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Untangling the Banking Web: The US & EU banking system

HDFC Bank, March 2023

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Key Highlights

 Structure of the EU and US banking system: Federal Reserve closely monitors the large banks, the level of central supervision
diminishes with the size of the banks. In the Euro Area, the ECB supervises significant banks directly and less significant banks
through national entities

 Where and What are “significant banks” in the EU? Significant banks are defined by the banks’ asset size, economic importance,
funding and cross border activities. The EU has 111 significant banks, with majority of these present in Germany. Non-significant
banks constitute ~18% of EU’s banking sector assets.

 The interlinkages and risk of contagion for EU banks: The level of interconnectedness within EU banks is relatively low and
markets are segmented in the euro area. Euro area banks appear to have few but sizeable exposures towards Chinese banks, many
but relatively small exposures to Swiss banks, and many and sizeable exposures to US and UK banks (ECB).

 Trouble with financial instruments (AT1 & CoCo bonds) – Going out of style? The loss of confidence in these instruments after
the UBS-Credit Suisse takeover raises the possibility that the AT1 and CoCo bond market might find it difficult to recover in the
future.

 Learnings from the savings and loans crisis (co-operative organisations) in the US in the late 1980s

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US Banking Regulations: A complex structure

• US has a complex banking system with several agencies monitoring/regulating the sector.

• While the Federal Reserve closely monitors the large banks, the level of central supervision diminishes with the size of the banks.

• In 2018, US authorities redefined asset threshold of “systemically important” banks to USD 250 bn from USD 50 Bn. The Fed also exempted
banks with USD 100-250 Bn in assets from maintaining a standardized LCR (Liquidity Coverage Ratio).

The Office of the The Federal Deposit

Federal Reserve Comptroller of the Insurance Corporation State banking agencies
Currency (OCC) (FDIC)

Regulates state- Supervises National Supervises state-

chartered member
banks, savings chartered banks that Regulates state banks
banks; foreign banking
associations & federal are not a member of & foreign banks
offices; banks that
engages in foreign branches of foreign the Federal Reserve located in a state
banking operations banks System

Source: Media Articles, HDFC Bank

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Troubled US banks

Bank Asset Size Date of collapse

(in USD, bn)
Silver gate bank 11.35 8th March
Silicon valley bank 194.5 10th March
(SVB)
Signature Bank 110.4 12th March

First Republic Bank 212.64 -

Policy Response

• US authorities safeguarded all depositors of SVB and Signature bank (not bound to the FDIC limit of USD 250K)

• The Fed launched a new program called “bank term Funding Program” to provide liquidity support to troubled banks.

• 11 US banks, including JP Morgan Chase, BoFA, Citi injected USD 30 Bn in First Republic Bank

• BoC (Bank of Canada), BoE, BoJ, ECB, Fed and Swiss National Bank announced coordinated action to enhance liquidity provisions via
standing US dollar liquidity swap line agreements.

Source: Fed, Media Articles, HDFC Bank

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How banks are regulated in the Euro Area?

The ECB supervises significant banks directly and less significant What are Significant Banks?
banks through national entities
A bank can be considered significant if it meets any 1 of the following
criteria (outlined by the ECB)
European Central
Bank (ECB)
Asset Size: >EUR 30 billion

Economic importance: to the EU/member country

Indirect Supervision via
Direct Supervision
National entities
Cross border activities: Asset size EUR 5 bn+;
Ratio of cross-border assets/liabilities to total
assets/liabilities is above 20% in more than one
participating member state.

Regional Banks/Small Direct public funding

Significant Banks Banks/Other Banks (Less
via European Stability Mechanism or European Financial
Significant banks)
Stability Facility.

Source: ECB, HDFC Bank

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Euro Area: Significant vs Less Significant banks

The EU has 111 significant banks, with majority of them present

in Germany
Some examples of significant and less significant banks in Europe

Significant Banks Less Significant Banks

Germany DZ Bank, Deutsche Bank, BMW Bank GmbH,
Commerz Bank, Dekabank KfW Betelligungs holding

Italy Unicredit, Mediocredito Centrale - Banca Del

Intesa Sanpaolo, Mediobanca Mezzogiorno,
Brianza Unione di Luigi Gavazzi e
Stefano Lado
France Societe General, BNP AXA Banque,
Paribas, Credit Agricole Financiere IDAT

Netherlands ING, Rabobank, ABN Amro Credit Europe Bank, Demir Halk
Bank Bank
Austria Erste Group, Raiffeisen Oberbank,
Non-Significant Banks Bank, BAWAG Group Hypo Vorarlberg Bank

• Constitutes ~18% of EU’s banking sector assets (Source: ECB) Portugal Caixa Geral de Depósitos, Caixa Económica Montepio Geral
Banco Commercial (Banco Montepio),
• EU has ~2400 small and medium sized banks, with ~53% in Germany, Português, Banco Bic Portugues
~16% in Austria. Italy, France & Portugal are other countries with high
number of such banks.

Source: ECB, HDFC Bank

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Health of the European Banking system

European banks have sufficient liquidity, primarily in cash and reserves

Liquidity coverage ratios as of September 2022

Source: ECB, S&P Ratings, HDFC Bank

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Is the “credit risk” overdone?

• In the aftermath of Great Financial crisis (2008-09), Sovereign Debt Crisis (2010-15), European authorities tightened banking rules to safeguard the banking sector.

• Unlike the US (where some regulations were relaxed in 2018), European authorities did not relax its banking regulations

• Bailouts in EU: Two Italian banks and one Spanish bank were rescued in 2017.

Credit default swaps fell after UBS-CS deal and stayed below pandemic-peak

Note: ITAXX index represents average CDS premium of underlying firms.

Source: Reuters, Media Articles, HDFC Bank

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The interlinkages and risk of contagion in the European banking system

How to read this chart? Shows interconnectedness of EU banks within euro area and the World. Size of bubbles shows how big is the
connectedness of a bank (in size and number of linkages), thickness of lines shows the amount of exposure in EUR bn (or % of capital),
colour shows the country colour which is borrowing. Example, red lines are linkages of EU banks with China – there are few lines but
are thick meaning EU banks have few but sizeable exposures to China compared to Switzerland (purple lines) that has many but smaller
exposures (thinner lines).
From the large exposure data in the Eurozone (ECB study,
2019*)

• A few banks play a central role in the EU banking system

• The level of interconnectedness is relatively low and

markets are segmented in the euro area

• Euro area banks appear to have few exposures but sizeable

towards Chinese banks (see red lines in the figure that are
few but thicker), many but relatively small exposures to
Swiss banks (purple line that are thinner), and many and
sizeable exposures to US (blue line) and UK banks (green
lines).

• Euro area medium and large-sized banks tend to lend

more to international banks than small domestic banks,
which by comparison tend to lend more to banks within
the euro area.

Note: EA-Euro Area, US=United States, UK=United Kingdom, CN=China, CH=Switzerland, SE=Sweden, No=Norway, DK=Denmark, BR=Brazil, IN=India, RU=Russia, JP=Japan, TR=Turkey, ROW= Rest of the world
Source: *CoMap: Mapping contagion in the euro area banking sector, working paper series, January 2019, ECB; Economic shocks and contagion in the euro area banking sector: A micro-structural
approach, ECB, part of Financial Stability Review May 2019

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Trouble with financial instruments (AT1 bonds and CoCo bonds)…

What are AT1 (Additional Tier 1) bonds?

• AT1 bonds and CoCo bonds (Contingent Convertible Why the worry now?
bonds) were introduced post the 2008 financial crisis as a
way to transfer banking risk away from taxpayers to bond • The Swiss regulator has written off 100% value of the AT1 bonds
holders. CoCo bonds are kind of AT1 bonds that have the of Credit Suisse valued at $17bn leading to concerns in the
option of being converted to equity contingent on some AT1/convertible bond market.
trigger events.
• However, to calm markets, EU regulators confirmed that unlike
• Loss-absorbing mechanism: During any trigger events the Credit Suisse case, they would impose losses on
(capital ratios fall below a certain level or if the bank shareholders before bondholders in crisis interventions as
becomes unviable) these bonds start absorbing losses and followed in the past.
can be converted to equity in case of Coco bonds or be
written off in case of AT1 bonds. These bonds are • In the past, RBI has written off Yes Bank’s AT1 bonds to bail out
perpetual instruments. the bank.

• The AT1 bonds form part of the Additional Tier 1 capital

of banks under the Basel III norms.

Source: Media Articles, HDFC Bank

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….starting with the Credit Suisse take-over and spreading through the system

The write down of Credit Suisse AT1 bonds to zero is being viewed negatively globally,
causing a fall in the AT1 bond market

• Size of the AT1 bond market -- $250bn globally

• This is estimated to include $100bn in the dollar market

and $70 bn in the euro market.

• The size of this market is small in comparison to the

total market of investment grade bonds ($10 trillion in
the US and EU combined) and a contagion to the
broader market therefore might be limited.

• However, the loss of confidence in these instruments

raises the possibility that the AT1 and CoCo bond
market might find it difficult to recover in the future.

Source: Reuters, Media Articles, HDFC Bank

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Case Study: High inflation and interest rate ‘triggered’ the savings and loan crisis in the US

S&L or ‘Thrifts’ were not for profit co-operative organizations in the US. These relied on deposits with short maturities from members and they primarily made
longer-term fixed-rate mortgages.

There were two broad reasons for the S&L crisis:

June, 1981
1. Asset Liability Mismatch: High inflation and higher interest rate in 1970s and
early 1980s led to asset liability mismatch for thrifts:
 The interest on deposit was capped by federal government, (much below being
April, 1980
offered elsewhere) leading to withdrawal of deposits from thrifts.
 With increasing interest rates, S&L mortgages lost considerable value, wiping
out S&L industry’s net worth.

2. Forbearance and Moral Hazard: In response, the government deregulated the

industry. This allowed insolvent thrifts (‘zombies”) to remain open and make new
and riskier loans with reduced regulatory oversight.
 ‘Zombie’ thrifts began paying higher interest rates to attract funds and invested
in even riskier assets for higher returns.
 If they failed, taxpayers would have to foot the bill as they were already
insolvent and thrifts’ insurance fund (FSLIC) lacked resources to cover losses.

Source: St. Louis Fed, Federal Reserve, FDIC, HDFC Bank

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S&L crisis downsized the ‘thrift’ market along with considerable ‘taxpayer cost’

 By 1980, there were 4,000 thrifts, with total assets worth $600 billion: Comprising of $480 billion in mortgage loans, 50 percent of total home mortgages at the time
 Between 1982 – 1985 industry assets growth was more than double that of banks. Deregulation, poor regulatory oversight and zombie thrifts, all contributing to this
growth. This eventually became unsustainable.

Impact Resolution
 In 1986, FSLIC - thrift's’ insurance fund, went insolvent.  1987: FICO (Financing Corporation) created to fund FSLIC by issuing
long-term bonds
 A long-drawn crisis: Between 1986 – 1995, 1043 institutions with $519
billion in assets were closed.  1989: FIRREA (Financial Institution Reform, Recovery and Enforcement
Act) was enacted beginning taxpayers' involvement in resolution of the
 296 thrifts with $125 billion in assets resolved by FSLIC1
problem.
between 1986-1989 .
 Series of measures including creation of FSLIC Resolution Fund
 747 thrifts with $394 billion in assets resolved by RTC2 between
(FRF), Savings Association Insurance Fund (SAIF), and RTC to
1989-1995.
resolve all troubled thrifts
 Taxpayer cost: Estimated at $124 billion
 RTC eventually closed in 1995 culminating the resolution process
 Decline in numbers: 1,645 thrifts left by 1995, compared to 4,000 in 1980

Source: Federal Reserve, FDIC, HDFC Bank

1: Federal Savings and Loan Insurance Corporation, 2: Resolution Trust Corporation

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Treasury Economics Research Team

Abheek Barua Chief Economist abheek.barua@hdfcbank.com +91 (0) 124-4664305

Sakshi Gupta Principal Economist sakshi.gupta3@hdfcbank.com +91 (0) 124-4664338
Mayank Jha Senior Economist mayank.jha1@hdfcbank.com +91 (0) 124-4664354
Avni Jain Economist avni.jain@hdfcbank.com +91 (0) 124-4664354
Swati Arora Economist Swati.arora1@hdfcbank.com +91 (0) 124-4664354

Disclaimer: This document has been prepared for your information only and does not constitute any offer/commitment to transact. Such an offer would
be subject to contractual confirmations, satisfactory documentation and prevailing market conditions. Reasonable care has been taken to prepare this
document. HDFC Bank and its employees do not accept any responsibility for action taken on the basis of this document.

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