Back to Banking and Finance September 1, 2014

The “greatest” carry trade ever? Understanding Eurozone bank risks

By Sascha Steffen, former ESMT Berlin Professor, and Viral V. Acharya

The “greatest” carry trade ever?

In an updated version of their research paper "The ‘greatest’ carry trade ever? Understanding Eurozone bank risks” (June 2014), Viral Acharya and Sascha Steffen, show not only that Eurozone bank risks between 2007−2013 can be understood as a form of “carry trade” behavior, but that this behavior was pervasive among European banks. The authors find strong support for risk-shifting and regulatory arbitrage motives at large banks, and banks with low capital ratios and high-risk weighted assets. They also find evidence for home bias and moral suasion among GIIPS (Greece, Ireland, Italy, Portugal, and Spain) banks. Their findings will be published shortly in the Journal of Financial Economics.

Analyzing the detailed information of 56 publicly listed banks supplied to the European Banking Authority for stress tests between March 2010 and June 2012, the authors find that banks, including non-Eurozone European Union banks, with access to short-term unsecured funding in wholesale markets appear to have used this funding to undertake long peripheral sovereign bond positions. They effectively gambled by placing a “bet” on the long-term recovery of the peripheral countries and an eventual economic convergence between the periphery and the core. They did this even as the relative spreads between GIIPS and German bund yields had already widened.

So how can this behavior be explained, something that created a “doom loop” between European banks and governments? What were the motives for such carry trades? The first explanation is the failure to recapitalize European banks following the financial crisis of 2007−2009. They find that the failure to clean up banks’ balance sheets acted as an incentive for excessive risk-taking, that is, the buying up of GIIPS sovereign debt.  Second, European banking regulations, such as Basel II, which requires banks to meet a capital ratio based on regulatory equity and risk-weighted assets also incentivized banks to shift into assets with lowest risk weights (regulatory arbitrage), that is, sovereign debt. In fact, sovereign debt in the EU carries a risk weight of zero, probably more so because of political rather than economic reasons.

The effect of this in Europe, according to Acharya and Steffen, was the strengthening of the nexus between sovereigns and the financial sector, turning the sovereign debt crises of the southern periphery countries into a pan-European problem. In addition, European Central Bank funding to Spanish and Italian banks, as part of its Long-term Refinancing Operations (LTRO), also failed to break the link between sovereigns and the financial sectors. Importantly, it even increased the linkages: The LTROs led to “home bias” in the periphery countries, as GIIPS banks bought up more of their own sovereign debt.

Their findings have important implications going forward. They highlight the strong link between asset-side risk and the short-term funding problem of banks. While on the one hand, the Basel III framework addresses the liquidity problems of banks, on the other hand, if sovereign bonds continue to count as “liquid,” then banks will continue to have incentives to load up on these assets. The findings of this paper highlight the need for further investigation into how bank solvency and liquidity risk interact. If banks continue to rely on short-term funding to fund long-term risky assets, then we will continue to see funding problems and a painful slow recovery of European banks compared to their UK and US counterparts.

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