3rd Bank of Greece WorkshopThe Euro Area Sovereign Debt Crisis and Its

Implications for the Economies of SEE

The implications for the financial sector and ECB policy initiatives to alleviate

the consequences of the crisis

Frank Moss (European Central Bank)Athens, 18 May 2012

The vicious cycle between fiscal/banking/growth developments

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• A shock to the fiscal outlook

• Will add to financial volatility/increased interest rates in the sovereign debt market

• Will reduce the foreign investor base for sovereign debt (and increase the sovereign CDS)

• Will necessitate more domestic bank funding for the sovereign

• Will reduce the appetite for wholesale investors in bank debt (and increase bank CDS)

• Will lead to higher bank funding costs and a reduction in access to interbank markets

• Will reduce the capacity for banks to extend credit

• Will reduce economic growth

• Will create a new shock to the fiscal outlook and will increase the NPLs for banks

The ECB’s crisis response – non-standard monetary policy action to address malfunctioning financial market segments

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I. Bank funding

• Fixed-rate full allotment mode in all refinancing operations (since October 2008)

• Lengthening the maturity of the refinancing operations (1, 3, 6, 12 and 36 months)

• Extending the list of eligible collateral (and not fully relying on rating agencies)

• Extending liquidity directly in foreign currencies (USD and CHF)

• Reducing reserve requirements

II. Covered bond market

• Covered Bond Purchase Programme 1 (CBPP1) EUR 60 bn purchased from July 2009-July 2010; CBPP 2 under way for EUR 40 bn (until November 2012)

III.Sovereign bond market

• Securities Markets Programme (launched in May 2010); EUR 241 bn purchased so far (but no QE !)

The 2 VLTROs made a distinct improvement in banks’ funding conditions

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Historical volatility of DE, FR, IT and ES 10-year government bond prices (1 June 2011 – 16 April 2012 in ppt.)

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60

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90

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Jun 11 Aug 11 Oct 11 Dec 11 Feb 12 Apr 12

German 10-year bondFrench 10-year bondItalian 10-year bondSpanish 10-year bond

3-year LTRO

SMP2

EU Summit26/27 October

3-year LTRO

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0

50

100

150

200

2008 2009 2010 2011 2012

EUR/USD FX basis swap

EURIBOR/OIS spread

Euribor-OIS spread and the EUR/USD basis swap (Jan. 2008 – Mar. 2012 in basis points

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… and had a beneficial effect on sovereigns, even outside the euro area

Sovereign spreads(basis points)

Sources: Bloomberg, Datastream, ECB and national sources.Notes: CDS spreads for Croatia and Turkey, bonds spread for the FYR of Macedonia.

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200

400

600

800

1000

1200

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

Croatia

Turkey

former Yugoslav Republic of Macedonia

Using the window of opportunity to address the real challenges

• Repairing the banking sector– Adequately provisioning for the sovereign risk

exposures (EBA exercise)– Capitalising the banks adequately (Basel III) – Orderly deleveraging (national supervisors and ESRB)

• Addressing the fiscal consolidation needs– Reinforcing the euro area fiscal frameworks – Enhancing fiscal sustainability through growth-

promoting structural reforms– Strengthening the euro area/international financial

support channels

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Bank deleveraging as a medium-term global trend

• Return to more sustainable business models is a global trend which can contribute to financial stability– less reliance on volatile funding sources– lower leverage

• Euro area banks may need earlier and more deleveraging than their international peers– Comparatively high leverage ratios– High reliance on wholesale funding– Regulatory changes requiring larger capital and

liquidity buffers (EBA re-capitalisation exercise, Basel III)

– On-going subdued economic activity

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Cross-border deleveraging in SEE countries

• Concern about ‘home bias’ of euro area banks• Mitigating factors

– Geographic proximity – Prospect of EU accession and euro adoption– Relatively bright medium-term growth prospects

(catching-up)– Banks mainly funded by local deposits

• Risk factors – Lack of economic growth in some countries– External and internal imbalances– Pockets of financial sector weaknesses– Volatile political environment in some countries

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SEE countries mainly funded by local deposits

Funding structure of banks in EU candidate countries(in percent of total bank liabilities)

Sources: National sources.

0102030405060708090

100

Croatia former YugoslavRepublic ofMacedonia

Montenegro Turkey

Capital External liabilities Deposits and other

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No firm evidence of ‘home bias’ during crises periods

Breakdown of EU banks’ value-adjusted divestments by location

Source: CapitalIQ

0%10%20%30%40%50%60%70%80%90%

100%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Domestic sale EU non-domestic sale Non-EU sale

Policy Initiatives aimed at mitigating cross-border deleveraging risks

• European Banking Authority (EBA)– Assessment of deleveraging plans in the EU– Co-ordination of cross-border discussions in the

Supervisory colleges• European Systemic Risk Board (ESRB)

– Focus on systemic risk dimension of deleveraging at the level of the EU

• Vienna 2.0 Initiative– Joint public/private initiative including non-EU

countries in Central, Eastern and Southeast Europe

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No dramatic recent cross-border deleveraging …

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-20

0

20

40

60

80

Croatia former YugoslavRepublic of Macedonia

Montenegro Turkey

Capital External liabilities Deposits and other

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0

10

20

30

40

50

60

70

80

Croatia former YugoslavRepublic of Macedonia

Montenegro Turkey

Capital External liabilities Deposits and other

Change in bank liabilities(Contributions to change in total bank liabilities in percentage points)

Sources: National authorities, Haver Analytics and ECB calculations. Notes: Data for Montenegro refer to Q3 2011 in the left panel chart as no data for Q4 2011 (and thus for the right panel) are available.

Q4 2011 versus Q3 2008 Q4 2011 versus Q3 2011

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Domestic deleveraging in some countries due to unsustainable lending booms

Real credit growth(annual percentage changes)

Sources: IMF, Haver Analytics and national sources.

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Croatia

former Yugoslav Republic ofMacedonia

Montenegro

Turkey

Summary and conclusions

• A process of disorderly deleveraging by euro area banks was avoided through the ECB’s VLTROs and other policy measures

• Especially European (but also other globally active) banks have good reasons to orderly deleverage over the medium-term

• Weak credit growth in some countries may reflect demand factors at least as much as supply constraints

• The SEE financial sectors should be increasingly based on local savings (‘new growth model’)

• SEE countries face similar challenges as the euro area to maintain conditions for sustainable growth of which a sound financial sector is part

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