European banks after the global financial crisis: a new landscape

Abstract

The global financial crisis has created a different macroeconomic and regulatory environment for banks. In this paper, using market-based and structural indicators, we try to provide a narrative for the new landscape in which European banks operate and, at least partially, to answer the question of whether banks are now safer. To that purpose, we separately consider three periods: pre-crisis (before October 2007), crisis and post-crisis (after July 2012), over a sample of 32 banks. Our analysis shows that, after the global financial crisis, there has been a decrease in the value of market-based indicators, which, nonetheless, still remain higher than pre-crisis levels. That would mark banks as less safe than before the global financial crisis. When turning to structural indicators, our findings do not align with those from market-based indicators, as they would qualify banks as safer now. This contrast may be signalling that from a pre-crisis period characterised by high risks in the banking sector which were not priced by market participants, we may have moved to a period of lower risks in the banking sector but with market participants fully aware of them. There are significant differences between large- and medium-sized banks, which could be due to the persistence of a certain Too-Big-To-Fail assumption only for larger banks. Finally, market-based indicators tend to suggest that the bail-in and the leverage ratio have been the two pieces in the regulatory reform with the largest impact.

Appendices

Appendix 1: Main aspects of the regulatory reform

In the aftermath of the global financial crisis, an ambitious regulatory reform for banks was undertaken, under the Basel Committee on Banking Supervision. The main objective of the regulatory reform is to increase the resilience of banks, including but not limited to additional capital buffers that can absorb losses in times of distress.

Pillar I of Basel III focuses on capital ratios which aim at ensuring that banks have sufficient capital to cover unexpected losses. The minimum level for common equity is required to amount to 4.5% of risk-weighted assets. This ratio can be increased by additional buffers to address institution-specific vulnerabilities or higher levels of risks depending upon the size and systemic relevance of a financial institution. These buffers include the capital conservation buffer (additional 2.5%), the countercyclical capital buffer (from 0 to 2.5%), the G-SII and O-SII buffers as well as the systemic risk buffer. In addition, Pillar I obliges banks to meet a leverage ratio requirement which is neutral to risk weights. The leverage ratio aims at addressing the cyclical effect of risk-based capital requirements and at limiting the excessive use of liabilities—instead of equity—to finance bank assets. In order to cover counterparty credit risk, Pillar I also introduces a limit of total exposure to a single counterparty which should not exceed 25% of its eligible capital. The supervisory review process associated with Pillar II assesses an institution’s resilience to external factors, such as the impact of cyclical developments, and its risk management practices. Here, microprudential supervisors may impose measures that go beyond the minimum requirements in Pillar I. Pillar III focuses on disclosure requirements with particular regard to securitisation and off-balance sheet vehicles.

Basel III also introduces global standards for liquidity. The liquidity coverage ratio (LCR) requires banks to have sufficient high-quality liquid assets to resist a 30-day stress scenario. The net stable funding ratio (NSFR) addresses potential sources of liquidity mismatch and compares a bank’s stable funding sources, i.e. deposits, with its assets.

Finally, it is worth referring as well to the introduction of a minimum total loss absorbency capacity (TLAC) for largest banks by the FSB, which in the EU has been mirrored by a minimum requirement for own funds and eligible liabilities (MREL), applied to all banks. In a nutshell, these two requirements are expected to avoid bail-out of banks in difficulties, by means of imposing losses to some of their debtholders (“bail-in”) before public support is granted. In the case of the EU framework, the cases where banks would be bailed-out have been much limited and that should remain now the exception rather than the rule.

Appendix 2: Price-to-book ratios of a sample of US and Japanese banks

Fig. 29

Source: Bloomberg and authors’ calculations

Distribution of price-to-book ratio of a sample of US banks.

Fig. 30

Source: Bloomberg and authors’ calculations

Distribution of the price-to-book ratio of a sample of Japanese banks.

Appendix 3: Link between return-on-equity and the price-to-book ratio

We start with the usual dividend-discount equation to determine the price of a given share:

$${\text{Price}}_{0} = \frac{{{\text{DPS}}_{1} }}{{r - g_{n} }}$$

where DPS₁ = dividends per share in the next period, r = risk-free rate, g_n = expected growth rate of dividends.

If we define ROE as ${\text{ROE}} = \frac{{\text{Earnings}}\,{\text{per}}\,{\text{share}}_{0}}{{\text{Book}}\,{\text{value}}_{0}}$, and the Payout ratio as ${\text{Payout}}\,{\text{ratio}} = \frac{{\text{Dividends}}\,{\text{per}}\,{\text{share}}_{0}}{{\text{Earnings}}\,{\text{per}}\,{\text{share}}_{0}}$, ${\text{Price}}_{0}$ then becomes

$$\begin{aligned} & {\text{Price}}_{0} = \frac{{{\text{Book value}}_{0} \times {\text{ROE}} \times {\text{Payout ratio}} \times \left( {1 + g_{n} } \right)}}{{r - g_{n} }} \\ & \frac{{{\text{Price}}_{0} }}{{{\text{Book value}}_{0} }} = \frac{{{\text{ROE}} \times {\text{Payout ratio}} \times \left( {1 + g_{n} } \right)}}{{r - g_{n} }} \\ \end{aligned}$$

Assuming that ROE can be derived from expected earnings in the subsequent period, we obtain

$$\frac{{{\text{Price}}_{0} }}{{{\text{Book value}}_{0} }} = \frac{{{\text{ROE}} \times {\text{Payout ratio}}}}{{r - g_{n} }}$$

If we finally assume that $g_{n} = \left( {1 - {\text{Payout ratio}}} \right) \times {\text{ROE}}$, the definition of the price-to-book ratio can be simplified to:

$$\frac{{{\text{Price}}_{0} }}{{{\text{Book value}}_{0} }} = \frac{{{\text{ROE}} - g_{n} }}{{r - g_{n} }}$$