Monday, September 12, 2011

The European debt crisis in charts

I present some basic statistics to highlight the problem in Europe. In short, there exists a deleterious positive feedback loop between overly leveraged banks and their sovereigns in key markets.

Exhibit 1: European Banks are overly levered. Spanning 2006 through the latest data point, key European banking systems - France, Germany, and Italy - increased leverage.

The chart above illustrates the ratio of bank assets to capital (see the IMF's Financial Soundness Indicators for the data and description of 'capital'). The countries are ranked by largest % drop in bank leverage spanning the period 2006 to current (Greece, Austria, and Belgium) to the largest % surge in leverage spanning the same period (France, Italy, and the UK). Note: the 2006 data is taken from the 2007 IMF Global Financial Stability Report.

The level of leverage is not strictly comparable across countries due to differences in national accounting, taxation, and supervisory regimes. However, while the US banks have delevered over the period, the big European banks - Germany, Italy, and France - have increased leverage. Assets need to be written down.

Exhibit 2. While leverage is too high, asset quality is dropping. The banks are increasing exposure to government loans and securities relative to traditional loans.

The chart illustrates the nominal stock of loans held on the bank balance sheets of the Monetary Financial Institutions in Europe. The data are from the ECB. Loans to governments and holdings of government securities are increasing more swiftly than traditional lending.

Exhibit 3. The asset quality of that rising stock of loans to the government sector is deteriorating...quickly. Italian and Spanish 10yr bonds are 1.5% and 1.2% higher, respectively, since the beginning of 2010, while German 10-yr yields are 1.5% lower.

The chart illustrates the 10-yr bonds across the euro area bond markets. The latest data point (today around 12pm) is listed in the legend.

Bond investors are clearly differentiating between the riskier bonds - Spain, Portugal, and Belgium - from the 'core' - Germany, Netherlands, Austria, Finland, and yes, France. Whether or not bond markets are right to regard Finland or France as 'core' is a different matter entirely. But the point is clear: bond markets are in crisis mode, and there's a stark segmentation in yields across the region.

Cross border exposure dictates that some of these highly levered banking systems are exposed to the same government securities currently trading at distressed levels. A case in point is France with outsized exposure to Italy and Greece (see Table 9B). This is a helpful graphic by Thomson Reuters .

Rebecca Wilder


  1. Traditionally, increasing exposure to sovereign debt is a way to reduce risk in a bank's asset porfolio.  When you report that loan quality is falling because of increased exposure to sovereign debt, you are reporting a special circumstance.  In part, this is the result of bad banking rules and poor ratings agency performance.  Greek debt can be carried at well above market value, and was considered, for regulatory purposes, high quality up to the day that ratings agencies bit the bullet and decided it wasn't. 

    In a broad sense, treating sovereign debt as high quality up to the point of crisis is analogous to holding MBS as a high quality asset because models of mortgage performance assumed an optimistic downside limit to home prices. In the end, the incentives for bankers are all on the side of optimistic assumption, so society needs to step in more forcefully to limit risk in the banking sector.  We aren't doing such a great job of that.  Just ask Lagarde - well not today, but a week ago maybe.

  2. Kharris,

    You are correct. This is a special situation, and one that is specific to Europe. The problem is, that many of these banks are heavily reliant on wholesale funding (50% in the aggregate), where capital makes up just 10% of the liabilities side of the balance sheet. So if you write down some of these GIIPS assets that they've been accumulating to market value, then equity is totally wiped out. Then wholesale funds pull out - then you have a real problem. Funding and asset quality along with the fiscal limitations in the region are the what's driving the recent funding/liquidity crisis in Europe.

    In the US, we didn't have this issue, since TARP was funded through budget deficits in the intiial year. France, Spain, nor Italy have such luxury.

    Thanks for coming by, Rebecca

  3. where did u get the euro area data from for the assets to capital bar chart? the tables available on the fsi website, unless i am mistaken, don't provide "euro area" data for those statistics. thanks

  4. I just averaged it to get a sense of the euro area's leverage - no, not precise; but I assume regulation is similar across countries.

    Thanks, Rebecca