Sovereign Debt Crisis in Europe - Essay Example

? Sovereign Debt Crisis in Europe of the number: Word count: Executive Summary The study will try to shed some light on underlying relationship between sovereign debt crisis and banking crisis. In the first section the essay will discuss briefly about sovereign debt crisis. In the second part, the essay will try to analyze the relationship between sovereign debt default and capital market modelling of banks with the help of research reports of Goldman Sachs Global Economics, Organisation for Economic Co-operation and Development or OECD. Understanding complex economic relationship in layman’s view point will be the crux of this essay. In the third part, the study will analyze proposed solution for resolving sovereign debt crisis in terms of advantages and disadvantages for countries with high credit ratings. In the last section, the essay will summarize the personal view of the researcher on sovereign debt crisis. Table of Contents Table of Contents 3 Introduction 4 Sovereign Debt Crisis 4 Banking System and Sovereign Debt Crisis 5 Analysis of Proposed Solution for Solving Sovereign Debt Crisis 9 Reference 11 Appendices 13 Introduction The essay will try to shed some light on new policies which are being proposed to solve the financial and sovereign debt crisis in Europe. The essay will try to analyze these policies in terms of their capability of resolving sovereign debt crisis. Aim of this report to analyze real underlying problems related to sovereign debt crisis. Organisation for Economic Co-operation and Development (2011) has reported that European banking sector failure and sovereign debt crisis is correlated; hence the study has the scope to analyze issues related to sovereign debt crisis on the ground of banking sector failure in Europe. Sovereign Debt Crisis Research scholars such as Barr (2010) have stated that sovereign debt crisis started during 2009 in Portugal, Ireland, Italy, Greece and Spain or PIIGS economies. Boyes (2009) and Gross (2009) have stated that fiscal deficit of PIIGS economies was increased during 2009 as a result of sovereign debt crisis. Papadimas and Graham (2010) have stated that sovereign debt crisis was triggered due to high borrowing costs for Euro zone countries. Lynn (2010) has defined sovereign debt crisis as financial crisis which created problems for some European countries to re-finance or repay government debt without taking support from third party. Generally, economic performance of European countries is determined by their ability to settle their external debt obligation, level of fiscal deficit of a country is determined by country’s sovereign debt default risk (Pescartori and Sy, 2004). In such situation, if a country fails to repay external borrowings from international market with the help of issuance of bonds then economic growth of that country is bound to get hampered. Banking System and Sovereign Debt Crisis Regulation Economists have stated that European banks underpriced the risks which have contributed significantly to sovereign debt crisis. Risk-weighted asset optimisation of banks nullified the significance of Tier 1 ratio which is amended by Basel rules. Prior to sovereign debt crisis, banks were allowed to use internal derivatives to decrease risk associated with assets but unfortunately majority of European banks failed control leverage risks which was associated with rise of funding problems. In Europe, many of the banks tried to form capital market banking system in order to decrease risk associated with high leverage ratio (Mody (2009); Gerlach et al (2010); Goldman Sachs Global Economics, 2010; and CGFS-BIS,2011). For example, investors went for short and long credit in capital market which increased risk for banks. Lack of efficient regulatory framework not only increased risks for banks but leveraged risk for investors also. Multilayer Relation Mouchakkaa (2012), who is Executive Director of Morgan Stanley Investment Management, has pointed out that “the sovereign debt crisis has significant linkages with serious implications to the European banking sector”. According to the Executive Director of Morgan Stanley Investment Management, many of the European banks invested in government bonds and showed them as assets in the balance sheet. As a result of financial turbulence caused by recession and the government’s weak monetary policies, yields of sovereign bonds increased in the following manner. (Source: Mouchakkaa, 2012) Increase in yield of sovereign bonds has subsequently decreased their value; on the other hand government’s dependency on bank’s exposure to external or sovereign debt had increased the scope for knock-on effect for both the parties. At that time, investors lose their confidence on European Banks due to the fear of sovereign default; as a result, investors withdraw their investment from the European banks which caused squeezing of assets from financial institutions (Bolton and Jeanne, 2011). Credit worthiness of banks was questioned after value of sovereign bonds decreased, as a result financial position of European banks deteriorated. Relationship between sovereign debt crisis and banking crisis can be depicted in the following manner. (Source: Mouchakkaa, 2012) According to Acharya et al (2010) and Allen et al (2011), liabilities of European banks are represented by deposits received from customers and loans received from other financial institutions, additionally equity investors also provide capital to banks through institutional funds. Hence, banks have the capability to leverage total equity with the help of these additional capitals (CGFS-BIS, 2011). International Monetary Fund (2011) has shown in global financial report that leverage ratio in Euro zone banks is almost 26 times higher than banks of other region, which means that Euro zone banks were lending by €26 for earning €1 of equity. Relying on government loan was a blunder for Euro zone banks because government loan is different from commercial loan or personal loan due to the fact that concept of recourse or collateral cannot be applied to government loans. Euro zone banks given loan to governments on the basis of faith and sovereignty. It has been already mentioned that decrease in value of sovereign bond had increased concern among investors regarding risk of solvency of banks and Wall Street Journal (2011) has reported that withdrawal of money by investors caused shutting down of many banks in Euro zone. For example, Northern Rock, which is a British bank, faced similar kind of threat in 2008. Due to “interconnectivity effect” poor performance of one bank created panic among other Euro zone banks, hence equilibrium of the banking system got perturbed. In such situation, banks required new capital in order to maintain its existence and unfortunately sovereignty could not provide additional capital to banks due to its weak financial position. Hence it is evident from the discussion that banking crisis in Euro zone and sovereign debt crisis were strongly related. Analysis of Proposed Solution for Solving Sovereign Debt Crisis Policy Advantages Disadvantages Designing fiscal compact rules in order to decrease future debt burden of Euro zone. Improvement of Euro credibility. Financial problem for banks might multiply. Richer countries should increase fund periphery by transferring funds to poorer country. Improvement of Euro viability. Difficulties regarding adjustment of politically wrong incentives may arise. Governments should issue Euro bonds. Decrease costs of countries with lower rating. Increase costs of countries with higher rating. Conclusion Following points should be drawn with the help of above discussion. Banking crisis in Euro zone and sovereign debt crisis are interlinked and these factors synergistically affected other factor. Sovereign debt crisis has not only decreased financial growth of banks but also decreased scope for them to achieve resource based competitive advantage (Dierickx & Cool, 1989; and Barney, 1986, 1991). Capital speculation played vital role in genesis of banking crisis of Euro zone. Proposed solutions for solving sovereign debt crisis require modification in order to meet the demand of countries with higher credit rating. Reference Acharya, V., Drechsler, I. and Schnabl, P., 2010. A pyrrhic victory? Bank bailouts and sovereign credit. Working Paper No. 17136, National Bureau of Economic Research, Cambridge, MA. Allen, F., Beck, T., Carletti, E., Lane, P., Schoenmaker, D. and Wagner, W., 2011. Cross-border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies. London: Centre for Economic Policy Research. Barney, J. B., 1986. Strategic factor markets: Expectations, luck, and business strategy. Management Science 32 pp. 1231-1241. Barney, J. B., 1991. Firm resources and sustained competitive advantage. Journal of Management 17 (1) pp. 99-120. Barr, C., 2010. Europe’s PIGS don’t fly. [Online] Available at: [Accessed 11 February 2013]. Bolton, P. and Jeanne, O., 2011. Sovereign default risk and bank fragility in financially integrated economies. Working Paper No. 16899, National Bureau of Economic Research, Cambridge, MA. Boyes, R., 2009. Meltdown Iceland: Lessons on the World Financial Crisis: From a Small Bankrupt Nation. London: Bloomsburg. CGFS-BIS., 2011. The impact of sovereign credit risk on bank funding conditions. Committee on the Global Financial System, 43, Bank for International Settlements, Basel. Dierickx, I. and Cool, K., 1989. Asset stock accumulation and sustainability of competitive advantage. Management Science 35(12) pp. 1504-1511. Gerlach, S., Schulz, A. and Wolff, G.B., 2010. Banking and sovereign risk in the euro area. [Online] Available at: [Accessed 12 February 2013]. Goldman Sachs Global Economics., 2010.Rising funding costs in the periphery. European Weekly Analyst Research Report, 10(13), pp. 1-21. Gross, D., 2009. Dubai World is a symptom of the problem. [Online] Available at: [Accessed 11 February 2013]. International Monetary Fund., 2011. Slowing Growth, Rising Risks. [pdf] Available at: [Accessed 12 February 2013]. Lynn, M., 2010. Bust: Greece, the Euro and the Sovereign Debt Crisis. Hoboken, New Jersey: John Wiley & Sons. Mody, A., 2009. From Bear Stearns to Anglo Irish: how eurozone sovereign spreads related to financial sector vulnerability. Working Paper No. 10, International Monetary Fund, Washington, DC. Mouchakkaa, P., 2012. Synchronicity III? The European Sovereign Debt Crisis and Implications for Commercial Real Estate Investing. [pdf] Available at: [Accessed 12 February 2013]. Organisation for Economic Co-operation and Development., 2011. Solving the Financial and Sovereign Debt Crisis in Europe. [pdf] Available at: [Accessed 11 February 2013]. Papadimas, L. and Graham, D., 2010 S&P cuts Greek debt to junk, downgrades Portugal. [Online] Available at: [Accessed 11 February 2013]. Pescartori, A. and Sy, N. R., 2004. Debt crises and the development of international capital Markets. IMF Working Paper No. 04/44, IMF, Washington, DC (March). Wall Street Journal., 2011. Raters fail to see defaults coming: History shows firms rarely anticipate sovereign failures. [Online] Available at: [Accessed 12 February 2013]. Appendices Bank Leverage Ratio in Various Countries (Source: Mouchakkaa, 2012) Debt-to-GDP Ratio in Euro zone during 2007-2011 (Source: Mouchakkaa, 2012) Read More