Exceptionally high systemic risk in major banks

ESB

Similar to the situation during the financial crisis more than a decade ago, banks experience significant macroeconomic shocks during the current corona crisis. Casper de Vries, Professor of Monetary Economics at Erasmus School of Economics, wrote an article about the high systemic risk of large banks together with alumnus Annegeke Jansen.

Systemic risk

Systemic risk covers the possibility of large banks running into trouble and is caused by roughly two forms of system failure. First of all, one bank can ignite the other, just as in the case of the flu. In the second form, banks are simultaneously affected by macro-economic factors, such as a drop in demand. In 2008, when many banks had the same financial products that turned out to be worth less than expected, the main cause of failure was exposure to macro factors. As a result of the corona crisis, the banking sector is now once again confronted with major macro-economic shocks. In their article de Vries and Jansen analyse the individual contribution of banks to the systemic risk. They measure this risk using the Marginal Expected Shortfall (MES) measure. The MES is often used for stress testing, and can also be interpreted as an individual bank's contribution to systemic risk.

Major banks

Whether a bank is a large bank depends, according to the European Central Bank (ECB), mainly on the size of its balance sheet. According to Jansen and de Vries, however, one major bank is not the same as another. The extent to which a bank is part of the systemic problem varies from bank to bank and depends, for example, on the complexity of an institution, how involved the bank is with other banks and the risks that a bank takes. On the basis of the MES classification, Jansen and de Vries determined the ranking of the most high-risk major banks in Europe. Based on the insight provided by the MES yardstick regarding the individual share of banks in systemic risk, differentiation can be applied in the requirements for large banks. For example, banks with a higher risk could be subject to higher capital requirements or a different tax regime.

Implications of the coronacrisis

The systemic risk has not decreased substantially in the years following the financial crisis. This makes it highly probable that a macro-economic shock will lead to large losses in the financial sector. During the current corona crisis, government intervention has limited spill-over effects. The various measures taken for banks, businesses and employees limit the losses on bank loans. In addition, the measures taken by the European Central Bank are of importance. Although easing capital requirements does not strengthen the bank balance sheets, the soft loans that banks can issue from the ECB are helpful. Also, the ECB's large-scale purchase of government bonds makes it easier for governments to provide more support.

Focus on the future

De Vries and Jansen emphasize the importance of reducing the increased leverage in the economy as soon as the corona crisis subsides. This can be done by eliminating underlying drivers, whereby they prove that it pays to have a higher capital requirement for the most risky banks. Another possibility is to reduce the fiscal protection of debt capital, in order to eliminate the incentive for banks to finance themselves with excessive debt capital. This increases the financing with equity, so that there is more scope to deal with possible shocks.

Article de Vries & Jansen ESB

Article Trouw 'Banken kwetsbaar ondanks buffers'

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Annegeke Jansen completed her master's degree in Economics and Business, specialising in International Economics, in 2018. She is currently a Junior Economist at the Dutch Ministry of Finance.

The article from de Vries and Jansen for ESB can be downloaded above, as well as an article in Trouw (both in Dutch).