Academic journal article Business and Economics Research Journal

The Fiscal Costs of Banking Intervention in the Eurozone

Academic journal article Business and Economics Research Journal

The Fiscal Costs of Banking Intervention in the Eurozone

Article excerpt

Abstract: This study aimed to reveal the fiscal cost of banking interventions in the Eurozone. To this end, firstly, the theoretical underpinnings of a banking crisis and its management policies are explained, then the policies used in the Eurozone and their costs are analyzed in detail. For analysis of banking interventions on budgets, Multidimensional Scaling (MDS) Analysis was used to see similarities and dissimilarities between countries. Two important conclusions emerged. First; countries that have faced a systemic banking crisis (Germany, the Netherlands and Ireland) were dissimilar from the group as a whole from the beginning of the financial crisis. After a sovereign debt crisis, the indebted countries were also affected and disintegrated (Greece and Spain). The second was that the net budgetary impact of these measures was found to be smaller than anticipated but the rise in gross debt was considerable in some countries. Furthermore, in those countries, contingent liabilities posed a threat for future public finances. In order to minimize the fiscal cost of a banking crisis, union-wide crisis management and institutions should be established. This calls for the completion of The Banking Union.

Keywords: Banking crisis, banking crisis management, fiscal cost of banking crisis, MDS Analysis.

JEL Classification: G01, G21, H12

1. Introduction

Since the early 1970s, through financial and capital account liberalization, banking crises have tended to occur frequently. The subprime mortgage market crisis, which began in August 2007, was rooted in the real estate market bubble, mainly fuelled by foreign capital as a result of capital account liberalization. As Bernanke famously stated, "a global savings glut" inflated this bubble. The savings of China, Japan and Germany flew to the deficit countries, especially to the US. Furthermore, those savings were invested in complex structured assets which were the result of financial engineering, another form of financial liberalization.

After the 1970s, an efficient market paradigm dominated the intellectual discussions. According to this paradigm, financial markets efficiently allocate resources to the most productive investment projects and maximize welfare. Two important outcomes of this paradigm are that bubbles cannot occur because asset values reflect fundamentals and as markets are efficient, they can regulate themselves. Self-regulation of the markets eventually led to a deregulation process with lobbying of bankers from US and Europe. However, with the help of financial innovation, new financial products were created. These new structured products allowed banks to secure loans and repackage them under the name of asset-backed securities (ABS). With a lack of prudent regulation and the optimism of the efficient market paradigm, it was thought that these products would spread and reduce inherent risk (De Grauwe (2008), Krugman (2009)).

However, that was not the case. When the bubble burst as a result of contractionary monetary policy in the US, the pricing of these structured assets became problematic. Fire sales began and asset prices collapsed accordingly. This also led to a rapid detoriation in bank balance sheets. Major investment and deposit banks needed the help of authorities to survive. In September 2008, the US authorities allowed Lehman Brothers, the fourth largest investment bank in the US with $600 billion assets, to go bankrupt. This shocked the markets and transformed the subprime mortgage market crisis into a fully-fledged global crisis1.

After the Lehman Brothers collapse, confidence in the credit-worthiness of banks, financial institutions and even firms fell significantly. Then the crisis began to spill over to the real economy (Allen et al., 2009: 3).

The crisis also revealed the serious solvency problems of several major European Banks as these banks played a significant role in structured product demand (Leaven & Valencia, 2008a: 26). …

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