SUNWAY UNIVERSITY BUSINESS SCHOOL

BACHELOR OF SCIENCE (HONS) ACCOUNTING AND FINANCE

FIN 2024: FINANCIAL INSTITUTIONS AND MARKETS

Group Members:

Chow Eva 12059416

Muhammad Zubair 12018644

Bwale Chisaka 11024874

Samyuktha Manoharan 12057543

(a)

(i) The Euro zone also known as the euro area, is an economic and monetary union that

consist of 18 different countries in the euro area that have taken up the use of one common

currency known as the euro. Economic and Monetary union involves management of economic

and fiscal policies, common monetary policy and the common currency as the sole legal tender.

The euro zone crisis also referred to as the sovereign debt crisis, it’s a current crisis that involves

several European countries facing the breakdown of financial institutions, and high government

debt and escalating bond yield in government securities ever since early 2009. There are many

and various reasons that caused the Eurozone crises, some are broad causes to the whole

Eurozone and some are country specific factors. The following part of the report will discuss

some key drivers leading up to the Eurozone crisis:

Monetary Policy - The single currency was initiated in 1999 adopted firstly by only 11

countries increasing to 18 countries to date and this was a major step in European integration, as

a result of this euro members gave control over the monetary policies to the European central

bank which safeguards price stability and setting the interest rates for the entire Eurozone.

Former president of Czech Republic Vaclav Klaus stated that the crisis was created by having

one exchange rate, one interest rate and one monetary policy to govern many diverse economies

in Europe. The crisis taking place in Europe at the moment has proven that the monetary policy

enforced through the various countries isn’t efficient. It is over regulated which create a

hindrance for the economy to develop concluded Klaus. Some large countries such as Germany

encountered weak growth this resulting in the central bank setting pretty low interest rates,

conversely this rate was too low for booming economies like Spain and that generated large

market booms. By implementing the one monetary policy and currency, countries with high debt

were restricted to the measures they could use to respond to the crisis as compared to countries

out the Euro could use like the United Kingdom, these include sanctioning higher inflation rates

to decrease the countries liability or directly or indirectly depreciate your currency to stimulate

exports.

Competitive Weakness - As things stand now countries in the euro zone are still

struggling with the competition. The central bank takes measures aiming to boost the demand

and improving the Eurozone export competitiveness, thus far the bank has failed to have positive

results as domestic demand is 5% smaller than it was in 2008 resulting in the European

economies are now more dependent on exports more than ever to improve their economic

growth. Some European countries continue to decline in export competitiveness compared to

their economic rivals and this is due to the shrinking of labor force and the increase in cost in

doing business in certain economies as well as the government inflexibility in many parts of the

Euro zone. Until very recently the euro remained over valued related to the emerging currencies

over the previous years, in result the Eurozone is limited the ability of pulling out of the slumb

because of lower local demands and other competitive factors.

Economic Divergence and Trade Imbalances- Financial time’s journalist Martin Wolf

declared that one of the major reasons of the crisis was the continuous rise in trade imbalances.

As mentioned in the above paragraphs its clear to see that different economies grow at a different

paces, many of the countries in the zone urgently required bailouts from other countries and

besides that had witnessed the decrease in level of productivity due to high cost relative to the

European average during this period. Paul Krugman stated in 2009 that the problem was the

euros assembly shaped trade alterations within the Eurozone, the chart below shows the major

Eurozone economies by current account as percentage of GDP.

Nation 2010 (%) 2011

(%)

Greece -11.2 -10.8

Portugal -10.0 -10.0

Spain -5.5 -5.2

Italy -3.2 -2.9

Ireland -3.0 -2.7

France -1.9 -1.8

Belgium 0.3 0.5

Finland 1.3 1.4

Austria 2.3 2.3

Germany 4.9 6.1

Netherlands 5.4 5.7

As seen Greece, Portugal, Spain, Italy and Ireland all have been running substantial

current account deficits, the problem present is that the countries are failing to fix these deficits

they’re stuck as trade deficit. When the financial crisis occurred and borrowing cost began to

increase in these countries their ability to pay back liabilities had been questioned. As a single

currency existing in the euro the easy way to regain Balance to devalue the currency wasn’t an

option for these countries

Misplaced confidence and assessment of risks - In an interview with Dr Spyros an

economist of the London school of economist stated that he believes the general problem that

caused the Eurozone crisis is the misplaced confidence and assessment of risks. Borrowing cost

for all Eurozone members congregated upon the euros formation, countries such as Greece

beforehand were forced to offer a greater interest rate than say Germany to appeal to investment

were at this time capable of borrow more reasonably. Similarly the private sector borrowing

costs also declined towards German levels, this action lead to an increase in government debt in

countries like Greece and Portugal. The allegations was that financial markets anticipated every

country in the Eurozone to have nearly the same amount of risk of failure to pay their loans

(possibly assuming all Eurozone countries were in it together). As soon as the financial crisis

began in 2008, investors contemplated in pumping in money into the countries in the Eurozone

thus countries with high debt problems and feeble economies, such as Greece shortly saw their

borrowing costs escalate.

(ii) Contagion risk refers to there being major economic changes in one country, and these

changes effect will spread through to other countries, and it could either be economic booms or

economic deficit through a region. Contagion had become a more noticeable occurrence in the

Eurozone, as all the countries in the Eurozone all become interrelated with one another.

Sovereign debt is commonly known as economic and financial problems initiated by the

observed disability of a country to reimburse its public debt. This regularly transpires when a

country gets to a critically high level of debt and battles the low economic growth. Thus the

Eurozone Debt crisis contagion refers to the potential spread of the current European debt crisis

to other Eurozone countries. This may perhaps make it challenging for countries to settle their

government liability without aid from outsiders. Public Debt in the Eurozone had rose from a

total GDP of 70.2% to an estimated 88.5% between the years 2005 to 2011, through 2008 and

2009 there was miniature to no alarm about the European sovereign debt as the European central

banks focused on addressing the global financial shock. All through this phase countries such as

Ireland and Spain provided some security that these countries could facilitate probable fiscal cost

connected with a medium size banking crisis hence the main focus for the banking system was

stability with specific countries. During the crisis the risk of contagion had increased in

significance and countries with leading involvement in the Securities commission were affected

most by the crisis e.g. (Austria Netherlands and Ireland). Late 2009 the sovereign debt crisis

moved into a new segment, many countries conveyed larger than anticipated escalation in the

deficit of the GDP ratio. In some countries namely Spain and Ireland fiscal revenues declined

much faster than the GDP, resulting in a high indifference of tax revenues and declines in

production activity and asset values. The balance of the recession and escalating approximations

of forthcoming banking sector losses on bad loans in a various countries likewise had adverse

unforeseen effect on sovereign bond values, since then investors realized that countries in the

Eurozone had a declining banking sector positioning themselves vulnerable to fiscal risks.

( Mody and Sandri 2012). The negative changes were revealed in increasing ranges on sovereign

bonds, the yearly range on ten year sovereign bond yields were close to zero before the crisis

between Germany countries like Greece and Ireland. As these countries are all combined by one

common currency, the euro, thus the variances in projected yield chiefly signify professed credit

risks and variances in in instability. (Buiter and Sibert 2006).

(iii) Euro zone Countries such as Greece, Spain and Ireland grew strongly for the most of

2000s , they all were benefitted from the lower interest rates brought by EMU. Resulting in

stimulating the consumer spending and residential construction, but the boom masked a marked

loss in external competitiveness, which effect in failure to control the wages and unit costs

growth. The European countries are distinguished as closely interdependent and any economic

crisis that impact a single country in the region is highly likely to spread through the whole

region because of financial institution and international trade. As the introduction of the euro as a

single currency in whole Europe eliminated the exchange risk, and it trigger the financial

institutions to lend across the member states. During the global financial crisis in 2007 the

sovereign countries were assumed as safe heaven to invest, resulting heavy investment and

lending from financial institutions. But the default sovereign debts caused sharp widening in

budget deficit among euro zone countries, In 2009 Greece shocked the investors by announcing

that its budget deficit has almost doubled, in early months of 2010 public debt of Greece risk

rose rapidly to the 90– 100% of GDP level.

The fiscal deficit of the Greece had a great exposure on the GIIPS countries (Greece,

Italy, Ireland, Portugal and Spain), it aggravated the creditworthiness of these GIIPS countries at

default risk and created instability in financial system and worsened their fiscal deficit. Countries

in the euro zone were obliged to restrict the government deficit ratio below 3%, however Greece

was detected to incurred 12.5% budget deficit ratio which increases to 13% in April 2010. In

respect in May 2011, IMF and EU declared the financial bailout package and European central

bank purchased the government bonds of Greece, Spain and Portugal to reduce the impact of

crisis. The intense effect of sovereign risk across the Europe can be describe by the

disappearance of foreign exchange risk , which triggered the expansion of portfolio and lending

by financial institutions in the core countries. Therefore if few of GIIPS countries went into

bankruptcy , the collision will not only reach to the financial institutions which are lending and

investing in GIIPS countries , but it will also affect the public sector which is suffering from the

instability of financial system. The Sovereign default affected the health of private banking

sector around euro zone countries, which as well as danger the health of public sector as a result,

in Greece since the end of 2009 private sector deposits dropped by 10 % and also a decline in

deposits in Ireland.

Other than that, financial instruction such as banks also suffered greatly due to the default

of sovereign debts. (Allen and Moessner, 2012) As a result of sovereign crisis, in august 2007

bank started to lose confidence in each other bank’s credit worthiness, and it widely sharpened

margin of interbank deposit rate and the interest rates on sovereign debts. Public start

withdrawing deposits from the banks in countries situated in euro zone as banking system and

public finances were sensed as weak, for some banks the failure was obvious but nobody knew

which banks were exposed to solvency. Banks in euro zone encountered huge losses during mid

2008 to 2011, they faced severe liability pressure and pressure to rebuild their depleted capital.

At the end of 2010 European banks faced gross exposure of Greek sovereign debt of 90 billion

Euros, the risk that the government’s will default puts the solvency of commercial banks in

danger around Euro zone especially Greece. The risk of sovereign default result in occurrence of

risk of bank failure, the risk of bank failure was one of the reason for the contraction in interbank

lending after the financial crises in 2008 globally

In addition, According to (Frum, 2012) Europe is facing the euro currency crises because

European countries not only have bumped up against their ability to borrow, but European

countries have bumped up their ability to borrow against Euros. There is possibility for the

countries like Greece to quite the euro and to resume their former currencies as an escape hatch

from the euro zone crises, as quitting the euro would make it less painful for the these countries

as they are facing high depression in unemployment, high taxes etc. it is expressed by many of

the economist that Greece have only one solution to overcome crises is to leave euro, and if

Greece leaves the euro then countries like Ireland, Portugal, Spain might also follow which lead

the banking crises in all the countries.

Moreover, the euro zone crisis, especially current Greece crises put a question on the

survival of the Euro in future (Madhusudhanan, 2012). The current Europe crises are showing

sign of breakdown of euro and soon euro may get dissolved, as the currency unions become

stronger if there is an expansion or boom but it fails when there is a contraction or slum.

Therefore any hint that Euro zone country will default will have an immediate adverse affect on

the euro.

During the worldwide banking crisis, banks encountered phenomenal shocks to their

funding models, as far as both market access and costs are concern. Substantially recognized and

active international banks have developed considerable amount of maturity and currency

mismatches between stakes and liabilities, exposing then on significant vulnerabilities (CGFS

(2010a)). Inparticular, investment banking-oriented institutions had significantly leveraged

uptheir funding structures (FCIC (2011);mainly throughshort-term wholesale funding from repo

and commercial paper (CP) markets. Therefore, solid growth and the development in total assets

were underpinned by low levels of equity.Banks had also opt to other unstable funding sources

on the “originate-to distribute”model, for example direct loans sales and securitization

(Brunnermeier, 2009).

In 2007, pressure waves from the US subprime mortgage marketsflew over to banks’

short-term wholesale funding markets, resulting certain unavoidable circumstances to decline

tremendously, especially for highly leveraged banks. Contagionthrough the interconnections of

major global banks and financial institutions and theirsubsidizing models prompted to sharp and

phenomenal builds over interbank spreads. European banks faced several severe obstacles in

order to perceive US dollar liquidity. In addition, profoundly leveraged US venture or

investments banks were hit by extreme dislocations in their predominantly short-term obligation

funding businesses and markets (Adrian andShin, 2010).

The failure of Bear Stearns and Lehman Brothers on both March and September 2008

were precipitated when investors lost certainty to their benefits of the business models and the

organizations were shut out of these markets. These issues were not restricted only to the US

venture banks, as illustrated by the dismissal of the Northern Rock in the United Kingdom with

its dependence on the short-term wholesale financing (Shin, 2009). Hence, the banks’ share

prices plunged across the world due to the inclining solvency concern.

(b)

(i) The European Monetary Union (EMU) will have a profound impact on the economies,

enterprises and the relationship between social partners, not only of the euro countries, as well as

of the nations staying outside. Particularly, the Euro acquires common alternative or at least

converging fiscal policies of the participating states, the measure to implement budgetary counter

for nations withdrawing from the stability pact and, on a long run point of view, the leap towards

political union (Weiss, 1998).

The main responsibility of the European Central Bank (ECB) is to ensure price stability

within the euro zone, yet the actual policy approach making will be impacted by the evolution of

the cyclical circumstance of the participating nations, the political pressures exerted by

legislatures and pressure groups representing adverse interests (Clarke and Daley, 2010). Hence

will substantially rely upon the co-ordination of national policies, currently positioned towards

prohibitive policies in vary of not participating nations. If the economic inclines in accordance to

the changeover to the Euro, then the level of government funded obligations such as the public

debt may create an opportunity for more expenditure on public investment and venture.

The newly established euro zone works without fiscal compensation to underprivileged

regions or less developed participating countries. The exchange rates, which will be ultimately

settledby prevailing market rates, will lose their function as voluntary stabilizers. This differs

from the solution chosen by the German government for the former East German Mark (Weiss,

1998). In contrast to the component adopted by the German after the reunification, there will be

no automatic financial transfer instruments within the euro zone.

A new approach has to be utilized by the governments to encounter cyclical issues and

eventually understand challenges in order to solve the difficulties arose (Weiss, 1998).In that

setting, it ought to be mulled over that, over the long haul, both financial and budgetary

approaches will be impacted by choices concerning redistribution approach, taken both at the

state level through immediate and indirect taxes and at the enterprise level through wage

settlements.Therefore, the question arises, whether efforts at government level should be

accompanied by agreements between social partners to maintain wage stability (Clarke and

Daley, 2010).

In any case, the prompt effect of the euro on the structure of the economy ought not to be

overestimated, except for the budgetary, banking money and insurance sectors where there will

be a further pattern to consolidating and rebuilding of operations, while a scope of new products

and services may be show cased. In different sectors of the economy, manufacturing industries

and service ventures have long back figured out how to adapt to exchange rate vacillations and

currency risks. While their elimination in the euro zone will be a cost advantage, this is not liable

to generally change the best approach to do business. The euro as such considered will likewise

not change the way that in numerous ranges relevant to business and relations among social

accomplices, there is abundant space for national enactment. Specifically assessment (tax) and

labor law will stay untouched, in any event initially.

(ii) The first shiver of euro zone’s financial crisis was in the beginning of year 2010. They

started from rising market concerns where the sustainability of open finances in observation of

debts in Greece, rising government deficits and other secondary euro zone economies. These

damages started before many banks from euro zone had completely taken those impaired assets

out of their balance sheets from the year 2007 to year 2009 financial crisis. Thus, sovereign

concerns will spill over to banks. These harsh market tension incidents, all banks in the euro

zone, no matter how strong or experienced they are, they faced major difficulties in both

admission to funding and cost. Thus sovereign stresses morphed into a banking crisis. Inter-bank

funding costs increased harshly for both euro’s pounds and others currencies such as sterling and

dollar. Unfortunately, euro zone banks went through tension in US dollar short-term funding

markets once again (Fender and McGuire, 2010). Moreover, International spillovers were also

observable in the frequently harsh declines in UK and US banks’ stock prices, which fell in

sympathy with those of euro zone banks. In order to worsen, this crisis became gradually tangled

with delays to economic progress in growth and competitiveness. These issues had worsened the

banking crises and the sovereign debt by placing further tension on bank funding.

The strong connection between banks and the sovereigns can be measured by the growth

of a variety of indicators. One of it includes the interconnection between the sovereign and bank

credit default swap (CDS) spreads. For most of the euro zone economies, the 90-day moving

correlations among these spreads have been mostly positive and performing an overall growing

trend as the euro zone crisis developed. Furthermore, the co-movement of sovereign and bank

CDS spreads built up among the euro zone countries after the nationalization of Allied Irish

Bank in January 2009. This is a trend that consequently assisted to send out sovereign risk to

banks even more strongly. It was mainly high for most euro zone countries during crisis episodes

involving a mixture of secondary countries, such as Greece, Ireland and Portugal, joined later in

the crisis by Spain and Italy.

This financial and economic confusion has influenced not only the developed world but

also the euro area. For instance, Greece faced inability to pay off debt which pushed the EU

towards the largest crisis ever, with probable major spill-over effect. If there is no crucial action

taken, a Greek sovereign debt default could possibly start off a huge effect that are able to affect

the main euro zone economies such as Italy and Spain, a harsh impact on France, UK and

Germany as well. Moreover, financial infectivity is one of the effects towards the euro zone

economies. The balance sheet matters of European banks, unstable stock markets and insufficient

investor confidence may rapidly credit lines cuts and deferred investments in the developing

countries. In addition, it also paused growth and fiscal consolidation plans. Thus, strictness

packages brought in by the European governments are to be expected to decrease the demand

for developing countries in exporting and lead to a reduce in spending. Moreover, high

unemployment rates also caused due to the weak economic activity which interpreted into lesser

transfer of funds aimed to developing economies. Besides, the Euro’s pounds also faced

depreciation against the dollar. With the weaker euro pounds, it may put additional tensions on

those developing countries which reply on dollars for exports and reduce the purchasing power.

The incident in the euro zone has again showed the strong relationship between financial

crises and bank funding. During period of harsh financial market tension which started mainly by

the sovereign stress causes short-term and longer-term general funding markets became tense

even for well rated euro zone banks, they are then forced to alternative funding sources or to

contract their balance sheets. Banks that did keep their market access, funding cost had increased

to much more costly, which reduced banks’ financial power and eventually decreased capacity in

order to supply financing to both retail clients and the corporate.

REFERENCES

Adrian, T and H-S Shin (2010): “The changing nature of financial intermediation and

the financial crisis of 2007–2009,” Annual Review of Economics, vol 2, pp 603–18.

Brunnermeier, M (2009): “Deciphering the liquidity and credit crunch 2007-2008”,

Journal of Economic Perspectives, vol 23(1), pp 77–100.

BBC News, (2011). UK unemployment hits 17-year high. [online] Available at:

http://www.bbc.co.uk/news/business-15271800 [Accessed 29 Oct. 2014].

Committee on the Global Financial System (2010a): “The functioning and resilience

of cross- border funding markets”, CGFS Papers, no 37.

Financial Crisis Inquiry Commission (2011): The financial crisis inquiry report.

International Monetary Fund (2012), Global Financial Stability Report, October.

Pierre, Weiss, 1998. Impact on single currency. The impact of the common currencies on

European economies, enterprises and employees, [Online]. 9, 3-8. Available

at:http://www.efta.int/media/documents/advisory-bodies/consultative-committee/cc-

opinions/impact-of-common-currency.pdf [Accessed 14 October 2014].

Shin, H (2009): “Reflections on Northern Rock: The bank run that heralded the

global financial crisis”, Journal of Economic Perspectives, vol 23(1), pp 101–190.

CIVITAS Institute for the Study of Civil Society 2010. 2010. The euro zone crisis.

[ONLINE] Available

at:http://www.civitas.org.uk/eufacts/download/TheEurozoneCrisis(Oct2010).pdf.

[Accessed 22 October 14].

APPENDICES

Reliance on ECB funding

As a percentage of banking sector assets

The vertical lines correspond to the following dates: 8 August 2011: re-activation by ECB of

SMP to purchase Italian and Spanish sovereign debt; 21 December 2011: first ECB LTRO; 29

February 2012: second ECB LTRO; 6 September 2012: decision by ECB’s Governing Council

on the modalities of OMTs.

Sources: ECB; IMF, International Financial Statistics; Bloomberg; national data; authors’

calculations.

Indicators of bank stress

1 Simple average across major banks; for the United States, Bankof America, Citigroup,

JPMorgan Chase, Goldman Sachs, Morgan Stanley;for euro area, Banco Santander, BNP

Paribas, Crédit Agricole, Deutsche Bank, ING Group, Société Générale, UniCredit SpA; for the

United Kingdom, Barclays, Lloyds, HSBC, RBS; for Japan, Mitsubishi UFJ, Mizuho, Sumitomo

Mitsui.

Sources: Bloomberg; DataStream; authors’ calculations.