European banking – a tale of fragmentation, financial repression and deleveraging

There has been so much fuss about the IMF’s analysis of fiscal multipliers one would almost forget there is a chapter 2 as well which has some pretty interesting stuff on European banking. It discusses topics such as debt issuance, deposit flows, bank credit to the private sector, and paints a picture of a banking sector facing fragmentation, financial repression, and deleveraging.

Fragmentation is due to the fact that banks are both fleeing to safe havens and withdrawing to their home countries. As a result the interconnectedness between the banking sectors of different countries and especially between north and south is decreasing. The graph below, showing the deposit flows in selected countries illlustrates this

Financial repression arises if countries more or less force their bank to buy home country sovereign debt. This creates an environment of low interest rates that allows the government to reduce its debt burden more slowly than it would otherwise. The IMF illustrates how Spanish and Italian banks increased their holdings of home country sovereign debt.

Finally, deleveraging. If banks have to increase capital levels, they can do so by stopping dividend payments, issuing capital, or reducing the size of their balance sheet. In times of distress, banks will preferable shrink their balance sheets. Banks have shrunk their balance sheets by roughly 600 billion from the 3rd quarter of 2011 to the 4th quarter of 2013.  In the southern countries this has resulted in a reduction in credit to the private sector, as shown below.


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