From Fragmentation to Financial Integration in Europe
Chapter

Chapter 8. Fragmentation of the Financial System

Author(s):
Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Author(s)
Luc Laeven and Thierry Tressel 

An earlier version of this chapter appeared as a Technical Note on “Financial Integration and Fragmentation in the European Union” (European Union: Publication of Financial Sector Assessment Program Documentation), IMF Country Report No. 13, March 2013. The authors thank Charles Enoch, Luc Everaert, Daniel Hardy, Jianping Zhou, and European authorities (especially the European Commission and European Central Bank) for comments and Lindsay Mollineaux for excellent research assistance.

In the European Union (EU), the integration of financial markets came to a halt in 2008 following the failure of Lehman Brothers (Figure 8.1). Fragmentation forces first affected emerging European countries as some banks from advanced EU countries, weakened by losses on legacy assets and facing funding pressures, aimed at curtailing liquidity lines to subsidiaries. The Vienna initiative achieved coordination and helped stabilize the foreign capital invested in some countries in emerging Europe, though it did not resolve underlying problems, while the creation of the European Supervisory Authorities and the European Systemic Risk Board (ESRB) improved policy coordination. Growing concerns about sovereign risk in the euro area and the lack of adequate buffers reignited deleveraging forces, this time affecting mostly the periphery of the euro area, while high dependence of euro area banks on wholesale funding made them highly vulnerable to funding shocks originating from money markets funds and other creditors. Overall, total intra-EU exposure to nonresidents has declined by €1.5 trillion through quarter two of 2012, among which €950 billion accounted for by the reduction of exposures to the euro area periphery.

Figure 8.1Financial Integration in the EU

Source: Authors’ calculations.

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

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

Uncoordinated actions resulted in a simultaneous reduction of cross-border exposures, in particular within the euro area, thereby contributing to fragment the financial system and disrupt the transmission channels of monetary policy. The collapse of cross-border exposures was particularly severe in the wholesale funding market and sovereign bond markets, and amplified adverse sovereign—bank links in the periphery of the euro area.

Substantial policy measures have been taken since the start of the crisis to stabilize financial systems and resolve the crisis and important steps toward the creation of a banking union for euro area countries have been taken to provide a common safety net and safeguard the single market. The EU also continued its regulatory effort to harmonize rules and remove barriers to cross-border financial transactions. The crisis and fragmentation of financial systems of the EU, however, and the deleterious effects on stability of the contamination of risk between banks and sovereign have raised important questions about the future of the EU financial structure. Restoring the solvability of banks is a necessity, but it must be achieved in a way that will preserve the single market for financial services and restore financial integration. Furthermore, while some degree of macroprudential flexibility at the national level is desirable to ensure early identification of national risks, it is essential to create a more integrated approach to systemic risk identification and macroprudential policy actions at the European level through the ESRB and the European Central Bank (ECB) to prevent uncoordinated actions that may further damage the single market for financial services.

Fragmentation and Deleveraging During the Crisis

Integration came to a halt during the financial crisis, raising concerns of de-integration of the euro area financial system:

  • Sharp reversals of capital flows in the periphery of the euro area. The Eurosystem and official creditors stepped in to cushion the shock of the capital flow reversal. In particular, net reliance on ECB funding has segmented along national lines, and the Eurosystem has intermediated funds from surplus countries’ banks to banks in the periphery of the euro area, resulting in an indirect mutualization of liabilities through the so-called “TARGET2 imbalances” (Figure 8.2).

Figure 8.2Intermediation Role of the Eurosystem

1 BGIIPS: Belgium, Ireland, Italy, Portugal, and Spain. GIP: Greece, Ireland, Portugal

  • Sharp increase in counterparty risks in euro area funding markets, on the back of sovereign risk concerns. Sudden changes in the availability of wholesale funding in secured and unsecured markets in the second half of 2011 amplified the crisis that spread to the core of the euro area financial system (Figure 8.3).

Figure 8.3Funding Markets and Counterparty Risk

Source: Thomson Reuters Datastream.

Note: LTRO = long-term refinancing operation; OMT = outright monetary transactions.

  • Euro area banks experienced severe funding pressures starting in mid-2011, on the back of concerns about sovereign risks. Part of the funding shock originated from U.S. money market funds (MMFs), which sharply reduced their exposures to French and other euro area banks. Between June 2011 and December 2011, the 10 largest U.S. MMFs reduced their exposures to French banks by about US$100 billion (Figure 8.4).

Figure 8.4Funding Shocks to U.S. Money Market Funds (MMF)

Source: Fitch Ratings.

  • Significant divergence of retail deposit markets also occurred. Retail deposit markets have exhibited divergent trends in the core and in the periphery since 2010 (for Greece, where deposit flight has been substantial) or mid-2011 (for Spain, where some firms have shifted deposits).1 However, the deposit base stabilized in the periphery after the summer of 2012, including in IMF program countries, perhaps a consequence of the outright monetary transactions (OMT) announcement (Figure 8.5).

Figure 8.5Retail Deposits

Source: European Central Bank (ECB)

Evidence from the Monetary and Financial Institution (MFI) data confirms that the deleveraging by euro area banks was a key driver of the sharp fragmentation of the EU financial system. Since the onset of the crisis in 2008, euro area banks as a whole have sharply reduced their cross-border exposures within the euro area and from other EU countries, while broadly preserving or increasing their domestic exposures. In other words, a very strong process of re-nationalization of euro area banking systems has taken place during the past years. In absolute terms, intra-euro area cross-border positions of euro area banks have fallen by about €1.5 trillion, while their cross-border exposures to other EU countries have on aggregate fallen by €370 billion. During the same period, the domestic positions of euro area banks (excluding claims on the Eurosystem) have increased by about €1.2 trillion.

Specifically, as shown in Figure 8.6, the following fragmentation took place in various financial markets as a result of euro area banks deleveraging:

Figure 8.6Euro Area Bank Domestic and Cross-Border Deleveraging

Sources: European Central Bank, Consolidated Banking Statistics; and IFS, International Financial Statistics database.

Note: Domestic claims on MFIs are adjusted to exclude claims on the Eurosystem. MFIs = monetary and financial institutions.

  • Interbank markets. Cross-border claims of euro area banks on MFIs located in other euro area countries and in other EU countries have collapsed by respectively €670 billion and €285 billion, or 42 percent and 23 percent, since the onset of the crisis in September 2008. In the meantime, domestic claims on other banks have fallen by €206 billion (or 3 percent).

  • Loans to the private sector. Evidence of domestic bias has also been very strong for loans to the nonbank private sector. Considering all euro area banks as a whole, loans to the domestic nonbank private sector have increased by €570 billion (or 5 percent) but cross-border loans have fallen by €450 billion (or 40 percent) vis-à-vis other euro area (and have been broadly stable vis-à-vis other EU countries).2

  • Securities other than shares. Home bias in bond markets has, perhaps, been the strongest. Indeed, domestic exposures of euro area banks have strongly increased by €860 billion (or 43 percent) since the 2008 crisis, while cross-border exposures vis-à-vis other euro area countries have fallen by 55 percent (about €340 billion), and by 50 percent (about €70 billion) vis-à-vis other EU countries.

  • Shares. Cross-border equity markets have been the most stable since the start of the crisis, but have also been subject to home bias. While domestic exposures have slightly increased (by 2 percent); cross-border exposures vis-à-vis euro area countries and other EU countries have fallen by 8 percent and 23 percent, respectively, since September 2008.

The financial fragmentation process and the associated decline in cross-border lending are a consequence of several factors, including a broader deleveraging process triggered by the global financial crisis, increased fragmentation within the euro area as a result of a repricing of risks, capital and funding shortages, and structural developments, including the new Basel III rules at banks. Bank deleveraging can be explained by combinations of both structural and cyclical forces (Figure 8.7).3 Structural forces include the need to adjust banks’ business models to the new regulatory and economic environment (and often reflected in business plans announced by banks), the need to further strengthen capitalization, and the necessity to reduce reliance on less stable (short-term, wholesale) sources of funding. But bank deleveraging has also been the outcome of cyclical factors such as financial conditions in sovereign and bank funding markets (where the ECB long-term refinancing operation [LTRO] liquidity provision helped cushion the funding shocks, and the OMT stabilized sovereign debt markets, with positive knock-down effects on bank access to wholesale markets), the state of the economy, which affects banks’ retained earnings, and forces of financial fragmentation and financial repression in the euro area. Moreover, the stronger reduction recorded in cross-border claims on distressed economies in the euro area periphery illustrates the increasing fragmentation between those euro area economies that are distressed and those that are not. Interbank lending from banks resident in countries less affected by the sovereign debt crisis to banks in the distressed countries has fallen substantially.4

Figure 8.7Factors Contributing to Deleveraging

Sources: IMF, Global Financial Stability Report: The Quest for Lasting Stability (April 2012), and IMF staff estimates.

EU banks also withdrew from overseas markets and U.S. dollar activities (Figure 8.8). Many European cross-border banks have significant overseas activities funded in U.S. dollars. A significant part of this funding has remained short term, contributing to creating structural funding gaps (e.g., a gap between long-term assets and long-term funding in U.S. dollars) in balance sheets, including among euro area banks. These funding gaps remained significant at the end of 2012:Q2, in spite of heavy reductions in U.S. dollar assets of French and German banks.5

Figure 8.8U.S. Dollar Activities of European Banks

Source: Bank for International Settlements (preliminary data for 2012:Q2).

Determinants of Cross-Border Leveraging and Deleveraging

To assess the determinants of the cross-border leveraging and deleveraging in the EU, a panel regression analysis of the evolution of foreign claims of international banks is performed. We estimate standard panel regressions to explain the determinants of the quarterly percent changes in bilateral bank exposures between EU home and host countries (where host countries include euro area countries, excluding Luxembourg, and other EU countries) and all Bank for International Settlements (BIS) reporting countries are included as home countries.

where FCijt is the total foreign claims of reporting banks of country i on country j, FCjt is the total claims of BIS reporting countries on country j,

is the change in bilateral foreign claims, scaled by GDP of the previous period, DXratejt is the percent change in the U.S. dollar exchange rate during the period, and Xjt is a set of additional control variables. Regressions contain home country (fi) and host country (gj) fixed effects to account for unobservable time invariant factors. The sample period covers 2005:Q1 to 2012:Q2. We also consider three subperiods: the precrisis period (2005:Q1 to 2008:Q3); the period following the Lehman collapse and global repercussion (2008:Q4 to 2009:Q4); and the euro area crisis period (2010:Q1 to 2012:Q2). We rely on various data sources: quarterly BIS consolidated banking statistics (ultimate risk basis); World Economic Outlook and Balance of Payments—International Investment Positions quarterly data of the IMF; ECB banking system structure data; and Bloomberg.6

Explanatory variables aim to capture various potential determinants of foreign bank activities. The exposure to country j of banks from country j captures whether there is momentum in the bilateral capital flows of country i’s banks to country j: a positive coefficient would imply that banks with a larger initial exposure are increasing their exposure at a faster pace than other banks, and therefore that there is a tendency in increasing concentrations of bilateral exposures. A negative coefficient would instead imply either that there is a correction mechanism stabilizing bilateral exposures at some level (if flows are positive) or that banks with a greater initial exposure are withdrawing faster than others (if flows are negative. Total claims of BIS reporting banks on country j is a measure of gross external liabilities to banks, and therefore a measure of external vulnerability to capital outflows. Additional control variables include (1) the share of country j in country’s banks’ foreign assets (as an indicator of portfolio composition); (2) the net international investment postion (IIP) in percent of GDP, as an indicator of potential external imbalances; (3) gross external liabilities of the government in percent of GDP; and (4) gross external liabilities of resident banks in percent of GDP. We also include quarterly indicators of macroeconomic performance, such as annual real GDP growth and inflation rate.

Regression analysis of the evolution of foreign claims of international banks, summarized in Table 8.1, offers the following insights:

Table 8.1Determinants of Leveraging and Deleveraging
(1)(2)(3)(4)(5)(6)
PrecrisisLehmanEuro area crisis
FC(ij)/GDP(j), t-10.0449***0.0457***−0.0247*−0.0165−0.0333***−0.0232***
0.0000.000(0.069)(0.300)0.000(0.004)
FC(j)/GDP(j), t-1−0.0214***−0.0019**−0.0472***−0.0011−0.0126***−0.0004
0.000(0.014)(0.001)(0.520)(0.002)(0.444)
FC(ij)/FC(i), t-1−0.024−0.02880.0747−0.01850.1232***0.0553**
(0.657)(0.360)(0.412)(0.797)(0.002)(0.033)
Drate (j), t−0.1234**−0.0720**−0.1275***−0.0758*−0.0483***−0.0457***
(0.018)(0.033)0.000(0.097)0.000(0.001)
Real GDP growth (j),0.1612*0.0989**0.3464***0.07660.04530.0792***
t-1(0.098)(0.026)(0.001)(0.136)(0.246)(0.008)
Inflation (j), t-10.01190.0081−0.4339**0.00410.0060.0093
(0.857)(0.839)(0.011)(0.925)(0.383)(0.130)
Net IIP(j)/GDP (j), t-1−0.0013*0.00010.0013*
(0.085)(0.953)(0.099)
Home and host fixed effectsyesnoyesnoyesno
Observations2,9332,2981,4971,2173,3312,934
R-squared0.180.160.140.050.150.1
Robust p-values in parentheses *** p < 0.01, ** p < 0.05, *p < 0.1Sources: Bank for International Settlements (BIS), Consolidated Banking Statistics on ultimate risk basis; IMF, International Financial Statistics and World Economic Outlook databases.Note: The sample includes the following BIS reporting countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Spain, Portugal, Sweden, and the United Kingdom. Host countries: Austria, Belgium, Bulgaria, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Netherlands, Portugal, Romania, the Slovak Republic, Slovenia, Spain, Sweden, and the United Kingdom.
Robust p-values in parentheses *** p < 0.01, ** p < 0.05, *p < 0.1Sources: Bank for International Settlements (BIS), Consolidated Banking Statistics on ultimate risk basis; IMF, International Financial Statistics and World Economic Outlook databases.Note: The sample includes the following BIS reporting countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Spain, Portugal, Sweden, and the United Kingdom. Host countries: Austria, Belgium, Bulgaria, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Netherlands, Portugal, Romania, the Slovak Republic, Slovenia, Spain, Sweden, and the United Kingdom.
  • Before the start of the financial crisis: Bilateral bank exposures to EU countries showed signs of momentum and increasing concentration of bilateral exposures as banks with greater initial exposures tended to increase exposures at a faster pace than other banks. Bilateral exposures were, however, growing at a slower pace in countries that had the largest gross liabilities to foreign banks—a finding consistent with the hypothesis that bank capital flows took into account potential gross external vulnerabilities. However, bilateral bank exposures were growing faster in countries with the largest net IIP liabilities. This finding implies that a key indicator of external imbalances was not only ignored by bank bilateral capital inflows; instead it had the opposite effect on these flows than what prudent behavior would have implied, as bilateral bank inflows where stronger in countries with larger net foreign liabilities, suggesting a mispricing of risks. There was no indication of significant portfolio reallocation among foreign exposures of EU banks.

  • The failure of Lehman Brothers and its aftermath. There was a reversal of bilateral bank exposures in the EU. Bilateral bank capital flows declined faster where bilateral exposures where the largest. Hence, the observed correction in bilateral flows was consistent with prudent behavior. However, other factors did not seem to influence bank capital flows significantly, in particular there was no indication of a stronger reversal in countries with the largest net foreign liabilities.

  • Euro area crisis. During the period 2010–2012:Q2, the reversal of bilateral exposures responded to the previous quarter’s bilateral exposure in a stronger way than during the period 2008:Q3–2009:Q4. There is, however, evidence that portfolio allocation mattered. In particular, the reversal of bank capital flows was weaker in host countries where EU banks had a larger share of their foreign activities. Moreover, bilateral bank capital flows were correlated with net foreign asset positions, consistent with the hypothesis of a correction mechanism as banks withdrew more from countries with initially larger external imbalances.

Next, we assess whether the patterns of cross-border leveraging and deleveraging of EU banks differed between emerging Europe and euro area countries. We perform cross-sectional regression over the periods 2005:Q1—2008:Q3 (precrisis) and 2008:Q4—2012:Q2 (postcrisis) of cumulative change in bilateral foreign claims of EU banks between home country i and host country j on a set of control variables defined at the beginning of the period (hence 2005:Q1 for the precrisis period, and 2008:Q4 for the postcrisis period). The variable of interest is an indicator variable EE for emerging European countries and/or log FGN defined as the log of the share of foreign banks in total banking assets:7

Control variables include the following: (1) the initial bilateral claims of country i on country j in percent of GDP; (2) the initial total claims of foreign banks on country j in percent of GDP; (3) the share of country j in the foreign portfolio of banks from country j; (4) the initial net foreign asset position in percent of GDP; (5) the initial gross public-debt-to-GDP ratio; (6) the initial current account balance-to-GDP ratio; and (7) the cumulative percent change in the bilateral exchange rate vis-à-vis the U.S. dollar.

There is little evidence that, before the crisis, the cumulative increase in foreign liabilities of emerging European countries was significantly larger than for euro area countries, after controlling for the factors cited in Table 8.1. After the crisis, it appears that foreign exposures to emerging European countries also turned more stable than the foreign exposures to other countries (notably countries in the euro area periphery) after accounting for the set of indicators above cited. Furthermore, when including the foreign ownership variable, we find that while this variable is insignificant during the precrisis period, it turns strongly and positively significant during the crisis period. From estimated coefficients, we find that a one standard deviation increase in foreign share is associated with foreign liabilities to foreign banks that are higher by 2 percentage points of initial GDP over years (Table 8.2). R-squared vary between 0.26 and 0.5, implying that our empirical specification explains a large share of the cross-sectional variation in the cumulative change of bilateral exposures of foreign banks.

Table 8.2Foreign Ownership and Exposures to Emerging Europe
PrecrisisCrisis
Log (Foreign)−1.63554.8095***
EE dummy6.6518**5.7968***
Source: Authors’ calculations.Note: *** p < 0.01, ** p < 0.05, * p < 0.1.
Source: Authors’ calculations.Note: *** p < 0.01, ** p < 0.05, * p < 0.1.

The pattern of capital flows before and after the crisis suggests that the type of financial integration matters in a crisis. Before the crisis, emerging European countries (with a large domestic presence of foreign banks, and large cross-border intragroup capital flows) experienced a significantly faster buildup of liabilities to foreign banks than other EU countries. However, after the crisis erupted in 2008 and capital flows started to reverse within the EU, emerging European countries experienced a slower reversal of capital flows on average, after accounting for various determinants and home country factors. This finding is consistent with the hypothesis that the Vienna initiative played an important role in stabilizing capital flows between some countries in emerging Europe and the rest of the EU. Furthermore, it seems that a larger initial foreign bank presence was indeed a stabilizing factor, perhaps as these banks were more likely to consider these countries as home markets. This suggests that the type of financial integration (local presence, potentially partially funded by intragroup flows, as opposed to cross-border flows between unrelated lenders and borrowers) matters in a crisis. Foreign bank presence can a stabilizing factor when the vulnerability is home grown, but this presence can also contribute in accumulating vulnerabilities.

We further make use of our empirical approach to estimate the extent to which the sovereign-bank nexus in the EU contributes in explaining the sudden stops in capital flows. Assessing such links is important. Financial fragmentation and the reversals of capital flows within the euro area and possibly the broader EU contribute to amplifying the crisis, disrupting the transmission channels of monetary policy in the euro area and causing contagions and spillovers through financial markets. Using bilateral exposures, we are able to control for all unobserved home factor effects that may have impacted capital flows during the crisis.

For this purpose, we re-estimate the panel regression, but focusing on the post—Lehman crisis period. To empirically test a link between sovereign and banking fragilities and the evolution of bilateral foreign exposures of EU banks, we add as explanatory variables sovereign credit default swap (CDS) spreads and bank CDS spreads averaged on a quarterly basis.8 The period of observation is 2010:Q1—2012:Q2.9 Specifically, we estimate the following regression, where control variables include (1) the initial bilateral claims of country i on country j in percent of GDP; (2) the initial total claims of foreign banks on country j in percent of GDP; (3) the share of country j in the foreign portfolio of banks from country j; and (4) the percent quarterly change vis-à-vis the U.S. dollar. In contrast to specification (1), we do not include host country fixed effects to ensure that identification also accounts for cross-sectional differences in sovereign or bank stress. Finally, building on the results of specification (2), we also include in some specifications, interaction terms between sovereign or bank CDS spreads with the foreign ownership variable described above. The period of observation is 2009:Q3 to 2012:Q2.

Bilateral changes in foreign bank exposures to a particular EU country are significantly and negatively correlated with bank CDS spreads (Table 8.3, column 1). According to our estimates, a one standard deviation increase in bank CDS spread is associated with a 0.28 percent of GDP average decrease in bilateral exposure of EU banks. Similarly, a one standard deviation increase in sovereign CDS spread is associated with a decrease in bilateral exposure of EU banks by 0.3 percent of host country GDP (column 3). Furthermore, there is evidence that the impact of bank CDS spreads on bilateral exposures of EU banks is muted when foreign banks have a larger presence in the domestic market (column 2). According to our estimates, the impact of a one standard deviation increase in bank CDS spreads translates into a 1.1 percent of GDP decrease in foreign banks bilateral exposures to that country if domestic bank presence is at the lowest level (about 9 percent of total bank assets), but translates into a 0.18 increase in foreign bank exposures if domestic presence is that the sample maximum of about 45 percent of bank assets (Figure 8.9).

Table 8.3Banking Stress and Deleveraging
(1)(2)(3)(4)
Bank CDS spread−0.0008***−0.0040***
Bank CDS spread0.0001**
* Foreign
Sovereign CDS spread−0.0003***−0.0013
Sovereign CDS spread0.0001
* Foreign
Observations2,1922,1923,0442,868
R20.150.150.130.13
Source: Authors’ calculations.Note: CDS = credit default swaps. *** p < 0.01, ** p < 0.05, *p < 0.1.
Source: Authors’ calculations.Note: CDS = credit default swaps. *** p < 0.01, ** p < 0.05, *p < 0.1.

Figure 8.9Quantification of the Effects of Banking Stress

Source: IMF staff.

Note: CDS = credit default swap; SD = standard deviation.

Real Effects of Financial Fragmentation

The fragmentation of the euro area financial system contributed to intensifying downward spirals between sovereigns, banks, and the real economy.10 The sudden stop of capital flows affecting euro area periphery countries reinforced the intertwining of sovereign—bank balance sheet risks as investors withdrew simultaneously from sovereign bond markets and interbank markets, and contributed to impairing the transmission mechanism of monetary policy across borders in the euro area (Figure 8.10, panel a). Furthermore, stressed banking systems curtailed the supply of credit through banks raising interest rates on loans, further disrupting the transmission channels of monetary policy (Figure 8.10, panel b). Sovereign—bank linkages were also strengthened in the periphery, as a side effect of the three-year LTROs, which allows funding the purchase of domestic sovereign bonds by local banks (Figure 8.11).

Figure 8.10aIntertwined Bank-Sovereign Stress

Source: Bloomberg, L.P.

Note: CDS = credit default swaps.

Figure 8.10bBanking Stress and the Real Economy

Source: Bloomberg, L.P.

Note: CDS = credit default swaps.

Figure 8.11Exposures to the Domestic Sovereign

Source: IMF, International Financial Statistics database.

1 Core euro area includes Austria, Belgium, Finland, France, Germany, and the Netherlands. GIP: Greece, Ireland, Portugal.

The fragmentation of the euro area financial system and the associated sovereign—bank nexus have disrupted the transmission channels and countercyclical role of monetary policy. High sovereign stress in the periphery has disrupted the traditional interest channel of monetary policy, while banking stress has impaired the bank lending channels. As a result, as lending conditions tightened in countries experiencing stronger downturns and interest rates diverged across countries, monetary policy has become procyclical across euro area countries. Bank funding costs in the periphery have increased as the cross-border interbank market is fragmented and banks in the periphery have to offer higher deposit rates to attract funds. With banks struggling to build capital buffers, credit risk remains high because of the weakening economic outlook. Thus, despite the recent easing in the ECB’s policy rate, lending rates in banking systems under stress have edged upwards (Figure 8.12), and monetary impulses from the policy rate are not transmitted to the real economy.

Figure 8.12Retail Lending Conditions

Note: Unweighted average; Monetary and Financial Institution lending to corporations over €1 million, 1–5 years. Belgium and Portugal reflect rates on all maturities. ECB = European Central Bank.

Core: Germany, France, Belgium, Netherlands. GIIPS: Germany, Italy, Ireland, Portugal, Spain.

The deleveraging process raises concerns about a credit crunch that would particularly affect the small- and medium-sized enterprises (SMEs). SMEs in the euro area periphery are particularly hard hit by the deleveraging process, as deposit outflows and capital shortages at banks limit the availability and raise the cost of bank loans. Data from the European Commission and European Central Bank Survey on the Access to Finance of SMEs show that the availability of external finance from banks has decreased since 2009, while the demand for external finance has increased (Figure 8.13). However, there is much cross-country variation, with the availability of external finance having deteriorated markedly since 2009 in Greece and Ireland and having remained fairly stable in countries like Finland and Germany. Regression analysis suggests that the deterioration in the supply of credit to SMEs is partly driven by the financial disintegration process, as measured by the decline in cross-border BIS claims (Table 8.4).

Figure 8.13Access to Finance of Small- and Medium-Sized Enterprises (SMEs)

Source: European Central Bank, Survey on the Access to Finance of SMEs in the euro area.

Table 8.4Access to Finance, Domestic Financial Activity, and Cross-Border Banking, 2009:H1-2012:H1
VARIABLESAvailability indexNeed for finance indexTurnover index
Change in total BIS claims/GDP0.00293**−0.000951−0.000761
(2.903)(−1.138)(−0.672)
Change in logarithm of GDP0.502−1.237**4.141***
0.475)(−2.629)(7.134)
Change in DFA/GDP−0.00399*0.0004650.00213
(−2.182)(0.453)(1.237)
Constant−0.209***−0.314***0.198***
(−4.966)(−8.750)(5.892)
Country and survey fixed effects×××
Firm characteristics×××
Observations23,06426,40534,269
R20.0570.0290.125
Sources: Bank for International Settlements (BIS); and European Central Bank, Survey on the Access to Finance of SMEs in the euro area.Note: Dependent variables are from the European Commission and European Central Bank (ECB) Survey on the Access to Finance of SMEs. Each index is calculated from responses where the variable of interest has increased, decreased, or remained unchanged over the past six months. These responses are coded 1, -1, and 0, respectively. The need for finance index is based on the change in need for external finance in the form of bank loans. The availability index is based on the change of the availability of bank loans for the individual firm. The turnover index is based on changes in the turnover of the firm. Total BIS claims is the sum of BIS claims on other countries and BIS claims by other countries from the BIS Consolidated Banking Statistics. DFA is the sum of all financial instruments invested in the country by resident financial institutions as defined by the ECB cross-border statistics. Regressions are estimated using ordinary least squares. Statistical significance levels are denoted as follows: *** p < 0.01, **p < 0.05, *p < 0.1. Robust t-statistics or z-statistics in parentheses, clustered at the country level. Firm-specific control variables included are dummy variables for whether the firm is small/medium, public/private, new/old, and in trade/other industries. Country and survey specific fixed effects are included in all regressions. BIS = Bank for International Settlements; DFA = domestic financial activity; ECB = European Central Bank; SMEs = small-and medium-sized enterprises.
Sources: Bank for International Settlements (BIS); and European Central Bank, Survey on the Access to Finance of SMEs in the euro area.Note: Dependent variables are from the European Commission and European Central Bank (ECB) Survey on the Access to Finance of SMEs. Each index is calculated from responses where the variable of interest has increased, decreased, or remained unchanged over the past six months. These responses are coded 1, -1, and 0, respectively. The need for finance index is based on the change in need for external finance in the form of bank loans. The availability index is based on the change of the availability of bank loans for the individual firm. The turnover index is based on changes in the turnover of the firm. Total BIS claims is the sum of BIS claims on other countries and BIS claims by other countries from the BIS Consolidated Banking Statistics. DFA is the sum of all financial instruments invested in the country by resident financial institutions as defined by the ECB cross-border statistics. Regressions are estimated using ordinary least squares. Statistical significance levels are denoted as follows: *** p < 0.01, **p < 0.05, *p < 0.1. Robust t-statistics or z-statistics in parentheses, clustered at the country level. Firm-specific control variables included are dummy variables for whether the firm is small/medium, public/private, new/old, and in trade/other industries. Country and survey specific fixed effects are included in all regressions. BIS = Bank for International Settlements; DFA = domestic financial activity; ECB = European Central Bank; SMEs = small-and medium-sized enterprises.

However, demand factors play an important role in the lack of borrowing by SMEs. Indeed, limited access to finance is not reported by most firms to be their main challenge (Figure 8.14). Limited demand for products is the most common obstacle according to this SME survey, indicating that demand for finance has reduced as well. Furthermore, regression analysis shows that the demand for credit is closely associated with declines in GDP, while the availability of credit is not.

Figure 8.14Constraints on Access to Finance

Source: European Central Bank, Survey on the Access to Finance of SMEs in the euro area.

Demand factors also play an important role in the lack of borrowing by corporations and households. Lending standards for corporations and households are stable but credit demand conditions remain weak, suggesting that the reduced lending activity is primarily demand driven (Figure 8.15). Data from the ECB bank lending survey show that lending standards for corporations and households have stabilized, while credit demand, especially for corporations continues to fall (both measured using the diffusion index).11 But, as lending standards and credit demand conditions are driven by common factors, such as economic conditions, it is difficult to infer a causal interpretation based on lending survey data (in the absence of exogenous shifts in the supply of credit).

Figure 8.15Bank Lending

Source: European Central Bank, Bank Lending Survey.

To disentangle whether changes in lending standards or credit demand conditions are driving loan growth, regression analysis of bank lending survey responses is used. To gauge the importance of supply-side constraints for credit growth, regressions of loan growth are estimated where demand is purged from supply factors, and vice versa. These regressions use ECB bank lending survey responses to changes in lending standards and credit demand conditions as proxies for changes in supply and demand factors, respectively. These regressions are estimated separately for lending to firms and households. Purging demand from supply factors, and vice versa, allows for an estimate of upper and lower bounds of the effect of supply-side factors on credit growth. While this approach is subject to criticism, primarily because it assumes that the loan survey responses are accurate and exogenous, it offers some guidance on the relative importance of supply and demand factors.

Regressions are first estimated using data on the bank lending survey for corporations. The basic regression model is:

where the dependent variable is the growth rate of loans to nonfinancial corporations in a given quarter. ΔS denotes the change in the supply of credit to corporate, measured as the change in lending standards over the past three months on loans or credit lines to enterprises.12 Higher numbers denote a relaxation in standards, which are taken to be equivalent to an increase in supply. ΔD denotes the demand for credit from corporate, measured as the change in demand for loans or credit lines to enterprises over the past three months. Higher numbers denote an increase in demand.

To purge demand factors from supply factors and obtain a lower-bound estimate of the effect of supply-side factors on credit growth, the regression model is adjusted as

where S^t denotes the residual of a country-specific ordinary least square (OLS) regression of S on D for corporations.

To purge supply factors from demand factors and obtain an upper-bound estimate of the effect of supply-side factors on credit growth, the regression model is adjusted as

where D^t denotes the residual of a country-specific OLS regression of D on S for corporations.

Regressions are estimated using ordinary least squares (OLS) and include quarterly fixed effects (Table 8.5). The sample consists of quarterly loan growth and survey data from March 2006 to September 2012 for a sample of EU countries. The regression in column (3) gives an upper bound of the effect of supply on loan growth because it removes supply factors from demand and therefore attaches maximum weight to supply factors, while the regression in column (4) gives a lower bound on the effect of supply on loan growth because it removes demand factors from supply and therefore attaches maximum weight to demand factors.

Table 8.5EU: Supply and Demand of Loans to Nonfinancial Companies 2006:Q1-2012:Q3
Dependent variable: Growth rate of loans to nonfinancial

companies
(1)(2)(3)(4)
Supply to corporations−0.0135−0.0277
(−0.630)(−1.258)
Demand from corporations0.110***0.108***
(3.798)(3.804)
Demand from corporations – residual0.116***
(3.580)
Supply to corporations – residual0.0181
(0.710)
Constant9.849***8.863**9.057**8.995**
(2.606)(2.477)(2.530)(2.513)
Quarter fixed effects××××
Observations222222222222
Adjusted R-squared0.5020.5290.5280.528
Source: European Central Bank, Bank Lending Survey.Note: Robust t-statistics in parentheses. ***p < 0.01, **p < 0.05, *p < 0.1.Countries in the sample are Austria, Cyprus, Estonia, Germany, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain.
Source: European Central Bank, Bank Lending Survey.Note: Robust t-statistics in parentheses. ***p < 0.01, **p < 0.05, *p < 0.1.Countries in the sample are Austria, Cyprus, Estonia, Germany, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain.

The economic effect of demand-side factors for lending to corporations is substantial. Based on the estimates reported in column (4) of Table 8.5, a one standard deviation increase in demand from corporations implies an increase in loan growth of nonfinancial companies of 1.7 percentage points. This is substantial, given that it amounts to about one-fifth the standard deviation in loan growth of nonfinancial companies.

Similar regressions are estimated using bank lending survey responses on lending to households (Table 8.6). The dependent variable in these regressions is the growth rate of loans to households for house purchase in a given quarter. Supply to households is the change in lending standards over the past three months on loans to households for house purchase, with higher numbers denoting a relaxation in standards (an increase in supply). Demand from households is the change in demand for loans to households for house purchase over the past three months, with higher numbers denoting an increase in demand. Otherwise, the regressions are similar to those for corporations.

Table 8.6Supply and Demand of Household Loans for Home Purchase 2006:Q1-2012:Q3
Dependent variable: Growth rate of household

loans for home purchase
(1)(2)(3)(4)
Supply to households−0.0384*

(−1.965)
−0.0507**

(−2.595)
Demand from households0.0811***

(4.439)
0.0811***

(4.480)
Demand from households – residual0.0967***

(3.893)
Supply to households – residual0.0388 (1.352)
Constant12.97***

(4.205)
10.93***

(3.555)
10.39***

(3.399)
10.74***

(3.516)
Quarter fixed effects××××
Observations249249249249
Adjusted R-squared0.1160.1710.1720.172
Source: European Central Bank, Bank Lending Survey.Note: Robust t-statistics in parentheses. ***p < 0.01, **p < 0.05, *p < 0.1.Countries in the sample are Austria, Cyprus, Estonia, Germany, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain.
Source: European Central Bank, Bank Lending Survey.Note: Robust t-statistics in parentheses. ***p < 0.01, **p < 0.05, *p < 0.1.Countries in the sample are Austria, Cyprus, Estonia, Germany, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain.

The economic effect of demand-side factors for lending to households is also substantial. Based on results in column (4), a one standard deviation increase in demand from households implies an increase in household loan growth for house purchase of 2.1 percentage points. This is substantial, given that it amounts to about one-fourth the standard deviation in loan growth of household loans for home purchase.

Regressions indicate that supply factors play a more important role in lending to households than in lending to corporations. Moreover, demand factors play a similar role in lending to households and lending to firms. Importantly, these results are for the corporate sector as a whole and may not prove a firm basis for inference of the relevance of supply factors for lending to SMEs.

Overall, the evidence suggests that the real effects of financial disintegration and deleveraging are mitigated by policy responses and sharp declines in aggregate demand, although there are pockets of vulnerabilities and signs of credit supply shocks. They also suggest that increased financial integration would be beneficial to credit conditions in individual member states.

Policy Options to Restore Financial Integration

The ongoing financial crisis has shown that it is essential that the EU regulatory and supranational institutional environment be strengthened to ensure that policies for the stability of the financial system are consistent with the single financial market. Two questions in particular have been raised:

  • How to stop the deleveraging and fragmentation process to restore the single financial market?

  • How to ensure that financial integration and stability of the financial system are supported by an adequate financial architecture?

Policy action should be coordinated to level the playing field and counter market forces that contribute to the deleveraging process and fragmentation of the financial system. Uncoordinated actions have resulted in a simultaneous reduction of cross-border exposures, in particular within the euro area, thereby contributing to fragmenting the financial system further and disrupting the transmission channels of monetary policy. The collapse of cross-border exposures has been particularly severe in the wholesale funding market and sovereign bond markets, and amplified adverse sovereign—bank links in the periphery of the euro area. While some policies have been coordinated (notable monetary policy and competition policy), other policies have been less so (such as supervision and financial safety nets) and have contributed to ring-fencing behavior, causing adverse cross-border externalities. A coordination of policies at the EU level will counter market forces that contribute to a fragmentation of the financial system and help repair the single market.

The establishment of a banking union with common supervision, resolution authority, and financial safety net would go a long way to provide the necessary underpinnings to a stable and integrated financial market. A banking union would substantially reduce the tail risk that an individual member state will not be able to honor the financial safety net provided in support of its financial sector, and it would help delink banks and sovereign risk. It would also bring about higher quality of supervision and help solve coordination problems in the resolution of cross-border banks within the union. Although the banking union is more urgent and essential for euro area countries, other EU countries would also benefit from joining the union. With the prospect of some member states, notably the United Kingdom, which plays a dominant role in the provision of international financial services, having expressed a desire not to join the banking union, questions are raised about unintended consequences of the establishment of a union for the single market. In particular, the creation of a single supervisory mechanism (SSM)—as recently announced—should not conflict with the role of existing EU regulatory agencies, such as the European Banking Authority (EBA), to avoid unintended consequences for the single market between the “ins” and the “outs.” For example, ECB decisions to issue its own supervision guidelines should be accompanied by efforts led by the EBA to harmonize supervision practices among the ins and the outs.

The possibility of European Stability Mechanism (ESM) direct recapitalizations would help speed up addressing solvency issues. It is primordial that solvency issues are addressed to restore proper financial intermediation and supply of credit to the real economy. Having in place the possibility of direct ESM recapitalization of banks would relieve contingent liabilities from the balance sheet of weak sovereign, thereby weakening incentives for forbearance and helping create some fiscal space.

The merits of limits on size and activities of financial institutions are being actively debated (for example, Vickers and Liikanen reports). Current initiatives aim to address the problems associated with size can be addressed through improving supervision and resolvability (including cross-border and bail-in arrangements) and the establishment of a banking union (which will weaken sovereign—bank linkages and ensure a more systemic and coordinated approach to supervision). However, too-big-to-fail considerations will remain. These can in principle be partially addressed through regulation or taxation. More generally, the introduction of financial sector taxes can address externalities associated with systemic risk created by the financial sector. However, the political reality of bank failures will remain complicated, including between countries that are part of the banking union and others. Importantly, regulatory and taxation initiatives to address systemic risk have to be closely coordinated among EU member states to ensure they do not distort the single market and that they enable a level playing field.

In this light, it should be stressed that the protection of financial centers out of national interests, or indeed the implementation of restrictive measures against a financial center, would be against the principle of a single market. In this context, the flexibility provided by the Capital Requirement Regulation (CRR) and Capital Requirement Directive IV (CRD IV) should, in practice, be used only for macroprudential purposes and not as a tool to protect specific national approaches which might impede integration of banking systems. In this regard, the ESRB should play a forceful role in coordinating the use of macroprudential instruments among member states, while efforts to establish a “single rule book” should be furthered.

The increasing focus on improving the resolvability of banks and limiting use of taxpayer money throughout the EU can help to reduce the risks associated with bank size. The EU Directive for the recovery and resolution of credit institutions will limit the use for bank bailouts in the future by ensuring preparedness, providing strong powers for early intervention and resolution of credit institutions in the EU. The possibility of statutory bail-ins and the establishment of resolution funds would provide first lines of defense to address individual bank failures and may help contain deleveraging pressures out of countries experiencing bank failures. It is also critical that the SSM is complemented by a single resolution mechanism involving a central resolution authority with strong intervention and resolution powers, and with common backstops.

Financial Integration Going Forward

Going forward, the answer is more and better, not less, financial integration. The evidence presented shows that there can be large benefits from financial integration, including ensuring a smooth transmission of monetary impulses. However, integration must be realized in a way that does not pose serious risks to financial stability, and must be accompanied by reforms to complete the financial architecture of the monetary union and of the broader EU.

Policy action thus far has mitigated the deleveraging process but more is needed to address underlying weaknesses. In the absence of major policy action in the areas of monetary and fiscal policy, as well as government recapitalization of banks and the Vienna Initiative, deleveraging would have been more severe and damaging, with substantial associated fire sales.

The integrity of rules and institutions for the EU’s single financial market has been maintained. The EU has continued to develop its regulatory framework designed to promote market integration so as to further dismantle regulatory hurdles to cross-border financial transactions, reduce scope for regulatory arbitrage, and ensure a consistent implementation and application of the EU financial market framework.

However, to ensure the functioning of the single market for financial services, increased financial integration will need to be supported by a credible financial safety net, higher supervisory quality, and strong resolution tools. This requires progress toward banking union;13 the centralization and strengthening of supervisory and resolution frameworks, and the harmonization of depositor guarantee schemes (more details can be found in a separate technical note on depositor guarantee schemes), as well as a strengthening of capital requirements under CRR/CRD IV (more on this in Chapter 18) and constraints on the provision of liquidity support to ailing financial institutions.14 It has become clear now that, in spite of the “no-bail-out clause” of the Treaty, imbalances do matter in a monetary union.

Part of the drop in deposits was driven by a temporary shift from bank deposits to commercial paper (“pagares”).

The reported figures are changes in position, hence include asset write-downs.

See the IMF’s Global Financial Stability Report: Restoring Confidence and Progressing on Reforms (October 2012), and Global Financial Stability Report: The Quest for Lasting Stability (April 2012).

Special feature in the European Central Bank’s December 2012 Financial Stability Review.

Estimates based on data from the Bank for International Settlements suggest that French and German banks reduced their gross U.S. dollar assets by US$270 billion and US$100 billion, respectively, between 2011:Q2 and 2012:Q2.

The sample includes the following countries. BIS reporting countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Spain, Portugal, Sweden, and the United Kingdom. Host countries: Austria, Belgium, Bulgaria, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Netherlands, Portugal, Romania, the Slovak Republic, Slovenia, Spain, Sweden, and the United Kingdom.

This variable is constructed as of end-2007.

Weekly bank CDS spreads for the sample of EBA banks are averaged per country and quarter.

In addition to the set of control variables defined above, we also add in some robustness tests the sectoral composition of foreign claims (public sector, banks, nonbank private sector), for which data are publicly available from 2010:Q4 onward.

This section focused on euro area countries where de-integration is a fundamental issue as it disrupts the transmission of monetary policy impulse.

It should be noted that the number of banks responding to the Bank Lending Survey in each quarter in some EU countries is very small.

The change in lending standards variable is based on the survey question: “Over the past three months, how have your bank’s credit standards as applied to the approval of loans or credit lines to enterprises changed?,” and the change in demand variable is derived from the survey question: “Over the past three months, how has the demand for loans or credit lines to enterprises changed at your bank, apart from normal seasonal fluctuations?” The survey responses on lending standards and credit demand conditions are effectively lagged one period in the regression analysis. For example, the results reported in the April 2012 bank lending survey relate to changes during the first quarter of 2012 and expectations of changes in the second quarter of 2012. This ECB Bank Lending Survey was conducted between March 23 and April 5, 2012.

For a motivation and characterization of the elements of the banking union, see R. Goyal, P. Koeva-Brooks, M. Pradhan, T. Tressel, G. Dell’Ariccia, C. Pazarbasioglu, and an IMF staff team, 2013, “A Banking Union for the Euro Area,” IMF Staff Discussion Note No. 13/1 (Washington: International Monetary Fund).

The recent decision to establish the SSM under the auspices of the ECB is a welcome step in this direction, but more is needed, as also highlighted by the blueprint issued by the European Commission.

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