The Monetary Policy of Central Banks before and during the Crisis

Table of Contents

List of Illustrations

List of Abbreviations

1 Introduction

2 The Global Financial Crisis
2.1 The Onset of the Global Financial Crisis
2.2 Causes of the Global Financial Crisis
2.2.1 The US Housing Bubble and Innovative Financial Instruments
2.2.2 Expansive Monetary Policy
2.3 Consequences for the United States Economy
2.4 Consequences for the European Economy

3 The Crisis of the European Union
3.1 The Linkage between the Global Financial Crisis and the Crisis of the European Union
3.2 The European Banking Crisis
3.3 The European Sovereign Debt Crisis
3.4 Consequences for the European Economy

4 The Role and Importance of Central Banks
4.1 Basics of Central Banks and Monetary Policy
4.2 The Federal Reserve System
4.2.1 The History of the Federal Reserve System
4.2.2 Organization and Objectives of the Federal Reserve System
4.2.3 Monetary Policy of the Federal Reserve System
4.3 The European Central Bank
4.3.1 The History of the European Central Bank
4.3.2 Organization and Objectives of the European Central Bank
4.3.3 Monetary Policy of the European Central Bank

5 The Role and Importance of Central Banks during the Crisis
5.1 Monetary Policy of the Federal Reserve System during the Crisis
5.1.1 Conventional Monetary Policy Measures of the Federal Reserve System
5.1.2 Unconventional Monetary Policy Measures of the Federal Reserve System
5.1.2.1 Short-Term Liquidity Provisions
5.1.2.2 Long-Term Liquidity Provisions
5.2 Consequences of the Federal Reserve System’s Monetary Policy Responses
5.3 Monetary Policy of the European Central Bank during the Crisis
5.3.1 Conventional Monetary Policy Measures of the European Central Bank
5.3.2 Unconventional Monetary Policy Measures of the European Central Bank
5.3.2.1 Enhanced Credit Support
5.3.2.2 Outright Asset Purchases
5.4 Consequences of the European Central Bank’s Monetary Policy Responses
5.5 Comparison of the Federal Reserve System’s and the European Central Bank’s Monetary Policy Responses
5.5.1 The use of Conventional and Unconventional Monetary Policy Measures
5.5.2 The Federal Reserve System’s and the European Central Bank’s Balance Sheet
5.5.3 The use of Forward Guidance and Transparency
5.6 Risks and Uncertainties of Unconventional Monetary Policy Measures

6 Conclusion

Bibliography

List of Illustrations

Figure 1: Federal funds rate 2000 - 2013

Figure 2: GDP growth rate 2002 - 2013

Figure 3: Exports of goods and services 2002 - 2013

Figure 4: Unemployment rate 2002 - 2013

Figure 5: EURIBOR-EONIA swap spread 2007 - 2012

Figure 6: Ten-year yield spreads of euro area Member State bonds over German bonds 2008 - 2012

Figure 7: Key interest rates ECB 1999 - 2014

Figure 8: Balance sheet Federal Reserve System 2007 and 2009

Figure 9: ECB main refinancing rate 1999 - 2014

Figure 10: Development of the FED’s and the ECB’s Balance Sheet 2007 - 2013

Figure 11: Annual inflation rate 2007 - 2013

List of Abbreviations

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1 Introduction

The global financial crisis that erupted in the fall of 2008 in the United States caused a severe contraction of real activity and changed the economic and financial environment of advanced as well as emerging economies significantly. The financial crisis subsequently turned into a crisis of the economies’ real sectors in the form of a deep recession. Most advanced economies tried to combat the negative impact of the global financial crisis and its aftermath with massive fiscal and monetary measures. Especially interventions by large global central banks were needed in order to restore the disturbed and partly dysfunctional global financial system and restore the monetary policy transmission mechanism, which is essential for the effectiveness of central banks’ implemented monetary policy measures.

Due to the severity of the global financial crisis, conventional monetary policy tools soon reached the limits of their effectiveness and central banks were required to implement additional measures in order to counteract the crisis. While the implementation of conventional monetary policy measures are widely understood by central banks, the use of unconventional monetary policy measures contains uncertainties and could incorporate risks and undesired negative consequences. However, the Federal Reserve System as well as the European Central Bank both applied unconventional monetary policy measures as the crisis intensified and spread from the US to the euro area. The intention of this thesis is to investigate how the Federal Reserve System responded to the effects of the global financial crisis and its aftermath in comparison with the European Central Bank. In this context, a particular focus is set on both central banks’ use of unconventional monetary policy measures.

The first chapter of this thesis deals with the development and the outbreak of the global financial crisis. The main causes for the evolvement of the global financial crisis are explained and consequences for the US and the global economy are given.

In the second chapter, the linkage between the global financial crisis and the crisis of the European Union is drawn. Reasons for the spread of the global financial crisis to the euro area are described and the causes for the transformation to a crisis of the European Union are analyzed. The two crises that the European Union is facing, namely the sovereign debt and the European banking crisis are described and differentiated from each other. Furthermore, specific consequences for the European Union and the euro area are pointed out.

The third chapter contains general information about the importance of central banks and the basic concept of monetary policy. Moreover, in the second part of the third chapter the Federal Reserve System and the European Central Bank are introduced and their characteristics are explained, which are prerequisite information and closely tied to the subsequent chapters.

The fourth chapter illustrates the role and importance of central banks during the crisis. In this part, the most important unconventional monetary policy measures adopted by the Federal Reserve System and the European Central Bank as a response to the global financial crisis and its aftermath are detailed, followed by an analysis how these measures affected money and capital markets as well as the monetary policy transmission mechanism. Finally, a comparison between the conventional and unconventional monetary policies of the Federal Reserve System and the European Central Bank is provided. Moreover, the uncertain effects of both central banks’ unconventional monetary policies and concerns about undesired consequences of these policies are explained, followed by a conclusion in which the most important aspects of this thesis are summarized and the key findings are concluded.

2 The Global Financial Crisis

2.1 The Onset of the Global Financial Crisis

From 2008 to 2009, the world experienced the deepest economic downturn since the great depression. The global financial crisis tremendously changed the economic landscapes of many countries and in terms of speed, scope and scale of its impact surpassed recent crises. The global financial crisis that originated in the United States mortgage markets erupted through financial markets and generated a global panic, which was followed by a sharp collapse in international trade. While the complexity of the crisis and the surrounding uncertainty have made little convincing consensus about its causes and consequences for economies around the world, the debate on the effectiveness of certain policies by governments and international institutions is still going on. However, there is a common consensus that the crisis had a significant impact on North America, Asia, Europe and also emerging economies such as Brazil, China and Russia. This resulted in varying policy responses and innovations, governments and institutions employed to restore stability and growth and to prevent the eruption of future crisis.¹ In addition, most industrialized countries faced huge budget deficits caused by near-zero interest rates as a policy result. Hence, it is difficult to forge an international consensus on the innovations in global economic governance that are required in today’s globalized economic and financial system.²

During the 2000s, the United States economy faced a steadily increasing investment in its housing sector. As more and more money was invested, the prices of houses further increased. This increasing investment in the housing sector was even more accelerated by extremely low interest rates that incentivized people to borrow money and which was again invested and further increased housing prices. A severe housing bubble developed, indicated by housing prices that went beyond anything that economic calculations would have reasoned. However, in the end of 2007 the bubble collapsed and housing prices decreased by more than 15 percent. As the bubble developed, banks gave out subprime loans or subprime mortgages to borrowers with poor credit histories, which were characterized by higher interest rates, poor quality collateral, less favorable terms and a higher default risk than prime borrowers.³

After the burst of the housing bubble, many banks were in trouble because of dropping housing prices. As mortgage backed securities (MBSs) turned out to be bad debts and investors had to be paid out through certain contracts that guaranteed payments, if their investments stopped to generate profits, banks faced severe solvency problems. Hence, the turning point from the burst of a housing bubble to a financial crisis was the collapse of the investment bank Bear Stearns on August 1st, 2008. Being one of the largest holders of MBSs, Bear Stearns faced tremendous losses when housing prices dropped. Moreover, investors became less confident in the company which caused a bank run. This contributed to a general loss of confidence in the market which also caused other holders of MBSs to fail. On September 7, 2008, the two largest mortgage lenders Freddie Mac and Fannie Mae had to be bailed out by the US government. On September 15th, 2008, Lehman Brothers, the fourth-largest investment bank in the US declared bankruptcy and in the following weeks Washington Mutual collapsed.⁴

However, the banking crisis was not limited to the US since worldwide banks and investors invested in US mortgages. Hence, as a result of the housing bubble burst, international banks faced the same problems of insolvency and indebtedness as US banks. In October 2007, the German government had to bailout the bank Hypo Real Estate, and around the same time Great Britain’s and Iceland’s government had to nationalize one of the countries’ largest banks. The banking crisis also negatively affected stock markets worldwide. The Dow Jones dropped to its lowest level since 1997, Japan’s stock market fell by almost 4 percent and Britain’s stock market was down by more than 5 percent⁵

2.2 Causes of the Global Financial Crisis

The decrease in the values of MBSs and the collapse in the subprime mortgage market as well as the development of a severe housing bubble that burst in late 2007 was without a doubt a crucial factor that led to the global financial crisis. However, it is an oversimplification to argue that the issuance of subprime mortgages and the housing bubble in the US were the only causes of the global financial crisis. Similar to previous crises, the global financial crisis developed out of various interrelated factors. Significant literature agrees that besides the burst of the housing bubble, the main causes for the global financial crisis were the greed of financial institutions, the weakness of banking regulations and the adoption of innovations in investment instruments that were poorly understood. Moreover, the Federal Reserve System’s (FED) expansive monetary policy from 2001 to 2004 that was indicated by extremely low interest rates is considered as one of the main causes of the development of the crisis.⁶

2.2.1 The US Housing Bubble and Innovative Financial Instruments

One of the greatest factors that caused the global financial crisis was a severe housing bubble in the United States followed by a dramatic decline in housing prices that was unprecedented in its scale. Driven by the concept of widespread home ownership, the US Congress and various administrations tried to implement policies to reduce down payment requirements for home owners with a special attention paid to the ability of minorities and low-income families to become home owners. While in the 1950s, the down payment for a real estate amounted to 20 percent of the purchase price, the Federal Housing Administration (FHA) subsequently lowered down payment requirements, implementing a “no money down” financing for qualified borrowers in the 1990’s. Furthermore, the Clinton administration together with the Congress decided to change regulations in favor of a significant increase of mortgage lending to low-income borrowers. However, lenders increasingly complained about the growing risk in their balance sheets and threatened to stop lending to low-income borrowers. Therefore, the Congress pushed the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) to extend their purchases of low-income mortgages. As a result, banks and other mortgage lenders were able to give out new loans and sell them off to Freddie Mac and Fannie Mae. Hence, lenders made huge profits out of the service fees associated with the new loans, but faced significantly low risk, as risky loans were sold off immediately. By 2005, lenders further increased giving out loans without neither verifying the income of borrowers, nor their ability to make the required payments. In addition, the widespread use of adjustable interest rate loans with low initial interest rates flawed uninformed borrowers, as the high demand increased real estate prices.⁷

The development of the US housing bubble was also accelerated by the subprime mortgage trend, as banks created financial instruments such as collateralized debt obligations (CDOs) and MBSs in order to meet the high demand for mortgages. By spreading the risk away from the original securities, those unregulated instruments provided a way to dissociate their risk with the banks that provided the subprime mortgages. However, those newly-designed instruments were fairly complex and vaguely understood. MBSs were repacked by banks as investments based on the idea that even if a creditor defaulted, the real estate itself could always be sold for a profit, as long as housing prices increased.⁸

In addition, banks created CDSs, which were insurance contracts that would guarantee payments to investors if their investments stopped to generate profits. CDSs were extremely popular since banks believed that investments would never default, as housing prices continuously increased. Moreover, MBSs were collateralized by a pool of mortgages assuming that this would give the securities value. However, the pool was an assortment of mortgages that varied considerably in terms of quality. The designers of MBSs gave no guidance on how to price those portfolios, and rating agencies were also unable to determine the value of securities. Hence, complex securities were rated and priced without examining the individual mortgages in the portfolio. As a result, the ratings tended to overrate the value of securities. Therefore, packaging and reselling of MBSs was hazardous to investors and mortgage borrowers.⁹

In 2007, out of eighty-million houses in the Unites States, more than half had mortgages and about 7 percent were behind on their payments. Thus, after the issuance of MBSs steadily increased, there was a dramatic drop in housing prices resulting from the burst of the bubble, since people were no longer able to pay their mortgages.¹⁰

In addition to the housing bubble, the United States faced a large trade deficit and a vast amount of foreign funds that were invested in its economy. Hence, the crisis also spread to other countries by forcing foreign companies and governments to take losses. It is estimated that 40 percent of the total US Bank assets were in non-federally controlled shadow banking or non-bank lending institutions. The attempt of financial institutions to achieve small spreads with highly increased risk characterizes the extent of the bubble. Due to the off-balance sheet activities of banks, people were not able to make investment decisions based on transparent information and thus many lost significant amounts of money.¹¹

2.2.2 Expansive Monetary Policy

Not only the belief that housing prices would increase indefinitely fueled the boom in mortgage lending and resulted in even higher real estate prices. The expansive monetary policy by the FED that was characterized by a low interest rate policy considerably affected investments in the housing sector to continuously grow. As a response to the recession of 2001, the FED drastically lowered interest rates in order to stabilize the economy, encouraging institutions and individuals to take on excess risk and debt. Alan Greenspan, the former chairman of the FED (1987 to 2006) introduced a monetary policy of low interest rates in late 2001, mainly in response to the post 9/11 recession. Another motive of such a low interest rate policy was the fear of deflation after the speculative dot-com bubble collapsed between 1999 and 2001.¹²

According to Farlow (2013), policymakers faced a trade-off between keeping interest rates high and allowing unemployment to rise or lowering interest rates and avoiding immediate deflation on the risk of creating bubbles that might cause an even bigger deflation in the future. Hence, in his opinion policymakers used extremely low interest rates to stabilize the economy in the early 2000s and avoid a moderate deflationary scenario only to face a high deflationary risk at the end of the decade resulting from those extremely low interest rates. Furthermore, he concludes that extremely low interest rates in the US in the early to mid-2000s are partly responsible for the housing boom and thus the creation of the bubble. Nevertheless, a crucial mistake was to keep interest rates too low for too long.¹³

However, the former FED Chairman Ben Bernanke argues that US housing prices already rose during the 1990s, prior to the period of low interest rates and the easing of monetary policy. Similar to that, housing prices in other countries increased as well. Therefore, he believes that there is no direct link between housing prices and monetary policy. In his opinion, the rise in US housing prices is grounded in increasing capital inflows from emerging markets into the US housing and residential construction sector.¹⁴

Moreover, Shiller (2010) argues that the loose monetary policy period of the FED between 2001 and 2004 was an exogenous cause of the bubble. In his opinion, the monetary policy of the FED and also of other central banks around the world was the reaction to the burst of the stock market bubble of the 1990s. The FED was primarily focused on preventing recession and deflation, not considering that their monetary policy would further encourage the development of a new bubble. Hence, the monetary policy has been partly driven by the same lack of understanding that produced the bubble itself. Thus, in his opinion decreasing the federal funds rate and maintaining it on a low level was substantially a product of the bubble and not an exogenous factor that caused the bubble.¹⁵

Figure 1 illustrates the development of the federal funds rate from 2000 to 2013, which is the interest rate set by the FED at which financial institutions provide liquidity to each other overnight. In late 2000 the FED started to lower the federal funds rate from 6.5 percent to 1.75 percent in December 2001 and finally to 1 percent in June 2003, which was at that time the lowest level in 50 years, and maintained that low level until mid- 2004. Furthermore, the real federal funds rate, which is the inflation-corrected federal funds rate, was negative from October 2002 to April 2005, which was an interval characterized by rapidly increasing housing prices.¹⁶ This resulted in low returns on traditional investments, causing investors and lenders to take bigger risks in order to achieve greater returns. Moreover, financial intermediaries extended their borrowings to families and companies with limited financial standings and inves tors invested in more lucrative but also riskier portfolios to increase their profits. The low borrowing costs seduced families to acquire assets that have always been beyond their means, while housing prices further increased and promised high returns. In June 2004, the federal funds rate was slowly raised again. It reached 5.25 percent in June 2006, after seventeen 0.25 percent increments. However, such a slow upward path created the thought that there would be no large correction in rates and encouraged excessive leverage.¹⁷

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Figure 1: Federal funds rate 2000 - 2013 (Source: Federal Reserve Economic Data)

2.3 Consequences for the United States Economy

The global recession that followed the global financial crisis was indicated by a sharp contraction in world trade with its peak by the end of 2008 and the beginning of 2009. In 2009, global trade declined by more than 10 percent in real terms on a year-on-year basis, which was an unprecedented development. However, the decline in world trade was more severe than the fall in real world GDP which only dropped by 0.6 percent in 2009. Hence, the change in world trade which affected all main economic regions on a different scale was greater than the change in global output.¹⁸

The real quarterly GDP growth in the US decreased to -8.9 percent in the last quarter of 2008 and amounted to -6.7 percent in the first quarter of 2009 and -0.7 percent in the second quarter of 2009. By the end of 2009, real GDP growth recovered to 3.8 percent and further increased in the beginning of 2010. The economic recovery was mainly driven by an increase in personal consumption expenditures, private domestic investments and exports since the second quarter of 2009.¹⁹

The global decline in the financial services sector had negative impacts on the employment in other service sectors. The greatest declines were noticeable in investment spending on capital goods as well as consumer spending on non-durable goods, causing industrial production and manufacturing to decline. In February 2009, the industrial production in the US declined by 11.8 percent compared to the previous year. Also, US merchandise exports were 22.6 percent and imports 30.4 percent lower than the previous year, due to the decline in national incomes and consumption as well as the collapse of trade financing as credit markets broke down.²⁰

The decline in consumer spending together with the sensitivity of certain sectors like the durable goods sector to the availability of credit caused unemployment to rise. In March 2009, the unemployment rate in the US increased to 8.5 percent, its highest rate in 25 years. Almost half of the job losses were in the male-dominated construction and manufacturing sector. Thus the rate for men was approximately 2 percentage points higher than for women. With 5.8 million in 2009, the number of people receiving unemployment insurance benefits was the largest one since record-keeping started in 1967. Moreover, the number of people receiving food stamps amounted to 32.3 million, also the largest number in history. By October 2009, the entire value of home equity in the United States decreased by $5.3 trillion from $13.3 trillion to $8 trillion while investment assets lost $3.5 trillion and the unemployment rate further rose to 10.1 percent.²¹

Besides macroeconomic consequences, the crisis also resulted in a significant loss of trust in government institutions and the capitalist economic system, especially in the US. In the Index of Economic Freedom, the US fell from 2nd in 2000 to rank 18th in 2012. The ranking is based on 42 variables, involving aspects of government size, property rights, international trade freedom and regulation. The lower ranking was based on the perceptions of less-secure property rights, increased regulations of companies and favoritism due to special interests. Because of a growing crisis of confidence and loss of public trust, government assistance was necessary to save the system from a complete collapse. However, bailing out giant financial institutions created the perception that primarily large, complex and interconnected financial institutions that became “too big to fail” and lacked accountability and discipline leading up to the crisis, receive public support.²²

2.4 Consequences for the European Economy

Following the collapse of Lehman Brothers in September 2008, the level of activity in all major economies worldwide deteriorated. Due to an increasing level of uncertainty, the confidence of businesses and consumers declined and households responded with a cut in discretionary spending. As a result, the global industrial production significantly dropped towards the end of 2008 and the GDP in most of the major economies contracted. During the last quarter of 2008, the downturn in the G7 economies (Canada, France, Germany, Italy, Japan, United Kingdom and United States) further intensified and stretched globally including Asia, Latin America and Eastern Europe.²³

The development of forecasts by the International Monetary Fund (IMF) for the world growth in 2009, indicated the abrupt nature of deterioration in global activity. In mid2008, the IMF forecasted a world growth of almost 4 percent for 2009. However, in January 2009, forecasts were revised and corrected to a growth of only 0.5 percent, which was again reduced to -1.5 percent. Such a downward revision of the global outlook by more than 5 percentage points in global growth within a few months was unprecedented and the weakest year of global growth in the post-war period. Similar to that, in 2009, the European Union experienced and anticipated negative growth accompanied by rising unemployment, large declines in international trade and capital flows, as well as worsened governmental fiscal positions.²⁴

Even though, the impact of the crisis on the European economy was not as severe as in the United States, policy responses were considerably weaker and slower and thus, Europe’s average decline in GDP has been similar to that in the US and the European economies experienced the deepest recession since the Great Depression of the 1930s. During the period between 2005 and 2007 prior to the crisis, real growth in the EU averaged 3.2 percent.²⁵

Figure 2 illustrates the GDP growth rate from 2002 to 2013. For 2008, GDP growth forecasts had been revised down to 2.8 percent in the EU and 1.7 percent in the euro area.²⁶ However, from the second quarter of 2008 the quarterly GDP growth rate in the EU decreased from -0.1 in the second to -1.5 percent in the fourth quarter of 2008 and from -0.2 to -1.6 percent in the euro area respectively. For 2009, growth forecasts expected the GDP growth rate to be 1.8 percent in the EU and 1.5 percent in the euro zone. Though, the negative development continued in the first quarter of 2009 with a GDP growth rate of -2.0 in the EU and -2.1 percent in the euro area.²⁷ In total, the GDP growth rate compared to the preceding year turned out to be 0.5 percent in the EU and 0.4 percent in the euro area in 2008 and -4.2 percent in the EU and -4.1 percent in the euro area in 2009. The most severe downturn was experienced by the Latvia and Lithuania, where GDP growth in 2009 almost amounted to -18 and -15 percent. For 2010, growth slowly recovered with a positive growth of 2.0 percent in the EU and 1.9 percent in the euro area.²⁸

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Figure 2: GDP growth rate 2002 - 2013 (Source: Eurostat)

While employment in the US housing sector had considerably declined following the burst of the housing bubble, Europe’s construction sector was down only slightly, except for a few markets with housing busts, such as Spain. The greatest declines were noticeable in investments on capital goods as well as consumer spending on non- durable goods, hitting industrial production and manufacturing. In the first quarter of 2009, industrial production decreased by 17.5 percent within the EU and by 18.4 percent in the euro area. Estonia (30.2 percent), Hungary (29.0 percent) and Latvia (24.2 percent) experienced the largest declines, followed by Spain (22.0 percent) and Slovenia (21.2 percent).²⁹

Due to the aforementioned decline in international trade and capital flows, the demand in the durable as well as non-durable goods sector also decreased. As shown in Figure 3, in 2009, there was a sharp decline in the exports of goods and services in the EU which was comparable to the US. The US exports of goods and services decreased by 14.8 percentage points to -9.1 percent, while the EU’s exports decreased by 13.2 percentage points to -11.7 percent.

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Figure 3: Exports of goods and services 2002 - 2013 (Source: Eurostat)

The sharp contractions in international trade also negatively affected the economies’ current account positions. Especially European economies like Germany, the Netherlands or Austria that are strongly driven by the demand of exports were exposed to this negative development. Some Member States in Central and Eastern Europe generated large current account deficits and thus faced a higher risk of reversals of capital flows. Hence, the lack of foreign investors forced governments to receive payment assistance from the EU, IMF or the World Bank.³⁰

Figure 4 illustrates the development of the unemployment rate in the EU compared to the US. In 2009, the unemployment rate in the EU has increased by 1.9 percentage points to 8.9 percent, varying significantly between countries. While countries like Spain (15.5 percent), Latvia (14.4 percent) and Lithuania (13.7 percent) faced a high unemployment rate, others like the Netherlands (2.7 percent) or Norway (3.2 percent) were relatively low. In 2010, however the average unemployment rate in the EU further increased to 9.6 percent and continued to rise in the following periods.³¹

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Figure 4: Unemployment rate 2002 - 2013 (Source: Eurostat)

3 The Crisis of the European Union

3.1 The Linkage between the Global Financial Crisis and the Crisis of the European Union

Due to the EU’s significant role in global capital markets as well as external and internal imbalances between Member States, the global financial crisis severely affected the European Union and the euro area. The crises that followed exposed structural weaknesses such as unsustainable levels of public debt and decreasing competitiveness in some European economies. Furthermore, it showed that there are systemic shortcomings in the architecture of the European economic and monetary union. Thus, national governments and European institutions tried to respond with several measures to safeguard the financial stability and strengthen the institutional architecture and the framework of the European Union as a whole.³²

According to Shambaugh (2012), the euro area is facing three interconnected crises that are challenging the viability of the currency union. There is a banking crisis, characterized by undercapitalized banks facing liquidity problems, a sovereign debt crisis through which several euro area countries were facing rising bond yields and difficulties funding themselves and lastly a growth crisis with slow and unequally distributed economic growth. While the notion of multiple crises is not new and their occurrence was experienced by several emerging and developing countries, the scenario for the euro area is slightly different. In the euro area the main portion of private and public debt obligations of troubled countries were held in euros, mostly by creditors in other parts of the euro area. In order to increase demand, policy actions such as an internal devaluation for deficit countries with falling prices of their goods and services relative to prices in other countries, without a nominal depreciation have been emphasized. However, theory and evidence prove that such a solution may be difficult in the euro area. Moreover, exchange rate adjustments of the euro are not an option within the currency union and thus not anywhere close to the ones experienced in Latin America and Asia during the mid-1990s.³³

The systemic risk of the European financial system resulting from the global financial crisis rapidly increased and European banks faced real solvency threats from their balance sheets, caused by their holdings of peripheral European sovereign debt. As fear of contagion spread within the European Union, the concern of a systemic risk of the European banking system became more and more apparent. Market participants began to consider worst-case scenarios, knowing that a sovereign default could lead to the failure of systemically important European banks which would result in disastrous financial instability. The sovereign debt crisis that was driven by increased default risk of troubled Member States reached its peak when investors were facing the possibility of a Greek default, while European Member States’ governments struggled with a fiscal situation that had no clear precedent. Towards the end of 2011, systemic risk started to decline due to additional liquidity injections from the ECB. However, in the second quarter of 2012, the systemic risk increased again caused by the potential default of Spain, the fourth biggest economy in the European Union.³⁴

The aspects of the aforementioned three crises are not only interrelated, but also reinforce each other. Slow economic growth is causing lower tax revenues and non performing loans. Those non performing loans negatively affect bank balance sheets and in turn have real effects on economic growth through the balance sheet channel or, in severe cases end in bank failures leading to bailouts by sovereigns. Large bailouts together with lower tax revenues increase stress on public finances and a higher debt burden in turn reduces economic growth because of reduced public investment. Furthermore, sovereigns defaulting on their debt might deteriorate the health of financial institutions with substantial holdings of sovereign debt.³⁵

3.2 The European Banking Crisis

According to Laeven and Valencia (2008), a banking crisis is a period of time in which a country’s corporate and financial sectors face huge difficulties in repaying contracts on time combined with increasing non-performing loans and exhausted banking system capital. Furthermore, this scenario may be accompanied by falling asset prices, rising interest rates and a reversal of capital inflows. Banking crises may also coincide or be intensified by currency or sovereign debt crisis.³⁶

Historically, banking crises mainly hit developing and emerging economies. However, the countries that constitute the today’s European Monetary Union and the OECD were also highly affected by the previous banking crisis. According to a report about the public finances in the European Monetary Union published by the European Commission by the end of 2008, approximately two thirds of the world’s largest economies, measured as a percent of world GDP were facing a systemic banking crisis. This was reflected by IMF-supported programs, the issuance of blanket guarantees and the injection of public capital into the banking sector.³⁷

The European banking crisis was preceded by large imbalances in current accounts as well as housing booms not only in the global economy but especially in the euro area where the peripheral southern Member States such as Greece, Italy, Portugal and Spain generated current account deficits. The concept of a global saving glut emphasizes the importance of gross capital flows and explains the boom in cheap credit conditions that were one cause of housing bubbles in some advanced economies during 1997 and 2007. The idea of the global saving glut is that countries running current account surpluses provide credit to deficit countries. Therefore, capital was flowing into deficit countries in the euro area such as Spain, Greece or Ireland and also the US causing cheap credits and fueling asset price booms and housing bubbles. Global European banks played a key role in the initiation and transmission of those gross capital flows and cheap credit before the crisis. Moreover, data on cross -border and net financial flows before the crisis revealed that almost half of all foreign holdings of toxic US assets were held by highly leveraged European banks in Germany, France, Switzerland and the United Kingdom.³⁸

In 2007, total assets held in the European banking system amounted to more than 300 percent of the euro area’s GDP at that time, compared to the US with less than 100 percent, although the largest individual banks in the US and in the euro area are similar in their size in terms of total assets. However, in contrast to US banks the largest euro area banks are significantly larger relative to their home economy’s GDP. They are also highly integrated and play a substantial role in the global financial system, which partly explains their size relative to their host-countries GDP and emphasizes the importance of their supervision. Considering the relative large size of the banking system in the euro area compared to the national economies, the functioning and health of the banking system is crucial. Despite the high integration and activity in the global financial system, the supervision and regulation of banking solvency problems remained on national levels before the European Banking Authority (EBA) was established in January 2011 as part of the European System of Financial Supervision (ESFS). However, providing liquidity to euro area banks remained the role of the ECB.³⁹

Besides the relative size compared to their home country’s GDP, another main cause of the European banking crisis are the interdependencies between financial institutions in the US and Europe which served as a crucial transmission channel of shocks across borders. Because in a globalized financial system banks are holding domestic and foreign assets, a global sale in assets resulted in a credit crunch which is a decrease in bank lending given a financial or macroeconomic shock in one country that lowers the capital of global banks. Moreover, the main portion of financial institutions’ assets was financed by short-term liabilities and the institutions’ internal funds accounted only for a small fraction of total assets. Therefore, they were relatively sensitive to even small declines in asset prices. Another factor that increased the European bank’s vulnerability of insolvency was the low capital to asset ratio that typically ranged from 3 to 5 percent for major European banks and major US investment banks within 1995 and 2010. Furthermore, the liquidity of bank assets is generally lower than bank liabilities, and has a higher maturity.⁴⁰

As housing prices in the US started to decline in 2007 and the value of MBSs’ underlying assets became questionable, banks in the US and the euro area started to face huge losses. Thus, the increasing uncertainty about the quality of banks’ assets made it difficult for them to borrow money and refinance themselves. Figure 5 shows the development of the three-month European interbank offered rate (EURIBOR) and the euro overnight index average (EONIA) swap rate before and during the crisis. The spread between the unsecured EURIBOR that is based on average interest rates derived by a panel of European banks lending and borrowing from each other and the secured EONIA swap rate being the standard interest rate for euro currency deposits calculated by the ECB is primarily used as an indicator of financial stress in Europe. Disentangling the two main aspects of the three-month EURIBOR-EONIA swap spread indicates the credit risk of banks in the EURIBOR panel and relates to liquidity risk representing the cost charged by a lender to secure against a liquidity shock.⁴¹ Therefore, the spread indicates European bank’s difficulty to refinance themselves. In March 2008, liquidity risk rose and the EURIBOR-EONIA swap rate spread increased, before slightly decreasing in the following period. However, prior to the collapse of Lehman Brothers and a few days after, credit risk started to increase and the liquidity risk rapidly grew, causing the spread to significantly increase.⁴²

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Figure 5: EURIBOR-EONIA swap spread 2007 - 2012 (Source: Shambaugh, 2012, p. 164)

In October 2008, the heads of states and governments of the EU Member States agreed to implement a coordinated rescue plan in order to stabilize the European banking sector. The plan was designed to restore the normal functioning of wholesale credit markets, safeguarding financial stability and to strengthen the supply of credit to the real economy. While the rescue plan comprised a set of broadly similar actions, it also contained separate national plans. Those national plans were consistent in terms of their main components such as recapitalization measures, asset exchanges and purchases as well as lending guarantees. However, the detailed design and implementation of the national plans was left to the individual Member States.⁴³

The common measures taken by the EU Member States, such as liquidity support and state guarantees were extended by the announcement of the implementation of Deposit Guarantee Schemes in order to increase the minimum level of deposit guarantees. Those schemes were designed to reimburse a certain amount of deposits to depositors in case of bank failures and to maintain confidence of depositors in the financial safety net which prevents panic withdrawals and severe economic consequences.⁴⁴ In addition to the existing components of the rescue packages, the EU Member States also implemented asset relief interventions in order to overcome the slowdown in credit to the real economy in the beginning of 2009. Those direct relief measures were intended to remove the high uncertainty related to asset valuations and to restore confidence in the banking sector to resume normal bank lending.

Governments came to rescue banks in EU countries like Germany, France, the UK, Ireland, Denmark, the Netherlands and Belgium. But the costs of bailing out those financial institutions were immense. Thus, in Ireland it highly indebted and almost bankrupted the government before financial assistance was given by fellow EU countries.⁴⁵ Between October 2008 and October 2013, the European Commission decided on more than 400 State aided measures to support the financial sector. In the period between 2008 and 2012, the overall volume injected for recapitalization and asset relief measures were € 591.9 billion amounting to 4.6 percent of the EU’s GDP in 2012. The guarantees and support measures reached its peak in 2009 with an outstanding amount of € 906 billion or 7.7 percent of the EU’s GDP in 2012. However, in many euro area countries the intensity of the crisis weakened since then and the outstanding amount of liquidity support declined to € 534.5 billion amounting to 4.14 percent of the EU’s GDP in 2012.⁴⁶

3.3 The European Sovereign Debt Crisis

The sovereign debt crisis that erupted in January 2010 entirely changed the nature of Europe’s crisis and its impact on the different regions’ economies. It developed from the interaction of several causes including mispriced risk and macroeconomic policy misbehavior over a certain period of time. The inefficiency of the framework and the governance of policy cooperation within the European Monetary Union played a crucial role and accelerated the imbalances of the private and public sector in several euro area economies. In addition, market integration and cross-border bank lending further increased while the supervision and regulation remained on a national level. Markets were operating under the assumption that governments and central banks would be able to provide a safety net in case of a default. The ECB however was explicitly not allowed to act as a lender of last resort. The situation in some economies and the banking system generated the perception that they became too big and complex to fail which generated the thought that their liabilities had implicit guarantees. These circumstances led to sovereign debts and credit risks to be mispriced and underestimated which resulted in crucial divergences in fiscal accounts and current account imbalances of euro area economies.⁴⁷

The enormous cost of bank rescues generated doubts in the financial markets if governments could really afford to support the banking sector and turned the focus on the health of euro area governments’ finances of which some had been borrowing increasingly in order to finance their budgets. The loss of competitiveness over a longer period of time as a result of not keeping up with economic reforms in other countries caused some governments to be dependent on debt. Governments also violated the rules designed to make the euro area work such as the Stability and Growth Pact, which restricted countries’ public deficits and did not coordinate their economic policies since sharing a common currency with a single monetary policy. Investors largely ignored and paid less attention to warning signs about the health of governments and the risks involved in lending more and more.⁴⁸

The sovereign debt crisis in the euro area experienced a number of acute phases and yields on the bonds of several countries increased to very high levels. The rise of sovereign default risk especially in advanced economies in the euro area substantially contributed to the sovereign debt crisis. As a stress indicator of the euro area’s market and the former’s sovereign debt, investors are focusing on the yield spread between a country’s bonds and German bonds.

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¹ See Obstfeld, Cho & Mason (2012), p. 2.

² See Savona, Kirton & Oldani (2011), p. 3.

³ See Berlatsky (2010), p. 15.

⁴ See Berlatsky (2010), p. 16.

⁵ See Berlatsky (2010), p. 17.

⁶ See Farlow (2013), p. 17.

⁷ See Savona et al. (2011), p. 20 et seq.

⁸ See Schwartz (2009), p. 18.

⁹ See Schwartz (2009), p. 19.

¹⁰ See Berlatsky (2010), p. 16 et seq.

¹¹ See Shachmaurove (2010), p. 368 et seq.

¹² See Farlow (2013), p. 17.

¹³ See Farlow (2013), p. 18.

¹⁴ See Ciro (2012), p. 39 et seq.

¹⁵ See Shiller (2010), p. 40.

¹⁶ See Shiller (2010), p. 41.

¹⁷ See Boeri & Guiso (2010), p. 56 et seq.

¹⁸ See Bussière, Callegari, Ghironi, Sestieri & Yamano (2013), p. 119.

¹⁹ See United States Department of the Treasury (2012), p. 2.

²⁰ See United Nations (2009), p. 33.

²¹ See United Nations (2009), p. 31.

²² See Luttrell, Atkinson & Rosenblum (2013), p. 3.

²³ See Edey (2009), p. 188.

²⁴ See Edey (2009), p. 189.

²⁵ See United Nations (2009), p. 30.

²⁶ See European Commission (2008), p. 1.

²⁷ See European Commission (3/2009), p. 134.

²⁸ See European Commission (2011), p. 206.

²⁹ See United Nations (2009), p. 32.

³⁰ See European Commission (7/2009), p. 29.

³¹ See United Nations (2009), p. 31.

³² See European Commission (5/2009), p. 1.

³³ See Shambaugh (2012), p. 157 et seq.

³⁴ See Black, Correa, Huang & Zhou (2013), p. 1 et seq.

³⁵ See Noeth & Sengupta (2012), p. 459.

³⁶ See Laeven & Valencia (2008), p. 5.

³⁷ See European Commission (5/2009), p. 149.

³⁸ See Noeth & Sengupta (2012), p. 459 et seq.

³⁹ See Shambaugh (2012), p. 162 et seq.

⁴⁰ See Bussière, Imbs, Kollmann & Rancière (2013), p. 78 et seq.

⁴¹ See Shambaugh (2012), p. 164.

⁴² See De Socio (2011), p. 14.

⁴³ See European Commission (5/2009), p. 145.

⁴⁴ See European Commission (2014), online source.

⁴⁵ See European Commission (2014), online source.

⁴⁶ See European Commission (2013), online source.

⁴⁷ See International Monetary Fund (2012), p. 3 et seq.

⁴⁸ See European Commission (2013), online source.