Is the banking union stable and resilient as it looks?

Viral V. Acharya (NYU, NBER and CEPR) Sascha Steffen (ESMT)

Conference on

“The new financial architecture in the Eurozone”

Florence, 23 April 2015

Motivation

n  On 29 June 2012, euro group members agreed to create a Banking Union (BU) n  Break link between banking sector and sovereign n  Avoid taxpayer bailouts n  Increase lending of banks to real sector and ignite

growth

n  BU as part of a wider regulatory framework that centralizes banking supervision and resolution n  Fragmented approach to supervision/resolution

impaired financial stability

Motivation

n  BU is supposed to prevent and deal with future crises n  Legacy assets should not be mutualized

n  Thus, before start of the SSM in Nov’14, the EBA and ECB conducted a comprehensive assessment n  Stop forbearance, identify problem assets, clean

up balance sheets

n  We conduct an objective stress test to assess the resilience of the European banking sector

Sample of 41 publicly listed banks in comprehensive assessment

n  Total market capitalization of €539 billion, an average book equity/asset ratio of 5.27% and 0.75 MTB ratio.

n  RWA/Asset ratio is 35% on average. n  Banks with low RWA/Asset ratios have low MTB ratios.

Country Market Equity/Assets Equity/Assets Market-to-

Book RWA/Assets MarketCap

Spain 7.05% 7.22% 1 0.48 146,082 France 3.23% 4.24% 0.68 0.26 127,696 Italy 4.29% 6.49% 0.61 0.48 83,000 Germany 2.19% 3.83% 0.61 0.23 50,570 Greece 8.26% 8.27% 0.95 0.58 26,945 Belgium 6.89% 4.00% 1.18 0.31 17,305 Austria 5.31% 7.24% 0.72 0.49 11,453 Ireland 6.11% 6.05% 0.98 0.43 9,816 Portugal 4.03% 4.48% 0.91 0.51 4,978 Malta 11.97% 7.70% 1.58 0.49 1,557 Slovakia 9.20% 11.94% 0.7 0.59 964 Cyprus 3.75% 6.25% 0.57 0.69 229 Total 4.27% 5.27% 0.75 0.35 539,083

SRISK as a benchmark stress test

n  Stress scenario is a systemic financial crisis with a stock market decline of 40% (VLAB) n  Similar to the financial crises of 2008 and 2011

n  Prudential capital ratio of 5.5% n  SRISK uses market data and market equity in

determining leverage n  Advantage: objective, no forbearance

Regulatory shortfall measure in ECB stress test

n  Stress scenario is the adverse scenario at the end of 2016.

n  Regulatory benchmark is CET1 ratio n  CET1 capital / risk-weighted assets (RWA)

n  Hurdle rate is 5.5% n  CET1/RWA is only capital ratio

n  Advantage: based on detailed regulatory data

Comparing SRISK and official ECB capital shortfalls

n  SRISK suggests a €450 billion capital shortfall in a systemic crisis.

n  ECB calculated €20 billion capital shortfall.

Country SRISK ECB Shortfall

Adverse Scenario

Spain 37,914 0 France 189,042 0 Italy 76,287 7,640 Germany 102,406 0 Greece 4,360 8,721 Belgium 26,616 339 Austria 6,677 865 Ireland 3,053 855 Portugal 3,821 1,137 Malta 0 0 Slovakia 0 0 Cyprus 167 277 Total 450,343 19,834

Banks that have the highest SRISK also have the highest “surplus capital” under the regulatory capital framework.

Austria

Belgium

Cyprus

France

Germany

Greece

Ireland

Italy

MaltaPortugal

Spain

−50000

0

50000

100000

150000

200000

SRISK(million euros)

−60000 −40000 −20000 0 20000Shortfall 5.5% CET1/RWA (million euros)

Adverse ScenarioSRISK vs. 5.5% CET1/RWA

n  The correlation between SRISK and regulatory capital shortfalls is large and negative.

Total losses in adverse scenario of ECB stress test versus SRISK

n  The correlation between SRISK and total losses in the adverse scenario is large and positive.

Austria

Belgium

Cyprus

France

Germany

Greece

Ireland

Italy

MaltaPortugal

Spain

−50000

0

50000

100000

150000

200000

SRISK(million euros)

0 20000 40000 60000 80000Total Loss (million euros)

Total Losses vs. SRISK

The use of risk weights in the regulatory benchmark explains the shortfall differential between our and the ECB’s assessment.

n  There is a high and positive correlation between SRISK and shortfalls based on a simple leverage (equity/assets) ratio.

Austria

Belgium

Cyprus

France

Germany

Greece

Ireland

Italy

MaltaPortugal

Spain

−50000

0

50000

100000

150000

200000

SRISK(million euros)

0 20000 40000 60000Shortfall 5.5% Book Equity/Assets (million euros)

Adverse ScenarioSRISK vs. 5.5% Book Equity/Assets

Are banks adequately capitalized?

n  Two different answers using the same loss scenario but two different leverage ratios n  a risk-weights based one and a non risk-weights

based one.

n  Banks that do well on risk-weighted capital adequacy but poorly on other approaches are likely “arbitraging” the static nature of risk weights to lever up using zero or low risk-weight assets.

Implications for Banking Union

n  Banking system still not adequately capitalized as Europe enters the Banking Union.

n  Despite consequences from 2 financial crises, Europe still hangs on to risk-weight based regulation n  Static risk-weights, do not reflect market’s risk

perception

n  Large banks calculate own risk-weights with room for gaming risk-weights

Implications for Banking Union

n  Banks naturally buy low risk-weight assets they can pledge to the ECB n  Inflated asset prices make banks appear healthy

as ECB purchases them

n  Impedes growth in the euro area as these assets crowd out real sector lending

n  Weak banking system is a huge reputational risk for ECB if bank failures occur

Other uncertainties surrounding Banking Union

n  Given the focus on euro-area institutions, what are the implications with regard to the consistency of EU bank regulation?

n  Moreover, banking supervision is not fully de-nationalized in BU. n  Does this supervisory model increase efficiencies in

banking supervision or make the SSM less resilient?

n  No “Single Rule Book” n  Still differences e.g. how to compute regulatory

capital

Implications for burden sharing

n  Differing capitalization of banks across the euro area implies different burden for the restructuring and resolution mechanism

n  How should burden sharing be designed?

n  Should it depend on the the capitalization of a country’s financial sector?