DSF POLICY BRIEFS No. 23/ February 2013

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1 DSF POLICY BRIEFS No. 23/ February 2013 Winners of a European Banking Union Dirk Schoenmaker, Duisenberg school of finance Arjen Siegmann, VU University Amsterdam Abstract The prospective Banking Union starts with supervision of European banks, but would also need to do resolution of banks in distress. While national governments confine themselves to the domestic effects of a banking failure, a European Resolution Authority would incorporate domestic and cross-border effects. A cost-benefit analysis of the hypothetical resolution of the top 25 European banks indicates that the UK, Spain, Sweden, and the Netherlands are the main beneficiaries of the Banking Union. 1. Introduction The aim of the prospective Banking Union is to foster financial stability in Europe. The euro sovereign debt crisis has shown that financial stability cannot be managed effectively at the national level, because of the diabolic loop between national governments and banks (Alter and Schüler, 2012). The fiscal position of several European governments is vulnerable, because of the perceived need by the market to back up weakened national banking systems. In turn European banks are in distress because they hold large quantities of debt from these governments. A truly integrated European-level banking system can do much to stabilise the euro area by breaking this diabolic loop. Beyond this immediate concern, the broader case for the Banking Union is that national governments concentrate on the domestic effects of bank failures and ignore cross-border externalities (Schoenmaker, 2013). The supranational approach of the Banking Union incorporates these cross-border externalities. While the Banking Union is scheduled to start with the Single Supervisory Mechanism, the real benefit from the Banking Union would come from the resolution of ailing banks at the European level. There is wide agreement among academics that this second stage is crucial to make the Banking Union effective. Recapitalisations of banks that should be closed down can be very expensive. The appropriate way to deal with banks weakness is to apply a resolution regime, clean up their balance sheets by separating good assets from the bad, and to recapitalise the good banks. While a resolution fund -fed by levying fees on banks- can act as a first line of defence, the European Stability Mechanism is the fiscal backstop for recapitalising banks from participating countries.

2 What are the incentives for countries to join the Banking Union? While all euro area countries are required to join the Banking Union, the non-euro area countries (also called the outs ) have the choice to opt in. So far, politics is dominating the debate on participation. The UK and Sweden have declared that they want to stay out. But what are the economic benefits and costs of joining? The contribution of this policy brief is to calculate the cost and benefits of participation. 2. Model of bank resolution The starting point of resolution of an ailing bank is that only the systemically relevant parts of that bank may be recapitalised, after writing down the shareholders and certain classes of debtholders (see debate on bailin of debt). Next, the authorities check whether the benefits of a bailout exceed the costs. Among other things, the benefits of a recapitalisation may include those derived from maintaining financial stability and avoiding contagion (Allen and Gale, 2000). An example is the Lehman collapse, which caused widespread contagion. A recapitalisation of Lehman may have prevented this outburst of financial instability. By contrast, a minor, idiosyncratic, bank failure (e.g. Barings) would pose no systemic problem. In such cases, an ailing bank should be closed. We develop a model for the resolution of ailing banks (Schoenmaker and Siegmann, 2013). The decision rule that a bank is only recapitalised if and when the benefits exceed the costs. Otherwise the bank will be closed. The model is based on game-theory. The rescue of an ailing bank is a non-repeated game with high financial stakes. Countries have to cooperate for the resolution a cross-border bank. Each country will try to minimise its contribution. In equilibrium, all countries would contribute close to nothing to the rescue. Cooperation will thus not emerge, as witnessed with the collapse of Lehman and Fortis. As most benefits accrue to the home country, the ultimate decision is with the home authorities. The home country only takes into account the domestic ( home ) benefits, denoted by. The home country decision is to rescue only if: In the Banking Union, a new European Resolution Authority would incorporate all benefits within the Banking Union. For banks with activities in the rest of Europe (outside their home country), the efficiency of resolution increases. The benefits in the rest of Europe are now incorporated. The share of benefits within the European Banking Union are denoted by. The decision then becomes: The costs of the rescue are shared among the participating countries (Goodhart and Schoenmaker, 2009). Strategic behaviour by countries will be prevented by adopting a fixed burden sharing key. Once the decision is taken, countries cannot escape and have to pay their share. For the burden sharing, we take the ECB capital key, which is used by the European Stability Mechanism (ESM). Figure 1 visualises the efficiency of the resolution regimes. The efficient solution is that a recapitalisation (bailout) will happen if the benefits (y-axis) exceed the costs (x-axis). In Figure 1, the line that separates bailout from no-bailouts has a slope of 1 ( 1 ). The solution under the home country approach is to have a bailout only when the home country benefits exceed the total costs:. This leads to the line with a slope of 1/ ( 1/ ) above which a bailout takes place. The Banking Union improves to a slope of 1/. The improvement is due to the fact that the activities in the Banking Union ( ) are larger than in the home country ( ).

3 Figure 1: Efficiency of the different resolution mechanisms 3. Cost-benefit analysis To analyse countries costs and benefits of participation in the Banking Union, we simulte the resolution of top 25 European banks. These banks count for the vast majority of cross-border banking in the European Union (EU), as small- and medium-sized banks are largely domestically oriented. The top 25 has average assets of 985 billion and capital of 40 billion. Table 1 reports total assets and capital for each bank in the first two columns. The equity (tier 1 capital) of bank is used as unit of calculation for the analysis. Required capital is a good indicator of a bank s unexpected losses that could arise and of the public bail out costs. In the simulation, we assume that each bank suffers a loss of two times equity, making the bank insolvent. If the bank is recapitalised to its original (required) equity capital, 100% of equity becomes the new value of the bank. Thus, the total net costs of the bailout are 100% of the initial (pre-shock) equity of the bank (gross capital injection minus new value of equity). Bailout benefits can be thought of as preventing a temporary reduction of credit availability (credit crunch) through shortening of balance sheets by a forced liquidation of the loan book in a particular country. Another source of benefits is the safeguarding of financial stability of the total banking system, which might be jeopardised by a fire sale of assets or other externalities. This is in accordance with the credit view on the impact of bank failures on the economy, see Bernanke (1983). Thus, we take size and distribution of bank assets to represent the bailout benefits. We calculate the geographic segmentation of the top 25 banks assets over the home country, the rest of Europe and the rest of the world (see Schoenmaker and Siegmann, 2013). It appears that on average 55 per cent of the assets are in the home country ( 0.55 and 22 per cent in the rest of Europe There are some large variations among the top 25. An international bank like Santander has only 27 per cent in its home country and 41 per cent in the rest of Europe. By contrast, a national bank like Llyods has 90 per cent at home and 7 per cent in the rest of Europe. In the latter case, the UK could do the resolution on its own. Banking Union would not add very much. The geographic segmentation of assets, measured by and, determines the efficiency of the resolution process. In the first case, the cross-border externalities are not incorporated. In the second case, only the externalities outside Europe are disregarded. The degree of efficiency of the home country resolution process is measured by the factor 1/ and of the banking union resolution by the factor 1/. As shown in Figure 1, the efficient benchmark has a factor of 1. The distance to this efficient benchmark 2

4 indicates the scope for improvement. Columns 3 and 4 of Table 1 report the distance to the efficient benchmark. In the case of Lloyds the distance is small: 0.11 for the home country and 0.02 for the banking union. Table 1: Efficiency improvement of resolution for the top 25 European banks Bank name Total assets Equity Distance to 100% efficiency Efficiency improvement EUR billion EUR billion Home Banking Union EUR billion HSBC (UK) 1, BNP Paribas (France) 1, RBS (UK) 1, Crédit Agricole (France) 1, Banco Santander (Spain) 1, Barclays (UK) 1, Lloyds Banking Group (UK) 1, Deutsche Bank (Germany) 2, UniCredit (Italy) Groupe BPCE (France) 1, ING Bank (Netherlands) Rabobank Group (Netherlands) Société Générale (France) 1, Intesa Sanpaolo (Italy) BBVA (Spain) Standard Chartered (UK) Crédit Mutuel (France) Commerzbank (Germany) Nordea Group (Sweden) CaixaBank (Spain) Danske Bank (Denmark) KBC Group (Belgium) ABN Amro Group (Netherlands) Allied Irish Banks (Ireland) Landesbank Baden Württemberg (Germany) Average Total 24, , The last step is the calculation of the efficiency improvement of the resolution process in euros (last column of Table 1). In this step, we multiply the difference between the home and banking union factors with the equity. The improvement for Llyods is 4.4 billion, calculated as ( ) * 52.6 billion (Lloyds equity). In the case of Banco Santander the efficiency improvement is far larger. The improvement is billion, calculated as ( ) * 61.8 billion. It appears that two banks with a roughly similar amount of equity have very much varying benefits from a banking union. As Santander has 41 per cent of its assets in the rest of Europe, banking union offers a far more efficient resolution regime than the home country. The efficiency improvement differs across the top 25. Banks with much activities in Europe profit most from a banking union. Examples are HSBC ( 73 billion), BNP Paribas ( 59 billion), Banco Santander( 138 billion), Barclays ( 81 billion), Deutsche Bank ( 70 billion), UniCredit ( 59 billion), ING Bank ( 46 billion) 3

5 and Nordea ( 83 billion). However, national banks, like Llyods, Crédit Mutuel, CaixaBank, ABN Amro, Allied Irish Banks and Landesbank Baden-Württemberg, have very limited benefits from the banking union. 4. Distribution over countries All countries benefit from the enhanced stability of a supranational approach under the Banking Union. Host countries benefit as the resolution of the parent bank becomes more efficient. The viability of the host country branch and/or subsidiary is dependent on the performance of the parent bank (De Haas and Van Lelyveld, 2013). Home countries also benefit from the improved efficiency of the resolution of their banks. Furthermore, the diabolic loop in which the solvency of countries and banks are intertwined (Alter and Schüler, 2012) is broken by the supranational approach. The improvement from the home to the supra resolution mechanism is collectively paid by the participating countries in the Banking Union. Although financial stability is a public good (i.e. the producer cannot exclude anybody from consuming the good and consumption by one does not affect consumption by others), we can calculate the benefits and costs for each participating country. The home country has a direct benefit from the burden sharing for the bailouts of its (cross-border) banks, as it must pay only a part of the costs under burden sharing. To measure these benefits, we sum the absolute efficiency improvements of all banks in each home country. Table 2 reports the results at country level in the first column. Only 10 out of the 27 EU countries have banks among the top 25. This reflects the fact that some countries are home to large banks that serve the domestic economy as well as foreign economies, while other countries rely on banking services from these countries (a few countries, like the Central and Eastern European (CEE) countries and Luxembourg, rely almost completely on foreign banks). Table 2 shows in the second column that the UK (with 5 large banks) and Spain (with two large banks) count for the vast majority of the benefits with 27 and 19 per cent. Other large countries, like Germany, France and Italy, have a more modest share ranging from 9 to 12 per cent. Finally, some smaller countries, like Sweden with Nordea bank and the Netherlands with three banks (ING, Rabo, and ABN Amro), have a relatively large share with 11 and 7 per cent. Next, Table 2 reports the cost share for each country in the third column. Following the ESM Treaty, this cost share is based on the ECB capital key, which is an average of the relative GDP and relative population share of each country. The cost share is more evenly divided in proportion to a country s size. Finally, the net effect is calculated in the fourth column of Table 2. Within the euro area, Spain and the Netherlands are the net benefiters with 11 and 3 per cent. Germany, France and Italy are net contributors with 7, 3 and 4 per cent. Although these three countries have large banks, these banks are smaller than the economic weight of these large countries would suggest. Overall, the euro area would be a net contributor with 10 per cent and the non-euro area a net benefiter with 10 per cent. From the non-euro area countries, the UK and Sweden are the key recipients with 13 and 9 per cent. While all CEE countries are contributing, Poland is the main contributor from the non-euro area side with 5 per cent due to its size. 4

6 Table 2: Country breakdown of benefits and costs Country Euro area countries Efficiency improvement Benefits Costs Net effect in EUR billion in % in % in % Austria 0% 1.9% 1.9% Belgium % 2.4% 1.6% Cyprus 0% 0.1% 0.1% Estonia 0% 0.2% 0.2% Finland 0% 1.3% 1.3% France % 14.2% 2.8% Germany % 18.9% 6.7% Greece 0% 2.0% 2.0% Ireland % 1.1% 0.7% Italy % 12.5% 3.9% Luxembourg 0% 0.2% 0.2% Malta 0% 0.1% 0.1% Netherlands % 4.0% 3.1% Portugal 0% 1.8% 1.8% Slovakia 0% 0.7% 0.7% Slovenia 0% 0.3% 0.3% Spain % 8.3% 10.9% Non euro area countries Bulgaria 0% 0.9% 0.9% Czech Republic 0% 1.5% 1.5% Denmark % 1.5% 0.3% Hungary 0% 1.4% 1.4% Latvia 0% 0.3% 0.3% Lithuania 0% 0.4% 0.4% Poland 0% 4.9% 4.9% Romania 0% 2.5% 2.5% Sweden % 2.3% 8.6% United Kingdom % 14.5% 12.9% Total euro area % 70.0% 10.1% Total non euro area % 30.0% 10.1% Total EU % 100% 0% 5. Conclusion A truly integrated European banking system with supervision and resolution at the European level fosters the stability of the Economic and Monetary Union. This policy brief shows that the non-euro area countries can also benefit from the stability of the Banking Union. It is interesting to note that the main non-euro area countries that do not wish to join the Banking Union for political reasons (i.e. the UK and Sweden) would be the largest beneficiaries from the Banking Union. Not joining is very costly on the budgetary front. It would be very demanding for the Swedish government to bear the full cost of a possible recapitalisation of Nordea outside the Banking Union, while only 20 per cent of the benefits accrue to Sweden. Similarly, the recapitalisation of some of the large UK banks during the great financial crisis put a severe strain on the UK 5

7 government budget. The UK and Sweden thus preserve the expensive right to do potential rescues of their banks on their own. Political calculus dominates economic calculus. Within the euro area, Spain with two large banks and the Netherlands with three large banks are the winners of the Banking Union. To reap these benefits, the second stage of resolution needs to be completed as well. So far, heads of state have focused on the first stage of supervision. References Allen, F. and D. Gale (2000), Financial Contagion, Journal of Political Economy 108, Alter, A. and Y. Schüler (2012), Credit spread interdependencies of European states and banks during the financial crisis, Journal of Banking & Finance 36, Bernanke, B.S. (1983), Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression, American Economic Review 73, De Haas, R. and I. Van Lelyveld (2013), Multinational Banks and the Global Financial Crisis. Weathering the Perfect Storm? Journal of Money, Credit, and Banking, forthcoming. Goodhart, C. and D. Schoenmaker (2009), Fiscal Burden Sharing in Cross-Border Banking Crises, International Journal of Central Banking 5, Schoenmaker, D. (2013), Governance of International Banking: The Financial Trilemma, Oxford University Press, New York. Schoenmaker, D. and A.H. Siegmann (2013), Efficiency Gains of a European Banking Union, Duisenberg School of Finance Tinbergen Institute Discussion Paper TI 13-26/DSF 51. 6