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Financial Stability Assessment of the European Union





Levin Laske
CID 00879609

5
th
September 2014
Imperial College London

Submitted for the degree of
Master of Science in Economics and Strategy for Business


Word Count: 5293



I

Table of Contents
Table of Contents I

List of figures II

Glossary III


1 Introduction 1

2 The EU Financial System 2
2.1 The general functioning and structure of the financial system . . . . . . 2
2.2 The current structure of the EU financial system . . . . . . . . . . . . . . 3

3 Defining Financial Stability 5

4 Assessing the Stability of the EU Financial System 7
4.1 Framing the analysis a focus on banking stability . . . . . . . . . . . . 7
4.2 Assessing banking stability . . . . . . . . . . . . . . . . . . . . . . . . . . 8
4.2.1 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
4.2.2 Credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
4.2.3 Solvency risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
4.2.4 Liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13


5 Conclusion 14

References 15

II

List of figures

Figure 1 An Overview of the Financial System . . . . . . . . . . . . . . . . . . . . . . . 2

Figure 2 The Features of the Financial System Required for Stability . . . . . . . . . . . 6

Figure 3 An Overview of Key Risks faced by Banks . . . . . . . . . . . . . . . . . . . . 8

Figure 4 Impaired and past due (>90 days) loans to total assets by bank size, EU . . . . . 10

Figure 5 Dispersion of impaired financial and past due (>90 days) assets to total assets by
bank size, EU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Figure 6 Impaired financial assets to total assets by bank size, EU . . . . . . . . . . . . . . 12

Figure 7 Tier 1 capital ratio by bank size, EU . . . . . . . . . . . . . . . . . . . . . . . . 13

Figure 8 Distribution of LCR in surveyed EU banks by bank group, June 2013 . . . . . . . . 13






III

Glossary
Asset price volatility The degree to which [asset] prices vary over a certain length of time.
Most commonly, it is defined as the standard deviation of changes in the
log of asset prices. (IMF 2003, pp. 62-63).
Bond market
(debt market)
The market where debt instruments[, i.e.] assets that require a fixed
payment to the holder, usually with interest, are traded. (FRB San
Francisco, 2005).
Credit institution An undertaking, the business of which is to receive deposits or other
repayable funds from the public and to grant credit for its own account.
(ECB, 2013).
Equity market
(stock market)
The market for trading equity instruments[, i.e.] securities that are a
claim on the earnings and assets of a corporation. (FRB San Francisco,
2005).
Eurosystem The central banking system of the euro area. It comprises the ECB and
the European Central Banks (ECB) and the national central banks (NCBs)
of the Member States which have adopted the euro. (ECB, 2013).
Eurozone / Euro area The economic region formed by the 18 member countries of the
European Union that have adopted the euro. (Oxford Online Dictionary,
2014).
Financial markets The sum of money, bond and equity markets.
Financial intermediary An institution, such as a bank, building society, or unit-trust company,
that holds funds from lenders in order to make loans to borrowers.
(Oxford Online Dictionary, 2014).
Funding liquidity risk The risk that a firm will not be able to meet its current and future cash
flow and collateral needs, both expected and unexpected, without
materially affecting its daily operations or overall financial condition
(FRB San Francisco, 2008).
Liquidity
(financial institution)
A financial institutions capacity to meet its cash and collateral
obligations without incurring unacceptable losses. (Federal Reserve,
2014).
Liquidity problem
(financial institution)
The inability (real or perceived) of financial institutions to meet their
contractual obligations. (Federal Reserve, 2014).
Money market A set of institutions, conventions, and practices, the aim of which is to
facilitate the lending and borrowing of money on a short-term basis. The
money market is, therefore, different from the capital market, which is
concerned with medium- and long-term credit. The definition of money

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for money market purposes is not confined to bank notes but includes a
range of assets that can be turned into cash at short notice, such as
short-term government securities, bills of exchange, and bankers
acceptances. (Encyclopaedia Britannica, 2014).
Money-market fund A type of mutual fund that is required by law to invest in low-risk
securities. These funds have relatively low risks compared to other
mutual funds and pay dividends that generally reflect short-term
interest rates. Unlike a money market deposit account at a bank,
money market funds are not federally insured. (U.S. Securities and
Exchange Commission, 2014).
Pareto principle A principle, named after economist V. Pareto, which states that for
many phenomena the majority of problems (80%) are produced by a
few key causes (20%). Also called 80/20 principle. (Cambridge Business
English Dictionary, 2014)
Real economy The part of the economy that is concerned with actually producing
goods and services, as opposed to the part of the economy that is
concerned with buying and selling on the financial markets. (Longman
Business English Dictionary, 2007)




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1. Introduction
As has become apparent with the World Financial Crisis (WFC) of 2008, the importance of financial
stability is evident given the consequences of its absence. The revealed fragility of the global
financial system has allowed for serious economic harm, lowering economic growth and lending to
levels not seen since the Great Depression (Admati and Hellwig, 2014). In particular, it is widely
acknowledged that banking system fragility was a main contributor to the severity of this downturn.
Numerous regulations to enhance stability have been proposed, amended and passed across the
globe in response to the 2008 crisis. The ultimate goal of such market intervention, of course, is to
correct for market failures. In this case, financial instability was the symptom of market failures that,
in hind-sight, required intervention to ensure stable, long-run economic growth.
Despite this apparent progress, numerous academics (Admati and Hellwig, 2014; Monnet, Pagliari
and Valle, 2014) argue that global progress to-date has been too slow and insufficient, quoting
lobbying (e.g. the modification of the Volcker Rule in 2010 as part of the Dodd-Frank regulation
(Acharya et al., 2010; Onaran, 2010), and a lack of understanding by policy makers as reasons.
This paper attempts to assess the current state of financial stability in Europe and with it the implied
progress of regulators. On the basis of such knowledge policies can be made that ensure stable,
long-run growth by reducing both the likelihood and impact of economic crises induced by financial
fragility.
While the geographic focus of the assessment is on the EU, it should be acknowledged that financial
stability outside of the EU will likely affect the EU financial system, given the interconnectedness of
the global economy. However, to allow for a more detailed analysis, the focus of this study is on the
European Union alone. That said, it should also be noted that much of the EU financial policy making
since 2008 has been influenced by the actions of US regulators (European Commission, 2010),
despite European authorities generally taking a stricter stance on financial stability than their US
counterparts (Schinasi, 2009).
With this as background, the purpose of the paper is four-fold: first, to establish the necessary
knowledge of the EU financial system to allow for an informed discussion of its stability; second, to
discuss the theoretical and practical requirements for financial stability in the European Union; third,
to assess the extent to which these requirements are currently being met; and fourth, to identify the
implications of any areas of instability. In combination, these insights should guide policy making and
ensure that further progress is made to stabilise the EU financial system.


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2. The EU Financial System
Identifying and assessing the requirements for financial stability in the EU demands an
understanding of a minimum of two elements. Firstly, it requires a solid understanding of the
functioning and structure of the system to be stabilised, namely the EU financial system. Secondly, it
requires rigorous definitions and knowledge of key concepts related to financial stability. In
particular, a clear definition of financial stability is required to systematically assess the extent to
which the EU is financially stable. This section focuses on the EU financial system, with the
subsequent chapter addressing the meaning of financial stability. In summation, Chapter 2 and 3 will
provide a solid background, on the basis of which the stability assessment can be made.

2.1 The General Functioning and Structure of the Financial System
The functioning of a financial system is shown in Figure 1. As can be seen, the system generally
comprises five components: ultimate lenders, ultimate borrowers, financial markets, financial
intermediaries and the financial infrastructure. Its main task is to transfer funds from net savers
(lenders) to net spenders (borrowers), in one of two ways.

Figure 1
An Overview of the Financial System

The first route, known as direct or market-based finance, refers to the use of financial markets by
the borrower and lender to exchange funds. As shown in Figure 1, financial markets take the shape
of money, bond and equity markets (see Glossary for clarification).
Financial markets
- Money markets
- Bond markets
- Equity markets

Financial intermediaries
- Credit institutions and other monetary
financial institutions (MFIs)
- Insurance companies, pension funds and
other financial intermediaries (OFIs)

Lenders
- Households
- Firms
- Central Banks
- Non-
Borrowers
- Firms
- Households
- Government
- Non-
Flow of funds facilitated by financial infrastructure
Source: adopted from Allen, Chui, and Maddaloni (2004) p. 491 and ECB (2011) p.39
Direct Finance
Indirect Finance

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The second route, known as indirect or bank-based finance, refers to lenders making deposits at
financial intermediaries who grant these as credit to the ultimate borrowers, either directly or via
investing it in the financial market (Haan et al., 2009). Financial intermediaries can be classified into
monetary financial institutions (MFIs) and other financial institutions (OFIs), the main distinction
being that only MFIs can take deposits from the public (ECB, 2011). Monetary financial institutions
include credit institutions (predominantly banks), non-credit institutions (predominantly money
market funds) and central banks (mainly the Eurosystem in the EU). It is worth noting that credit
institutions account for the largest part of MFIs in the Eurozone (Ibid). Other financial intermediaries
comprise pension funds, mutual funds, insurance corporations, securities and derivatives traders,
and financial businesses involved in lending. Having provided a general overview of the financial
system, the next section focuses on how the European financial system is structured.

2.2 The Current Structure of the EU Financial System
As noted by Allen, Chui and Maddaloni (2007), there is a multitude of ways to categorize the
structure of a financial system. A common approach, as well as the approach taken here, is to make
the distinction between a market-based and a bank-based system (Ibid). In this regard, the Euro
area, along with Japan, has traditionally been described as a bank-based system in the literature, as
opposed to the USs market-based system (Allen, F. et al., 2005). The following provides a discussion
of the extent to which the EU is bank-based.
Bank-based or market-based: what makes the difference?
To make this type of distinction a wide array of measures has been used by academics (see Bijlsma
and Gijsbert, 2013 for a survey). Commonly, bank-oriented countries are characterised by large
amounts of bank loans to the private sector, as well as large amounts of bank credit to non-financial
firms, both as percentage of GDP (Ibid). A problem with the former measure is that it includes all
bank credit to private sector, including e.g. consumer mortgages. This means that a high figure may
simply be the result of a housing boom, driving up bank lending in terms of consumer mortgages,
instead of indicating a bank-based economy. The second method, measuring bank credit to the
corporate sector, avoids this by focusing on the importance of banks as source of funding for firms.
Note, that the figure of interest is bank credit to non-financial firms as percentage of GDP, as this
shows the relative significance of banks versus financial markets in providing credit to the real
economy (see Glossary for clarification). This is because a focus on bank credit to non-financial firms
omits interbank loans, or the like. It thus prevents an overestimate of the importance of banks as
credit provider to the real corporate sector of the economy. Having established two key indicators of
a bank-based system, the following will briefly discuss the counterparts for market-oriented
economies.
Conversely to bank-oriented economies, market-oriented economies are typically characterised by
the importance of their financial markets in the credit provision to firms, relative to financial
intermediaries (Ibid). They are thus associated with high stock market capitalization (the size of the
equity market), and large corporate bond markets, both as percentage of GDP (Ibid).
Having reached an understanding of common methods for differentiating between the two types of
financial systems, the following section applies this knowledge to come to a conclusion on whether
the EU is bank or market-based.


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The European Union: bank-based or market-based?
In line with traditional views, a first look at the EU and Eurozone columns of Table 1 suggests that
Europe is still very much a bank-based set of countries. Comparing the first two rows, we can see
that about 99% of the Eurozones and EUs domestic credit to the private sector is supplied by banks.
In contrast, in the US this is less than a third. However, as previously stated, a large value of bank
credit to the private sector is not necessarily a sufficient indicator of a bank-based financial system.
To re-affirm the traditional EU/US divide between bank and market-based systems, one must simply
shift his attention to the figures for bank credit to non-financial firms. Although country differences
exist, in comparison to the US, EU non-financial firms obtain more than twice as much credit from
banks as percentage of GDP than American firms. This renders the EU as relatively bank-oriented.
Table 1: Financial structure in Europe and the US (% of GDP), 2012

EU Eurozone Germany France UK US
Domestic credit to private sector 132.4 128.5 101.1 116.0 176.8 183.6
Bank loans
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132.2 128.3 101.1 115.9 176.6 50.1
Bank loans to non-financial corporations 43.4 47.7 34.1 43.1 27.4 19.3
Stock Market Capitalization 62.5 51.7 43.4 69.8 122.7 114.9
Source: World Development Indicators, The World Bank (2014); ECB MFI balance sheet data; Eurostat; FRB commercial
banks balance sheet data
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Refers to domestic credit to private sector by banks.
Table 1 also highlights that, as expected, equity markets play a much less important role in the
European Union than in the United States. In fact, EU stock markets are only about half the size of
their US counterparts in relation to GDP. While this measure provides some insight, it is by no means
exhaustive. However, for the purpose of this analysis, one measure of the role of equity market shall
suffice. The role of bond markets is not further emphasised as other authors have shown that such
an analysis confirms the traditional views of the US being market-orientated and the EU being bank-
orientated (Ibid).
While the traditional views have been confirmed, significant cross-country differences in the EU are
evident from Table 1. The United Kingdom, for example, provides an exception to the strong reliance
on banks of most EU member countries. The UKs financial system has often been described as
market-based (Ibid), given the importance of capital markets in the UK economy. Table 1 confirms
that the UK still classifies as such, due to the much higher relative market capitalization in
comparison to the EU average. However, the classification as market- or bank-based is not always
that clear cut. With a large stock market and even larger bank loans as percentage of GDP, the UK is
likely to be both market and bank-based.
To conclude, this section has shown that, on average, intermediaries, in particular banks, play the
leading role in the overall functioning of the EU financial system, more so than financial markets and
financial infrastructure. This insight will be an important element of Chapter 4.

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3. Defining financial stability
The term financial stability first came into use by the Bank of England in 1996 as part of their
Financial Stability Review (Federal Reserve Bank of Cleveland, 2014). However, to-date there has
been no global consensus on the exact definition of financial stability (Crockett, 1997; Foot, 2003;
Goodhart, 2004; Haldane et al., 2004; Allen and Wood, 2005; Rosengren, 2011; Federal Reserve
Bank of Cleveland, 2014). Surprisingly, even recent regulations on financial stability, such as the US
Dodd-Frank Act, do not explicitly define the term (Rosengren, 2011). To quote Schinasi (2009, p.16),
some authors define financial instability instead of stability, and others prefer to define the
problem in terms of managing system risk rather than maintaining or safeguarding financial
stability. What definitions usually have in common is that they equate financial stability to the
smooth functioning of the key elements of the financial system (Duisenberg, 2001). To better
understand the debate, let us consider the different approaches in more detail, starting with the
definitions for financial instability, followed by their positive counterparts.
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Financial instability itself has been defined in different ways by the literature. Some authors define it
as a situation where asset price volatility or liquidity problems of financial institutions [see Glossary]
have the potential to cause real economic costs (Crockett, 1997 and Davis, 2002). Others define it
using systemic risk as the underlying concept of instability (De Bandt and Hartmann, 2000; Group of
Ten, 2001; Summer, 2002). The former group of definitions highlights that it is not the actual
damage to the real economy, but the potential thereof, that renders a financial system unstable. The
latter group of definitions raises the question of what is meant by systemic risk.

Unfortunately, as with stability, there is no universally accepted definition for systemic risk by
academics, regulators or policy makers (Osterloo and Haan, 2003; Bisias et al., 2012). To add to the
confusion, systemic risk is often defined using the very term it is supposed to help define:
(in)stability. This renders the process of defining stability as a slight chicken-and-egg dilemma. To see
this, consider for example Billio et al.s (2012, p. 537) definition of systemic risk as any set of
circumstances that threatens the stability of or public confidence in the financial system.
Similarly vague, but with a focus on real economic damage, the European Central Bank (ECB) defines
systemic risk as the risk that financial instability becomes so widespread that it impairs the
functioning of a financial system to the point where economic growth and welfare suffer materially
(ECB, 2010, p. 129). Others have outlined definitions that focus on particular mechanisms of
systemic risk, ranging from correlated exposures, contagion, asset bubbles and information flow
problems to negative externalities and spillovers to the rest of the economy (see Bisias et al., 2012,
p.256 for a discussion). In summary, the varying interpretations of systemic risk do not allow for a
consistent definition of term financial instability.

Moving away from defining instability, Schinasi (2004, p.11) proposes the following, positive
definition of financial stability: a situation in which the financial system is capable of: (1) allocating
resources efficiently between activities across time; (2) assessing and managing financial risks, and
(3) absorbing shocks. This is in line with the most recent definition of the European Central Bank
which will serve as definition of financial stability for the purpose of this paper (ECB 2014a, p.5):

Financial stability can be defined as a condition in which the financial system intermediaries,
markets and market infrastructures can withstand shocks without major disruption in financial
intermediation and in the effective allocation of savings to productive investment.


1
An alternative survey of definitions of financial stability is provided by Houben, Kakes and Schinasi (2004,
pp.10-11, 38-42).

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The Financial System
(Intermediaries Markets Infrastructure)
Efficient and
smooth inter-
temporal allocation
of resources from
savers to investors,
and of economic
resources more
generally.
Reasonably
accurate
assessment, pricing
and management
of financial risks.
Absorption of
financial and real
economic shocks
and surprises with
relative ease.
Financial Stability
In fact, the ECB (ECB 2014b, para. 3) appears to have adopted its definition directly from Schinasi
(2004 and 2006), given their identical wording of the conditions for financial stability. These
conditions are the ability of the financial system to achieve the three activities shown in Figure 2.

Figure 2
The Features of the Financial System Required for Stability




















Source: conditions adapted from Schinasi (2009)

While being slightly vague, the above conditions are accessible and in line with other definitions, in
the sense that they discuss the smooth functioning of the key elements of the financial system. A
positive framing of the term is also better aligned with the objective of achieving stability, as it
avoids focusing on a potentially incomplete set of instability drivers. It is thus more holistic and
avoids the risk of omitting factors.
Should any of the conditions be violated, both Schinasi and the ECB expect the financial system to
depart from a state of stability and move towards instability (ibid). Such prospect of instability raises
the question of whether the European Unions financial system is currently on a path towards
increasing instability or returning to stability. Chapter 4 addresses this question.



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4. Assessing the Stability of the EU Financial System

4.1 Framing the analysis a focus on banking stability
Having established the meaning of financial stability, the objective of this chapter is to assess the
extent to which the financial system of the European Union is currently stable. To do this effectively,
we can combine knowledge of the structure of the EU financial system discussed in Section 2 with
the theoretical conditions for stability discussed in Section 3. The theoretical conditions allow us to
split the assessment of overall financial stability into a matrix structure, as shown in Table 2.

Table 2
Matrix of Financial Stability

Efficient
resource
allocation
Sound assessment
and management
of financial risk
Smooth
absorption
of shocks
Financial
intermediaries

Financial
markets
Financial Stability
Financial
infrastructure


Applying previous insights of the structure of the EU financial system (see Section 2) to this matrix
gives us an indication of the relative significance of the individual components as stability drivers. In
particular, the earlier analysis suggests that, despite cross-country differences, financial
intermediaries are disproportionately important to the EU financial system. This is true both in
comparison to other regions, such as the United States, and to the remaining two components of the
financial system. More precisely, having established that the EU is, on average, a bank-based set of
countries, the banking system can be regarded as a, if not the, central aspect of stability. Along with
recent developments, such as the ECBs Banking Union, this provides a motivation for focusing the
assessment of EU financial stability on the banking sector. Such a focus also reflects the need for a
narrower scope to bring sufficient depth to the assessment.

By no means should this be seen as an indication of the insignificance of financial markets and
infrastructure to the overall stability of the system. In addition, it is crucial to note that even if all
components were fully assessed based on their individual stability, the result may not accurately
indicate the stability of the financial system as a whole due to fallacy of composition issues
(Hanson, Kashyap, and Stein, 2011). This means that, in practice, the stability of the components of
the system may only be a necessary, but not sufficient condition for overall stability (Osiski, Seal
and Hoogduin, 2013). All of the above should be kept in mind when putting the evaluation of
banking stability into a wider context.







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4.2 Assessing banking stability

4.2.1 Methodology
Unsurprisingly, there is no universal method for assessing the stability of the banking sector and its
implications for the overall stability of the financial system (De Grauwe and Gros, 2009; Gadanecz
and Jayaram, 2009; Cheang and Choy, 2011). As De Grauwe and Gros (2009, p.5) note, the
dimensions of financial stability do not lend themselves to be captured by one measure. Thus,
such an assessment naturally involves a certain degree of judgment, especially when it comes to
picking quantitative measures and using them to establish an absolute level of stability.

Focus on credit, market and liquidity risk
To give structure to the assessment, let us consider the factors that may imply a threat to the
stability of the banking sector. These factors are well documented and take the shape of risks and
vulnerabilities that individual banks are exposed to (Sundararajan et al., 2002; Schinasi, 2009; Bank
of England, 2013; European Banking Authority, 2014a). An overview is given in Figure 3 below. It is
based on surveying global publications by academics and regulators, as well as by reviewing risk
management literature (Bank of England, 2013; Basel Committee on Banking Supervision (BCBS),
2000, 2009, 2010; Drehman and Nikolaou, 2010; European Banking Authority 2014a ; Hull, 2012;
Pyle, 1997; Schinasi, 2009; Sundararajan et al., 2002; United States Office of the Comptroller of the
Currency, 2012). In the following, a discussion of the relative importance of these risks is provided.

As established by Basel III, the first four risks listed in Figure 3 are usually regarded as the most
significant and relevant when assessing the stability of banks and designing prudential regulation
(Bank of England, 2013). Out of these, credit risk has traditionally been seen as the greatest risk
faced by banks (Hull, 2012). However, since the financial crisis of 2007, the threat posed by liquidity
risk has become increasingly evident. With the introduction of Basel III, the importance of liquidity
risk management for financial stability has, for the first time, also been reflected in international
standards around liquidity (BCBS, 2010; Deloitte; 2013). It can thus be concluded that both credit
and liquidity risk are key threats to banks.
Moving our attention to market and operational risk, it becomes apparent that financial regulators
have traditionally focused much more on the management of market risk than operational risk,
treating it as more substantial (BCBS, 2003, p.1). This may also be motivated by the fact that
operational risk is inherently difficult to quantify, along with the more intangible reputational and
strategic risks (Manjarin, 2012; Keller and Bayraksan, 2012).
In conclusion, to assess the stability of the banking sector credit, market and liquidity risks can be
identified as a core subset of risks to be considered. Following the pareto principle (see Glossary),
the analysis will thus focus on this subset, acknowledging the implied limitations of omitting
operational, reputational and strategic risks. The degree to which banks are exposed to these three
risks typically depends on their portfolio, the resulting interconnectedness with markets and other
institutions, as well as macro-economic variables like investor and depositor confidence
(Sundararajan et al., 2002).

Financial soundness indicators
To assess the aforementioned risks, financial soundness indicators (FSIs) will be used. They
aggregate micro-prudential measures of the risks faced by single financial institutions (Figure 3) to
establish an overall picture of the shape of the banking sector. Since their development by the
International Monetary Fund (IMF) in 2003, FSIs have become more sophisticated and increasingly
used by other authorities (Gadanecz and Jayaram, 2009; IMF, 2014a). The European Banking
Authority (EBA) monitors and quarterly publishes its own set of FSIs relevant to the European Union
under the name key risk indicators (KRIs). In the following sections of Chapter 4, the EU banking

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The risk of loss due to default by a counterparty on its contractual obligations, or as a result of
reduction in the credit quality of the counterparty.
(UniCredit Group, 2012)



Credit risk

The risk of loss arising from the cost associated with liquidating a position.
(Capper, 2009)

Liquidity risk

The risk of losses in on and off-balance sheet positions arising from adverse movements in
market prices. (European Banking Authority, 2014a)



Market risk
Default risk Concentration risk Country risk
Funding liquidity risk Trading liquidity risk
Interest rate risk Exchange rate risk Equity risk Commodity risk

The risk of losses resulting from inadequate or failed internal processes, people, and systems or
from external events. This includes legal risk but excludes reputational risk.
(European Banking Authority, 2014a)



Operational risk

The risk arising from negative perception on the part of customers, counterparties,
shareholders, investors, debt-holders, market analysts, other relevant parties or regulators that
can adversely affect a banks ability to maintain existing, or establish new, business relationships
and continued access to sources of funding.
(BCBS, 2009, p.19)

Reputational risk
IT security risk Legal risk Other risks

The current and prospective risk to earnings or capital arising from adverse business decisions,
improper implementation of decisions, or lack of responsiveness to industry changes
(United States Office of the Comptroller of the Currency, 2012, p.5)
Strategic risk
sector is assessed by looking at levels and trends in selected KRIs. The focus of the analysis is on
credit and solvency risk (to be introduced below), partly due to their importance and partly due to a
scarcity of appropriate data relating to the remaining risks.

Figure 3
An overview of key risks faced by banks





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4.2.2. Credit risk assessment

Credit risk is driven by the underlying quality of the asset side of a banks balance sheet. This asset
side is made up of a banking book (loans and bonds held to maturity) and a trading book (market-
related assets that are regularly traded) (Financial Times, 2014). It should be noted that credit risk is
an inherent driver of solvency risk (the risk of a bank having less assets than liabilities (Hill, 2012)).
Solvency risk can thus be seen, not as a separate risk to those listed in Figure 3, but as the result of
those risks, combined with inadequate capital holdings. Therefore it has not been explicitly referred
to in the previous section. Given that it is, nonetheless, an important risk to consider, it is discussed
separately in Section 4.2.3.

Banking book: loans
To quote the Basel Committee on Banking Supervision (2000, p.1), for most banks, loans are the
largest and most obvious source of credit risk. Thus, one important measure of credit risk is the
ratio of impaired loans to total loans. Impaired loans refer to those which are past due more than 90
days and / or are unlikely to be repaid (EBA, 2014c).
2
A high value is an indicator of poor asset quality
in the loan portfolio and thus high credit risk.

Figure 4
Impaired and past due (>90 days) loans to total loans by bank size, EU

Source: European Banking Authority. Note: Largest 15 banks refer to banks with the greatest average total
assets between Dec. 2009 and Sep. 2013.


As shown in Figure 4, the average quality of loan portfolios of EU banks has declined almost
continuously since December 2009. This has been driven by a dramatic deterioration in the quality of
loan portfolios of small and medium-sized banks (labelled Others). Their average loan impairment
peaked at 9.7% in December 2013, the highest recorded level since 2009. In fact, this represents an
enormous 40% decrease in loan portfolio quality.

Adding to the worry is the upward trend in the 75
th
percentile of the loan impairment ratio (Figure
5). As indicated by the light blue bar in Figure 5, it has risen steadily from about 10% in 2009 to over
16% in at the end of 2013. Shockingly, at the 95
th
percentile, there are EU banks to be found with
ratios close to 45%. A country breakdown identifies 11 countries with ratios above the EU average of

2
Definitions and measurements of impairment vary and are currently the topic of much debate. Defining such
problem loans is an important component of the ECBs Asset Quality Review (Gandy et al., 2014). However,
this is not the focal point of this section and thus the most recent EBA definition has been used for simplicity.
3%
4%
5%
6%
7%
8%
9%
10%
11%
Largest 15 banks Others All banks

11

0%
10%
20%
30%
40%
50%
16.2 %
Trend in 75th percentile
6.5% in December 2013. While the EBA anonymises most of these countries, combining IMF data
(IMF, 2014c) with the EBA data set provides the following insight: the most at risk banks are located
in Greece (37%), Cyprus (above 30%), Ireland (above 20%), Romania (above 20%), Slovenia, Hungary,
Croatia and Italy (all above 15%).

Figure 5
Dispersion of impaired and past due (>90 days) loans to total loans, EU











Although these findings present a rather negative picture, the data gives rise to two positive
observations. Firstly, the loan portfolio quality of the EUs 15 largest banks has remained steady
since 2009, fluctuating at a loan impairment ratio of around 4%. This is much lower than the EU
average and implies that those banks with the biggest absolute risk, in terms of total assets, have
relatively low credit risk stemming from their loan portfolio. While this is good news, the question
remains: how systemically important are the remaining 5985 banks in the EU, given that they show
higher loan portfolio credit risk (European Commission, 2014b)? Secondly, between December 2012
and 2013 the average impairment ratio across the EU has fallen by 0.8%, driven partly by a 0.1%
reduction in the ratio of the 15 largest banks. The former is a 10% reduction and indicates an
improvement in average financial stability. As an average, it does however hide the negative trends
exhibited by the 5985 Other banks. According to the EBA figures (2014b), 45% of EU banks are
currently at medium to high loan credit risk.
3


In conclusion, despite short-term improvements in EU averages, loan credit risk provides a
substantial and possibly growing threat to EU financial stability, driven by the deterioration in loan
portfolio quality of small and medium-sized banks (labelled Other).


Banking and trading books: total assets
Besides loans, banks have been increasingly exposed to credit risks through other financial assets,
including derivatives, equities and inter-bank loans, to name a few (BCBS, 2000, 2009). Thus, the
ratio of impaired financial assets to total assets (Figure 6, below) provides useful information on the
total amount of assets that are immediately affected by credit risk. From Figure 6, two observations
can be made. Firstly, although the relationship and trends of the total asset impairment ratio are
very similar to those of the loan impairment ratio (Figure 4), the absolute level of credit risk affecting
total assets is considerably lower. Over the time horizon shown, the EU-wide ratio for total asset
impairment has been around 3-4% lower than the equivalent for loan impairment. While this is
positive, the second observation is not.

3
December 2013 figures. The EBA uses thresholds of 5%, 5-10% and above 10% to categorise banks as being at
low, medium or high loan impairment credit risk (EBA, 2014b).

12


Figure 6
Impaired financial assets to total assets by bank size, EU

Source: European Banking Authority

As with loan impairment, at the end of 2013 total asset impairment reached its highest levels since
2009, but for both size groups. While average rates have only grown by an absolute value of 0.6%,
the 5985 banks grouped under Others have experienced a 36% increase in their total asset
impairment ratio between December 2009 and 2013 (from 2.5% to 3.4%). This indicates a growing
instability in the banking sector. In addition, using the EBAs benchmark guidelines (EBA 2014b), one
can observe that around 60% of EU banks are currently at medium to high total asset credit risk.
4

While this can be, in part, explained by stringent benchmarks, it is nonetheless worrying.

4.2.3 Solvency risk assessment
Solvency risk relates directly to financial stability by acting as proxy for the ability of banks to absorb
financial and real economic shocks without major disruption (Figure 2, right column). It is commonly
assessed using capital adequacy ratios (CAR) which measure a banks capital against risk-weighted
assets (RWA).
5
A distinction is usually made between tier 1 and tier 2 capital (Admati and Hellwig,
2014), the former being of more importance to actively prevent insolvency. This is because tier 1
capital, mainly equity and retained profits, can absorb losses without a bank being required to
cease trading (European Commission, 2014c). From Figure 7, we can observe that solvency risk has
fallen continuously since 2009, with the average for both large and other banks now falling into the
EBAs low risk area of 12% or above (EBA, 2014b). This improvement can be attributed to the EBAs
establishment of EU-wide legal requirements for a 9% Core Tier 1 capital ratio (EBA, 2014a). We can
thus conclude that, as of December 2013, the average EU bank is well equipped with capital buffers
to absorb shocks, should they arise.




4
December 2013 figures. The EBA uses thresholds of 1%, 1-2% and above 2% to categorise banks as being at
low, medium or high total asset impairment credit risk (EBA, 2014b).
5
A discussion of the accuracy of risk-weights given by regulators and credit ratings is not provided. However,
the world financial crisis has shown that inaccurate risk weights, especially of sovereign bonds issued by
heavily in-debt countries, limit the usefulness of capital adequacy ratios as a measure of solvency risk. This is
because, in such a scenario, RWA measures will not accurately reflect the inherent credit risk of assets.
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
Largest 15 banks
Others
All banks

13

Figure 7
Tier 1 capital ratio by bank size, EU

Source: European Banking Authority


4.2.4 Liquidity risk assessment

The EBA does not currently have a data set covering liquidity that can be analysed. However, as part
of the Basel III monitoring exercise, a sample of 174 banks has been used to establish a picture of the
current liquidity risk environment in Europe (EBA, 2014d). The study measured the liquidity coverage
ratio (LCR) of these banks, a new prudential tool currently being rolled out by the EBA. According to
the EBA, the LCR defines the minimum stock of unencumbered, high-quality liquid assets that must
be available to cover the net outflow expected to occur in a severe stress scenario lasting 30 days
(Ibid, p.34). The aim is for all EU banks to have a 100% LCR by 2019 and thus be resistant to the
stress scenario. The survey results (Figure 8) indicate that EU banks are, on average, already
meeting this requirement. This is a good sign for the overall reliance of the EU banking sector to
bank runs.
Figure 8
Distribution of LCR in surveyed EU banks by bank group, June 2013

Source: European Banking Authority (2014c). Data as of 30 June 2013
8%
9%
10%
11%
12%
13%
14%
Largest 15 banks Others All banks
Medium risk threshold
Low risk threshold

14

5. Conclusion
The objective of this report was to establish an indication of the stability of the EU financial system,
focusing on the prominent role played the banks. To do this, developments in the risks facing banks
since 2009 have been analysed using financial soundness indicators.

As is evident in the data, the banking sector of the European Union has shown both positive and
negative trends since the aftermath of the global financial crisis. However, aggregating the trends
and absolute levels of FSIs, the overall stability of the EU banking system has been deteriorating
since 2009. From a country perspective, this has been driven largely by Europes periphery whose
asset quality has worsened dramatically. From a bank size perspective, the largest banks have
generally been more financially sound than their smaller counterparts who have contributed to
much of the aforementioned deterioration. Due to an absence of better data the analysis of liquidity
risk is not completely representative of the EU as a whole. Nonetheless, the Basel III monitoring
exercise indicates that, on average, European banks have become increasingly resilient to bank runs
and liquidity threats.

To conclude, it is of utmost importance that the European community, in particular the European
Banking Authority, continues to develop new ways to monitor the varying and changing risks of the
banking sector. In particular, an independent and continued adjustment of risk weights is important
to ensure that solvency risk as adequately managed. Furthermore, a transparent implementation
and continued monitoring of liquidity coverage ratios across the European Union is important to
support the goal of maintaining the 100% level until 2019 and beyond. A key area of future work in
this regard relates to the design and continuous adjustment of appropriate stress scenarios for the
LCR. This ensures that banks are forced to adopt to changing liquidity risk levels. In summary, all of
the above points towards one central idea. Only through fast innovation and responses on the side
of academics, regulators and policy makers can the stability of a constantly evolving system such as
the European financial system, be achieved and maintained. This calls for a more forward-looking
approach to prudential regulation than it has been the case traditionally.





15

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