In these circumstances, managing the crisis has proven very difficult. The crisis was initially perceived as localized and treated with national solutions. However, even national crisis management frameworks were insufficient to deal with it effectively. Many EU countries had to substantially modify their crisis management and resolution regimes to address banking problems. The need for coordination of such regimes in a single market for financial services has been duly recognized, leading to the EU directive on resolution, which should support a better cross-border response to future crises.

Many of the decisions taken by national and EU authorities, while well-intentioned, led to significant adverse policy spillovers. The break-up of Fortis along national lines ended the usefulness of the Memorandum of Understanding process for handling cross-border institutions, thus creating uncertainty about how problems in other cross-border institutions could be resolved efficiently.

The guaranteeing of all liabilities of the Irish banking system by the Irish sovereign unleveled the playing field in the single market for financial services as creditors and depositors of banks in other countries suddenly ended up comparatively less protected. On the one hand this attracted depositors to the Irish banks at the expense of mostly U.K. institutions, and on the other it caused difficulties in resolving the institutions as no bail-in of investors was deemed possible.

The proposal launched by the European Commission to bail-in unsecured creditors on the heels of a bail-out of these creditors, in the context of Ireland’s rescue, caused market jitters. There was no doubt that the Commission proposal was well intended: in the long run it is necessary to ensure that financial institutions are resolvable at the lowest cost to the taxpayer, a position that is now embraced throughout the world and embedded in the Financial Stability Board’s principles for effective resolution. However, launching such proposals in the middle of a crisis may not have been the most opportune time as it aggravated the funding difficulties of the banking system.

The handling of the Greek crisis also contributed to the turbulence. The authorities’ position on sovereign debt shifted considerably. On April 15, 2010, Olli Rehn, the Economic and Monetary Affairs Commissioner, told a conference in Brussels: “There will be no default.” However, in May 2011, the commissioner suggested that a voluntary debt reprofiling could be considered. And in July 2011 came a clear statement from European leaders that a haircut would be necessary. In addition, some leaders indicated that euro area exit would be Greece’s choice.

At this point, contagion was spreading rapidly throughout the euro area, threatening other sovereigns with financing difficulties. Spain and Italy had to embark on significant adjustment programs, triggering discussions about their financing needs and the capability of the European Financial Stability Facility and subsequent European Stability Mechanism (ESM) to meet funding needs should they arise. Policy reversals on how to handle the crisis in Cyprus, and the difference in approach compared to the other programs, once more added to uncertainty.

Policy Decisions to Manage the Crisis

In these circumstances, financial market turbulence has been difficult to address. Central banks, and in particular the European Central Bank, had no choice but to step in with unconventional measures to buy time and to guard against tail risks. The decision-making process on these measures was also drawn out, and tail risks were not removed until the outright monetary transactions (OMT) were introduced (Table 5.1).

Table 5.1European Central Bank: Unconventional Measures 2007–2012
Decision dateMeasure
October 8, 2008Fixed rate, full allotment tenders adopted for weekly main refinancing operations, for as long as needed.
Reduction of the corridor between standing facilities to 100 basis points, for as long as needed.
October 15, 2008Expansion of eligible collateral through end-2009.
Enhance longer-term refinancing operations through end-Q1 2009.
Provision of U.S. dollar liquidity through foreign exchange swaps.
December 18, 2008Increase of corridor between standing facilities to 200 basis points.
February 5, 2009Fixed rate, full allotment tenders to continue for as long as needed on all main, special term, supplementary, and regular longer-term refinancing operations.
Supplementary and special term refinancing operations to continue for as long as needed.
May 7, 2009One year long-term refinancing operations introduced.
Covered bond purchase program announced.
March 4, 2010Return to variable rate tender for three-month long-term refinancing.
May 10, 2010Securities Markets Program introduced to intervene in the euro area public and private debt securities markets.
Fixed rate, full allotment tenders adopted for regular three-month long-term refinancing, extended through today.
August 4, 2011Supplementary longer-term refinancing operation with a maturity of approximately six months, fixed rate and full allotment introduced—subsequently extended through today.
October 6, 2011Two longer-term refinancing operations introduced—one with a maturity of approximately 12 months in October 2011, and another with a maturity of approximately 13 months in December 2011.
New covered bond purchase program launched.
December 8, 2011Further nonstandard measures introduced, notably: (1) to conduct two longer-term refinancing operations with a maturity of approximately three years; (2) to increase the availability of collateral; (3) to reduce the reserve ratio to 1 percent; and (4) for the time being to discontinue the fine-tuning operations carried out on the last day of each maintenance period.
February 9, 2012Further collateral easing by approving specific national eligibility criteria and risk control measures for the temporary acceptance in a number of countries of additional credit claims as collateral in Eurosystem credit operations.
September 6, 2012Outright Monetary Transactions (OMTs) introduced to purchase sovereign bonds in the euro area in secondary markets.

Liquidity support provided by central banks has been extraordinary, especially in the euro area and the United Kingdom. In the euro area, the ECB provided enhanced support by (1) broadening the scope of eligible assets for central bank funding and setting up full allotment liquidity facilities for banks; (2) undertaking refinancing operations at fixed and historically low rates; (3) extending the maturity of central bank funding to a historical high via the Long-Term Refinancing Operations; and (4) actively purchasing assets (Figure 5.5). National central banks have also granted Emergency Liquidity Assistance in crisis situations. In the United Kingdom, the Bank of England set up an Asset Purchase Facility, for example, to buy high-quality assets, with cumulative assets purchased net of sales and redemptions totaling £360 billion (as of September 2012). However, while central banks can provide liquidity, they cannot address the underlying real problems or the need to restructure banks and resolve fiscal problems.

Figure 5.5European Central Bank Monetary Financing Operations vis-à-vis Euro Area Banks

(In billions of euros)

Source: Bloomberg, L.P.

Hence, moving banks and sovereigns jointly to sustainability was and still is the key challenge to decisively end Europe’s crisis. Meeting this challenge is essential to restore confidence and a functioning financial system, which is in turn indispensible for growth and fiscal sustainability. The right combination of policies that strengthen banks and public sector balance sheets should do the trick:

  • Strengthen market capitalization of banks: raising regulatory capital, solvency ratios, asset quality, and economic growth; eliminating nonviable banks and supporting consolidation.

  • Increase bank liabilities available for bail-in.

  • Provide sovereign guarantees to bank creditors or through asset protection schemes, provided there is fiscal room.

  • Reduce sovereign debt and deficits and engage in asset-liability management exercises to improve sovereign sustainability.

  • Provide support from supranational entities: direct support for banks and asset management companies (capital and guarantees); common safety nets (deposit guarantees and resolution funds); and further fiscal integration (e.g., through joint debt issuance).

Each of these policies on its own has its limits, however. In the middle of a crisis, it is difficult to raise bank capital from private sources or raise debt subject to bail-in. Pushing too hard on deficit reduction could jeopardize growth in such a way that consolidation fails. Sovereign debt restructuring could undermine the banking system. Charging high fees for bank support from sovereigns, where those very sovereigns are the source of the banking system difficulties, further weakens the financial system. And public sector backstops are only effective if fiscal capacity and room are available.

Against this framework, good progress has been made along many dimensions but gaps still remain to be closed.

  • Bank recapitalizaton: Banks have raised a considerable amount of new capital, especially in the context of the European Banking Authority recapitalization exercise and national efforts. However, some EU banks have used the recalibration of risk weights to release capital, and there are still concerns about the underlying quality of bank assets.

  • Banking system restructuring (see Chapter 7 for details). Over the past five years (2007–2012), the number of credit institutions has decreased by 5 percent. Under the State Aid regime, 20 banks were liquidated, or are in the process of liquidation, of which five are in Denmark; four in Spain; two each in Ireland, Luxembourg, and the United Kingdom; and one in Finland, Germany, Greece and Portugal. Meanwhile 60 banks have undergone deep restructuring as part of the State Aid process.

  • Burden sharing with creditors. Some burden-sharing with private investors was achieved via partial nationalization and with some bail-in on subordinated debt in Denmark, Greece, Portugal, and Spain, and broader bail-in in Cyprus. But many market participants express concern that this approach may not be adequate to resolve underlying balance sheet problems.

  • National sovereign support: During the crisis, EU governments have committed unprecedented support for backstopping the financial sector with taxpayer money. Over the period September 2008 to December 2011, member states committed a total of nearly €4.5 trillion, that is, 37 percent of the EU gross domestic product (GDP).1 The amount of taxpayer money effectively used (mainly via capital injections, State guarantees issued on bank liabilities, etc.) amounted to €1.7 trillion, or 13 percent of EU GDP (Table 5.2). Guarantees and liquidity measures account for €1.2 trillion or 9.8 percent of EU GDP. The remainder of the state aid used refers to recapitalization and impaired assets measures. Out of the 76 top EU banking groups, 19 had a major or even a 100 percent government stake at end-2012.

Table 5.2Public Interventions in the EU Banking Sector: 2008–2011(In billions of euros, unless indicated otherwise)
Used AmountsApproved Amounts
% of GDP% of GDP
Capital injections2882.45984.9
Guarantees on bank liabilities1,1129.13,29026.8
Relief of impaired assets1211.04213.4
Liquidity and bank funding support870.71981.6
Source: European Commission (2011).Note: Figures do not include the amounts owing to Long-Term Refinancing Operations (LTROs); including LTROs, the amount committed to banks stands at 23 percent of EU GDP.
Source: European Commission (2011).Note: Figures do not include the amounts owing to Long-Term Refinancing Operations (LTROs); including LTROs, the amount committed to banks stands at 23 percent of EU GDP.
  • Sovereign adjustment. Virtually all countries in the EU have embarked on fiscal adjustment and other reforms that should strengthen the sovereign. In some cases, there are concerns that the pace of adjustment could jeopardize growth.

  • Supranational support. The European Financial Stability Facility and—more recently—the ESM have provided support to sovereigns with funding difficulties. IMF support has been called upon in the context of adjustment programs in the EA periphery and in some emerging European economies. A decision has been taken to allow the ESM to directly recapitalize banks, but it is contingent on the effective functioning of the single supervisory mechanism.

To end the crisis durably and handle future ones, it would be helpful to adopt a unified approach to crisis management. Ideally, actions by national authorities, central banks, and pan-European institutions should be centrally coordinated. This would allow the adoption of consistent and balanced solutions that bring banks and sovereigns jointly to safety. A unified approach would be able to take into account all externalities, feedback loops, and cross-border contagion effects. Absent a political consensus on such an approach, the crisis is likely to linger and measures such as extended liquidity support to banks and sovereigns may need to remain in place, even though they blunt incentives to restructure and adjust. Solutions that may be economically optimal, such as cross-border consolidation of institutions, will remain out of reach.


Estimated at €4.9 trillion or 39 percent of EU GDP in October 2012.

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