The purpose of this 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. The assessment focuses particularly on the role of banks in the EU financial system and is based on macro-prudential tools such as financial soundness indicators (FSIs).
Original Title
Financial Stability Assessment of the European Union
The purpose of this 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. The assessment focuses particularly on the role of banks in the EU financial system and is based on macro-prudential tools such as financial soundness indicators (FSIs).
The purpose of this 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. The assessment focuses particularly on the role of banks in the EU financial system and is based on macro-prudential tools such as financial soundness indicators (FSIs).
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
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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
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
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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 1 132.2 128.3 101.1 115.9 176.6 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 1 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. 1
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
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)
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
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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).
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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
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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
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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.
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