European Union Banking System

9 Pages   |   1,725 Words

Banking Crisis In Europe

 
Banking Crisis (Undercapitalization and liquidity issues)

 

Table of Contents
Introduction. 2
Identification of Issues in the EU Banking System.. 2
Critical Analysis of the Issues. 2
1.      Undercapitalization. 3
2.      Reduced liquidity. 5
Recommendations and Conclusion. 6
References. 8
 

Introduction

Resolving the financial crisis is one of the most important issues in global policy making debate. Financial crisis is heavily based upon commercial banking that in turn is linked to the economic growth and progress of the state. Downfalls and capital reductions lead to destruction of the banking system. The EU banking industry has always remained focused on resolving such financial issues by gathering data from different banks throughout the region (Barisitz, 2007). Gathering and analyzing data is important mainly because it provides an insight into the working of the economic system and collateral markets. The following paper aims to analyze two major aspects of Europe's banking problem i.e. undercapitalization, as well as the liquidity crisis.
 

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Identification of Issues in the EU Banking System

There have been various debates going on in during the last decade about problems in the European banking system. From 2000 onwards, the era called Eurozone crisis took over the region, and it was marked some of the major downfalls and problems of the banking industry. The major problem out of which all other problems stem out is that money was thrown in a black hole, and there were huge debts that could not be easily repaid. Unnecessary changing of market rates, too much decline of liquidity, problems in asset management and reduction of capitalization are some of the issues that haul the EU banking system (Martin Hesse & Seith, 2012).

Critical Analysis of the Issues

As already discussed, two major issues in the banking system are undercapitalization and liquidity problems. An in-depth analysis of these two issues is presented below:

1.Undercapitalization

As the name suggests, undercapitalization refers to the situation where a business, country or economy has insufficient capital or funding to carry out its operations. It is a warning sign towards a larger financial crisis, and it might lead to the overall growth and profitability of the system (Greuning & Bratanovic, 2009).
Economic Outlook research conducted in EU in 2012 showed that the European banking system faced a capital shortage of approximately EUR 400 billion. It constitutes almost 4.2% of the total GDP of the Eurozone. This capital shortage is distributed unevenly in the region. The following chart depicts how different countries within EU face undercapitalization.
Source: The Bottom Euro (2012)
For example 5 out of nine banks in Netherlands had an average leverage ratio of less than 5 percent. This data has been collected on the basis of 200 euro banks with the largest number located in Germany followed by Austria (The Bottom Euro, 2012).
The topic at hand requires an understanding of various different banks because all of them contribute a significant portion to the European banking system and economy. A leverage ratio of 5 percent is a suitable figure and to bring all the banks to this level is a difficult task being faced by the policy makers in European Union. This holds true particularly for France because bringing a 5% ratio in French banks will require almost 7.4% of the GDP or around EUR 147 billion of capital (The Bottom Euro, 2012).
Another problem is undercapitalization of banks is the cash outflow. This means that the costs of constructing and retaining Basel are huge for a normal sized European bank. It is almost equal to the cost of money taken up by 200 full-time jobs. Since total Eurozone has more than 350 banks, applying Basel III in all of them will require more than 70,000 jobs. Thus, it can be said that the problem is linked to various other problems and therefore; it is not easy to resolve (The Bottom Euro, 2012).
Undercapitalization is not just the insufficiency of money but also other factors. This is known as the TIER 3 capital of the banking system. Equally important is the human capital. Europe is also facing undercapitalization of human capital that means that technically oriented people with right skills called as "Euromanagers' are not available in the right number. Thus, Eurozone crisis faces multi-lingual, risk neutral and service oriented professionals who could boost up the growth of commercial banking (Chevalier & Segalla, 1996).
As the competition between Europe’s banks becomes intense, either through cross boundary operations or foreign expansion; or through the domestic market, the human capital will still be in short supply in the current scenario. Research suggests that in such time of crisis, policy makers need to develop a holistic approach in order to understand the deep rooted causes and thus in order to develop possible solutions to overcome these problems (Falzon, 2013).

2.Reduced liquidity

The second problem in banking system crisis is the reduced liquidity in European banks. Although the concept of liquidity and capital are interrelated yet, there are differences. Liquidity refers to the overall ability of the bank to convert its assets into cash. These assets might include central bank reserves, government debt and other such financial obligations. So, this means that liquidity is the lack of capital. This is how the two concepts are interlinked (Duttweiler, 2009).
Since the European banks are facing a crisis of capital, this means that they are facing a shortage of liquidity and the banking organizations in EU are not efficient enough to generate the right amount of money or cash to pay government debts and fulfill other financial obligations.
The liquidity crisis in Europe stems from the problem that Europe is under a huge amount of sovereign debt. Even though, the debt is falling in value but the European banks are still insolvent. Due to this reason, they are facing increased risk of credit changes. EU is under a type of the liquidity crisis under which the banks are reluctant to lend and borrow from each other, and even the Central Bank is not interfering in this issue which makes the problem more complex. This problem is old and deep rooted because the creation of ECB had a different purpose. It was created to guard inflation and not to oversee the overall efficiency and productivity of the banking system. This task is associated with the central banks of individual states, but they are bound within their areas. They are restricted, and they cannot print more money with their will. Thus, it can be said that right now there is no major player who can take the initiative to step in and solve Europe's liquidity crisis (Falzon, 2013).
The EU banks are not lending to each other. Instead, they are involved in hoarding cash. Same goes for the general public. Due to the banking crisis, they have become reluctant to invest in banks. They are reluctant not become they are afraid of the solvency issues that because they are afraid of liquidity problems. Moreover, there is no properly defined amount of capital or cash that can resolve the issue of liquidity shortage. Hence, the risk increases. A BIS report released in 2011 showed that the downfall of liquidity is also based upon monetary policies, deviations in growth rates, as well as domestic imbalances and risk appetites (Salmon, 2011).
Policy makers around the world, usually, focus their attention on solvency issues. They try to move up solvency instead of looking for deep rooted causes and problems that lead to the crisis of capitalization and liquidity. Due to this, the cycle of crisis continues in circles. It ends and begins again and thus, this process continues. An example of this can be the two large banks of Ireland i.e. Bank of Ireland and Allied Irish had too many loans and a very minor percentage of deposits. They were exclusively dependent upon the money from other big investors and banks. These two were completely unreliable resources. They continued to dry up, and these banks had to rush to ECB (Dixon, 2010). The situation was even worsened when big corporate investors also withdrew their money. This example illustrates that liquidity crisis in the bank can lead to the ultimate death of the bank.
Some states for instance: Germany, Britain and France are now imposing higher taxes on such banks that rely on short term unreliable sources of money. This is a good step towards resolution of this crisis because it warns the banks and thus forces them to search for more stable sources to manage their liquidity.

Recommendations and Conclusion

There is a need to resolve all the above-mentioned banking crisis by taking certain measures that would lead towards enhancement of productivity. For instance: the growth of small business banking and personal banking could prove effective. Similarly, apart from the central bank, there must be some kind of a universal bank that could offer all type of financial services at one forum. It would provide a standardization of rates, and thus, policy making will also be uniform. Moreover, in EU, the improvement in person-client relationships can prove to be effective. There must be forums that can provide financial advice at small scale level because it would eventually lead to stabilization of financial ratios and the GDP. These banking strategies and tactics are not exclusive. They are inter-dependent on several other economic issues. Hence; a broader perspective and understanding would help in resolving the crisis. 

References

Clear and simple, European banks are seriously undercapitalized. (2012, December 5). Retrieved from The Bottom Euro: http://www.bottomeuro.com/2012/12/clear-and-simple-european-banks-are.html
Barisitz, S. (2007). Banking in Central and Eastern Europe 1980-2006: From Communism to Capitalism. Routledge.
Chevalier, F., & Segalla, M. (1996). Organizational Behaviour and Change in Europe: Case Studies. London: SAGE Publications.
Dixon, H. (2010, November 29). Europe's Crisis of Liquidity. Retrieved from New York Times: http://www.nytimes.com/2010/11/30/business/global/30views.html?_r=0
Duttweiler, R. (2009). Managing Liquidity in Banks: A Top Down Approach`. John Wiley and Sons.
Falzon, J. (2013). Bank Stability, Sovereign Debt and Derivatives. New York: Palgrave Macmillan.
Greuning, H. v., & Bratanovic, S. B. (2009). In Analyzing Banking Risk: A Framework for Assessing Corporate Governance and Risk Management (p. 147). Washington DC: World Bank Publications.
Martin Hesse, C. P., & Seith, A. (2012, May 7). The EU's Black Holes: Saving the Euro Will Require Banking Sector Reform. Retrieved from http://www.spiegel.de/international/europe/europe-needs-to-reform-its-banking-sector-a-831712.html
Salmon, F. (2011, 11 14). Europe's liquidity crisis. Retrieved from Reuters: http://blogs.reuters.com/felix-salmon/2011/11/14/europes-liquidity-crisis/

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