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Market turbulence highlights bumpy transition to Europe’s new bank policy regime

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  • Aine Quinn

Abstract

Bank shares have been hammered on both sides of the Atlantic, as investors fear that a new period of negative (or in the United States, continued low) interest rates, or another major economic downturn, will eat into banks’ profitability. Shares rebounded in recent days, but to these general worries, investors have added specific concerns about European banks. This is justified - European banks suffer from problems that their US counterparts don’t. However, none of the issues that have caught the market’s attention of late are new system-wide threats. The radical policy change initiated in mid-2012 with the inception of Europe’s banking union is delivering positive results, and the uncertainties associated with this change are gradually, if too slowly, eroding. European banks suffer from problems that their US counterparts don’t. Both sides of the Atlantic suffered from the financial shock of 2007–08, but European and US policymakers have addressed their banking problems very differently. The United States applied a comparatively logical sequence - first, the combination of forceful recapitalization and well-timed stress testing restored confidence in the core of the system by mid-2009; second, legislative reform (the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010) framed the policy response; and third, this legislation was implemented through rulemaking by federal agencies in the years that followed. No indication of systemic fragility in the United States has emerged since then, despite recent energy sector weakness. By contrast, the European Union has remained embroiled in banking system fragility, despite rolling out a stream of new legislative and regulatory initiatives. Europe has lagged behind the United States on financial reform for several reasons. Europe’s financial system is dominated by banks, whereas the US system is cushioned by the variety of its financial markets and other nonbank financial channels. Pervasive banking nationalism prevented adequate action by national bank supervisors. Consequently, Europe has a harder time addressing large banking crises. Starting in 2009, the bank-sovereign vicious circle, in which problems in a country’s public finances and banks feed each other, aggravated the situation greatly. Pervasive banking nationalism—the tendency of governments to protect their own national banking champions—and the occasional instance of regulators being captured by banks they were supposed to regulate, prevented adequate action by national bank supervisors Eventually euro area leaders, with their backs against the wall, initiated the supranational pooling of banking sector policy known as banking union in mid-2012. The diverging paths of nonperforming loans (NPLs) in Europe and the United States summarize this contrast. With this context in mind, the recent market volatility represents a belated acknowledgment by investors of risks that had been insufficiently recognized until now, rather than adjustment to the emergence of new risks. This is true of the three main issues that have driven uncertainty. Untested contingent convertible securities CoCos, a new form of debt that may be converted into equity, faced their first test under adverse market conditions. They were first issued in 2013 by Credit Suisse and have become widespread in Europe, though not in the United States, where their tax treatment is unfavourable. They typically yield a higher rate than senior debt, but coupon payments can be stopped and the debt may be converted into equity if a pre-agreed trigger is crossed. The Basel Committee on Banking Supervision has excluded them from its preferred Core Equity Tier One (CET1) yardstick of regulatory capital. Depending on the contractual trigger, they form part of Additional Tier One (AT1) or Tier Two capital. CoCos issued by Deutsche Bank lost significant value when they came close to missing coupon payments. But in spite of all the alarm, the experience with CoCos remains inconclusive. When a bank approaches the trigger point, there is (destabilizing) additional volatility and uncertainty but also a (stabilizing) incentive for that bank to quickly reinforce its balance sheet. Deutsche Bank did exactly that by buying its own debt at a discount. More investors now realize that despite their loose labelling as “capital,” CoCos do not absorb losses in an orderly manner like common equity, and may thus weaken financial stability. But whether CoCos serve their intended purpose can be known only when a CoCo conversion is triggered, which has not happened yet. CoCos are thus untested as a potential protection against sudden balance sheet deterioration, and it is too soon to conclude that they create their own major problems. Unfinished banking system clean-up Markets continue to reflect concerns about the soundness of euro area banks, and by implication about the ability of banking union to address the problem.

Suggested Citation

  • Aine Quinn, 2016. "Market turbulence highlights bumpy transition to Europe’s new bank policy regime," Policy Briefs 13187, Bruegel.
  • Handle: RePEc:bre:polbrf:13187
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