10 - Financial system

Index

1. Functions and regulation of the financial system

• Financial markets
• Financial intermediation
• Financial regulation: markets and banks.

2. Banking system in Spain

3. The 2007 financial crisis and its effects on banks

1. Function and structure of the financial system

The ability to invest is a key element for any economy’s growth.

Investment is made possible by savings, as S=I.

How are saved resources made available to investors?

Through the financial system, in two alternative ways:
- Through financial intermediaries
- Directly, from savers to investors via financial markets

Depending on the relative importance of each channel, financial systems can be of one of
the following two types:

• Intermediated (bank-oriented):
banks provide most of the contact between savers and investors.
Examples: Spain, United Kingdom, Germany, Japan.

• Disintermediated (marketoriented): more reliance of markets. Example: United States.

Ratio of ‘Bank assets/GDP’ is 250% in EU, just 80% in US.

Differences between investment fund and commercial banks:

- Customers: government, investors, corporatios/normal public

- Main service offered: buying and selling of stocks and bonds/deposit, mortgage
(secured loan) and lending loan

https://www.educba.com/commercial-bank-vs-investment-bank/

1a. Financial Markets

 direct contact between savers and investors is a financial market

Stock exchanges (stock markets):

- Market for securities: Shares, bonds (public & private), derivatives...
- Stock indexes (FTSE, S&P500, NASDAQ, EUROSTOXX): weighted share prices.
- Primary and secondary markets.

Money and capital markets. Liquidity lending and borrowing.

- Interbank market: balance banks’ short term liquidity: 1 day to 1 year. Sets the
reference interest rate for other transactions: EURIBOR (European InterBankm
Offered Rate), US overnight rate.
 The interbank market is a network of international banks operating in financial centers
around the world.
each trade representing an agreement between the banks to exchange the agreed
amounts of currency at the specified rate on a fixed date.

1b. Financial intermediation

Intermediation involves signing two different financial contracts:

- A deposit: between the saver (lender) and the bank (borrower)
- A credit or loan: between the bank (lender) and the investor (borrower).
 To lenders, the contract reflects an asset, to borrowers it is a liability.

Intermediation margin:

Difference between interest rates charged for the loan and payed to the deposit.
Traditionally, this was the banks’ main source of revenue.

Financial intermediaries: banks

Banks are the main financial intermediaries.

Bank types:
• Commercial banks: standard intermediation between households and firms
• Investment banks: provide finance to business activities, including investment of their own
funds, asset management, raising funds, insurance, etc.

As intermediaries, banks provide two important functions:

• Liquidity management. Savers can recover their deposit even if the loan to the investor
has not yet been paid back to the bank.
• Risk insurance: A failed loan does not put the deposit at risk. It is the bank, not the saver,
who bears the investor’s default risk.

 Without banks, savers would have no liquidity access to their

investments and be exposed to full default risk

Financial disintermediation

In bank-oriented financial markets (like Spain’s) a trend is observed of increasing reliance on

financial markets, and away from traditional intermediation. Examples:

- investment funds (shares) increasingly used as instruments to save, away from deposits.
- firms issuing shares or financial derivatives instead of asking for loans.

 reduces banks’ intermediation revenues and forces them to become players in the
financial markets.
Examples:
- manage and sell participations in investment funds or pension plans.
- obtain more revenue from services’ commissions, and less from the
intermediation margin.

1c. Financial regulation

The financial system is subject to different types of market failures that justify its regulation.

Both financial markets and banks are heavily regulated.

a) Financial Markets’ Regulation.

Focuses on providing symmetric information to all agents.

Tries to avoid cases of insider trading using private information.
Regulatory bodies in charge of stock exchanges: SEC, CNMV, FSA...

Examples:
• Quoted firms are required to publish results on a quarterly basis.
• Firms have to communicate to the regulator all the ‘relevant events’.
• Stricter auditing requirements on quoted firms.

b) Banking regulation

The confidence in the banks’ ability to return its deposits is key for the stability of the
financial system.

Banks are exposed to two types of risks:

• Solvency risk (default): a bank can go bankrupt if it does not properly
assess the risks on the loans it grants.
• Liquidity risk: if savers claim back their deposits simultaneously, there
will be not enough cash to return them.

A ‘bank run’:
The fear that banks may go bankrupt can propagate claims on deposits,
making all banks illiquid.
Eventually, such loss of confidence would bankrupt them: a systemic
crisis.
• Many historical examples: 1870s, 1910s, 1930s, 1970s (Spain), 2008-
2012, …

In order to avoid bank runs, an important element of banking regulation are Deposit
Guarantee Schemes: compulsory insurance system (paid by depositors) to bail-out banks.
systems in each member state that reimburse depositors (up to a defined limit) if
their bank fails and deposits become unavailable.
DGS explain limited bank runs in the 2008-2012 crisis (although the DGS funds became
quickly empty, public resources were used refund them)

The creation of a Euro-wide DGS is the remaining obstacle to the Banking Union (common
EU regulatory rules for banks and bailing out mechanisms)

Banking regulations involve a trade-off:

• if tight, banks become safer but they earn lower margins and don’t compete.
Innovation will suffer (new financial products or derivatives) and financial
liquidity will be lower (less credit)
• if loose, banks will compete and innovate, and more capital will be available
at cheaper rates. But banks will be exposed to higher risks.
• Example: High DGS provide more safety, but are costly for banks

An example: historical changes in US banking regulation:

• Glass-Steagall Act (1933) separated commercial and investment banking:

stricter regulation. This made banks safer, but limited competition in finance.
• Gramm-Leach Act (1999) More innovative financial products made more
credit available, but at the cost of higher risks affecting all activities: subprime
mortgages crisis bankrupted many commercial banks & Lehman Brothers.
• Dodd-Frank Act (2010) restricts banks’ activities: no risky investments with
their own accounts & annual stress tests.

In Europe, the EU can impose conditions on certain banks as part of the resolution process,
but a structural reform directive failed to be approved in 2018

Bank supervision is responsibility of central banks (ECB and National CBs in EMU, Federal
Reserve in US).

Since 2012, The ECB is responsible for the ‘micro-prudential supervision’ of ‘systemic banks’
(>30bn €in assets)

ECB carries annual ‘stress tests’ to assess banks’ solvency in crisis scenarios.

Instruments for banking regulation:

Banking supervision focuses on reserves and equity capital.
• Higher reserves keeps more liquidity in the bank to face deposit claims, but they also
limits lending by banks, and their profitability.
• Higher levels of equity capital (provided by shareholders) make it possible to sustain
higher losses and avoid bankruptcy, also at the expense of lower lending activity and
profitability.

Reserve coefficients (ratios)

• Required Reserve Ratios (RRR) (are the minimum percentages of

deposits that banks are required to keep (in cash or as central bank
deposits)
• Reserve coefficients are also a monetary policy tool: If central banks
increases (decreases) RRR requirements, banks decrease (increase)
their lending. This triggers the monetary multiplier

Given current expansionary monetary policy, RRR are on historical minima: ECB sets RRR at
1%, Federal Reserve at 0% (since March 15, 2020).

Capital requirements regulation

Requirin banks to have a high level of capital over loans makes them
more solvent. But also less profitable.

Example with 1 Equity vs 10 Equity

 There is a clear trade-off between banks’ profitability and solvency.

Setting capital requirements

The key issue in banking regulation is how to define the minimum amounts of capital that
banks should be required to have.

 Capital Adequacy Ratios (CAR, or CR for short): ratios of bank’s capital to assets.

There are two definitions of equity capital:

- Common Equity Tier 1 capital (CET1, core capital) is the primary funding source of the
bank:
shareholder’s equity + retained earnings (reserves).
When ‘fully loaded’, it considers past reserves and those due to take effect shortly.

- Tier 2 capital = Tier 1 capital + reserves’ reevaluation + hybrid capital and

subordinated debt instruments + loan default provisions.

Tier 2 is larger, but less reliable since it is less liquid and more difficult to compute precisely.
 Tier 1 has become the preferred measure.

Capital Ratio: Tier 1 or Tier 2 capital/ risk-weighted assets.

Ex.

Tier 1 = 16m€
three types of loans:
100 m€ in high risk (weight:1),
200m€ in medium risk (0.5) and
200 m€ in low risk (0).
CAR ratio = 16/ 100*1 + 200*0.5+ 200*0 = 8%
Assume that the financial regulator imposes a new CAR limit at 16%.

The bank can react in three ways:

- Increase equity (or retain profits as additional reserves) up to 32.
- Sell assets, for instance, all mid risk loans. CAR becomes 16/100=16%
- Reduce risks (by asking for additional collateral or guarantees). If all 100m€ of high
risk loans become low risk ones, CAR increases to 16/100=16%

In each case the bank becomes more solvent, but less profitable.

The strategies banks use to increase their solvency have implications for economic growth:
• If banks decrease their supply of credit or lend only to high quality
borrowers, consumption and investment will fall.
• If banks increase their equity levels, economic growth is not negatively
affected

In practice, banks react to a 1% increase on CET1 ratios by reducing credit growth between
1% and 4%.

 Why don’t banks react by raising more equity?

• For banks, equity is more expensive than other fund sources (like debt). (But) It gets paid
later in case of default, thus it bears more risk & investors ask for higher return.

• Debt payments are tax-deductible, making it even cheaper. For instance, in Spain financial
expenses of up to 30% of profits are tax deductible.

International financial regulation

• Minimum limits on Capital Ratios are set at the Basel Committee on Banking Supervision
(part of Bank of International Settlements). The BCBS
sets minimum standards for the regulation and supervision of banks. Its
decisions have no legal force until they are adopted nationally.
Three rounds of Basel Accord (agreements):
• Basel I (1974-1988): Developed methodology to calculate risk-weighted
assets (RWA). Required CET1/RWA>8% for international banks.
• Basel II (2008) : Aims at making capital requirements more risk-sensitive. At
the time of Lehman Brothers bankruptcy, CET1/RWA was set at 6%.
• Basel III (2010-2017): Complete revision following the financial crisis:
- CET1/RWA > 10.5%
- Counter-cyclical provisions: computed according to average long run default rates, not
with latest rates (which are pro-cyclical).

2. Banking system in Spain

Three types of deposit-taking institutions:

• Commercial banks. Listed private companies, operate in the whole national market.

• Savings banks (Cajas de ahorros). Foundations (no shareholders), evolved from mutual
savings funds at the local or regional level. Until 1980s, operated only in their local region.

• Cooperatives, specialised in local agricultural credit (ex: Caja Rural).

There are no investment banks. Commercial banks play this (minor)

role. For large companies, UK or US investment banks are available.

Banks

• Two large (Santander and BBVA) and some smaller ones (Sabadell, Bankinter, etc.)

Current outlook as a the result of mergers between the ‘big 7’ in the 1980/90s , facing risk
of increasing competition from EU banks:
- Bilbao + Vizcaya + Argentaria (previously: Banco Exterior) => BBVA
- Santander + Central + Hispano => BSCH => Santander
- Popular decided to go alone. Performing relatively well, until it went bankrupt in 2017
and was bought by Santander.
- Sabadell absorbed Atlántico, Guipuzcoano & Herrero: strategy of gaining size to avoid
being taken over by.

 Spanish banks have succeeded in blocking entry of EU rivals in their

retail banking market.

Savings banks (cajas, caixes)

Particular ownership structure: no shareholders, governed by founding institutions.

Regulation as shared responsibility of regional governments and Bank of Spain.

Savings banks were traditionally specialised in household savings at the local level:

- Net generators of savings, with limited lending opportunities

- Channeled savings to banks as lenders in the interbank market

The limits on their functions were progressively eliminated in 1970s1980s. Since 1989 they
could open branches anywhere and effectively act operate as commercial banks (but
without shareholders)

 During the housing boom (1995-2007), savings banks expanded geographically and
competed with commercial banks in providing housing mortgages.
They were the main casualties from the financial crisis: most savings <banks required partial
or complete bail-out.

2012 reform turned them into banks:

- They have proper ownership structures that assess risks.
- They can be bought by other banks.

‘La Caixa’  Caixabank ; ‘Caja Madrid’  Bankia, etc.

Only two tiny well-managed savings banks survive as such: Caixa Pollença and Caixa
Ontinyent.
Strong reduction of savings banks consolidation of the banking sector

Characteristics of Spanish banking sector

1. Continuing financial intermediation.

Despite financial disintermediation, Spanish banks continue to carry out most of their
activity as financial intermediaries.
Banks account for a large portion of Spain’s financial system, although disintermediation
with the crisis the weight of banks increased again ( Eurozone, where they dereased)

 Loans and deposits account for about 50% of banks’ assets and liabilities, some 15%
above the EU average.

 predominance of deposits as the main source of financing for Spanish banka limited
market finance

More dependency on traditional intermediation and higher financial margins/assets: Around

0.5% above the Euro Zone average.

Evolution:
Banks asset / GDP

2000-2012: intense growth, highest peak, close to European average

2012-2014: drop, below European average, explained by the economy’s deleveraging (with
less leverage)

2. Profitability.

Measured by ROE, Spanish banks have been more profitable than EZ ones (before and after
the crisis, except for 2012).

 Is this because they are more efficient, or they are able to exert market power?
3. Operational efficiency

Spanish banks are more efficient than European ones: Cost/income ratio is below the EZ
average.

4. Market concentration

• Measured by HHI or CR5 ( concentration measured as the sum of the shares of the 5
largest companies in terms of national assets), concentration in Spanish banking has clearly
increased after the crisis. It’s above EU from 2014

• At the provincial level (measured by number of branches) we also

observe some large increases in concentration between 2008 and
2016.

Competition has therefore decreased with the crisis, although the effects on stability may
have been beneficial (nonperforming loans have decreased as competition decreased)

• So, it is not clear if higher profitability is due to more efficiency or to

lower intensity of competition. Probably, to both causes.

5. Solvency

Measured as Tier 1 Capital / RWA, solvency of Spanish banks is lower than the EU average
(RWA is not computed in the same way in all countries).

• The stress tests carried out in 2018 show Spanish banks around the average, but too close
to (or below) the 8% threshold in an adverse scenario:

The stress tests due in 2020 were postponed to 2021 due to covid crisis.

3. The financial crisis’ impact on banks

During the long growth period before the crisis, different imbalances were built in the
Spanish banking system which are at the origin of its later problems.

1. Excessive credit growth.

Between 2000 and 2008 credit grew at an annual rate of 16% (7% in EU).

In the case of construction industry and property business, credit grew by 40% in 2006.

(crisis 2010-2014: credit fell by 27%, crisis and excess private debt made deleveraging
unavoidable)

2. Concentration of risks in the construction sector

Between 2000 and 2008, credit awarded to construction, property development and home
purchases grew from 45% to 61% of total private credit.

(property and development suffered the highest default rates)

3. Excess capacity. (in terms of branches and employees)

Particularly in the case of savings banks, which carried out a massive expansion, both in
terms of branches and employees.

Rapid credit growth granted by savings banks, especially for property-related businesses 
From 2000-2008: savings banks increased their market share by 6.6 pp at the expense of
banks

 they were hit hard by the crisis, due to their great exposure to the sector worst affected
by the crisis, capacity was drastically cut

(Savings banks took almost 10% market share from banks in this period)

4. Dependency on wholesale capital markets.

Given that national savings were not enough to finance all credit given, banks and savings
banks had to borrow at wholesale capital markets.
 This is shown by the credit/deposit ratio (liquidity gap) which reached almost 1.3.

(During the crisis, the wholesale markets were closed to pay its debt Spain had to rely on
ECB funds and deposits
But savings banks could not find ways to attract capital and solve solvency, they didn’t have
shares nor equity, they could only capitalize profits but they were making losses)

5. Weak governance structures at savings banks.

- Since they had no shareholders, they could not issue shares and raise equity.
- They did not develop proper risk assessment mechanisms when awarding credit.
- And since they were heavily politicised (representatives of regional governments sat
on their boards), many of their strategic decisions were mistaken in financial terms.

Measures taken as a response to the crisis

Initially, based on the diagnosis that the crisis would lead to liquidity (and not solvency) risk
for banks, public funds were made available through the FAAF (Financial Asset acquisition
Fund) with funding to buy top quality assets from the banks to stimulate credit to
businesses and individuals.
By 2010 it was clear that there was a need to restructure troubled banks. This was done
through the FROB fund, which bailed out savings banks set up a plan to reduce excess
capacity via mergers.
Initially FROB gave aid with capital
All the help was lost in its entirety

However, merging savings banks with each other did not work.

2010, allow savings banks to create banks to which to transfer their businesses and access
good quality capital from the markets through them. They were then forced to become
banks, so that they could be bought by other banks in better situation.
Only two savings banks didn’t covert

As the public debt crisis exploded (2011) and the doom loop problem became evident, CAR
thresholds of 10% were imposed in those entities that did not have at least 20% of private
capital and were more than 20% dependent on wholesale market funding (which were
mostly savings banks, to the others it still applied 8%)

 incentive to convert into a bank

 the ones that weren’t able to obtain the necessary capital, Funds were made available
via FROB  nationalisation of bad banks.

2012: Recognition of bad assets related to the construction sector led to bailing out of the
Spanish banking sector by the ESM (European Stability Mechanism).
The Memorandum of Understanding included the following measures:
- Stress tests to be carried out on all banks
Las pruebas de resistencia consisten en simulaciones hechas sobre el papel acerca de
la capacidad de los bancos y cajas para enfrentarse a un deterioro general de la
economía y algunas de sus secuelas como un aumento del desempleo, el impago de
créditos y la devaluación de sus inversiones. Las consecuencias de todo ello son las
mismas: recorte del volumen de negocio y aparición de las pérdidas, particularmente
en la cartera de crédito, pero también por el deterioro de activos como los
inmobiliarios.
La clave es que los bancos superen estos escenarios adversos con un mínimo nivel de
solvencia, que se mide a partir del indicador Tier 1, que en castellano sería decir Nivel
1. Esto es, el dinero que tienen garantizado, sus recursos propios, frente a aquel que
tienen comprometido en alguna inversión no del todo fiable.
- Increase of solvency ratios to 9%
- Reform of supervision methods by the Bank of Spain
- SAREB: a ‘bad bank’ to sell 51bn€ of construction assets over 15 years, owned by
FROB (45%) and private investors (55%) ( not a public law institution  not
“government” debt or “public” deficit  to avoid the doom loop)
- Savings banks forced to become small lenders and remain regional, depolitisation
- Promoting non-bank intermediation
Reduction of over-capacity, write-offs, improved solvency, narrowed liquidity gap, reform of
the savings banks and sector’s consolidation through mergers.

These measures eliminated overcapacity (by consolidation), helped cleaning up the balance
sheets and recovered solvency of the system.

Memorandum of Understanding (MoU)

Spain: Sovereign debt markets and need to support restructuring and recapitalisation of the
banking sector  Financial assistance from the European authorities

Two documents

1) Financial-sector policy conditionality conditions

2) Agreement on financial aid: Up to 100 bn€ were made available by the ESM
(European Stability Mechanism).

• Main objective: support banks and restore confidence in them, so that they could borrow
again in international capital markets.

Lessons from the crisis to the banking sector

a) The error in the diagnostic proved very expensive. Before 2010 it would have been
possible to fund and restructure most savings banks.
b)Mergers are not the solution when all the entities involved are in difficulties. Mergers of
bad savings banks with each other are not a solution. Some mergers that took place were
defensive moves by savings banks based in the same region as regional governments did not
want to loose control over them. These merged entities failed and needed to be bailed out
and then sold off with the State suffering huge losses.
c) The quality of bank management and governance is important. Injecting capital (FROB) is
not enough when the management of the entities remains poor.
d) Geographical diversification helps in times of crisis. BBVA and Santander did not suffer so
much, thanks to their Latin American and European businesses.
e) Regulation and supervision need to be carried out at the same level as banks operate:
Eurozone (at least)

in Spain 2002-2008: lower overnight interests rates led undercapitalized banks to relax their
credit policy by extending and expanding credit to riskier firms with larger loan volumes and
lower collateral requirements

This is the basis for the ‘banking union’: Single Supervisory

Mechanism (2014), Single Resolution Mechanism (2016) and
European Deposit Insurance Scheme (pending)

Future challenges for banks

1. How to make profits from intermediation with negative interest rates? Banks will seek to
increase the share of income from sources other than interest charges (such as fees) which
requires changes in the banking business.

2. How to face competition from non-banking technological companies entering payment

systems, and eventually accepting deposits.

These companies are a concern from:

- Regulatory perspective: is more difficult to detect risk

- Competition perspective: competition with these companies has led Spanish banks to
move away from their traditional business model. Introducing online and mobile
banking and integrating some of the new competitors

3. Too much public debt in their balance sheets. What will happen when the ECB stops
buying it?

4. Current covid-19 crisis: adverse shocks in stress tests were not as bad as current forecasts
of GDP contraction. ECB will continue providing liquidity.

5. Fintech rivals: digital companies enter into payments market erode part of the banks’
revenue base. They may start accepting deposits soon.

5. Large volume of non-performing assets

Non-performing loan rate although has been decreasing from 2014, still represents a
considerable amount.  constraint on profitability

6. Regulatory requirements
Banks must hold more and higher quality capital
But is not easy to attract capital when the profitability of the business is still recovering

7. Banking Union

In this integrated market, competition has increased.

Banks in the past have grown also thanks to mergers. Now they consider cross-border
mergers, also because experience has shown that geographical diversification of the
business is one strategy for reducing future risks.

8. The impact of increased concentration on competition

9. New capacity adjustments

increase in online and mobile banking  need of branch (where they provide face-to-face
services to customers) closure but is difficult to take the first step given the risk of losing
market share.