Crisis in the Eurozone. Costas Lapavitsas
second half of the 2000s (starting March 2005, notwithstanding a statistical adjustment in March 2007)17 peaking in September 2008. As gross flows in figure 24 indicate, this change has been driven mainly by lending from core to periphery, which rose throughout this period. It is also notable that claims by periphery to core began to fall earlier than those from core to periphery.
Fig. 24 Gross cross-border bank claims (euro, bn)
Source: BIS Consolidated Bank Statistics
Fig. 25 Net cross-border claims, core to periphery (euro, bn)
Source: BIS Consolidated Bank Statistics
The evidence presented here shows that exposure of core banks to peripheral countries increased considerably after the first signs of the international financial crisis in 2007. There are several probable reasons for this phenomenon. Core banks had no concerns about the creditworthiness of peripheral states until 2009, indeed lending to governments seemed a reasonable course of action. ECB policy, furthermore, was to support all banks, thus increasing the creditworthiness of peripheral banks. Above all, money markets became very volatile after August 2007 and there were significant differences between individual inter-bank rates (LIBOR). Core banks found themselves holding surplus euro in 2007–8 and, given overall credit concerns, perceived peripheral banks to be safer than banks in other countries (especially the US and the UK). While the Anglo-Saxon financial systems had already been hit by the crisis, European countries appeared to be safer locations. This lack of concern about the state of the European periphery can also be inferred from the Credit Default Swap (CDS) spreads shown in figure 32, which were low and stable until mid September 2008 (when Lehman Brothers failed). Rising spreads in Greece and Portugal and a buoyant housing market in Spain appeared to offer high and reasonably secure returns to core banks.
Fig. 26 Core bank gross claims on periphery vs. capital & reserves (euro, bn)
Source: BIS Consolidated Banking Statistics; ECB Eurosystem Statistical Data Warehouse
Figure 26 above shows the gross exposure of the core countries compared to their Capital and Reserves. Additionally it shows the equity of the banking system at the end of 2008, which is the only date for which this type of data is available from the ECB or Eurosystem Central Banks. The graph shows that exposure of core banks to the periphery grew faster than their capital and reserves until early 2008. At that time banks began to rein in lending while continuing to strengthen their capital base. The main contributors to core lending to the periphery are France and Germany, whose trajectories are shown in figure 27.
The single point in figure 26 marks the equity of core banks in December 2008, allowing for visual assessment of exposure. At the end of 2008 the gross exposure of core banks to the periphery stood at around 1.4 trillion euros. Meanwhile, total equity of the core banking system was 0.6 trillion euros, making the exposure to peripheral countries approximately 2.6 times equity. The two single points in figure 27 indicate the equity of French and German banks, respectively, in March 2009. On this basis, the exposure of German banks appears perhaps somewhat heavier than that of French banks.
Fig. 27 French and German bank gross claims on periphery vs. capital & reserves
(euro, bn)
Source: BIS Consolidated Banking Statistics; ECB Eurosystem Statistical Data Warehouse
Be that as it may, there is no doubt that core banks have become heavily exposed to peripheral countries. Yet, the assets are loans and therefore it is probable that they have not been entered on the balance sheet on a mark-to-market basis, reflecting current market prices. Consequently, provision against losses would presumably take place only when the possibility of default by borrowers became very high and the loans began to look impaired. Judging by Credit Default Swap (CDS) spreads (fig. 32), which capture risk premia, the risk to core banks did not look forbidding in March 2010.
However, things could change very rapidly, if peripheral countries took a turn for the worse.18 A 10 percent drop in the value of banking assets would be serious for the core banking systems, but it may not necessarily be terminal. If, on the other hand, 50 percent of loans to the periphery defaulted with a 50 percent recovery ratio, resulting in a loss of 25 percent of total exposure; or equally, if an exit from the euro resulted in a 25 percent devaluation of domestic currencies, the outcome would be disastrous for the banking system of the core nations, given current levels of equity. German and French banks would be particularly vulnerable.
This was the hard reality behind the negotiations between core and periphery regarding a rescue plan for the weakest, in the first instance, Greece. If the periphery was not rescued and generalised default occurred, the banking system of the core would find itself in a very difficult position. Needless to say, banks were rescued by states once in 2007–9, and they would probably be rescued again, should this eventuality arise.
ECB operations allow banks to restrict their lending
When the financial crisis hit in 2007, many European banks found that their assets were worth less than estimated. In the preceding period European banks had attempted to keep in step with large US banks by borrowing to acquire speculative mortgage-backed and other asset-backed securities, thus raising their returns. When the interbank market froze in 2007–8, European banks struggled to find liquidity, thus coming under heavy pressure.
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