Financial crises and bank funding: recent experience in the euro area

Financial crises and bank funding: recent experience in the euro area 


by BIS 

Full text


1. Introduction 

Banks fund themselves through a wide range of financial instruments, from both 

retail and wholesale sources. Accounting for most of the former sources are 

customer deposits, predominantly from households. The latter consists broadly of 

funding from private markets, used to supplement customer deposits in financing 

bank operations (IMF (2012)). On the short end, wholesale funding includes 

interbank loans, with a prominent role for short-term US dollar funding and other 

short-term debt, most notably repurchase agreements (repos) and commercial 

paper (CP), as well as certificates of deposit. At longer maturities, banks issue 

medium-term notes (MTNs) and bonds. In addition to deposit and wholesale 

funding, banks can access central bank liquidity and raise capital, much of which 

consists of equity. 

During the past few decades, the composition of bank funding has changed 

significantly owing to various structural developments. First, financial markets and 

banks became strongly interconnected (Borio (2009), Boot and Thakor (2010); CGFS 

(2010c), Song and Thakor (2010)). Banks improved their risk-hedging abilities 

through financial markets and opened new avenues of funding, such as the 

“originate-to-distribute” securitisation model. Second, the rapid growth of 

investment banking activity, both by pure investment banks and universal banks, led 

to a growing reliance on wholesale funding, especially at short maturities (Merck et 

al (2012)). Third, financial globalisation let banks tap funding markets beyond 

national borders, promoting the rapid growth of international interbank US dollar 

markets on which banks from various countries became heavily dependent 

(McGuire and von Peter (2009); Fender and McGuire (2010a and b)). In all of this, 

changes to supervisory and regulatory frameworks often played a crucial role. 

The funding pattern that emerged from these structural changes underwent 

unprecedented dislocations during the 2007–09 global financial crisis. This acted as 

a catalyst for major adjustments in banks’ business and funding models – 

adjustments that, in many cases, were reinforced by the subsequent euro area crisis. 

While the 2007–09 episode was predominantly a banking crisis, the euro area’s 

problems have centred on strongly interconnected sovereign and banking crises. 

This paper investigates the development of bank funding within the euro area 

in the context of these two major crises. Experience over this period shows that, 

when financial markets are severely stressed, even highly rated banks can struggle 

to access wholesale funding markets, including those for secured financing. 

Our analysis points at the following key trends in the main funding segments of 

euro area banks. First, banks reduced their interbank unsecured liabilities and 

securitisations. As a corollary, they relied more on secured sources of financing, in 

particular covered bonds, which have become the main instrument of longer-term 

wholesale funding for the banks of several euro area countries. Second, direct and 

indirect funding support from both governments and the Eurosystem has been 

crucial in stabilising funding conditions during episodes of severe market stress. 

Third, at the height of the crisis, funding markets in the euro area became 

increasingly segmented according to bank nationality, as the access of banks to 

specific funding instruments was no longer determined primarily by their 

standalone credit rating but by their country of origin. Fourth, various institutional 

investors that had become important sources of funding for euro area banks, such 

as US money market funds, sharply reduced their exposure as the crisis deepened. 

Finally, an increasing fraction of bank debt from the most crisis-hit countries has 2 Financial crises and bank funding: recent experience in the euro area

been retained by the issuing banks. In several episodes of extreme market 

turbulence, banks retained most of their bond issuance, as the investment appetite 

of their traditional investor base had faded and the bonds were eligible as collateral 

for ECB liquidity operations. 

The structure of this article is as follows. Section 2 provides a brief overview of 

the interconnection between financial crises and bank funding (2.1) and a 

classification of financial crises (2.2). In addition, it describes how the 2007–09 

global banking crisis affected bank funding structures (2.3) and summarises the 

findings of recent empirical research on this topic (2.4). Section 3 gives background 

information on the euro area financial crisis. Section 4 discusses developments in 

various sources of funding in relation to the crisis, ie customer deposits (4.2), shortterm (4.3) and long-term (4.4) wholesale funding, ECB liquidity (4.5) and bank capital 

(4.6). Section 5 concludes. 

2. Financial crises and bank funding 

2.1. How crises and funding are interconnected 

Financial crises and developments in bank funding are strongly intertwined, as 

weaknesses on the asset side of banks’ balance sheets tend to trigger funding 

problems (Borio (2009)). Ultimately, these strains expose growing problems in the 

quality of the underlying assets, leading to fire sales of assets which accelerate 

declines in asset prices, resulting in further balance sheet pressures. Throughout this 

process, funding liquidity crises can exacerbate solvency concerns. These tensions 

feed on imbalances in bank funding structures, such as excessive recourse to debt 

financing that is reflected in historically high degrees of leverage. As the increase in 

debt often finances expansion into riskier business areas, this spills over into a 

deterioration of the quality of bank assets. If it goes unchecked, the process may lay 

the foundation for future financial crises and severe dislocations in bank funding 

markets. 

Experience shows that many financial crises have been characterised by major 

currency and maturity mismatches between banks’ assets and liabilities, while in 

others a prominent role has also been played by large off-balance sheet exposures 

in the banking sector (Laeven and Valencia (2008); Reinhart and Rogoff (2009); 

Karim et al (2012)). In numerous cases, these mismatches were of systemic 

proportions and helped to propagate shocks across countries, exposing 

shortcomings in existing measures of system-wide funding risk (Fender and 

McGuire (2010b)). 

2.2. A classification of financial crises 

Financial crises may be categorised into banking, currency and sovereign debt 

crises. Recent research showed that, for a large sample of both mature and 

emerging market economies during the 1970–2011 period, currency crises occurred 

most frequently, (218), followed by banking crises (147) and sovereign debt crises 

(66). 

The links between financial crises and bank funding may be strongest during 

banking crises. Such crises tend to arise primarily from deteriorating economic inancial crises and bank funding: recent experience in the euro area 3

fundamentals, notably declines in asset quality (Borio and Lowe (2002, p 44)). 

Banking crises often originate in credit-induced asset price boom-bust cycles, 

during which banks build up large exposures to specific asset classes such as real 

estate or equity. During the bust, plummeting asset prices lead to a sharp rise in 

non-performing loans, thus eroding the banking sector’s financial strength. 

Examples of important banking crises – which are all related to shocks originating 

from the real estate sector – are the Nordic and Japanese crises of the 1990s and 

the 2007–09 global crisis (for the former, see van Rixtel (2002)). 

Banking crises have been amplified by banks’ overreliance on specific sources 

of financing. With the growing diversification and complexity of funding 

instruments, the variety of channels through which these imbalances may develop 

into systemic banking crises has greatly increased. These vulnerabilities relate to the 

composition of funding in terms of type of instrument, maturity and currency. The 

2007–09 global banking crisis showed the shortcomings of business models that 

depended disproportionately on short-term wholesale funding, such as those 

adopted by Northern Rock in the United Kingdom and Bear Stearns and Lehman 

Brothers in the United States. The crisis revealed particularly serious problems with 

funding instruments in the realm of structured finance and the quality of the 

underlying assets, which included asset-backed commercial paper (ABCP) and 

mortgage-backed securities (MBS) (Borio (2008); Criado and van Rixtel (2008); Van 

Rixtel and Criado (2010)). It also helped to trigger a shift towards more stable 

sources of bank funding. 

The overreliance of banks on specific funding sources has also been implicated 

in currency crises – as characterised by large declines in exchange rates and foreign 

reserves. A case in point is the 1997–98 East Asian crisis (World Bank (1998)). This 

episode was precipitated partly by domestic banks’ sudden loss of access to largescale, short-term borrowing in foreign currency that had been insufficiently hedged 

in terms of both maturity transformation and currency risk (Lamfalussy (2000)). The 

resulting banking and currency crises exposed major problems in the banking 

systems of countries hit by exchange rate depreciations. 

The sovereign debt crisis, our third main category of financial crisis, is at the 

centre of our exposition. Since the first quarter of 2010, sovereign debt tensions and 

their spillovers into banks and funding markets have dominated financial and 

economic developments in the euro area. Events have thrown into stark relief the 

strong two-way interaction between government finances and banks (Caruana 

(2011); Caruana and Avdjiev (2012); Caruana and van Rixtel (2012)). Sovereign risk 

may affect bank funding through several channels (CGFS (2011a)). First, many banks 

hold significant amounts of predominantly domestic sovereign bonds on their 

balance sheets and these large exposures may easily lead to valuation losses and 

solvency concerns when sovereign yields rise sharply. Second, sovereign debt serves 

as collateral for various financial transactions, including private repos. Sovereign 

tensions may result in lower collateral values, due to larger haircuts or margin 

requirements, which effectively reduce the ability of banks to obtain funding. Third, 

sovereign downgrades may spill over to banks, affecting both their access to 

funding and its cost, while reducing the funding benefits they derive from implicit 

and explicit government guarantees. 

In the next section we focus in more detail on the 2007–09 global banking 

crisis, and its role as a catalyst for changes in bank funding models (Merck et al 

(2012)). Financial crises and bank funding: recent experience in the euro area

2.3. The 2007–09 global banking crisis and its impact on funding 

During the global banking crisis, banks experienced unprecedented shocks to their 

funding models, in terms of both market access and cost. Large internationally 

active banks had built up considerable maturity and currency mismatches between 

assets and liabilities, exposing them to major vulnerabilities (CGFS (2010a)). In 

particular, investment banking-oriented institutions had significantly leveraged up 

their funding structures (FCIC (2011); Kalemli-Ozcan et al (2012)); mainly through 

short-term wholesale funding from repo and commercial paper (CP) markets. 

Hence, strong growth in total assets was supported by relatively low levels of equity. 

Banks had also resorted to other volatile funding sources on the “originate-todistribute” model, such as direct loans sales and securitisation (Brunnermeier (2009); 

Van Rixtel and Criado (2010)). 

In the summer of 2007, tensions from the US subprime mortgage markets 

spilled over to banks’ short-term wholesale funding markets, causing liquidity 

conditions to deteriorate rapidly, particularly for highly leveraged banks. Contagion 

through the interconnectedness of major global banks and their funding models led 

to sharp and unprecedented increases in interbank spreads (Graph 1, left-hand 

panel). European banks experienced severe difficulties in obtaining US dollar 

liquidity. Moreover, highly leveraged US investment banks were hit by severe 

dislocations in their predominantly short-term debt funding markets (Adrian and 

Shin (2010)). The failures of Bear Stearns and Lehman Brothers in March and 

September 2008 were precipitated when investors lost confidence in their business 

models and the firms were shut out of these markets. These problems were not 

limited to US investment banks, as exemplified by the demise of Northern Rock in 

the United Kingdom with its dependence on short-term wholesale financing (Shin 

(2009)). With solvency concerns on the rise, bank share prices tumbled across the 

globe (Graph 1, right-hand panel).