Previous chapters have documented how the EU banking sector as a whole (Chapter 2) and the business models pursued by individual banks (Chapter 3) have evolved in the years preceding the current crisis as well as after it began. The problems described below were global in nature and did not necessarily originate in Europe, but nevertheless affected large parts of the EU banking sector.
In the years preceding the global financial crisis that started in 2007, the banking landscape had undergone major changes. Global financial institutions had grown ever bigger in size and scope and their organizational complexity had increased. They had become strongly interconnected via increasingly long chains of claims, as well as correlated risk exposures arising from increasingly similar investment strategies. Leverage had strongly increased and the average maturity of their debts had shortened.
Behind these trends were forces that intensified competition in financial services. Advances in information technology as well as in investment theory and practice meant that commercial banks faced increasing competition both on the liability and asset sides of their balance sheets. New savings alternatives to bank deposits, such as money market mutual funds, proliferated and new opportunities for borrowing, in addition to bank loans, emerged. In fact, an entire shadow banking sector developed, comprising a chain of non-bank institutions which were able to provide similar financial intermediary services as traditional banks. 52
In Europe, the universal banking model has a relatively long history of combining commercial banking and investment banking under the same roof. However, there was a trend before the crisis among the biggest European banks to strengthen their focus on investment banking, including trading operations, and to increase their reliance on wholesale funding. This was driven in part by the growing demand of non-financial firms for risk management products. Banks sought economies of scale and scope and strived to take advantage of diversification benefits from multiple sources of income. In the US, the gradual unwinding and the ultimate repeal of the Glass-Steagall Act in the late 1990s made it possible to reunite investment banking and commercial banking, which had been kept separate since the 1930s crisis.
Commercial banking moved increasingly away from customer relationship-based banking, where loans are granted and then held until maturity, to the “originate and distribute” model, where granted loans are pooled, then securitized and sold to investors. This shift in the business model increased traditional banks’ connections to the shadow banking sector. They became part of the long intermediation chains that are characteristic of shadow banking.53 The increasing influence of an investment banking-oriented management culture also spurred a focus on short-term profits in commercial banking, reinforced by shareholder pressure and short-term performance-based managerial compensation schemes. Investment banks, in turn, transformed themselves from partnerships into public corporations. This helped them grow, but also provided them with incentives to take risks that their partners would not have taken with their own money.
The expansion of banks’ balance sheets in the run-up to the crisis was fuelled by several macroeconomic factors. First, global imbalances (especially between the leading emerging economies and the United States) developed as globalization progressed. Accumulating surpluses in the emerging economies increased their demand for safe assets. The advanced western financial markets, partly as a response to this growing demand, offered financial innovations that increasingly utilized securitization of previously illiquid assets such as (subprime) mortgages. In Europe, macro- economic imbalances started to develop within the euro area, and many countries experienced property market overheating. Another important macroeconomic factor was that in the aftermath of the slower economic growth of the early 2000s, the monetary policy stance both in the US and Europe was relatively loose.
On the basis of those developments, a number of specific problems can be highlighted that undermined the resilience of a number of European banks and by extension the safety and efficiency of the market place leading up to the crisis. Although the banking sector has undergone significant changes since the beginning of the crisis, including in response to regulatory and market pressure, shortcomings in a number of areas remain:
Excessive risk-taking fuelled by intra-group subsidies: A combination of poor risk management; distorted incentives; underestimation and underpricing of risks; and, lack of
52 See e.g. Hoenig and Morris (2011): “Restructuring the Banking System to Improve Safety and Soundness”.
53 See e.g. Adrian and Shin (2010): “The Changing Nature of Financial Intermediation and the Financial Crisis of 2007 – 2009”.
oversight led banks to take excessive risks. Alongside their rapid balance sheet expansion, which for a number of banks included the build-up of large asset inventories to meet their market-making and other trading functions, banks became increasingly funded through and reliable on wholesale markets and thereby more vulnerable to market illiquidity and instrument illiquidity. The expansion of trading activities has been fuelled by funding benefits for those activities within integrated banking groups ("intra-group subsidies"). Integrated banking groups benefit from access to intra-group deposit funding that is relatively stable, long in duration, less risk sensitive and explicitly guaranteed. Moreover banks issuing debt to fund investment bank activities pay a blended interest rate, as bank investors take into account the non-investment bank part of the bank (e.g. deposit funding). In both cases, the risks inherent in the integrated banks' trading activities are not fully priced into their funding costs in normal times, thereby increasing the incentives for excessive trading risks. While the increase in the extent and nature of bank activities may have been driven by client demand and market-making, it has led to a disproportional increase in intra-financial business often promising higher returns for the industry than other activities. Banks' balance sheets have increased much more than their traditional customer-facing activities (e.g. customer loans and deposits)54;
Increased complexity, size, and scope: in the years leading up to the crisis, banks have increased significantly in size and complexity. For the largest banks, this increase has coincided with an expansion of investment bank activity, such as brokerage, trading and market-making activities. This has made it more difficult for bank management and the board of directors to exercise control throughout the organisation. It has also made it more difficult for external parties (be they investors, other market participants or supervisors) to monitor effectively the behaviour of banks;
Leverage and limited ability to absorb losses: the expansion of activities has been accompanied by an increase in leverage, whereas the capital base of banks has not expanded in parallel. Prior to the crisis, banks' balance sheets grew at a much faster pace than their capital and deposit base. Banks accordingly have a very narrow capital base, which could be rapidly depleted were asset prices to fall precipitously. Furthermore, the crisis also illustrated that a large part of banks' capital stock was effectively unable to absorb losses. Their increased reliance on short-term funding also increased banks' exposure to liquidity shocks;
Inadequate supervision and overreliance on bank management, boards and market discipline: Basel II led to the wide-spread use of banks' internal models. However, there was insufficient oversight and challenge of those models. This enabled banks significantly to reduce risk-weighted assets and the real amount of capital held. Newer trading activities were inadequately captured in regulatory capital requirements. Reliance on market discipline failed. Investors demanded increasingly unrealistic returns and banks responded by taking unacceptable risks;
Increased interconnectedness, systemic risk and limited resolvability: the expansion of trading activity and the increased reliance on wholesale funding increases links between banks and renders them more vulnerable to counterparty risks, with an associated increase in the use of complex financial instruments (e.g. derivatives, structured finance, etc.). The strong linkages between banks have led to an increase in systemic risk. The increase in complexity and interconnectedness also had the effect of making it very difficult to resolve
54 Part of the European banks balance sheet increase resulted from holding securitized assets and mortgages originating from other areas, particularly the US; see Shin (2012).
banks in an orderly manner, without triggering further financial turmoil. The situation was exacerbated by the lack of a regulatory framework giving authorities the necessary mandate and tools to manage failing banks, and as well as by the hesitation of authorities to act on time;
Competitive distortions and implicit public support leading to competitive distortions and negative bank-sovereign feed-back loops: In the EU, nearly all failing banks, and banks of systemic importance in particular, have been supported by public funds in the form of capital injections, guarantees and liquidity support. The public support extended to banks has created competitive distortions.55 Banks benefiting from explicit or implicit public support can raise funds more cheaply than other banks, as investors have factored in the decrease in investment risk arising from the likelihood of state support should the bank run into trouble.
This support amounts to an implicit subsidy from the public sector to the banks in question, tilting the playing field to their advantage and generally limiting efficient entry and exit from the market. This support has significantly drained public finances and was one of the reasons triggering concerns about the sustainability of sovereigns in parts of the EU. Investors have by extension also questioned the solvency of banks headquartered in those Member States;
and
Lack of EU institutional framework governing the single market in financial services: the increases for example in risk-taking, size, complexity and interconnectedness have been accompanied by an expansion of cross-border activity, as banks have used the opportunities created by EU law to provide their services in other Member States. However, the arrangements governing the single market for financial services – notably the institutional architecture (e.g. supervisors and resolution authorities), as well as safety nets (e.g. deposit insurance) – have not evolved accordingly. As a result, while banks became increasingly transnational in nature, the institutional governance arrangements remained largely national. Faced with this mismatch, many Member States have taken measures aimed at safeguarding domestic financial stability. These measures have adversely affected banks with business models predicated on a single market scope.
These problems have increased the likelihood of the failure of EU banks. They have furthermore increased the potential impact of a banking crisis on society. They have also reduced the stability, efficiency and fairness of the market place.