Tackle the fundamental problems surrounding the banking crisis to avoid worse

14 April 2015

After a credit crisis governments should implement drastic measures in the banking sector. Failure to do so can result in a downward spiral involving weak banks and weak governments, says University of Amsterdam researcher Christiaan van der Kwaak.

Christiaan van der Kwaak is doing his PhD according to the traditional model. Even though it has recently become the standard to research three or four sub-topics, he is researching just one central topic. Originally a physicist, Van der Kwaak is fully focussed on the interaction between banks and governments in times of crisis. 

After having attained his degree in physics in 2012 Van der Kwaak chose to continue research in the field of economics. ‘This is closer to practice and it is more in line with my societal interests’, Van der Kwaak explains. After two years of collaboration with the Tinbergen Institute he started his PhD research at the University of Amsterdam in 2012, under the supervision of professor Sweder van Wijnbergen. 

Van der Kwaak constantly focussed on  unifying theory and practice during his research. The credit crisis erupted in the banking sector in 2008 from where it spread to several European governments. Greece is the most evident example, but governments in Spain, Iceland, Ireland, and Portugal were all severely tested by the consequences of the crisis. 

According to Van der Kwaak European countries have made several mistakes in dealing with these problems. ‘Most European governments offered capital support during the financial crisis to prevent a systemic crisis but they neglected to implement capital requirements that would stabilise banks’ positions.’

Furthermore, Van der Kwaak believes that the stress tests of European Banks in 2011 were not credible. ‘The tests were only partially transparent and made some optimistic assumptions, for example that government loans do not involve risk. Just several days after the test the first bank, Dexia from Belgium, fell.’ 

Downward spiral

In short, Van der Kwaak claims that underfunded banks and a weakly financed government can unnecessarily hold each other down. After initial interventions governments need to force banks to attract more own capital, otherwise these banks will remain weak and according to Van der Kwaak this will result in a downward spiral. ‘A bank that is underfunded cannot permit itself to default bad loans. This leaves few options other than supplying weak debtors with credit. This means that healthy companies will not be helped by banks so weak companies are being kept alive while strong companies have a worse chance of surviving. This negatively affects economic growth.’ 

At the same time weak governments are strongly dependent on banks for the initial capital injections. ‘Governments give out extra government bonds in order to finance their extra support of banks. At the start of the crisis it was especially appealing for banks to buy these bonds. The interest rate that was accrued on these loans was particularly appealing to the Southern European countries and on top of that, these loans did not seize banks’ capital. This is not the case when banks lend money to companies.’ 

At some point at least half of the government bonds that Southern European countries offered were owned by banks from those countries. That leads to a complex interplay if there is no economic recovery. ‘Investors in government bonds remain fearful that governments will have to rescue the banking sector again. This may lead to a further decrease in the price of government bonds and therefore to losses on these bonds that the banks own. This in turn promotes the downward spiral. In practice this has also been observed with huge increases in the interest rate for government bonds of the Southern European countries.’ 

Strong intervention

In the United States things went very differently. In 2009 the American government threatened to introduce severe restrictions on banks that were deemed underfunded by intensive stress tests, or to nationalise these banks if they did not quickly ensure that their buffers were in order. To prevent shareholders and directors from forfeiting their control, the banks swiftly looked to the capital markets. Within half a year almost all banks had brought their buffers to an acceptable level. 

According to Van der Kwaak economic recovery is far slower in countries that have underfunded banks. ‘It is no coincidence that the US is recovering faster than Europe.’ 

Van der Kwaak does see light at the end of the tunnel. ‘The European stress test in 2014 was more thorough and did account for the possibility that government loans may default.’ Also, several banks have started to attract new capital and economic recovery gives banks some extra leeway. ‘The number of loans that are extended is increasing, even if it is only slight.’ 

Van der Kwaak believes that governments should learn from this experience that the banking sector needs to be drastically restructured after a credit crisis. There might even be another crisis, Van der Kwaak believes. ‘The new Basel requirements for banks do increase tenability, but ultimately banks do not need to hold much more than 4% of their own capital relative to their total balance. A small shock would still be enough to cause a bank to fall.’

Bendert Zevenbergen

Published by  Economics and Business