Why does the health of
the banking sector matter?

The Joint Research Centre makes the scientific case

Why did the financial crisis happen?

Europe’s debt crisis was initially triggered by events in the American banking sector.

European banks that had invested heavily in the American mortgage market were hit hard.

As Europe slipped into recession in 2009, a problem that had started in the banks began to increasingly affect governments, as markets worried that some countries could not afford to rescue banks that were in trouble.

Economic and social impact of
the financial crisis

After a financial crisis, it takes about 6-8 years to return to pre-crisis levels

From 2008 to 2012, European governments injected € 1.5 trillion into the financial system to support it

75% of company financing in the EU comes from banks

In the United States it is only 30%

This generates an extra source of vulnerability for EU companies

Source: European Banking Federation, 2012

The financial crisis led to a credit crunch for industry ...

Loans to manufacturing companies (peak 2008) — Source: European Central Bank

... and consumers

Credit to consumers (peak 2010) — Source: European Central Bank

Unemployment has increased since the beginning of the financial crisis

In the euro area, the unemployment rate went from 7.5 % in 2007 to a peak of 12 % in 2012 and 2013.

Source: European Central Bank

The financial crisis also had an impact on citizens’ confidence

According to a survey in 2012, more than 60% of EU citizens had lost confidence in the financial sector.

Source: Gallup

What does the EU financial system look like?

All of the EU’s financial institutions are interconnected. When one bank is affected by financial turbulence, there may be repercussions for other banks in other countries.

Some banks are more important than others

If global systematically important banks (G-SIBs) are in trouble, there are repercussions on the whole financial system. These banks are subjected to special rules.

What are G-SIBs?

Global systematically important banks (G-SIBs) are financial institutions whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.

Compared to other banks, G-SIBs must maintain a higher capital level — a capital surcharge.

In 2014, 31 G-SIBs were operating worldwide. Among them, 14 were based in the EU.

These 14 G-SIBs represent roughly 40 % of EU-28’s aggregate total assets.

A list of G-SIBs is published annually by the Financial Stability Board (FSB).

Key EU players for financial stability

European Systemic Risk Board (ESRB): its objective is to prevent and mitigate systemic financial stability risk in the European Union in the light of macroeconomic developments.

European Banking Authority (EBA): it aims to ensure sound, effective and consistent regulation and supervision, to contribute to the stability and effectiveness of the financial system, to prevent regulatory arbitrage, to ensure consumer protection and an equal level of supervision, to strengthen international supervisory coordination and appropriate regulation of supervision of credit institutions.

European Insurance and Occupational Pensions Authority (EIOPA): its scope is directed at insurance undertakings.

European Securities and Markets Authority (ESMA): its scope covers securities markets and their participating institutions.

Joint Committee of the European Supervisory Authorities (ESAs): it is responsible for overall and cross-sectoral coordination, with the aim of ensuring cross-sectoral supervisory consistency.

European Central Bank (ECB)

With the establishment of the Single Supervisory Mechanism, the ECB becomes the central prudential supervisor of financial institutions in the euro area, providing for more consistent and harmonised supervisory practices and standards within the euro area.

European System of Financial Supervision (ESFS) includes:

European Systemic Risk Board (ESRB)

European Banking Authority (EBA)

European Insurance and Occupational Pensions Authority (EIOPA)

European Securities and Market Authority (ESMA)

The competent or supervisory authorities in the Member States, as specified in the legislation establishing the three European Supervisory Authorities (ESAs) – EBA, ESMA and EIOPA:

each Member State designates its own competent authority or authorities. These competent National Supervisory Authorities form part of the ESFS.

What is Europe doing to build a safer financial system?

Since 2009, the European Commission has proposed more than 60 initiatives to render the EU banking sector safer and more resilient.

The ultimate goal is to establish a banking union.

Banking union

The Single Supervisory Mechanism (SSM) brings together the European Central Bank and the National Supervisory Authorities of each participating country. It aims to ensure the safety and soundness of the European banking system, to increase financial integration and stability and to ensure consistent supervision.

The single rulebook aims to provide a single set of harmonised prudential rules that institutions throughout the EU must respect.

The Single Resolution Mechanism (SRM) aims to ensure that, in case of serious difficulties, banks subject to the SSM can be resolved efficiently.

A single rulebook for all 8 300 banks in Europe

The rulebook covers all financial actors and products and brings together the following legislative texts.

The Agreement on the recast of the Deposit Guarantee Scheme Directive (DGSD) aims to ensure that bank deposits in all Member States remain guaranteed up to € 100 000 per depositor per bank if a bank fails.

The package on capital requirements for banks (Capital Requirements Directive IV) implements the new global standards on bank capital (commonly known as the Basel III Agreement) into the EU legal framework via a regulation and a directive.

The Agreement on Bank Recovery and Resolution Directive (BRRD) aims to ensure that the taxpayer will not have to repeatedly offer money to banks by helping EU countries intervene to manage banks in difficulty.

The Joint Research Centre (JRC) makes the scientific case!

The JRC, together with other Commission services and academic partners, has developed a statistical model called Systemic Model of Banking Originated Losses (Symbol).

The JRC uses Symbol to assess potential impacts of new reforms and monitor how reforms perform.

How does Symbol work?

It depicts the EU banking system using public information from balance sheets published by the bank.

It assesses the effect of the various policy options.

It analyses different policy options aimed at enhancing financial stability.

It runs random simulations and estimates potential losses generated in individual banks’ portfolios and at the aggregate level (i.e. country or EU).

JRC’s Symbol model can estimate how much public finance costs could be reduced
as a result of a new legislation ...

... if the EU experiences another financial crisis similar to the most recent one.

The JRC makes the scientific case!

Click on each Commission’s initiative and see how much it would help reduce taxpayers’ money in the event of a crisis, based on Symbol simulations.

Potential impact of the Capital Requirements Directive IV

More capital would reduce taxpayers’ money by 30 %.

Potential impact of the Bank Recovery Directive

Making banks’ shareholders and their creditors bear the costs of a bank failure could reduce taxpayers’ money by another 40 %.

Potential impact of the Single Resolution Fund

A Single Resolution Fund, financed by the banking sector, could further reduce taxpayers’ money by another 12 %.

The package on capital requirements for banks (Capital Requirements Directive IV) implements the new global standards on bank capital (commonly known as the Basel III Agreement) into the EU legal framework via a regulation and a directive.

The Agreement on Bank Recovery and Resolution Directive (BRRD) aims to ensure that the taxpayer will not have to repeatedly offer money to banks by helping EU countries intervene to manage banks in difficulty.

The Single Resolution Mechanism (SRM) applies to banks covered by the Single Supervisory Mechanism (SSM). In the cases when banks fail despite stronger supervision, the mechanism will allow bank resolution to be managed effectively through a Single Resolution Board and a Single Resolution Fund, financed by the banking sector. Its purpose is to ensure an orderly resolution of failing banks with minimal costs for taxpayers and to the real economy.

Add Capital Requirements

Capital Requirements

Add Bank Recovery

Bank Recovery

Add Single Resolution Fund

Single Resolution Fund

Capital requirements

Bank recovery

Single resolution fund

Taxpayers’ money

Now become a researcher yourself!

Play the game

Financial health

The bank’s capital/asset ratio is a measure of its financial health.
Bank regulators require this to be above a prescribed minimum level.

Bank capital, bank assets and bank Risk Weighted Assets are the key parameters of the JRC Symbol model.

Bank capital

What is it? Capital is the difference between the value of a bank’s assets and its liabilities.

A bank’s capital can be thought of as the margin to which creditors are covered if a bank liquidates its assets.

Effect: The higher the bank capital, the more losses will be covered by the bank’s shareholders.

Source: http://www.investopedia.com/terms/b/bank-capital.asp

Risk-weighted assets

What is it? Risk-weighted assets (RWA) are bank assets weighted in relation to their relative credit risk levels.

What for? RWA are computed by adjusting each asset class for risk in order to determine a bank’s real world exposure to potential losses.

Which percentage? Under the Basel III rules, banks must have top-quality capital equivalent to at least 7 % of their RWA or they could face restrictions on their ability to pay bonuses and dividends.

Effect: If capital is kept fixed, higher RWA (with respect to total assets) will mean more defaults and higher losses.

Source: http://lexicon.ft.com/Term?term=risk_weighted-assets

Bank assets

What is it? Bank assets represent what a bank owns, including loans, reserves, investment securities and physical assets.

What is the largest asset? For most banks, loans are the largest asset category and generate interest revenue.

Effect: The larger a bank is, the higher potential losses will be.

Source: http://glossary.econguru.com/economic-term/bank+assets

Banking system scenarios

Variables

Capital

The higher the capital is, the more the losses will be covered by the bank shareholders.

Total assets

The larger a bank’s size, the higher potential losses will be.

Risk-weighted assets

Keeping the capital fixed, the higher risk-weighted assets (RWA) are with respect to total assets, the greater the number of defaults and the higher the losses will be.

Total losses

8.47%

100

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The game simulates how much bank losses would increase or decrease if one of these 3 key variables (capital, total assets and Risk-Weighted Assets) changes.

The reference value for losses is 100.

In general, losses would be larger than 100 as Risk-Weighted Assets increase and smaller than 100 as capital increases, but for each simulation losses would differ depending on the particular combination of the 3 variables.

Use the sliders to experiment with different scenarios and see the effects they have on the total losses.

I’m ready!

Why does the health of the banking sector matter?