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SOLVING THE FINANCIAL AND SOVEREIGN DEBT CRISIS IN EUROPE

OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2011 ISSUE 2 © OECD 2012 5
These policies with a growth and structural change focus provide a chance for Europe
to solve its problems without fracturing the euro. But this remains a risk. Leaving the euro
permits countries to convert credit risk into inflation risk: monetisation of their debt and
an exchange rate route to a growth strategy. But the cost for Europe as a whole would be
large. It is to be hoped that this can be avoided.
II. The vulnerable banking system and the sovereign crisis
1. Regulation and the two forms of bank risk
At its core, the cause of the financial crisis has been the under-pricing of risk.
Excessive risk in banking can always be traced to two basic causes: first, to too much
leverage; and second – for given leverage – to increased dealing in high-risk products.
Risk-weighted asset optimisation has made a nonsense of the Basel rules – the so-called
Tier 1 ratio, which provides no meaningful constraint on either form of risk. By having
nothing to say about the ratio of risk-weighted assets to total assets, the Basel Tier 1 rule
controls very little at all.
2
Systemically important banks are permitted to use their own
internal models and derivatives to alter the very risk characteristics of assets to which the
capital weighting rules apply.
3
The Basel rule as constructed – and so widely supported by
the banks – cannot control the two forms of risk at the same time. Following the
introduction of Basel II, leverage accelerated sharply.
4
Now, as funding problems arise,
banks are being forced to cut back leverage with negative consequences for the economy.
At the same time deregulation and financial innovation has been rapid. There has been
a move away from traditional banking based on private information to a form of capital
markets banking.
5

Before the late 1990s under Glass-Steagall, US securities‟ dealing was
carried out via specialist firms, while in Europe this occurred as separate businesses and
products within universal banks. There was a state of „incomplete markets’ in bank credit
and securities. However, in the past two decades securitisation, derivatives and repo
financing has facilitated a move to „complete markets’ in bank credit and changes in bank
business models to exploit opportunities for fees and for regulatory and tax arbitrage.
Investors can go long or short bank credit in the capital markets, like any other security,
and the structuring of products via derivatives has opened up new opportunities for
earnings growth and profitability, while repo-type products have facilitated the
management of liabilities including margin call financing.
2. ‘Complete markets’ and the mixing of high-risk products into traditional
banking
This move away from traditional banking to a form of „capital markets banking‟ was
associated with an explosion of leverage and a greater mixing of mark-to-market products
with retail and traditional commercial banking assets and liabilities. Stand-alone investment
banks (IBs) were subsidised by their favourable treatment under Basel II in their dealings
with other banks. IBs, holding companies that owned IBs and universal banks were all
direct beneficiaries of the boom in new instruments through their securities dealing, prime
broking and OTC derivatives businesses as regulations became even more lax.
Far from acting to contain the risk of the proliferation of high-risk financial products,
regulatory practices moved to clear the way for them.
6
In the US the removal of Glass-
Steagall opened the way for contagion between IBs and traditional banking in this new
world. In Europe it is often argued that since Glass-Steagall did not apply, and there had
been no great difficulties until recent years, then there should be no problem with the
SOLVING THE FINANCIAL AND SOVEREIGN DEBT CRISIS IN EUROPE
6 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2011 ISSUE2 © OECD 2012
universal banking model as such. This is exactly the sort of argumentation – a fallacy of
hasty generalisation – that does not recognise the nature of the secular changes and the
changed environment for banking. In the days of incomplete markets the universal bank
model was much less dangerous and Glass-Steagall much less needed than is now the case
with complete markets. Internal contagion between products booked at fair value (mark-
to-market, where valuation changes are immediately reflected in profit-and-loss accounts)
and (traditional) products booked at amortised cost is now much more material, and
interconnectedness risk through derivative counterparties has risen to levels that simply
did not apply a couple of decades ago.
3. The explosion of derivatives and counterparty risk
Figure 1 shows primary securities and assets that essentially fund investment and
growth (equities, securities and bank assets), which has grown in line with world GDP.
The notional value (the correct measure of exposure in the event of extreme unexpected
events) of global derivatives grew from 2½ times world GDP in 2008 to a staggering 12
times world GDP on the eve of the crisis. Derivatives do not fund real investments yet
carry all the bankruptcy characteristics of debt. Banks‟ justification in the past for this
mountain of derivatives has been that they were necessary for risk control and for
innovation and productivity in the economy – yet these trends have been accompanied by
the worst decade of growth in the post-War period and the biggest financial risk event
since the Great Depression.
Some of this mountain of derivatives is for socially useful purposes, such as end-users
hedging business risks (e.g. an airline hedging the cost of fuel, a pension annuity product
minimising the volatility of income, etc). However, in the past decade socially less useful
uses of derivatives have abounded. Notable in this respect is the use of derivatives for tax
arbitrage (e.g. interest rate swaps to exploit different tax treatment of products). Credit
default swaps (CDS) have been used extensively for regulatory arbitrage to minimise the
capital banks are required to hold. How this creates bank instability has been discussed in
previous OECD papers,

7
and some of the technical mechanics recently at work in Europe
are elaborated further below.
This process has permitted leverage to rise and counterparty risk to become extreme.
Important in this respect is the widening gap between derivatives and primary securities in
Figure 1, keeping in mind that derivatives are based on primary securities which provide
the collateral for the trades. These divergent trends are indicative of re-hypothecation
(repeated re-use) of the same collateral that multiplies counterparty risk throughout the
banking system.
The payouts to SIFIs from their exposure to the single counterparty AIG during the
crisis were enormous. When the US government chose to settle the AIG derivative
exposures to avoid a global meltdown, the amounts involved for some large European
banks with respect to one single counterparty were in the vicinity of 30-40% of their
equity capital – and it would have become even larger had it been allowed to go on.
Nowhere does one see in any bank publication before the AIG crisis risk exposure reports
approaching anything remotely like the amounts that were actually paid. Capital markets
banks never have much ex-ante risk with their hedges and netting (as reported by their
models), but they certainly can have massive ex-post exposures. It is precisely the fear of
contagion and counterparty risk, and the funding problems to which these give rise, that
are affecting bank credit default swap spreads in Europe right now.
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OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2011 ISSUE 2 © OECD 2012 7
Figure 1. Global primary securities versus OTC derivatives

Source: OECD, BIS, World Federation of Stock Exchanges, Datastream.
4. ‘Capital markets banks’ & the spread of interconnectedness risk
To understand how massive losses for banks via counterparties may arise, it is
important to look at what the capital markets banks actually do – as compared to the
traditional banking functions. Their main operations include:
 Securities underwriting and dealing in companies, sovereigns and securitised
credit products funded via repurchase agreements (repos).
 Prime broking, typically with hedge funds.
 OTC derivative transactions.
These IB activities boost leverage in the financial system and expose it to severe
counterparty risk. It is for this reason that the OECD has argued from the outset of the
crisis for a sensible leverage ratio (e.g. 20) and for the separation of these IB activities
from traditional retail/commercial banking.
5. How volatility puts banks with significant IB activities and little capital at
risk
Bank dealer financing via short-term repo-style transactions
Dealer banks fund their holdings of much longer-term euro and dollar sovereigns,
asset-backed securities, corporate bonds, etc. by rolling short-term repos and other credits
on a daily basis – mostly backed with collateral. While creditors could keep lending in
volatile periods and take possession of the collateral of the dealer bank in the event of
insolvency, they are loath to do this due to the legal complexity and the risk that the sale
of assets would not cover the shortfall in cash in the event that the dealer does not return
it. Instead, these creditors cut off funding with the dealer who would then have to rely on
central bank funding. While a liquidity shortage is observed, the fear that gives rise to this
shortage in a causal sense is the potential insolvency of the dealer bank. Haircuts on
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
Total
Primary Securities
Derivatives
SOLVING THE FINANCIAL AND SOVEREIGN DEBT CRISIS IN EUROPE
8 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2011 ISSUE2 © OECD 2012
collateral increase when there is uncertainty, falling confidence and volatility in collateral
values. This requires more collateral and hence prompts the sale of assets by dealer banks,
which itself results in falling prices and further pressure for haircuts in an unstable
feedback loop. In Europe, US money market funds (MMFs) have been huge creditors to
EU banks – funding more than US$ 650bn in this way. As solvency concerns rose, they
have shortened the maturity of lending and cut exposures sharply. Real money creditors
have also begun to cut credit lines. It is for this reason that coordinated dollar swap
arrangements have again been put in place by major central banks in September 2011 and
more forcefully at the start of December 2011.
To believe that these issues are merely liquidity problems that can be smoothed away
by central banks misunderstands the fundamental cause of how breakdown mechanisms
come into play. They are not primarily liquidity problems that arise randomly without
cause. The problem arises in the first place due to concerns about solvency of dealer
banks with little capital and no balance sheet flexibility in the face of unexpected
volatility. These problems will not be solved and will recur until banks have adequate
capital and a structure that does not comingle these high-risk activities with traditional
retail banking.
Prime broking
Prime brokers deal mainly with hedge fund clients in derivatives, margin and stock
lending. The prime broker keeps an inventory of securities and derivatives and provides
financing for hedge funds. It may take cash from hedge fund A, hold some in reserve and
lend that to hedge fund B. It may also take assets from hedge fund A, and re-hypothecate
those cash or securities using them as collateral for a loan from another lender in order to
lend to hedge fund A or indeed to another hedge fund. The ability to re-hypothecate a
hedge-funds‟ assets is what makes prime brokerage accounts more profitable and enables
brokers to offer securities and derivatives instantly and at efficient prices.
The mixing of this activity with retail banking – which is never a problem in normal
times – can be quite disastrous in a crisis unless the hedge fund has demanded segregated
accounts for its assets. In the event of a solvency concern with respect to the broker/dealer
bank, the un-segregated client would find itself in the position of being an unsecured
depositor (if it had not demanded segregated accounts and/or did not take protective
action) and may never get its assets back. As with the repo situation, when uncertainty
about solvency rises, a hedge fund client may decide to move its account to another
broker/dealer bank or demand to move its assets into segregated accounts. This protective
action following a solvency fear once again creates a liquidity crunch: the prime broker
has to come up with the cash lent and/or the securities re-hypothecated and may not be
able to do so, foreshadowing a collapse. When this arises, hedge funds often buy CDS on
the dealer bank at risk in order to hedge the risk to their assets. These actions explain
some of the patterns in recent bank CDS spreads.
OTC derivatives
A simple derivatives illustration is provided in Figure 2 for the CDS contract most
often used for regulatory arbitrage. In this example notional protection of $100m is
bought, and a 50% recovery rate in the event of an actual default is assumed (so the
maximum final value of the contract payout would be $ 50m).
8
A four-period model is
used. In the first period, four successive re-evaluations of the survival in each of the
subsequent periods are considered: 95%, 90%, 70% and 30%. The bottom rung shows the
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OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2011 ISSUE 2 © OECD 2012 9
value of the contract where the probability of the reference entity surviving in each of the
4 periods is 95%. So the probability of default over the life of the contract is only 19%,
shown on the left-hand side, and the value of the contract is $ 4.6m. The second rung
shows a rise in the value to $ 11.7m as the survival probabilities have fallen, resulting in a
34% probability of default over the life of the contract. This rises to $ 33.3m for a 76%
chance of default over four periods and $ 45.2m for a 99% chance.
Figure 2. Simple derivative interactions

Source: OECD.
It is not difficult to see how a bank (or insurance company like AIG) that wrote this
contract would come under scrutiny from its creditors if the probability of default of the
reference entity rises in a crisis situation – the diagram begins to take on an „atomic
bomb‟ shape for potential losses. If a bank‟s counterparty fails to post collateral in such
cases and perceptions of solvency problems for the dealer bank rise, other banks and
intermediaries will begin to take defensive action. A dealer bank at risk to the insolvency
of the writer bank can try to cover by borrowing from the at-risk dealer, or by entering
into further offsetting new OTC derivative contracts with the dealer (that can be netted).
However, all of these actions exacerbate the dealer‟s weak cash position. The most likely
defensive response of a broker/dealer bank or client exposed to a bank at risk of
insolvency would be to request novation away from the bank concerned. This creates
huge pressure for the bank under attack, as it has to transfer cash collateral to the new
bank. This means selling assets and unwinding trades at possibly fire-sale prices. It is
these very processes that lead to rapid bank failures.
More generally, for all OTC derivatives, the moment a bank does not have sufficient
cash buffer of short-term securities of sufficient quality to be able to meet collateral calls
it is essentially, in the absence of direct official support, going to go rapidly into a failure
situation.
The risk of a sovereign default (spread widening) or the downgrading of the credit
rating of a bank or sovereign will exacerbate the situation by requiring new collateral to
be posted and larger haircuts to collateral to apply, thereby further increasing the cash
pressure on the dealer bank. When the OTC derivatives market allows banks not to post
collateral in their book squaring trades, and also permit this for favoured clients such as
sovereigns and some corporations with good credit ratings, market participants have little
choice but to buy CDS contracts referencing the bank or government concerned – as there
Price of derivative for a notional amount of € 100m
and 50% recovery rate
0.99
0.76
0.34 €11.7m
0.19 €4.6m
Probability of default
after 4 periods
€45.2m
€33.3m
SOLVING THE FINANCIAL AND SOVEREIGN DEBT CRISIS IN EUROPE
10 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2011 ISSUE2 © OECD 2012
is no other way to hedge a „jump-to-default‟ risk situation. The bidding for such cover
forces up the spread.
6. Sovereign and bank crisis interactions
The interaction between bank CDS and sovereign CDS spreads can be seen in
Figure 3, which shows the weighted average CDS spreads for European Sovereigns and
for European banks.
They have been moving in a correlated way, showing the interaction of market
concerns about the jump-to-default of sovereign risks and the impact the increased
financial volatility might have on banks. Some break in the correlation occurs from late
2011 as ECB tightening policy is reversed.
Figure 3. Bank versus sovereign CDS spreads

Sources: OECD, Datastream.


7. Bank exposures to sovereign debt & interaction with collateral for
derivatives
Table 2 shows the exposure of banks of the country in the left column to the sovereign
debt of Greece, Ireland, Portugal, Spain, Italy and France. The data are shown in millions
of Euros and as a percentage of core Tier-1 capital.
9
A few observations stand out:
 For Europe as a whole, bank balance sheet exposures to the sovereign debt of the
periphery countries is actually quite small: only € 76bn in total for Greece, or 8%
of core tier 1 capital, and much less for Ireland and Portugal. These holdings
suggest very clearly that this is not a sovereign crisis spilling into banks right
across Europe via direct holdings of periphery sovereign debt. The exposures
outside of the “own” country are simply not big enough.
0
200
400
600
800
1000
1200
1400
Wtd Sprd BP
EU Wtd. Bank CDS Sprd Index
EU Sov. CDS Sprd Index
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OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2011 ISSUE 2 © OECD 2012 11
Table 2. Bank exposures by country to the sovereign debt of six countries
In millions of euro and in per cent of Core Tier 1 capital, as of December 2011
a)


a)
Greek exposure to Greece is based on the August 2011 stress test (it was not updated in December).
Source: Bank reports, December 2011 stress test, OECD.



 Own-country banks do have very big exposures. Greece and Cyprus for example
have a € 53bn exposure (top left of Table 2) – a 50% haircut for Greece would
require a € 26bn injection to Greek and Cypriot banks, which is not a large sum
for Europe, to avoid bank failures in that country. € 38bn should cover the
exposure of all banks in Europe to a 50% haircut in Greece. This is not the reason
that bank share prices and CDS spreads reflect insolvency fears which, in turn,
lead to dangerous liquidity crises.
Banks Sov. Exp.€m Core_Tier_1 €m % Core Tier 1 Banks Sov. Exp.€m
Core_Tier_1 €m
% Core Tier 1
GR 48376 22819 212% IE 12,844 30,626 42%
CY 4,926 3,804 129% CY 361 3,804 9%
BE 4,267 20,460 21% PT 547 17,386 3%
PT 1,020 17,386 6% BE 376 20,460 2%
LU 82 1,480 6% FI 41 4,945 1%
DE 6,450 120,092 5% FR 1,144 172,357 1%
FR 7,053 172,357 4% DE 751 120,092 1%
IT 1,459 93,410 2% SI 9 1,447 1%
Other 2,659 558,205 0% Other 1,124 616,078 0%
Total 76,292 1,010,014 8% Total 17,197 987,196 2%
Banks Sov. Exp.€m Core_Tier_1 €m % Core Tier 1 Banks Sov. Exp.€m
Core_Tier_1 €m
% Core Tier 1
PT 22,680 17,386 130% ES 155,175 102,066 152%
BE 1,993 20,460 10% DE 16,895 120,092 14%
LU 143 1,480 10% BE 2,605 20,460 13%
DE 3,760 120,092 3% LU 173 1,480 12%
ES 3,177 102,066 3% IT 3,529 93,410 4%
FR 2,938 172,357 2% FR 5,610 172,357 3%
NL 659 73,609 1% NL 1,238 73,609 2%
GB 1,288 235,367 1% GB 3,371 235,367 1%
Other 464 213,752 0% Other 345 168,354 0%
Total 37,113 987,196 4% Total 188,941 987,196 19%
Banks Sov. Exp.€m Core_Tier_1 €m % Core Tier 1 Banks Sov. Exp.€m
Core_Tier_1 €m
% Core Tier 1
IT 150,636 93,410 161% FR 84,207 172,357 49%
LU 1,396 1,480 94% NL 21,683 73,609 29%
BE 17,409 20,460 85% SI 268 1,447 19%
DE 26,259 120,092 22% CY 493 3,804 13%
FR 30,775 172,357 18% DE 15,471 120,092 13%
PT 959 17,386 6% BE 2,194 20,460 11%
AT 1,050 19,402 5% GB 20,251 235,367 9%
ES 5,344 102,066 5% SE 2,379 46,290 5%
Other 9,886 440,542 2% Other 3,190 313,769 1%
Total 243,715 987,196 25% Total 150,136 987,196 15%
Sovereign Exposure to Portugal
Sovereign Exposure to Spain
Sovereign Exposure to Italy
Sovereign Exposure to France
Sovereign Exposure to Greece
Sovereign Exposure to Ireland
SOLVING THE FINANCIAL AND SOVEREIGN DEBT CRISIS IN EUROPE
12 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2011 ISSUE2 © OECD 2012
 The failure to quarantine the problem from larger countries is another matter. The
exposure of EU banks to the sovereign debt of Spain and Italy are quite
substantial at 19% and 25%, respectively, of core Tier-1 capital in Europe as a
whole. Once again, the own-country exposure is very large: for Spain 152% of
Tier 1 capital and for Italy 161%. The countries with big IB banks, i.e. Germany,
Belgium, Luxemburg, Italy and France, are the most exposed to Spain and Italy.
While the default of these countries is much less likely than for Greece, the failure
to contain the contamination of spreads results in mark-to-market losses and it
reduces the value of these securities when offered as collateral for the derivatives
exposures of EU banks that mix traditional and IB activities.
8. Cross-border exposures to Italy, Spain and France are the problem
Table 3 shows the foreign (cross-border) exposure of banks in the countries shown
across the top row to the sovereign debt, bank debt, and non-bank private debt of some
key EU countries shown in the leftmost column. The extent of banks‟ foreign exposure to
these countries through guarantees, including CDS, is also shown. The most notable
features of the table are:
 Foreign banks‟ cross-border exposure to the sovereign debt of Greece, Portugal
and Ireland is actually quite small and essentially negligible outside of Europe.
But it is large for Italy, France and Spain and heavily concentrated within
European banks. This underlines why it is essential for the ECB to put a lid on
rates to prevent contamination. Similar observations can be made with respect to
cross-border exposures of banks to other banks (small vis-à-vis the periphery and
large with respect to France, Italy and Spain).
 There are also very large cross-border exposures between banks and the non-bank
private sector in Europe. As parts of Europe enter into recession in 2012 the
extent of cross-border losses from these sources will rise, and may present a new
leg to the crisis. If the recession is bigger than expected the contagion from such
losses could be large.
 One surprising feature of the table is the interconnectedness of US banks to
Europe in the case of CDS derivatives (for all sectors). Cross-border guarantees
extended including CDS to securities of the six countries on the left are large
(US$ 1.2tn), with US$ 344bn from EU banks and a much higher US$ 865bn from
US banks (US$ 347bn to France, US$ 238bn to Italy and US$ 149bn to Spain).
This diversification of risk makes sense for Europe, but it underlines how the EU
crisis could quickly return to the United States in the event of insolvencies within
Europe.
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Table 3. Cross-border exposures of banks
In millions of US dollar, 2001H1

Source: BIS, OECD.
III. Dealing with the sovereign/financial crisis in Europe
1. The growth problem
While the current financial crisis is global in nature, Europe has its own special brand
of institutional arrangements that are being tested in the extreme and have exacerbated the
financial crisis:
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 The euro area consists of a monetary union amongst 17 countries with very
different structures that are being subject to asymmetric real shocks – most
notably via external competitiveness and trade.
10
German unit labour costs are
thought to be 25% more competitive than those of Greece and some 33% more
competitive than Italy‟s. At the same time, the industrial development of China
and the emerging world more generally constitutes a massive global real shock
affecting commodity prices and the demand for higher technology investment
goods. Northern Europe is generally more vertically integrated into the emerging
markets through its high-technology investment goods focus than is southern
Europe that is subject to greater competition in manufactured consumer goods.
 In the absence of exchange rate flexibility, these pressures are forced into the
labour markets and (as these are not flexible enough) to unemployment. Europe
does not have a single fiscal authority, and governments have tried to avoid these
social pressures by allowing differential fiscal imbalances to emerge. These
imbalances have been exacerbated by the financial crisis and recession and these,
in turn, contribute to the financial instability.
 The EU financial system mixes traditional and capital markets banking and this is
interacting with the sovereign crisis in a dangerous way. Securities dealing, prime
broking and OTC derivatives are based on margin accounts and the need for
collateral, which is being undermined by significant mark-to-market price shifts.
When banks are unable to meet collateral calls liquidity crises emerge and banks
are not given the time to recapitalise through the earnings benefits of low interest
rates and a positive yield spread. SME funding depends on banks, and
deleveraging as a consequence of the above pressures is reinforcing the downward
pressure on the economy.
The basic problem can be seen in Figure 4, which shows the familiar internal and
external balance lines, in the real exchange rate domestic absorption space (drawn for
existing levels of debt, bank, industrial and trade structures, etc.).
Figure 4. Policy problems in Europe

Source: OECD.
C/A DEFICIT
UNEMPLOYMENT
Real SPA X ITA X
Exchange GRE X Internal
Rate POR X Balance
C/A SURPLUS C/A DEFICIT
UNEMPLOYMENT INFLATION
GER X
C/A SURLUS External Balance
INFLATION
Domestic Absorption