Banks Problem in Eurozone Crisis and Its Brief Model
Authors:   Asia-Europe Perspective Association, Choi Sung-Sup(Brian) 
Published: June 2018

In Eurozone crisis, the enormous debt that European banks have accumulated in booming periods has played an important role of market amplification mechanism and has aggravated the market crash in falling markets. In addition, the misplaced regulation has made the situation worse at the same time. In this context, the paper investigates the problem of European banks in terms of various data and statistics, and proposes a brief model which could explain how the problem of European banks amplifies the market crash during the crisis. The brief model is based on expansion/contraction of the balance sheet. If the price of a risky asset goes up from p to p’, the price of a representative European bank’s equity rises from e to e’ as well. As the equity price rises from e to e’, an European bank makes its optimal selection on a risky asset by increasing y to y’. An important point is that the process of increasing y to y’ involves 2 separate steps. When e rises to e’, the asset size rises to start with, which is the first step of increasing y to y’. As the asset size rises, however, more rooms are made to use more debt, while satisfying VaR requirement, because of the first step of increasing y to y’. Then the use of more debt leads to the second step of rise in the asset size. As a result, debt and asset of a representative European bank move upward in a lock step (i.e. 1:1 ratio) in booming periods. Note that a representative European bank satisfies Basel requirements easily, and yet as the first step its asset size goes up with increase in equity, and its asset size continues to rise when the bank uses extra debt, which is the second step of rise. As the market turns its swing during 2007-8 global crisis, the opposite happened. When the price of a risky asset falls, the price of equity falls, leading to the first step of decreasing y’ to y. Deleveraging then follows, which makes the asset size further contracted. Hence, a vicious cycle.
Since European banks are closely related to American financial markets and its shadow banking system, 2007-8 global crisis affected the Eurozone and worsened the matters in Eurozone. By the same token, the Eurozone crisis will certainly affect the United States, if it is not well taken care of. BIS banking statistics point to the combination of two important features for understanding Eurozone crisis. First, the US-dollar denominated assets of banks outside the United States are comparable in size to the total assets of the US commercial banking sector, peaking at over $10 trillion prior to the crisis. The BIS banking statistics reveal that a substantial portion of external US dollar claims are the claims of European banks against US counterparties. Second, on the funding side, European banks have been financed their activities by tapping the wholesale funding market in the US. For instance, the interoffice accounts of foreign bank branches in the US reveal that foreign banks were raising large amounts of US dollar funding in the US and then channeling the funds to head office. Through these and other means, the large gross claims of European banks on US counterparties are matched by their large gross liabilities to US-based savers. As a result, European banks draw wholesale funding from the US and then lend it back to US residents. Although European banks’ presence in the domestic US commercial banking sector may not look large, their impact on overall credit conditions looms much larger through the shadow banking system in the United States that relies on capital market-based financial intermediaries who intermediate funds through securitization of claims.