international standards on bank capital and liquidity just like everyone else.
European banks and financial markets were badly affected by the global financial crisis, but from early 2010 European financial markets suffered additional problems specifically related to economic trends in Europe. These problems particularly affected the Eurozone– the group of 17 countries that had adopted the euro as their currency and whose monetary affairs were therefore governed primarily by the European Central Bank.
The difficulties experienced by European financial markets over this time were the result first and foremost of a sovereign debt crisis arising from unsustainable spending and borrowing by some governments. However, one of the features of the crisis was the close connection that emerged between the sustainability of government finances in a particular country and the health of that country's banking system.
The response to the crisis has had far-reaching consequences for the way in which banks are regulated and supervised in the European Union (EU) – for both Eurozone and non-Eurozone countries.
Ireland was the first EU country to need financial support from the European Union and the International Monetary Fund, although Ireland's problems arose from problems in its banking system that became apparent in 2007-2008, rather than from budgetary difficulties. As a result, the European crisis is deemed to have begun with Greece in 2009.
In late 2009, concerns began to grow that the Greek government would not be able to repay its debts, and in February 2010 the European Union announced a financial support package for Greece that was coupled with requirements that the Greek government drastically reduce public spending. Over the course of 2010, new figures revealed that the Greek government's financial situation was even worse than expected, and further support from international bodies was provided.
Although the Greek crisis originated with problems in the Greek government's finances, it quickly became clear that Greek banks would be affected. Most obviously, they held large amounts of their own government's bonds, and the government's ability to repay these bonds was now in doubt. Furthermore, as investors worried about the ability of the Greek government to repay its debts, they pushed up the cost of new borrowing to Greece and this in turn led to higher funding costs for Greek banks. More generally, the Greek government's budgetary crisis revealed broader mismanagement within the Greek economy, including state-owned enterprises that were not servicing the loans that they had received from banks.
As the problems in Greece unfolded, analysts turned their attention to other Eurozone countries that had been running large budget deficits, such as Portugal, Spain, and Cyprus. Although the fundamental problems lay with government budgets, banks based in these countries also experienced difficulties either as a result of their direct exposure to their governments, because international investors were refusing to provide funds to any institutions in that particular country, or because the problems at the government level were symptomatic of broader economic mismanagement whose full extent only came to light as a result of the crisis.
The difficulties of resolving the European financial crisis were exacerbated by a lack of clarity over who was responsible for solving the problems. It was clearly in the interest of the Eurozone as a whole to prevent financial collapse in any member country, but some countries were reluctant to commit their own taxpayers' money to resolve problems in other countries that had been caused by years of overspending. These issues have now been largely resolved though the implementation of a “banking union” among Eurozone countries, with a central fund to support troubled banks and centralized supervision conducted by the European Central Bank.
The European financial crisis illustrated not only how budgetary problems at the government level lead to problems for individual banks, but also how lack of clarity over who is responsible for resolving banking crises can result in those crises deepening and becoming more widespread.
Until recent times, the provision of credit and the collection of deposits were performed almost exclusively by banks that were regulated by a central bank or an equivalent institution, and these banks could expect to receive support from their central bank in the event that they ran short of liquidity. In the mid-1980s in the United States, and shortly after that in other developed financial markets, a variety of nonbank institutions and investment vehicles began to conduct many of these banking activities alongside the traditional banks. This network of nonbank institutions and vehicles is known as shadow banking.
Examples include finance companies that make loans for specific purposes, such as car purchases; money market mutual funds that offer deposit facilities similar to those offered by banks, but with the prospect of higher returns than banks can pay; financial vehicles that are created by banks to issue short-term commercial paper and invest in longer-dated assets while remaining off the balance sheets of the banks themselves; and special purpose vehicles created to securitize assets such as mortgages and sell them to institutional investors.
Shadow banks perform many of the functions of banks but exist outside the regulated banking industry. A report published by the Federal Reserve Bank of New York in 2010 estimated that in March 2008 the size of the shadow banking industry in the United States had reached USD 20 trillion, almost twice the size of the traditional banking industry.
It was often the case that activities were conducted through shadow banks in order to avoid the regulatory scrutiny accorded to banks and to take advantage of lower capital requirements than those imposed on banks.
One of the many causes of the global financial crisis of 2007-2009 was that regulators and bankers did not understand how important these shadow banking institutions had become to the everyday functioning of financial markets. Since the financial crisis, regulators have moved to impose rules and standards on shadow banking activity as well as reporting requirements that enable them to monitor the extent and influence of shadow banking on global financial markets.
The volume of shadow banking activity declined as a result of the global financial crisis. (The Federal Reserve Bank of New York report mentioned above estimated that the size of the market had fallen to about USD 16 trillion by the first quarter of 2010.) Factors contributing to this decline included reduced activity in securitization markets and the winding up of many structured investment vehicles.
Despite increased regulatory scrutiny, shadow banking is here to stay. As a result, those analyzing banks and financial markets must take account of competitive pressures on banks from nonbank financial institutions, and the effect that the behavior of large nonbank financial institutions could have on the health of a financial system as a whole.
EXAMPLE
On September 16, 2008, Reserve Primary Fund, a U.S. money market fund, announced that the net asset value of its shares had fallen below USD 1 per share and that it was therefore not able to repay investors in full if they asked for their money back. This was the first time since 1994 that a money market fund was not in a position to repay depositors in full.
Money market funds had grown rapidly in the United States as an alternative to bank deposits. Money market funds offered customers instant access to their money but paid higher interest than that offered by banks. On the eve of the global financial crisis, the amount of money invested in money market funds in the United States was more than the amount of money placed in commercial bank deposits. Reserve Primary's asset size of USD 125 billion at the end of June 2008 was equal to that of the biggest and best-known U.S. banks.
Coming just one day after Lehman Brothers had filed for bankruptcy, Reserve Primary's announcement that it had “broken the buck” (meaning that it was not able to repay customers a full dollar for every dollar invested) added to the panic that was engulfing U.S. and international financial markets. The effect was not confined to those investors who had placed their money in Reserve Primary and similar institutions. Money market funds had been major buyers of short-term bonds issued by banks and other financial institutions and as such had been important providers of liquidity to the financial system as a whole. As investors withdrew their money, the funds were no longer able to buy new financial instruments and as a result liquidity tightened across the financial system.
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