Back to Banking and Finance February 16, 2015

European banks gamble for redemption

By Sascha Steffen, former ESMT Berlin Professor and

Karl-Heinz Kipp Chair in Research

Karl-Heinz Kipp Chair in Research

By Sascha Steffen, former ESMT Berlin Professor

This article presents an overview of Sascha Steffen’s research, which includes research on the carry trade behavior of European banks, and also the effect of the removal of government guarantees on risk taking by banks. While his research provides an important contribution to explaining and understanding European banks’ risky investment decisions during the global 2007–2009 financial crisis and the European sovereign debt crisis since 2010, it also raises a number of questions for policy makers and financial institutions about whether their response to the financial crisis accelerated the very behavior they set out to curb, and as a result made the European financial crisis deeper and longer lasting.

The “greatest” carry trade ever?

Steffen’s research with Viral Acharya from June 2014 into carry trade behavior – a risky practice that was common in the lead up to the financial crisis – has attracted the attention of media and policy makers. Carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return. Their research reveals that the response of European banks to the financial crisis of 2007–2009 can be viewed as a form of carry trade behavior; a behavior that was widespread.

Analyzing the information supplied by banks to the European Banking Authority for stress tests, they found that banks with access to short-term unsecured funding in wholesale markets appear to have used this funding to undertake long peripheral sovereign bond positions. Banks effectively gambled for redemption by placing a “bet” on the long-term recovery of peripheral countries like Spain and Greece, and an eventual economic convergence between the periphery and the core. In doing so they created a “doom loop” between European banks and governments.

Steffen and Acharya find that the failure to clean up the balance sheets of banks following the financial crisis of 2007–2009 acted as an incentive for excessive risk taking, that is, the buying up of peripheral sovereign debt. European banking regulations, such as Basel II, which requires banks to meet a capital ratio based on regulatory equity and riskweighted assets also incentivized banks to shift into assets like sovereign debt with lowest-risk weights.

The effect of this – the strengthening of the nexus between sovereigns and the financial sectors – has turned the sovereign debt crises of the southern periphery countries into a pan-European problem. The authors highlight the strong link between asset-side risk and the short-term funding problem of banks, and the need for further investigation into how bank solvency and liquidity risk interact. Their research makes clear that if banks continue to rely on short-term funding to fund long-term risky assets, and if sovereign bonds continue to count as “liquid,” then we will continue to see funding problems and a painfully slow recovery of European banks.

Removal of government guarantees and increased risk taking

A common policy response to the financial crisis was the issuing of government bank guarantees. This was done in order to stem public panic and to help inject liquidity and capital into the financial system. While it is clear that such guarantees helped boost credit ratings and prevented a meltdown of the banking system, what is less clear are the consequences when these guarantees are removed.

As central banks and governments consider the removal of some of these guarantees, Sascha Steffen and Jörg Rocholl have produced timely and relevant research analyzing the effect of the removal of such guarantees on the risk-taking incentives of banks. Drawing on the lessons of the lifting of the guarantee to German Landesbanken in the early 2000s, they analyzed data before and after the lifting of the guarantee to see if there was a noticeable change in lending practices.

They found that before the announcement of the lifting of the guarantee in July 2001, there was little difference between Landesbanken and private banks in relation to lending practices (whom they lent to and at what rate). However, after July 2001 they found that the removal of the guarantee resulted in a substantial increase in the risk-taking of the Landesbanken. The riskiness of borrowers increased significantly. This change was particularly pronounced for Landesbanken that faced the largest decrease in franchise value.

The key lesson for policy makers today is that the risk-taking behavior of banks is closely linked to the way in which guarantees are withdrawn. Current governments considering such a move should look to the experiences of the Landesbanken and ensure a short transition period for ending guarantees.

Summary

Steffen’s research presents a bleak picture of the reaction of the banks to the financial crisis. Their behavior resembles that of a chronic gambler prepared to do whatever it takes. His research provides a vital insight into explaining such risktaking behavior. Governments and financial institutions need to find policy solutions that address incentives for banks to engage in risky practices, practices that risk prolonging and exacerbating the financial crisis. Current flaws in European banking regulations and the failure to effectively recapitalize banks must be urgently dealt with.

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