International Money and Finance

Part V: Banking crisis and banking

integration

Prof. Dr. Ivo J.M. Arnold

email: I.Arnold@nyenrode.nl
DR-Building room 2-24
Banking crisis & banking integration

• Bank business models

• Pre-crisis approach
• Issues during crisis
− Sovereign – Bank Nexus
− Financial fragmentation
• Towards banking union

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Banks: big in Europe

Source: IMF (2013)

Traditional business models in
banking

• Relationship-oriented model (ROM)

− Relationship banking is financial intermediation that invests in
obtaining proprietary information about its clients, evaluating the
profitability of its investments by engaging into multiple transactions
with one client, either across product ranges, or over time (Boot,
2000)
• Transactions-oriented model (TOM)
− Transaction-oriented banking focuses on independent, often
impersonal transactions, whereby financial services are
commoditized and marketed (Buiter, 2008)
• Other terms: retail, investment & universal banking
• Banking integration: easier in TOM than in ROM?
Relationship-oriented banking
Transactions-orienting banking
Bank business models & growth

• In good times, TOM enables fast growth

− But more risk
− During crisis: market liquidity & funding liquidity issues
• ROM expansion is easier in domestic markets
− Cost saving – market power – trust & proximity &
asymmetric information
• General issues in banking:
− Too much leverage - too little equity - flawed RWA (risk-
weighted assets) approach (e.g. zero risk weightings for
sovereign debt)
Banking integration: pre-crisis approach

• Aim: Single Market in Financial Services

• Approach
− Home control with minimal harmonization of national
regulations
− Common passport (2nd Banking Directive 1989)
− Comitology (culminating in Lamfalussy process)
− Slow harmonization (CRDs)
• Key elements
− Home country control on solvency
− Distinction branch – subsidiary determines DGS
National supervisory approach
was kept in place

• Official reason: “supervision follows the market”

• But:
− Self-interested supervisors wanting to maintain lead
supervision
− For banks: national supervisors are easier victims for
regulatory capture and regulatory forbearance

− Governments want to maintain hold over banks

• Strategic industry, protection national champions
• Politically steered lending
• Easy source of funding (indirect monetary financing)
Risky mix of ingredients

• Changing banking business models, enabling fast growth

• Old national supervisory approach, yet national financial
systems varied in size and structure and relative to fiscal
capacity
• Establishment of a monetary union more conducive to
boom-bust cycles
− The elimination of currency risk and interest rate convergence
− Walters critique (procyclical real interest rates)
− Exacerbated by rising cross-border bank lending
− Mechanisms to instill discipline through the SGP and markets
failed
Effects on euro area banking sector

• In some countries: strong domestic consolidation in

retail banking
• Limited euro area integration in retail banking through
greenfield operations or M&A
• Expansion in wholesale banking activities
• Limited yet dangerous forays into foreign retail
markets via cross-border branch banking (e.g.
Icesave, ING Direct)
Þ Increase in systemic risk from national perspective
(TBTF & TBTS)
Credit crisis hits EU banking sector

• Evaporation of market & funding liquidity:

− ECB steps in, effectively taking over the function of the money
market
• Slow recognition & resolution of bad assets

Euro area specific problems

• Sovereign – banking nexus
• Financial fragmentation
Sovereign – bank nexus

• Bi-directional causation

• From banks to sovereign

− Capital injections, DGS, guarantee bondholders (Ireland, Spain)
• From sovereign to banks
− Sovereign exposure of banks (e.g. Greece)

• Or even: from sovereigns to banks to sovereigns

(Cyprus)
Sovereign risk in bank portfolios

Source: Arnold & Lemmen, International Finance (2001)

Sovereign – bank nexus

Source: BIS (2012)

Financial fragmentation

• Money markets dried up in 2007

• Private capital flows repatriated from GIIPS countries
• Flight to quality of deposits
• Breakdown of bank lending channel of monetary
transmission
• Regulatory nationalism, fend-for-yourself approaches to
insulate own banks
− German supervisor BaFin ordered Italian bank Unicredit to stop
borrowing from German subsidiary
• Eurosystem fills the gap (TARGET exposures)
Cumulative deposit flows, 2011–12
(billions of Euros)

Source: IMF (2012)

Financial fragmentation

• Financial integration may have gone too far in the past

• Too much interconnectedness, especially via banking
system, exacerbating boom-bust cycles
• Ring-fencing may be inefficient, but possibly more stable

Type of capital flow is important

• If financial integration returns, better through:
− Markets
− Foreign direct investment
Banking union

• Prevent negative feedback loop between sovereigns &

banks
• Prevent fragmentation of single financial market along
national boundaries and thus preserve single market
• Break regulatory capture and regulatory forbearance
• Level-playing field
• Stop inter-agency conflict between supervisors
What would banking union imply ?

1) A single rulebook (EBA)

2) A single supervisory mechanism (SSM, ECB)
3) A single European bank resolution mechanism
(ERM)
4) A single deposit guarantee scheme (?)
Big issue: timing & sequencing

• Accountability principle:
− Match level of supervisory responsibilities with level of
burden sharing
− SSM needs ERM
• Governance issue:
− SSM needs to be independent from national supervisors
− Can this be done?
• DGS:
− Difficult to insure euro exit
• Legacy issues
The other unions: fiscal and political

• Relation between Banking Union and Fiscal Union

• Cutting link from bank to sovereign
− European Resolution Mechanism needs resources
• Cutting link from sovereign to bank
− Now € 2500 bln sovereign debt on balance sheets
− Where should governments turn to?
− Do we need a Lender of last resort in bond markets?
• SSM needs democratic legitimacy
• Obvious link Fiscal & Political Union
Or: fixing the banks without union?

Bank balance sheet

Risk-weight sovereign debt More capital (CRD)

Cap on sovereign exposure Bail-in bond holders

(EC, Barnier)
Earlier loss recognition
on bad assets Lower DGS limit

And: limit size banks sector relative to GDP

Ban risky business models
Post Cyprus: Dijsselbloem doctrine

• Use bail-ins to protect taxpayers

• Will this make banking union more/less likely?

• What is effect on banks & economies of euro area

periphery ?
Future

• Austerity alone is not enough

• South will continue to need Northern financing; in return the
North will demand reform
• Euro will probably not survive without closer integration
− 3U: Banking union, Fiscal Union, Political Union

• There are no quick fixes. Addressing the flaws in the eurozone

will take time.
• How will businesses cope with a prolonged period of corporate
uncertainty regarding the euro project?

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