Working Paper Series no. 668: A General Equilibrium Appraisal of Capital Shortfall

A fundamental difference in corporate funding between the euro area and the United States is that European firms rely more heavily on bank lending. Of all corporate debt in the euro area, 80% comes from bank lending and 20% from corporate bond markets, almost the inverse of the situation in the United States. In this context, when a global financial crisis occurs, the safeguard of the bank lending channel may lead to potentially high costs for European taxpayers. In a recent comprehensive assessment combining an asset quality review and a stress test on 130 euro-area banks, the European Central Bank (ECB) estimated that in a severely adverse scenario, the lack of capital would be close to 263 billion euros (ECB, 2014). This assessment, which is performed at individual bank level, requires a massive analysis of bank portfolios, including the valuation of loans and collateral items and the review of valuation models. It is therefore very time consuming and has been performed so far on a biannual basis only. It also suffers from two major drawbacks. First, it evaluates the impact of the scenario on individual bank balance sheets, assuming that banks do not react to the scenario (static balance sheet assumption). Second, and more importantly, it does not take the interaction between the banking system and the rest of the economy into account.

The goal of this paper is to estimate the capital shortfall of the banking system in a severe adverse scenario while taking the interactions between the financial and real sectors of the economy into account. For this purpose, we develop and estimate a macro-finance dynamic stochastic general equilibrium (DSGE) model in which we introduce two types of banks: deposit banks, which receive deposits from households and provide (risky) loans to merchant banks; and merchant banks, which use short-term loans from deposit banks to buy long-term claims on producing firms’ assets. This description of the banking system allows us to capture several key stylized facts. In particular, merchant banks borrow from deposit banks by posting collateral assets, generating an amplification phenomenon if the value of the assets fall. In addition, in a crisis, this mechanism can result in an increase in deposit banks’ leverage and a decrease in merchant banks’ leverage, as observed in 2008. In this model, capital shortfall is the additional equity that would be necessary for deposit banks to repay their deposits in bad times. We quantify this measure, which we call the stressed expected loss (SEL), by implementing a counterfactual experiment similar to the adverse scenario assumed by the ECB in its stress test. Furthermore, we investigate the case of a cycle-dependent capital ratio (similar to a countercyclical capital buffer promoted in the Basel III regulatory framework) as a way to mitigate the impact of the crisis on economic growth and bank health.

We obtain three important results. First, our model estimates indicate that most of the variability in the macroeconomic and financial variables at business cycle frequencies is due to the investment shock and risk shock. We therefore define a crisis as an adverse combination of these two shocks. Second, when we simulate a crisis similar to that observed in 2008, we generate a substantial increase in the probability of deposit banks’ default and consequently in their capital shortfall. Our estimate of the SEL is equal to 2.8% of GDP, which corresponds to approximately 250 billion euros (see the table below). We also find that a deposit bank’s total loss of equity in the crisis is equal to 46% of its steady-state equity. This number can be compared to the decrease in the market capitalization of European banks between the end of 2007 and the end of 2008 (approximately 50%). Third, using a standard countercyclical capital ratio that relies on output and credit growth as indicators of the state of the economy allows us to improve welfare at the expense of a more fragile banking system. However, if we consider a capital ratio that combines concern for both output or credit growth and SEL, a positive effect on welfare can be attained while mitigating the excessive risk taking in the banking system.