Meet the Author

Ben R. Craig |

Senior Economic Advisor

Ben R. Craig

Ben Craig is a senior economic advisor in the Research Department. His principal fields of activity are the economics of banking and international finance.

Read full bio

Meet the Author

Matthew Koepke |

Research Analyst

Matthew Koepke

Matthew Koepke is a former research analyst in the Research Department of the Federal Reserve Bank of Cleveland.

11.04.11

Economic Trends

Sovereign Debt Implications on the European Banking System

Ben Craig and Matthew Koepke

As European leaders work to define the terms of the European Financial Stability Facility (EFSF), concerns have arisen about sovereign debt write-downs and the impact they could have on the European banking system. European finance ministers just approved a plan that would require euro-zone banks to raise $150 billion (€108 billion) in additional capital over nine months to cover potential losses. The additional capital would allow banks to meet a 9.0 percent threshold for tier-one capital after positions in distressed euro-zone debt are marked-to-market.

The additional $150 billion of capital, while steep, was less than the $417 billion (€300 billion) that the International Monetary Fund (IMF) estimated the cumulative spillover effects of the write-downs on the euro-zone banking system would be. According to the IMF’s September Global Stability Assessment Report, cumulative spillovers from the high-spread area (Belgium, Greece, Ireland, Italy, Portugal, and Spain) account for nearly $278 billion (€200 billion) of the $417 billion, with an additional $139 billion attributed to interbank exposures. The IMF expects the spillover effects to mostly affect the banking systems in the high-spread euro area. Nonetheless, the Bank for International Settlements exposure tables show that the banking systems of Germany, France, and the United Kingdom have significant exposure to the high-spread euro area, accounting for nearly 70.0 percent of the euro-zone’s total exposure.

The specter of sovereign defaults and bank exposures to the debt has increased credit risk in the euro zone interbank lending markets. Evidence of the increased credit risk can be seen by examining the euribor-OIS spread. Since June, the euribor-OIS has risen to levels not seen since the financial crisis of 2008. The euro interbank offered rate (euribor) is the rate at which banks participating in the European Union money markets are willing to lend to other banks for a specified term. The overnight indexed swap (OIS) is a fixed-for-floating interest rate swap where the overnight rate (in Europe, the eonia rate) is the reference rate for the floating leg of the swap. Because there is no exchange of principal in an interest rate swap and payment only occurs at the maturity of the contract—where one party pays the net interest obligation—there is very little default risk associated with an overnight index swap. As a result, the euribor-OIS spread reflects the associated default risk for banks lending in the interbank market (for more, see this explanation).

As the fiscal situation deteriorated in Greece and other countries in the high-spread euro area, the spread between the three-month euribor rate and the three-month eonia swap rate increased, suggesting that the euro-zone’s interbank lending market has become more risky. The euribor-eonia spread kept rising as various estimates of the spillover effects from sovereign defaults were released. They ranged from private analyst estimates as high as €275 billion to an initial estimate by the European Banking Authority as low €80 billion. From June 14, 2011, to September 23, 2011, the three-month euribor-eonia swap spread increased 72 basis points, reflecting increased default risk for banks lending in the European interbank market. Since September 23, the euribor-eonia spread has tapered off, falling nearly 13 basis points. The narrowing of the spread has coincided with the greater visibility of the ESRF and better estimates of the potential spillover costs to European banks of the sovereign debt write-downs.

The higher funding costs associated with increased default risk may have caused some banks to seek out alternative sources of liquidity. One such source for European banks is their subsidiaries in the United States.

The most recent weekly banking statistics from the Board of Governors shows that foreign subsidiaries in the United States have a balance due with their foreign-related entities. In other words, foreign banks have been transferring funds from their U.S. subsidiaries to their home offices. Additionally, the increase in the net due to foreign-related entities coincides with the increased uncertainty in the euro zone. Since May 2011, the net due to foreign-related offices has increased from −22.0 billion (the foreign-related bank had a balance with the U.S. subsidiary) to $289.6 billion (the U.S. subsidiary has a balance with the foreign-related bank). This increase suggests that foreign banks are using their U.S. subsidiaries to shore up liquidity.