The Euro Crisis through the Lens of Capital Flow Reversals Hyun Song Shin Boston College 4 December 2012
The Euro Crisis through the Lens of Capital Flow Reversals 1 Three (Interlocking) Features of the Euro Crisis Sovereign debt crisis Banking crisis Balance of payments crisis Cross-border capital flow reversal SuddenStop Common thread is the bank leveraging/deleveraging cycle
The Euro Crisis through the Lens of Capital Flow Reversals 2 Corporate Finance of Banking A L Equity Assets Debt
The Euro Crisis through the Lens of Capital Flow Reversals 3 A L A L Assets Equity Debt Assets Equity Debt
The Euro Crisis through the Lens of Capital Flow Reversals 4 A L A L Assets Equity Debt Assets Equity Debt
The Euro Crisis through the Lens of Capital Flow Reversals 5 1,000 Barclays: 2 year change in assets, equity, debt and risk-weighted assets (1992-2010) 2 year change in equity, debt and risk-weighted assets (billion pounds) 800 600 400 200 0-200 -400-600 -800 y = 0.9974x - 0.175 R 2 = 0.9998 2yr RWA Change 2yr Equity Change 2yr Debt Change -1,000-1,000-500 0 500 1,000 2 year asset change (billion pounds) Figure 1. Barclays: 2 year change in assets, equity and debt(1992-2010)(source: Bankscope)
The Euro Crisis through the Lens of Capital Flow Reversals 6 Societe Generale: 2 year changes in assets, risk-weighted assets, equity and debt (1999-2010) 400 2 year change in risk-weighted assets, equity and debt (billion euros) 350 300 250 200 150 100 50 0-50 y = 0.9986x - 6.65 R 2 = 0.9988 y = 0.0014x + 6.65 2yr debt change 2yr equity change 2yr RWA change -100-100 0 100 200 300 400 2 year asset change (billion euros) Figure 2. Société Générale: 2 year change in assets, equity and debt(1999-2010)(source: Bankscope)
The Euro Crisis through the Lens of Capital Flow Reversals 7 Core and Non-Core Bank Liabilities Core: Liabilities to domestic household and non-financial claim holders Non-Core: Liabilities to financial intermediaries and foreign creditors Ratio of non-core to core liabilities is: Procyclical Mirrors lowering of credit standards
The Euro Crisis through the Lens of Capital Flow Reversals 8 Borrowers Banking Sector Domestic Depositors
The Euro Crisis through the Lens of Capital Flow Reversals 9 New Borrowers Borrowers Banking Sector Foreign Creditors Domestic Depositors
The Euro Crisis through the Lens of Capital Flow Reversals 10 Composition of Northern Rock's Liabilities (June 1998 - June 2007) 120 100 80 Equity Billion pounds Other Liabilities Securitized notes 60 Retail Deposits 40 20 0 Jun-07 Dec-06 Jun-06 Dec-05 Jun-05 Dec-04 Jun-04 Dec-03 Jun-03 Dec-02 Jun-02 Dec-01 Jun-01 Dec-00 Jun-00 Dec-99 Jun-99 Dec-98 Jun-98 Figure 3. Liabilities of Northern Rock(1998-2007)(Source: Shin(2009))
The Euro Crisis through the Lens of Capital Flow Reversals 11 Credit Quality and Non-Core Bank Liabilities Non-core liabilities reflect expansion in lending beyond normal levels Loans financed by non-core liabilities are of lower credit quality Even if liquidity support is forthcoming, loans made with lower credit standards go bad eventually Prolonged economic slumps exacerbate bad loans, without or without liquidity support(e.g. Japan) Short-term non-core is vulnerable to reversal
The Euro Crisis through the Lens of Capital Flow Reversals 12 Trillion Won 800 700 600 500 400 300 200 100 0 [Other] FX borrowing [Lf] Debt Securities [Lf] Repos [M2] Promissory Note 2 [M2] Promissory Note 1 [M2] Certificate of Deposit Jan-09 Jan-07 Jan-05 Jan-03 Jan-01 Jan-99 Jan-97 Jan-95 Jan-93 Jan-91 Figure 4. Non-core liabilities of Korean banks(source: Shin and Shin(2010), data from Bank of Korea)
The Euro Crisis through the Lens of Capital Flow Reversals 13 0.55 Non-Core Liabilities as Fraction of M2 0.50 Jan-09 0.45 0.40 0.35 0.30 Jan-98 0.25 0.20 0.15 0.10 Jan-10 Jan-09 Jan-08 Jan-07 Jan-06 Jan-05 Jan-04 Jan-03 Jan-02 Jan-01 Jan-00 Jan-99 Jan-98 Jan-97 Jan-96 Jan-95 Jan-94 Jan-93 Jan-92 Jan-91 Figure 5. Non-core liabilities of Korean banks as proportion of M2(Source: Shin and Shin(2010), data from Bank of Korea)
The Euro Crisis through the Lens of Capital Flow Reversals 14 Trillion Euros 7.0 6.0 5.0 4.0 Crossborder claims in domestic currency of eurozone banks 3.0 2.0 1.0 1999-Q1 1999-Q4 2000-Q3 2001-Q2 2002-Q1 2002-Q4 2003-Q3 2004-Q2 2005-Q1 2005-Q4 2006-Q3 2007-Q2 2008-Q1 2008-Q4 2009-Q3 2010-Q2 2011-Q1 Crossborder liabilities in domestic currency of eurozone banks Figure 6. Cross-border euro-denominated claims and liabilities of eurozone banks (Source: BIS Locational Statistics, Table 5A)
The Euro Crisis through the Lens of Capital Flow Reversals 15 30% 25% 20% 15% 10% 5% 2011-Q1 2010-Q3 2010-Q1 2009-Q3 2009-Q1 2008-Q3 2008-Q1 2007-Q3 2007-Q1 2006-Q3 2006-Q1 2005-Q3 2005-Q1 2004-Q3 2004-Q1 2003-Q3 2003-Q1 2002-Q3 2002-Q1 2001-Q3 2001-Q1 2000-Q3 2000-Q1 0% -5% -10% -15% -20% Figure 7. Four quarter growth rate of cross-border euro-denominated liabilities of eurozone banks (Source: BIS Locational Banking Statistics Table 5A)
The Euro Crisis through the Lens of Capital Flow Reversals 16 Claims of European Banks on Counterparties in Spain Trillion Dollars 1.2 1.0 0.8 0.6 0.4 0.2 Other European BIS reporting countries Switzerland United Kingdom France 0.0 2005-Q2 2005-Q4 2006-Q2 2006-Q4 2007-Q2 2007-Q4 2008-Q2 2008-Q4 2009-Q2 2009-Q4 2010-Q2 2010-Q4 Germany Figure 8. Foreign claims of European BIS-reporting banks on counterparties in Spain (Source: BIS consolidated banking statistics, Table 9D)
The Euro Crisis through the Lens of Capital Flow Reversals 17 Claims of European banks on Counterparties in Ireland Trillion Dollars 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 Other European BIS reporting countries Switzerland United Kingdom France 0.1 0.0 2005-Q2 2005-Q4 2006-Q2 2006-Q4 2007-Q2 2007-Q4 2008-Q2 2008-Q4 2009-Q2 2009-Q4 2010-Q2 2010-Q4 Germany Figure 9. Foreign claims of European BIS-reporting banks on counterparties in Ireland (Source: BIS consolidated banking statistics, Table 9D)
The Euro Crisis through the Lens of Capital Flow Reversals 18 Current Account Balance as % of GDP 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 3.0 Ireland Spain 1.0-1.0-3.0-5.0-7.0-9.0 Current Account Balance as % of GDP -10% -11.0 Figure 10. Current account of Ireland and Spain(Source: IMF International Financial Statistics)
The Euro Crisis through the Lens of Capital Flow Reversals 19 Trillion Euros 2.0 1.8 1.6 1.4 Dec 2008 1.87 trillion IE_8.9.12,13,14 Other loans to households and nonprofits IE_8_9.11 Credit for purchase of consumer durables IE_8_9.10 Credit for homeownership 1.2 1.0 0.8 0.6 0.4 0.2 414 billion Dec 1998 8_9.9-9_9.10 Home improvement credit IE_8_9.7 Loans for real estate financing IE_8_9.5 Credit for construction funding 8_9.6-8_9.7 Credit financing services (non real estate) IE_8_9.4 Credit financing industry (excluding construction) 0.0 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 IE_8_9.3 Credit for financing agriculture, hunting, forestry and fishing Figure 11. Spain: banking sector total domestic credit(source: Bank of Spain)
The Euro Crisis through the Lens of Capital Flow Reversals 20 Trillion Euros 1.2 1.0 0.8 0.6 Dec 1998 IE_8_2.5 Other bank liabilities (deposits > 3m, securities and repos) held by households, nonfinancial corporations and non-profits 0.4 413 billion 0.2 0.0 IE_8_2.1 Cash and deposits (<3m) held by households, nonfinancial firms and non-profits Dec-11 Dec-10 Dec-09 Dec-08 Dec-07 Dec-06 Dec-05 Dec-04 Dec-03 Dec-02 Dec-01 Dec-00 Dec-99 Dec-98 Dec-97 Dec-96 Dec-95 Figure 12. Spain: Core liabilities of banking sector(source: Bank of Spain)
The Euro Crisis through the Lens of Capital Flow Reversals 21 Trillion Euros 2.0 1.8 1.6 1.4 1.2 1.0 0.8 Private crossborder liabilities (total credit - core liabilties - Eurosystem LTRO Eurosystem Long term refinancing operations 0.6 0.4 Core Liabilities to residents 0.2 0.0 Dec-11 Dec-10 Dec-09 Dec-08 Dec-07 Dec-06 Dec-05 Dec-04 Dec-03 Dec-02 Dec-01 Dec-00 Dec-99 Figure 13. Spain: funding gap of Spanish banks(source: Bank of Spain)
The Euro Crisis through the Lens of Capital Flow Reversals 22
The Euro Crisis through the Lens of Capital Flow Reversals 23 ECB
The Euro Crisis through the Lens of Capital Flow Reversals 24 ECB
The Euro Crisis through the Lens of Capital Flow Reversals 25 Billion Euros 900 800 700 600 500 400 300 200 100 Private crossborder liabilities (total credit - core liabilties - Eurosystem LTRO Eurosystem Long term refinancing operations 0 Mar-12 Mar-11 Mar-10 Mar-09 Mar-08 Mar-07 Mar-06 Mar-05 Mar-04 Mar-03 Mar-02 Mar-01 Mar-00 Mar-99 Figure 14. Spain: funding gap of Spanish banks(source: Bank of Spain)
The Euro Crisis through the Lens of Capital Flow Reversals 26 0.90 0.80 0.70 0.60 0.50 Non-core to core liabilities ratio 0.40 0.30 0.20 0.10 0.00 Mar-12 Sep-11 Mar-11 Sep-10 Mar-10 Sep-09 Mar-09 Sep-08 Mar-08 Sep-07 Mar-07 Sep-06 Mar-06 Sep-05 Mar-05 Sep-04 Mar-04 Sep-03 Mar-03 Sep-02 Mar-02 Sep-01 Mar-01 Sep-00 Mar-00 Sep-99 Mar-99 Figure 15. Spain: Ratio of non-core liabilities to core liabilities of Spanish banks(source: Bank of Spain)
The Euro Crisis through the Lens of Capital Flow Reversals 27 Billion Euros 350 300 Loans and advances to Spanish government Spanish government securities 250 200 Securities issued by Spanish enterprises and households 150 Loans and advances to Spanish enterprises and households 100 Spanish money market paper, bonds and notes 50 Securities issued by Spanish banks 0 Loans and advances to Spanish banks 2012-03 2011-05 2010-07 2009-09 2008-11 2008-01 2007-03 2006-05 2005-07 2004-09 2003-11 2003-01 2002-03 Figure 16. Claims of German banks on Spanish counterparties(source: Bundesbank)
The Euro Crisis through the Lens of Capital Flow Reversals 28 Billion Euros 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 Other USA Austria Finland Greece Ireland Portugal Canada Italy Netherlands Switzerland Norway UK France Sweden Germany Denmark Spain Figure 17. Mortgage covered bonds outstanding by country and by year (Source: European Covered Bond Council Factbook 2012)
The Euro Crisis through the Lens of Capital Flow Reversals 29 400 300 Billion Euros 200 100 Other USA Austria Finland Greece Ireland Portugal Canada Italy Netherlands Switzerland Norway UK France Sweden Germany Denmark Spain 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 Figure 18. Mortgage covered bonds outstanding by country and by year (Source: European Covered Bond Council Factbook 2012)
The Euro Crisis through the Lens of Capital Flow Reversals 30 Billion Euros 400 350 300 250 200 Spain: stock of mortgage covered bonds (end year) 150 100 50 Spain: new issuance of mortgage covered bonds 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 Figure 19. Spain: stock and new issuance of mortgage covered bonds (Source: European Coveren Bond Council)
The Euro Crisis through the Lens of Capital Flow Reversals 31 100% 90% 80% Other Iberia 70% 60% 50% Benelux UK & IRL 40% 30% 20% Nordics France 10% 0% 2007 2008 2009 2010 2011 2012 Germany Figure 20. Covered bond investors by residence(source: European Covered Bond Council 2012)
The Euro Crisis through the Lens of Capital Flow Reversals 32 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Other Central banks Insurance & pension funds Asset managers Banks 0% 2007 2008 2009 2010 2011 2012 Figure 21. Covered bond investors by type of institution(source: European Covered Bond Council 2012)
The Euro Crisis through the Lens of Capital Flow Reversals 33 Comparing Spain and Korea Both Korea and Spain highlight role of non-core liabilities Korea s non-core is Shortmaturity Denominated in foreign currency Spain s non-core is Medium to long maturity Denominated in domestic currency Euro crisis is a tale of cross-border banking flows in domestic currency
The Euro Crisis through the Lens of Capital Flow Reversals 34 Some Historical Parallels for Spain USmortgagecrisis2007 Japan s bursting bubble 1990 2003 Slow deleveraging eventually results in bad assets and public recapitalization of banks How much? How soon? How? Some lessons from Japan
The Euro Crisis through the Lens of Capital Flow Reversals 35 M2 Loans and Discounts 9.0 8.0 7.0 100 Trillion Yen 6.0 5.0 4.0 3.0 2.0 1.0 2012/01 2010/09 2009/05 2008/01 2006/09 2005/05 2004/01 2002/09 2001/05 2000/01 1998/09 1997/05 1996/01 1994/09 1993/05 1992/01 1990/09 1989/05 1988/01 1986/09 1985/05 1984/01 1982/09 1981/05 1980/01 Figure22. Japan: Loansanddiscountsofmajorandregionalbanks(inred)andM2moneystock(inblue) (Source: Flow of Funds, Bank of Japan)
The Euro Crisis through the Lens of Capital Flow Reversals 36 Trillion Euros 12.0 11.0 10.0 9.0 8.0 7.0 Sept 2012 Loans to nongovernment borrowers 6.0 5.0 4.0 Deposits due to non-banks 3.0 Jul-12 May-11 Mar-10 Jan-09 Nov-07 Sep-06 Jul-05 May-04 Mar-03 Jan-02 Nov-00 Sep-99 Jul-98 May-97 Mar-96 Jan-95 Figure 23. Numerator is loans to non-mfis (monetary and financial institutions), excluding general government. Denominator is deposit liabilities to non-mfis excluding central government(source: European Central Bank)
The Euro Crisis through the Lens of Capital Flow Reversals 37 1.20 1.15 1.10 1.05 Sept 2012 1.00 0.95 0.90 Sep-12 Jun-11 Mar-10 Dec-08 Sep-07 Jun-06 Mar-05 Dec-03 Sep-02 Jun-01 Mar-00 Dec-98 Sep-97 Figure 24. Eurozone: Loan to deposit ratio. Numerator is loans to non-mfis (monetary and financial institutions), excluding general government. Denominator is deposit liabilities to non-mfis excluding central government(source: European Central Bank)
The Euro Crisis through the Lens of Capital Flow Reversals 38 Normalized loans (Japan) Normalized Loans (Euro area) Normalized loans 1.2 1.1 1.0 0.9 Sept 2012 0.8 0.7 0.6 0.5 Crisis date Japan (Jan 1991) Eurozone (Sept 2008) 0.4 252 240 228 216 204 192 180 168 156 144 132 120 108 96 84 72 60 48 36 24 12 0-12 -24-36 -48-60 -72-84 Months from crisis date Figure 25. Eurozone and Japan: Loans ineuro area (inred) and in Japan(in blue) normalizedto1.0at crisis date, and measured in months from the crisis date. Eurozone crisis date is September 2008. Crisis date for Japan is January 1991(between stock market peak and real estate peak)
The Euro Crisis through the Lens of Capital Flow Reversals 39 60 50 Fiscal Cost (% of GDP) 40 30 20 10 0 Sweden Norway Finland Malaysia Mexico Japan South Korea Uruguay Thailand Chile Indonesia Argentina 1980 1982 1997 1981 1983 1997 1981 84 1997 1992-1994 1997 1991-1994 1987-93 1991-94 Figure 26. Fiscal costs of banking crises(source: Patrick Honohan and Daniela Klingebiel(2000) Controlling Fiscal Costs of Banking Crises, World Bank)
The Euro Crisis through the Lens of Capital Flow Reversals 40 Credit to GDP ratio (%) 240 220 200 180 160 227.75 171.64 213.89 Japan JPN 140 Spain ESP 120 100 80 60 73.19 40 20 0 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 Figure 27. Ratio of domestic private credit to GDP(Source: World Bank)
The Euro Crisis through the Lens of Capital Flow Reversals 41 Lessons for Eurozone from Japan Liquidity versus solvency Comparing Eurozone LTRO with BOJ s monetary policy in 90s Loans granted during the bubble phase almost always go bad, and must be written off eventually... Pre-condition for restructuring is political will, which needs shared diagnosis of crisis Japan s deleveraging started 7 years after crisis date(see figue) Restructuring entails fiscal costs, which is an added complication in Eurozone Question: How well can the institutions and governance structure of the Eurozone cope with strains of the restructuring process?