Conference: The New Financial Architecture in the Eurozone - Pierre Werner Chair, Robert Schuman Centre for Advanced Studies, European University Institute By: Sascha Steffen (ESMT)

1. Is the banking union stable and
resilient as it looks?
Viral V. Acharya (NYU, NBER and CEPR)
Sascha Steffen (ESMT)
Conference on
“The new financial architecture in the
Eurozone”
Florence, 23 April 2015

2. Motivation
n On 29 June 2012, euro group members
agreed to create a Banking Union (BU)
n Break link between banking sector and sovereign
n Avoid taxpayer bailouts
n Increase lending of banks to real sector and ignite
growth
n BU as part of a wider regulatory framework
that centralizes banking supervision and
resolution
n Fragmented approach to supervision/resolution
impaired financial stability

3. Motivation
n BU is supposed to prevent and deal with
future crises
n Legacy assets should not be mutualized
n Thus, before start of the SSM in Nov’14, the
EBA and ECB conducted a comprehensive
assessment
n Stop forbearance, identify problem assets, clean
up balance sheets
n We conduct an objective stress test to assess
the resilience of the European banking sector

4. Sample of 41 publicly listed banks in
comprehensive assessment
n Total market capitalization of €539 billion, an average book
equity/asset ratio of 5.27% and 0.75 MTB ratio.
n RWA/Asset ratio is 35% on average.
n Banks with low RWA/Asset ratios have low MTB ratios.
Country
Market Equity/
Assets
Equity/Assets
Market-to-
Book
RWA/Assets MarketCap
Spain 7.05% 7.22% 1 0.48 146,082
France 3.23% 4.24% 0.68 0.26 127,696
Italy 4.29% 6.49% 0.61 0.48 83,000
Germany 2.19% 3.83% 0.61 0.23 50,570
Greece 8.26% 8.27% 0.95 0.58 26,945
Belgium 6.89% 4.00% 1.18 0.31 17,305
Austria 5.31% 7.24% 0.72 0.49 11,453
Ireland 6.11% 6.05% 0.98 0.43 9,816
Portugal 4.03% 4.48% 0.91 0.51 4,978
Malta 11.97% 7.70% 1.58 0.49 1,557
Slovakia 9.20% 11.94% 0.7 0.59 964
Cyprus 3.75% 6.25% 0.57 0.69 229
Total 4.27% 5.27% 0.75 0.35 539,083

5. SRISK as a benchmark stress test
n Stress scenario is a systemic financial crisis
with a stock market decline of 40% (VLAB)
n Similar to the financial crises of 2008 and 2011
n Prudential capital ratio of 5.5%
n SRISK uses market data and market equity in
determining leverage
n Advantage: objective, no forbearance

6. Regulatory shortfall measure in
ECB stress test
n Stress scenario is the adverse scenario at the
end of 2016.
n Regulatory benchmark is CET1 ratio
n CET1 capital / risk-weighted assets (RWA)
n Hurdle rate is 5.5%
n CET1/RWA is only capital ratio
n Advantage: based on detailed regulatory data

7. Comparing SRISK and official ECB
capital shortfalls
n SRISK suggests a €450 billion capital shortfall in a systemic
crisis.
n ECB calculated €20 billion capital shortfall.
Country SRISK
ECB Shortfall
Adverse
Scenario
Spain 37,914 0
France 189,042 0
Italy 76,287 7,640
Germany 102,406 0
Greece 4,360 8,721
Belgium 26,616 339
Austria 6,677 865
Ireland 3,053 855
Portugal 3,821 1,137
Malta 0 0
Slovakia 0 0
Cyprus 167 277
Total 450,343 19,834

8. Banks that have the highest SRISK also have
the highest “surplus capital” under the
regulatory capital framework.
Austria
Belgium
Cyprus
France
Germany
Greece
Ireland
Italy
MaltaPortugal
Spain
−50000
0
50000
100000
150000
200000
SRISK
(million euros)
−60000 −40000 −20000 0 20000
Shortfall 5.5% CET1/RWA (million euros)
Adverse Scenario
SRISK vs. 5.5% CET1/RWA
n The correlation between SRISK and regulatory capital shortfalls
is large and negative.

9. Total losses in adverse scenario of ECB stress
test versus SRISK
n The correlation between SRISK and total losses in the adverse
scenario is large and positive.
Austria
Belgium
Cyprus
France
Germany
Greece
Ireland
Italy
MaltaPortugal
Spain
−50000
0
50000
100000
150000
200000
SRISK
(million euros)
0 20000 40000 60000 80000
Total Loss (million euros)
Total Losses vs. SRISK

10. The use of risk weights in the regulatory
benchmark explains the shortfall differential
between our and the ECB’s assessment.
n There is a high and positive correlation between SRISK and
shortfalls based on a simple leverage (equity/assets) ratio.
Austria
Belgium
Cyprus
France
Germany
Greece
Ireland
Italy
MaltaPortugal
Spain
−50000
0
50000
100000
150000
200000
SRISK
(million euros)
0 20000 40000 60000
Shortfall 5.5% Book Equity/Assets (million euros)
Adverse Scenario
SRISK vs. 5.5% Book Equity/Assets

11. Are banks adequately capitalized?
n Two different answers using the same loss
scenario but two different leverage ratios
n a risk-weights based one and a non risk-weights
based one.
n Banks that do well on risk-weighted capital
adequacy but poorly on other approaches are
likely “arbitraging” the static nature of risk
weights to lever up using zero or low risk-
weight assets.

12. Implications for Banking Union
n Banking system still not adequately
capitalized as Europe enters the Banking
Union.
n Despite consequences from 2 financial crises,
Europe still hangs on to risk-weight based
regulation
n Static risk-weights, do not reflect market’s risk
perception
n Large banks calculate own risk-weights with
room for gaming risk-weights

13. Implications for Banking Union
n Banks naturally buy low risk-weight assets
they can pledge to the ECB
n Inflated asset prices make banks appear healthy
as ECB purchases them
n Impedes growth in the euro area as these
assets crowd out real sector lending
n Weak banking system is a huge reputational
risk for ECB if bank failures occur

14. Other uncertainties
surrounding Banking Union
n Given the focus on euro-area institutions,
what are the implications with regard to the
consistency of EU bank regulation?
n Moreover, banking supervision is not fully de-
nationalized in BU.
n Does this supervisory model increase efficiencies in
banking supervision or make the SSM less resilient?
n No “Single Rule Book”
n Still differences e.g. how to compute regulatory
capital

15. Implications for burden sharing
n Differing capitalization of banks across
the euro area implies different burden
for the restructuring and resolution
mechanism
n How should burden sharing be
designed?
n Should it depend on the the
capitalization of a country’s financial
sector?