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

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). Belgium, Luxemburg, Ireland, Germany, Austria and the Netherlands faced a systemic crisis. The severity of the crisis in those countries was related to the size of their financial system and financial links with US banks.

The authorities in the US and Europe intervened in the financial markets to lessen the systemic consequences. Prior to September 2008, they intervened in financial institutions on an ad hoc basis. In this phase, they injected liquidity into the banks and forced them to merge with other banks2. After Lehman's default, it became evident that individual solutions would not be enough. Counterparty risk began to emerge and more comprehensive strategies evolved.

These intervention policies have enormous costs. First, these policies have direct fiscal costs in terms of taxpayers' money. The direct fiscal costs can be followed from budget balances and debt ratios. Second, these policies have indirect fiscal costs related to the misallocation of capital and the moral hazard of distorting incentives (Calomiris et al.,2003: 71). Third, a banking crisis is usually followed by a recession, so output loss can also be seen in the aftermath of a financial crisis.

This study is focused only on the direct fiscal costs as a result of banking interventions in 12 Eurozone countries which experienced a banking crisis3. …

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