1. The financial crisis and its economic impact
1.1. Recent developments
The financial crisis can be divided into two episodes. In a first phase, the uncertain exposure to the US subprime crisis caused banks to become weary of lending to each other, while the economic impact of the financial market turmoil was mainly felt through housing market corrections in a few European countries. However, following the failure of the US investment bank Lehman Brothers on 15 September 2008, commercial banks stopped lending to each other, tightened their credit standards to companies, and stopped assuming their role of capital markets intermediary.
Today, financial markets remain under severe pressure. Following the collapse of Lehman Brothers, interbank spreads reached almost 2% in October 2008 from pre-crisis levels close to zero. The implementation of national rescue plans and coordinated interest rate cuts by central banks brought them close to 1% in early January 2009 (Figure 1). This remains exceptionally high. Paralysed interbank lending markets and deteriorating lending conditions for households and corporations create a vicious circle of high risk awareness and increasing risks of defaults (Figures 2 and 3).
Companies’ access to finance at affordable rates has deteriorated substantially, irrespective of their sources of external financing:
- Corporate bond issues face substantial difficulties (Figure 4). The spread on euro-denominated BBB-rated bonds with a 5-7 maturity has tripled since mid-2008, reaching close to 6% by year end. The primary markets for corporate debt issuance are clogged, and BBB-rated corporations pay over 8% on their long-term debt. While the euro-denominated corporate bond market is roughly halve the size of the US counterpart in terms of outstanding debt, it has steadily increased over recent years.[1]
- In most EU countries, companies continue to rely on traditional forms of financing, in particular bank loans. While the growth of loans to non-financial corporations was still sustained in the ECB’s November 2008 survey, over 60% of euro area banks have tightened lending conditions (Figure 5), in particular for larger companies[2]. Deteriorating lending conditions affect also UK companies. According to the Bank of England’s lending survey from January 2009, the "key factor" contributing to the decline in credit available to corporates was the "changing cost and availability of funds" and not the economic outlook (although this was a factor).
- Financing debt through equity has become one of the most expensive sources for financing. With a $32.000bn decline in global stock market capitalisation, due to the financial crisis, the current climate makes raising money by stock issuance or IPOs almost impossible. In the course of 2008, EU stock markets lost over 40% in value, mirroring preceding trends in the United States and Japan (Figure 6).
1.2. Economic impact
Past experience illustrates that banking crisis tend to lead to protracted economic consequences. In a recent paper, Carmen Reinhart of Maryland University and Kenneth Rogoff of Harvard describe what past banking crisis have meant for subsequent economic developments. They note that banking crises generally lead to recessions lasting on average two years, leading to output declines of around 9% and rising unemployment by 7 percentage points. Strikingly, the real value of government debt increases by 85% on average, resulting less from the cost of rescue measures than from plummeting tax revenues.
While financing conditions deteriorate around the world, this could hit corporate activity in the euro area with particular strength[3]. While euro area household indebtedness remains relatively modest[4], the non-financial corporate sector is more leveraged than in the United States or the United Kingdom. Higher debt service has already hit corporate profitability and the amount of corporate debt to roll over is huge in the euro area.
Higher corporate indebtedness in the euro area (240% of value added compared with 180% in the US - Figure 7) is explained by rising investment rates and the huge fall in risk premia on long-term debt of ‘peripheral’ countries following the inception of monetary union which reduced the costs of raising new debt. The degree of leverage differs across euro area countries with the Spanish corporate debt ratio now more than 50% higher than that of Germany or France from roughly same levels in 2001. This makes adjustment efforts even more painful for a country which faces a major adjustment in the labour-intensive construction sector.
Hence a deterioration of financing conditions is likely to restrict capital expenditure and employment significantly in the euro area, with more minor direct effects on consumption and residential investment. This makes the state of the corporate sector “crucial” for the economic prospects of the euro area.
1.3. Policy Response
The Financial Stability Forum (FSF) established an international framework for a policy response to the financial turmoil in April 2008.[5] The recommendations were adopted by the G7 finance ministers and central bank governors and became an international benchmark for reforms but stopped short of proposing any fundamental shift in the regulatory framework. The G-20 meeting on 15 November 2008 proposed a reform of the Bretton Woods institutions with a broader participation of countries and a central role for the IMF to detect financial system problems.
In the EU context, the Ecofin Council of October 2007 had set up a “roadmap” to revise the regulatory framework and to strengthen authorities’ ability to respond to the crisis “without unbalancing the current institutional structure”[6]. To respond to systemic risks that crystallized following the failure of Lehman Brothers, the Eurogroup tailored a concerted action plan to temporarily guarantee bank recapitalization in its Paris meeting of 12 October 2008, subsequently endorsed by the European Council. The aim of this plan was to restore confidence in the markets and to promote the proper functioning of the financial system while avoiding distortions in banking markets.
As the impact of the financial crisis on growth and employment prospects has intensified over recent months, the policy focus has gradually shifted towards stimulus measure to support economic activity and alleviate social consequences in the difficult months ahead.
However, persistent tensions on financial markets strikingly illustrate that the most urgent priority is to restore access to finance in the short term in order to support investment and economic activity and to avoid a protracted downturn. In addition, medium-term measures targeting financial market reforms are required to prevent a systemic disruption in the future.
2. Further actions to be taken
2.1. Restoring access to finance in the short-term
The financial crisis has affected financing conditions and significantly weakened the channels through which monetary policy can support the economy. Under current circumstances, interest rate cuts will take longer to affect growth and their overall impact will be weaker.
It was therefore highly warranted for EU governments and central banks to undertake bold steps to preserve the stability of the banking systems by addressing liquidity needs and strengthening capital positions. National schemes to support the banking sector could take the form of capital injections against preferential shares, government guarantees for new bank debt issuance, and deposit guarantees. The euro area summit in Paris on 12 October had set conditions to the design of such schemes to avoid measures deterring banks from seeking private capital and distortions to the level playing field.
These measures had a stabilising effect and could prevent a run on the most vulnerable banks. However, the well-functioning of financial markets continues to be severely hampered with high levels of risk aversion among market participants. In addition, market distortions arise as the state aid rules set for national rescue plans have already been violated several times.[7]
Also, governments might find it increasingly difficult to raise new financing. Three euro area countries (Ireland, Greece, Spain) have already received a credit rating warning by Standard & Poor’s and more could follow. The warning could involve a downgrade and is likely to further drive up borrowing costs for those countries in a situation where government bond issuance is expected to double to above 1000bn EUR in 2009.
It is thus of outmost urgency to assess the measures undertaken so far and to propose actions to effectively restore lending conditions. This should create the conditions for a sustained recovery and avert a protracted downturn.
a. Bank recapitalisation process
Many European governments have implemented bank rescue plans which could take the form of capital injections, guarantee schemes or asset purchases (Figure 8). The total volume of direct interventions (capital injections and asset purchases/swaps) for the euro area amounts to 300bn EUR (3.3% of euro area GDP). Guarantees were accorded for a total amount of almost 1,700bn EUR (19% of euro area GDP).
Bank recapitalization was the most frequent response to attenuate systemic risks.[8] Usually, government cash is injected in return for preferential shares with a view to reduce the solvency risks and to restore lending activity. Furthermore, several countries offer temporary government guarantees on newly issued debt, against a fee.
By the end of 2008, 82bn EUR had been injected in the euro area and 37bn GBP in the UK. The ECB’s Financial Stability Review confirms that well-capitalised banks have a higher propensity to lend: an increase of 1 percentage points in the capital ratio yields on average an increase of 3.15% in credit supply after three quarters.
Another option to stabilise balance sheets consist in guaranteeing the value of a trench of banks’ toxic assets for an appropriate fee, without the need to buy unpriceable assets outright, cf. report to Congress on the use of the US Asset Guarantee Programme for Citigroup.[9]
According to the ECB, large and complex euro area banking groups have covered crisis-related write-downs of 93.8bn EUR with capital injections of 125.6bn EUR. While capital ratios and solvency ratios improved slightly, it remains to be seen whether they have reached adequate levels. To reach pre-turmoil levels, the total deleveraging would require an additional 540bn EUR – if this would crystallize, credit growth would be further depressed.
- What are the recapitalisation needs among European banks?
- How far should governments go in committing tax payers’ money?
- What is the risk of distortion due to national fragmentation?
- How can governments in new member states be helped in their bank rescue measures?
b. Public guarantees for inter-bank loans
While the rescue plans helped to stabilise liquidity concerns, tensions remain high. Currently, banks hoard money on little remunerated overnight accounts at the ECB, instead of lending to each other at far higher rates. Thereby, the ECB has de facto become the clearing house for the collateralised inter-bank market in the euro area. However, the normal, unsecured, inter-bank market remains frozen.
Governments in different countries have recently extended guarantees to interbank loans for systemic banks for a limited period (Annex II). However, interbank lending is mostly cross-border within the EU and segmented guarantees along national borders are unlikely to be very effective.
Daniel Gros, Director of the Centre for European Policy Studies, suggests to have each government guarantee its own banks reimbursement of inter-bank loans, including cross-border loans, if they are to a bank from another country that participates in this scheme. This comes down to a guarantee on the asset side of banks’ balance sheets, while currently a bank’s liabilities are being state insured.
An ECB-organised clearing platform would facilitate and guarantee all interbank lending, with the intention of overcoming distrust between banks. The idea of a European clearing house is “potentially applicable” according to the ECB’s Vice-President Lucas Papademos. A working group at the German Central Bank is studying this possibility for short-term bank-to-bank loans of 3 months or less.
- Are such guarantees credible, considering the risk of exploding public debt?
- How can the ‘appropriate fee’ be calculated in current market conditions?
- Can EU interbank market tensions be effectively alleviated through national measures?
- Can an ECB-organised clearing platform be an effective answer?
c. Government guarantees for loans to the private sector
One of the main reasons for the financial crisis was the mispricing of risk and the increasingly sophistication of financial products in a legal vacuum. Yet, financial innovation is a key bone of our economy and a functioning financial system is required for an efficient allocation of capital. This is of particular importance for the financing of risk capital, innovation and research and thus for the growth path of our economies.
Some governments have proposed to share the risk of default from new loans to encourage new credit. The German government agreed on 12 January 2009 on a substantial stimulus package which will be spread over two years. It includes the creation of a 100bn EUR fund for loan guarantees to industrial companies through the government-owned KfW bank. The KfW will guarantee up to 80% of the loan. France has announced to implement comparable measures.
The European Investment Bank (EIB) has in December 2008 approved anti-crisis measures for the period 2009-2010 which include “a new product line allowing risk sharing with banks” and additional lending of 2.5bn EUR over two years for SMEs and an additional 1 EUR bn for “mid-cap” companies.
- Can risk sharing facilities be effective tools to facilitate companies’ access to finance?
- How should the government be remunerated for the risk it endorses?
- Is there a risk of phasing out commercial lending activity?
- Again, how can competitive distortions be prevented?
d. State aid rules and the internal market
Governments are mobilizing unprecedented levels of capital in response to the financial crisis. However, not all governments have the same financial clouts and measures implemented differ considerably across countries. This poses a problem of competitive distortions and could harm the functioning of the internal market.
According to the EU Treaty, “any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the common market.”
However, even if a measure fulfils the criteria for being State aid, there are a number of situations where an aid can be deemed as compatible State aid. To coordinate and facilitate targeted measures to tackle the crisis, the Commission has adopted a Communication on the application of State aid rules to banking recapitalization and a temporary framework for horizontal State aid measures to support access to finance in the current crisis, valid until 2010. In addition, the Commission has considerably accelerated procedural steps, replying within days to submitted notifications.