Mon, Nov 07, 2011 - Page 9 News List

Europe’s nationalized banking system poses problem for ECB

By Daniel Gros

A central bank always has a crucial role to play in a financial crisis. However, the European Central Bank’s (ECB) role within the eurozone nowadays is even more “central” than that of the Federal Reserve or the Bank of England.

A key difference between the eurozone and the US is that lending between two banks located in two different member countries is still perceived as carrying quite different risks than “domestic” lending (between two banks in the same country). This is not the case in the US, because it has an integrated financial system and support for banks (deposit insurance or outright bailouts) is administered at the federal level.

As a result, the fact that California might be closer to bankruptcy than some eurozone countries has no influence at all on the credit rating of banks headquartered there, or on their ability to obtain funds on the interbank market. In Europe, by contrast, the fate of all banks depends upon their home governments.

During the credit boom before 2007, enormous cross-border interbank claims built up, because banks trusted one another. Then in 2008, the interbank market suddenly froze as that trust evaporated. This was a generalized phenomenon, not focused on particular countries, because it was still assumed at the time that all eurozone governments would be able to bail out their own banks.

Now that the “southern” eurozone governments’ solvency no longer seems assured, distrust has grown along national lines. German banks continue to lend to each other (and to other banks in northern Europe), but they are no longer willing to lend to Italian, Spanish or other banks in southern Europe.

A sudden withdrawal of interbank funding has the same consequences as a bank run. A bank that suddenly has to repay its interbank debt must cut credit to its own customers or sell off other assets, leading to large losses. This is precisely what happened when the interbank market froze after Lehman Brothers collapsed in 2008.

When the cross-border interbank market stopped working this summer, a similar economic collapse was avoided only because the ECB, without much fanfare, became the eurozone’s central clearing house. German and other northern European banks that no longer trust their southern counterparts parked their funds at the ECB’s deposit facility, whereas southern European banks used the ECB’s lending facilities to make up for the loss of private interbank funding.

Regional imbalances in interbank funding can, of course, also arise in the US Federal Reserve system. However, they are mostly intermediated within nationwide financial institutions. For example, high-tech firms in California might deposit cash surpluses with local branches of a large bank operating throughout the US, which might then choose to lend to oil companies in Texas.

Adjustment to shocks is also independent of location in the US. If the price of oil falls, oil companies become less creditworthy and receive less credit — not because they are in Texas, but because they are oil companies.

In the eurozone, however, banking is still predominantly concentrated along national lines. A savings surplus in Germany is recycled to Spain mainly through interbank lending (German to Spanish banks). Moreover, although the EU is supposed to have an integrated banking market, the few existing cross-border banking groups are not even allowed to operate as integrated international banks because national regulators and supervisors are “ring-fencing” the liquidity and assets of foreign banks’ local subsidiaries. For example, an international banking group headquartered in Italy was recently barred by supervisors from using the cash surplus of its subsidiary in northern Europe to fund the group’s operations elsewhere.

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