Is the Euro Crisis Over?

Hyun Song Shin Princeton University Bendheim Center for Finance Spring Alumni Event New York City, April 18, 2012

BCF Spring Event, NYC: Is the Euro Crisis Over?

Three (Interlocking) Features of the Euro Crisis

Sovereign debt crisis Banking crisis Balance of payments crisis Cross-border capital ow reversal Sudden Stop Common thread is the bank leveraging/deleveraging cycle

BCF Spring Event, NYC: Is the Euro Crisis Over?

Trillion pounds

1.4

1.2

1.0 Equity 0.8 Other Liabilities 0.6 Total MMF funding Customer Deposits

0.4

0.2

0.0

Figure 1. Total Liabilities of Barclays (1992 - 2007) (Source: Bankscope)

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

BCF Spring Event, NYC: Is the Euro Crisis Over?

Trillion pounds

1.4

1.2

1.0 Total Assets 0.8 Risk-Weighted Assets

0.6

0.4

0.2

0.0

Figure 2. Barclays, risk-weighted assets and total assets (Source: Bankscope)

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

BCF Spring Event, NYC: Is the Euro Crisis Over?

Trillion Euros

1.2

1.0

0.8

Equity
0.6

Other Liabilities
0.4

Total Customer Deposits

0.2

0.0

Figure 3. Socit Gnrale liabilities 1999 - 2010 (Source: Bankscope) ee e e

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

BCF Spring Event, NYC: Is the Euro Crisis Over?

Trillion Euros

1.2

1.0

0.8

0.6

Total Assets

0.4

RiskWeighted Assets

0.2

0.0

Figure 4. Socit Gnrale risk-weighted assets and total assets (1999 - 2010) (Source: Bankscope) ee e e

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

BCF Spring Event, NYC: Is the Euro Crisis Over?

Corporate Finance of Banking

L Equity

Assets Debt

BCF Spring Event, NYC: Is the Euro Crisis Over?

L Equity

L Equity

Assets Debt

Assets

Debt

BCF Spring Event, NYC: Is the Euro Crisis Over?

L Equity

L Equity

Assets Debt Assets Debt

BCF Spring Event, NYC: Is the Euro Crisis Over?

Barclays: annual changes in assets, equity, debt and risk-weighted assets (1992 -2010)
1,000
y = 0.9957x - 2.81 R2 = 0.9998

Annual change in equity, debt and risk-weighted assets (billion pounds)

800 600 400 200 0 -200 -400 -600 -800 -1,000

Equity Change

y = 0.0043x + 2.81

Debt Change

-500

500

1,000

Annual change in assets (billion pounds)

Figure 5. Barclays: annual change in assets, equity and debt (1992-2010) (Source: Bankscope)

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BNP Paribas: annual change in assets, equity and debt (1999 - 2010)
500 400 Change in equity and debt (billion euros) 300 200 100 0 -100 -200 -200 Debt Change
y = 1.0051x - 6.2 R2 = 0.9987

Equity Change

-100

100

200

300

400

500

Asset change (billion euros)

Figure 6. BNP Paribas: annual change in assets, equity and debt of (1999-2010) (Source: Bankscope)

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Societe Generale: annual changes in assets, equity and debt (1999 - 2010)
300 Annual change in equity and debt (billion euros) 250 200 150 100 50 0 -50 -100 -150 -200 Equity change
y = 0.996x - 3.15 R2 = 0.9985

Debt change

-100

100

200

300

Annual asset change (billion euros)

Figure 7. Societe Generale: annual change in assets, equity and debt of (1999-2010) (Source: Bankscope)

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Barclays: 2 year change in assets, equity, debt and risk-weighted assets (1992 -2010)
1,000 800 600 400 200 0 -200 -400 -600 -800 -1,000 -1,000
y = 0.9974x - 0.175 R2 = 0.9998

2 year change in equity, debt and risk-weighted assets (billion pounds)

2yr RWA Change 2yr Equity Change 2yr Debt Change

-500

500

1,000

2 year asset change (billion pounds)

Figure 8. Barclays: 2 year change in assets, equity and debt (1992-2010) (Source: Bankscope)

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Societe Generale: 2 year changes in assets, risk-weighted assets, equity and debt (1999 - 2010)
400 2 year change in risk-weighted assets, equity and debt (billion euros) 350 300 250 200 150 100 50 0 -50 -100 -100
y = 0.0014x + 6.65 y = 0.9986x - 6.65 R2 = 0.9988

2yr debt change 2yr equity change 2yr RWA change

100

200

300

400

2 year asset change (billion euros)

Figure 9. Societe Generale: 2 year change in assets, equity and debt of (1999-2010) (Source: Bankscope)

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Why did European banks expand so much?

Two candidate hypotheses: Regulatory environment: circumvention of Basel I, impending Basel II and EU Capital Adequacy Directive (CAD) Advent of Euro opened up cross-border banking market within the eurozone

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Trillion Euros

7.0

6.0

5.0

4.0

Crossborder claims in domestic currency of eurozone banks Crossborder liabilities in domestic currency of eurozone banks
1999-Q1 1999-Q4 2000-Q3 2001-Q2 2002-Q1 2002-Q4 2003-Q3 2004-Q2 2005-Q1 2005-Q4 2006-Q3 2007-Q2 2008-Q1 2008-Q4 2009-Q3 2010-Q2 2011-Q1

3.0

2.0

1.0

Figure 10. Cross-border euro-denominated claims and liabilities of eurozone banks (Source: BIS Locational Statistics, Table 5A)

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30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20%

2000-Q1 2000-Q3 2001-Q1 2001-Q3 2002-Q1 2002-Q3 2003-Q1 2003-Q3 2004-Q1 2004-Q3 2005-Q1 2005-Q3 2006-Q1 2006-Q3 2007-Q1 2007-Q3 2008-Q1 2008-Q3 2009-Q1 2009-Q3 2010-Q1 2010-Q3 2011-Q1

Figure 11. Four quarter growth rate of cross-border euro-denominated liabilities of eurozone banks (Source: BIS Locational Banking Statistics Table 5A)

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Claims of European Banks on Counterparties in Spain Trillion Dollars

1.2 1.0 0.8 0.6
United Kingdom Other European BIS reporting countries Switzerland

0.4
France

0.2 0.0
Germany 2005-Q2 2005-Q4 2006-Q2 2006-Q4 2007-Q2 2007-Q4 2008-Q2 2008-Q4 2009-Q2 2009-Q4 2010-Q2 2010-Q4

Figure 12. Foreign claims of European BIS-reporting banks on counterparties in Spain (Source: consolidated banking statistics, Table 9D)

BIS

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Claims of European banks on Counterparties in Ireland Trillion Dollars

0.9 0.8 0.7 0.6 0.5 0.4 0.3
France United Kingdom Other European BIS reporting countries Switzerland

0.2 0.1 0.0

2005-Q2 2005-Q4 2006-Q2 2006-Q4 2007-Q2 2007-Q4 2008-Q2 2008-Q4 2009-Q2 2009-Q4 2010-Q2 2010-Q4 Germany

Figure 13. Foreign claims of European BIS-reporting banks on counterparties in Ireland (Source: consolidated banking statistics, Table 9D)

BIS

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Current Account Balance as % of GDP

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

3.0

Current Account Balance as % of GDP

1.0 -1.0 -3.0 Ireland -5.0 -7.0 -9.0 -11.0 -10% Spain

Figure 14. Current account of Ireland and Spain (Source: IMF International Financial Statistics)

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ECB

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ECB

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Figure 15. Share of Eurosystem Main and Long-term Renancing Operations (Jan 2003 - Nov 2011) (Source: Sudden stops in the Eurozone Silvia Merler and Jean Pisani-Ferry (2012), data from European Central Bank)

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Figure 16. TARGET 2 net balances in the Eurosystem (Source: Sudden stops in the Eurozone Silvia Merler and Jean Pisani-Ferry (2012), data from Eurosystem central banks)

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Some Historical Parallels

US mortgage crisis 2007 Japans bursting bubble 1990 2003 Slow deleveraging eventually results in bad assets and public recapitalization of banks How much? How soon? How? Some lessons from Japan

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M2

Loans and Discounts

100 Trillion Yen

9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0

Figure 17. Japan: Loans and discounts of major and regional banks (in red) and M2 money stock (in blue) (Source: Flow of Funds, Bank of Japan)

1980/01

1981/05

1982/09

1984/01

1985/05

1986/09

1988/01

1989/05

1990/09

1992/01

1993/05

1994/09

1996/01

1997/05

1998/09

2000/01

2001/05

2002/09

2004/01

2005/05

2006/09

2008/01

2009/05

2010/09

2012/01

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Some Characteristic Features of Boom and Bust

Boom phase Rapid increase in lending Increase in loan to deposit ratio Increasing incidence of non-core liabilities Bust phase Loans and loan-to-deposit ratio decline Liquidity support by central bank cushion (or delay) the process Zombie banks and zombie rms

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12.0

Trillion Euros

11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0

Jan-95 Mar-96 May-97 Jul-98 Sep-99 Nov-00 Jan-02 Mar-03 May-04 Jul-05 Sep-06 Nov-07 Jan-09 Mar-10 May-11

Loans to nongovernment borrowers

Deposits due to non-banks

Figure 18. Eurozone: Loans to non-MFIs (monetary and nancial institutions), excluding general government (in red) and deposit liabilities to non-MFIs excluding central government (Source: European Central Bank)

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Loan to deposit ratio 1.20 1.15 1.10 1.05 1.00 0.95 0.90

Figure 19. Eurozone: Loan to deposit ratio. Numerator is loans to non-MFIs (monetary and nancial institutions), excluding general government. Denominator is deposit liabilities to non-MFIs excluding central government (Source: European Central Bank)

Sep-97

Dec-98

Mar-00

Jun-01

Sep-02

Dec-03

Mar-05

Jun-06

Sep-07

Dec-08

Mar-10

Jun-11

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Normalized loans (Japan) Normalized loans 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 0.4 Crisis date
Japan (Jan 1991) Eurozone (Sept 2008)

Normalized Loans (Euro area)

Feb 2012

Figure 20. Eurozone and Japan: Loans in Euro area (in red) and in Japan (in blue) normalized to 1.0 at crisis date, and measured in months from the crisis date. Eurozone crisis date is September 2008. Crisis date for Japan is January 1991 (between stock market peak and real estate peak)

252 240 228 216 204 192 180 168 156 144 132 120 108 96 84 72 60 48 36 24 12 0 -12 -24 -36 -48 -60 -72 -84 Months from crisis date

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Lessons for Eurozone from Japan

Liquidity versus solvency Comparing Eurozone LTRO with Bank of Japans monetary policy in early 1990s But loans granted during the bubble phase almost always go bad, and must be written o eventually Pre-condition for restructuring is political will, which needs shared diagnosis of crisis Japans deleveraging started 7 years after crisis date (see gue) Restructuring entails scal costs, which is an added complication in Eurozone Question: How well can the institutions and governance structure of the Eurozone cope with strains of the restructuring process?

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What Implications for Rest of the World?

Implications for the US economy Emerging economies

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Trillion Dollars

11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1999Q1 2000Q2 2001Q3 2002Q4 2004Q1 2005Q2 2006Q3

2008Q1

US chartered commercial banks' total financial assets US dollar assets of banks outside US

Figure 21. US dollar foreign currency claims of BIS banks and US commercial bank total assets (Source: Flow of Funds, Federal Reserve and BIS locational banking statistics, Table 5A)

2007Q4

2009Q1

2010Q2

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European Global Banks

Shadow banking system

Wholesale funding market

US Borrowers

US Banking Sector

US Households

border
Figure 22. European global banks add intermediation capacity for connecting US savers and borrowers

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Figure 23. US Dollar-denominated assets and liabilities of euro area banks (Source: ECB Financial Stability Review, June 2011, p. 102)

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TrillionDollars

7.0 6.0 5.0 4.0 3.0 2.0

France Non-European BIS reporting countries Other European BIS reporting countries Switzerland

United Kingdom

1.0
Germany

0.0

Figure 24. Foreign claims of BIS reporting banks on US counterparties (Source: BIS consolidated banking statistics, Table 9D)

2005-Q2

2005-Q4

2006-Q2

2006-Q4

2007-Q2

2007-Q4

2008-Q2

2008-Q4

2009-Q2

2009-Q4

2010-Q2

2010-Q4

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(%) 90
80 70 60 50 40 30 20 10 0 Belgium,Italy, Spain,Portugal, Ireland,Greece 2009H1 2009H2 2010H1 2010H2 2011H1 2006H2 2007H1 2007H2 2008H1 2008H2 Othereuroarea OtherEurope Asia

UnitedStates

Figure 25. Amount owed by banks to US prime money market funds (% of total), based on top 10 prime MMFs, representing $755 bn of $1.66 trn total prime MMF assets (Source: IMF GFSR Sept 2011, data from Fitch).

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Emerging Economies
Emerging Europe Rebalancing in China Asia ex China and Latin America