To What Extent Did Government Bailouts Distort Competition in the European Banking Sector Following the Recent Financial

Crisis?

By

H.P. Green

2013-14

Abstract

The financial crisis of 2008 proved to be an extremely turbulent period for the European banking sector. Greater connectivity with the global banking community resulted in many European banks incurring substantial losses. EU member states provided vast quantities of state aid in order to prevent a wider financial meltdown. This paper sets out to explore whether government bailouts, granted for many of Europe’s largest banks, had the effect of distorting competition in the European banking sector. The paper finds overwhelming evidence to suggest that many of Europe’s largest banks deemed ‘too big to fail’, have enjoyed significant cost of funding advantages as a result of government bailouts. A relaxation of EU state aid rules during the crisis was also found to be a contributing factor.

An Advanced Economics Dissertation (309ECN) presented in part consideration for the degree of BA (Financial Economics), Coventry University

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Acknowledgements

The author wishes to acknowledge Michael Walsh for his continual support and

guidance as a dissertation supervisor. Thanks also go to Paul Gower, lecturer in

Economics of Banking and Finance, for his valuable comments and feedback

throughout the project. Any errors or omissions remain the author’s responsibility.

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Table of ContentsPage

Glossary 4

Chapter 1 – Introduction 5-7

Chapter 2 – Methodology 8-9

2.1 Key Assumptions and Limitations 8-9

Chapter 3 - Literature Review 10-17

3.1 What Were Government Bailouts Trying to Prevent? 10-113.2 What Methods of Intervention Were Used? 11-133.3 Can Government Bailouts Distort Competition in the Banking Sector? 13-17

Chapter 4 - Theoretical Framework 18-27

4.1 BE COMP Theoretical Framework 18-204.2 BE COMP – No Collusion 20-224.3 State Aid to All Firms 22-234.4 State Aid to Some Firms 23-244.5 EU State Aid and Competition Policy 24-254.6 An Assessment of Temporary State Aid Rules 25-27

Chapter 5 - Analysis of Funding Advantage Models 28-33

5.1 Background of the Size and Ratings Based Approaches 285.2 Review of Testing Literature 29-33

Chapter 6 - Conclusion 34-35

References 36-41

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Glossary

AC – Average Cost

BE-COMP – Break Even – Competition

BFS – Moody’s Bank Financial Strength

ECB – European Central Bank

EU – European Union

LTD – Moody’s Long Term Deposit

MC – Marginal Cost

NAMA – National Asset Management Agency

TBTF – Too Big To Fail

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1. Introduction

The recent global financial crisis, including the sovereign debt crisis in the Eurozone,

has had adverse effects on regions of the European banking sector. Countries from

across the Eurozone area such as Spain, Ireland and Denmark have injected billions of

Euros into many of their distressed banks in order to prevent large bank failures and

the consequence of widespread contagion effects. The unprecedented number of bank

bailouts as a result of increased interconnectedness among Eurozone banks, along

with the exposure these banks have had to new and complex derivative products and

trading methods, has meant that the sector has become highly fragile. Figure 1

illustrates the vast quantities of financial crisis aid approved for various EU countries

between 2008 and 2012. The chart illustrates that Denmark, Germany, Spain, Ireland

and France were granted the greatest amount of state aid over the four year period.

During the financial crisis, tax payers across Europe and in the UK were required to

shoulder the majority of the burden in terms of financing government guarantees for

banks. As a result, this became an implicit government guarantee for banks. This

highlighted the moral hazard issue in which banks who had previously taken on too

much risk were rewarded for failure at the expense of taxpayers and other banks in

the sector.

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Figure 1: Approved State Aid in the EU

Greece

Sweden

Belgium

Ireland

Denmark

United Kingdom

0.00 100.00 200.00 300.00 400.00 500.00 600.00 700.00 800.00 900.00

State Aid - Approved between 2008-2012 (€ Billion)

Source: European Commission, 2012 ‘State aid approved (2008 – Oct 2012) and state aid used

(2008 – 2011) in the context of the financial and economic crisis to the financial sector (2008 -

2011), in billion Euro’ [Accessed 10th March 2014]

This paper will aim to investigate the various methods of government bailout used for

banks across Europe during the recent financial crisis. Secondly, it will examine the

reasons behind their use in addition to what they were trying to prevent. Thirdly, this

project will provide an overview of European Integration and State Aid theory, focusing

specifically on the ‘Break Even-Competition’ (BE-COMP) framework. The EU’s state aid

rules included in the Treaty of Rome will be discussed along with temporary rules

adopted during the crisis. These are a highly important part of the EU’s legal

framework for controlling the competition of sectors in the event of government

bailouts. Provisions are included in this framework, allowing the DG competition

commission to prevent or attach conditions to state aid. However, due to the growing

complexity of the banking sector during the recent crisis, the effectiveness of these

conditions has recently been questioned. Therefore, an assessment of these rules and

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the temporary framework adopted during the crisis will be carried out in order identify

if they were effective in preventing any distortions to competition. Finally, the

literature review and analysis section on Funding Advantage Models will assess to

what extent the approval of state aid has caused a distortion in competition for

European banks.

This paper will establish whether or not banks who were granted state aid during the

crisis gained a competitive advantage in the form of reduced funding costs. This will be

carried out by firstly assessing the relevant academic literature in order to establish

whether a general consensus can be reached. Secondly, previous ‘Funding Advantage

model’ testing will be examined with the aim of analysing whether large banks deemed

as being ‘too big to fail’ and who were granted government support, benefited in the

form of lower funding costs.

The paper will proceed as follows: Chapter 2 will outline the methodology including

key assumptions and limitations. Chapter 3 discuss relevant literature on state aid

measures and distortions to competition. Chapter 4 will analyse the EU integration

theoretical framework. Chapter 5 will examine previous Funding Advantage model

testing and, finally, Chapter 6 will present concluding remarks.

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2. Methodology

Secondary research in the form of journals and articles relating to bank bailouts and

the distortions these can have on competition will be used; for example, Beck (2010)

from the Centre for Economic Policy Research. Textbook and journal based

information will also be used to provide an overview of European Integration theory in

addition to the EU’s legal framework for state aid and competition policy. Secondary

data from the European Commission – DG Competition database will be obtained in

order to illustrate the total amount of state aid approved for various EU member

states.

Funding Advantage Models including the ‘Size-based’ and ‘Ratings-based’ approach,

used by (Sowerbutts, 2012) and (Kloeck, 2013), will be examined in order to compare

the ‘stand-alone’ and ‘support’ credit ratings for banks that have received government

bailouts in order to establish whether the support credit ratings for these banks are

higher compared to the stand-alone ratings. A higher ‘support’ credit rating would

indicate that a bank has gained a competitive advantage in the form of lower costs of

funding as a result of a bailout.

2.1 Key Assumptions and Limitations

A key assumption for this project is that the credit ratings data within the Funding

Advantage Model literature and empirical analysis found is accurate, reliable and not

bias. Additionally, this project assumes that bank bailouts will continue to be required

and provided in future financial crisis.

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A significant limitation to this project is that literature on the distortive effects of state

aid in the recent financial crisis as well as the Funding Advantage Model testing is still

at an early stage of development. Consequently, there could be a limit as to how much

information is readily available. A further limitation is that the BE-COMP theoretical

model that has been analysed is relatively basic. It provides a simplistic representation

for the effects of European integration on firms. However, it assumes only two

identical countries are involved. Finally, due to time constraints and the complexity of

econometrics used in previous Funding Advantage literature, new testing was not an

option in this instance.

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3. Review of Literature

The recent financial crisis has shown that insufficient regulation and the

mismanagement of banks can have severe repercussions for the banking sector in the

form of financial instability, loan freeze problems and zombie lending. This literature

review will explore the issues behind what government bailouts aim to prevent and

why they are required. Additionally, methods of government intervention used by

various EU member states during the recent financial crisis will be discussed. Finally,

the effects on the competition of the banking sector as a result of government

intervention will be examined.

3.1 What Were Government Bailouts Trying to Prevent?

Financial instability refers to systemic risk caused by the failure of a single bank or

number of banks. In turn this can affect the banks daily functions, for example,

managing liquidity risk. The likelihood of severe financial instability is low; however,

the consequences of a complete suspension in banking activities might be so great that

governments intervene in order to mitigate this. The loan freeze problem occurs when

banks are unable to carry out basic functions of intermediation, essential for the wider

economy. This problem can arise due to a collateral squeeze, a savings squeeze and a

credit crunch (whereby banks hold insufficient levels of capital). A bank’s inability to

provide capital to firms outside of the sector can be damaging for the wider economy.

(Beck, 2010) Zombie lending arises when banks continue lending money to borrowers

to make debt service repayments, regardless of the creditworthiness of that borrower.

This can result in the bankruptcy of the bank and borrower as the bank is able to avoid

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writing down their loans. Mitchell (2001) found that there is a high inclination for

banks to avoid restructuring loans when faced with strict regulation.

The severity of these problems means that the state is compelled to intervene in order

to prevent contagion effects; but more specifically to protect the banks depositors and

avoid large bank runs. Governments may also attempt to reduce moral hazard. If a

bank anticipates bankruptcy and a heavy loss in equity capital they are more likely to

remain risk prudent. However, if the banks risks are shifted towards the taxpayer as a

result of bailouts this might incentivise the bank to increase risk taking, raising the

likelihood of financial instability. In order for an intervention to be successful, banks

losses should be imposed on the shareholders and creditors of the bank rather than

taxpayers. (Beck, 2010)

3.2 What Methods of Intervention Were Used?

The main intervention method used by EU member states during the recent crisis was

guarantees for bank liabilities aimed at the entire banking system. From 2008-2012,

the European commission granted €3,646 billion for guarantees, equivalent to 29% of

EU GDP. (European commission, 2012) In 2008, Ireland extended their deposit

guarantee scheme for 2 years to cover individual deposits entirely, bound by a

€100,000 limit. This was applied to the Anglo Irish bank, Bank of Ireland and Allied Irish

Bank. (Kelly, 2009) Furthermore, due to difficulties faced by the Dexia Group,

guarantees were provided by the Dutch government for the provision of new bank

borrowing.

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Government capital injections were also provided to European banks in return for

direct equity in order to strengthen a bank’s capital base. From 2008-2012,

approximately €780 billion (6% of EU GDP) was granted for recapitalizations schemes.

The largest budget was granted to Ireland, amounting to 58% of their GDP. (Kelly,

2009) A €7 billion recapitalization scheme was then approved in February 2009 for

Allied Irish Bank and the Bank of Ireland in exchange for preferred shares. Beck (2010)

argues that an injection clarifies that the initial beneficiaries are the banks

shareholders and taxpayers would bear the costs. If the bank is able to resume its daily

functions, shareholders would benefit at the expense of taxpayers. The purchase of

HBOS by Lloyds TSB has further highlighted transparency issues with regards to

recapitalization. The first issue is morale hazard, whereby shareholders of bailed out

banks might increase risk-taking if they know their losses will be covered. The second

issue is that the level of recapitalisation may be inadequate. If banks are holding more

risky assets than originally declared, this might incentivise them in the future to try and

obtain additional recapitalisations in order to better protect shareholders. It is

important to note, however, that following recapitalization, a bank will be able to issue

debt. Therefore, the banks cost of capital can become distorted as a result. (Sutton,

2010)

The creation of a ‘Bad Bank’ can also be used in order to absorb banks losses. Banks

are relieved of bad assets in order for them to increase liquidity and improve their

balance sheets. In this situation, bad banks would not be required to repay creditors

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until their asset position had improved. The Irish government created a National Asset

Management Agency (NAMA) in 2009. This was set up to purchase non-performing

bank assets. (Goddard, 2009) There are, however, competition policy issues with this

relating to distortions that arise when defining the new value of the bad assets on the

balance sheet.

Finally, a government can nationalise a bank by ‘taking over’ a large majority of its

assets and managing it as a commercial entity. The bank would then be sold back to

the private sector after becoming stable. Due to the concealment of loans, Anglo Irish

bank was nationalized in January 2009 in an attempt to prevent severe runs on the

bank. Lastra (2008) argues that nationalisation can help address morale hazard as it

does not involve state ‘funded’ aid. Therefore, unsecured debt holders lose out and

market discipline is imposed on the bank, resolving the ‘too big to fail’ problem.

Conversely, the paper also argues that by the time Northern Rock was nationalized it

had become too complex for the state to manage and had gained a competitive

advantage from the ability to offer cheaper mortgages compared to its competitors

who received less support.

3.3 Can Government Bailouts Distort Competition in the Banking Sector?

The issues explored above show how a bank failure can have severe consequences for

the stability of other banks through contagion effects. It could therefore be argued

that state aid for insolvent banks can have positive impacts for competitor banks by

reducing systemic risk. Alas, it can also negatively affect competition in banking by

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reducing the marginal costs of banking activities in addition to promoting risk taking.

(Szczepanski, 2013) According to EU law, conditions can be attached to state aid in

order to prevent distortions to competition. Nevertheless, the increasing complexity of

financial markets can somewhat jeopardise the effectiveness of these conditions.

(Kapsis, 2012)

Market expectation of future bailouts, combined with the fact that the government

will feel compelled to intervene if the bank is ‘too big to fail’, should cause a reduction

in marginal costs. Overall, the bailed out bank gains a competitive advantage provided

that bailouts of this magnitude are not granted for its competitors. Sowerbutts (2012)

and Kloeck (2014) support this view and imply that banks holding government

guarantees can grow further to the detriment of other banks without support. If there

is an expectation from the creditors of banks that state aid will be provided in order to

prevent the bank from failing; this can lower the banks cost of capital by reducing the

compensation they request for taking on the risks of the bank. Kapsis (2012) justifies

this assumption with the premise that state aid enables inefficient banks to remain in

the market whom, without aid, would have otherwise been forced out. Bailed out

banks can then apply unfair competitive pressure towards other banks who were more

disciplined in their risk taking prior to the crisis.

Loan guarantees can also create competitive distortions in lending markets by

influencing the level of risk taking. (Kloeck, 2014) Implicit guarantees can incentivise

banks to increase risk taking and threaten market discipline as depositors are unaware

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of the price of risks that banks are taking on. A vicious cycle can develop whereby the

expectation of a government guarantee can incentivise banks to increase risk taking,

amplifying the chance of bank failure and the associated consequences, hence raising

the subsidy level further. (Anginer, 2011) Overall, it is clear that banks who acquire

guarantees from the state gain a competitive advantage over their competitors who do

not receive them. This can induce greater risk taking (Acharya, 2012) and amplify the

problems of moral hazard. (Hakenes, 2010)

During the recent crisis a number of bank mergers also took place, notably Lloyds TSB’s

acquisition of HBOS. Smith and OFT (2008) carried out an assessment of the effects

that this merger could have on bank competition. It was agreed that there would be

more incentives to risk take if a failing bank is merged with a more stable bank. This is

consistent with the views of (Kloeck, 2014), (Perotti, 2002), and (Miera, 2008).

Furthermore, Perotti (2002) and Miera (2008) came to the conclusion that it was

unlikely that a merger, i.e. an increase in the size of the bank, would result in better

overall risk prudence.

The studies mentioned above point towards a fall in bank competition as a result of

government bailouts. However, Calderon (2013) contradicts this to some extent. This

study uses a data sample containing 41 banking crisis (including 29 systemic crisis) for

124 countries from 1996-2010. Empirical tests carried out by this study found that

competition rose in countries such as Thailand and Haiti following recapitalisation and

liquidity support schemes due to falls in the Lerner Index. However, this was not the

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case for other countries such as Germany. This indicates that market structure before

intervention could alter the competition effects of intervention either way. Calderon

(2013) therefore explores whether competition after the bailout depends on market

structure and contestability prior to the announcement of the intervention. It was

found that if the banking sector was highly concentrated with high barriers to entry

(i.e. minimum capital requirements) prior to intervention, the result would be an

increase in competition reflected by lower Lerner indices. In more concentrated and

less contestable markets, the competition increasing effect from nationalizations and

recapitalizations were found to be greater. The influence of foreign bank entry is also

explored and in countries with a greater presence of foreign banks, such as Ireland,

reductions in competition as a result of intervention are less owing to the fact that

these banks are not intervened.

Calderon (2013) also examines the correlation between government interventions and

the emergence of ‘zombie’ banks. It finds a positive correlation between the existence

of zombie banks and their market share and recapitalisation and liquidity support

interventions. Statistical results suggest that in the first year after the announcement

of intervention, the number of zombie banks increased. Provided they could continue

to avoid writing down their loans, their market share also increased. Finally, it was

found that the market share for zombie banks in the second and third year after

intervention rose in the case of recapitalisations and liquidity support schemes.

Overall, these results suggest that the competition increasing effects were greater due

to the emergence of more zombie banks.

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There seems to be a clear consensus from the reviewed literature that competition in

banking can fall, as a result of government interventions, as banks are able to reduce

the marginal costs of their banking activities relative to their competitors.

Furthermore, it is evident that this competitive advantage is made more extreme if the

competitors of the bailed out bank do not receive the same level of intervention.

Conversely, Calderon (2013) suggests that in some instances bank competition can

increase as a result of liquidity support and recapitalisation schemes. Although, this

depends on the market structure and contestability of the banking sector prior to the

announcement of intervention. It is important to note, however, that the data sample

used by Calderon (2013) includes emerging markets unlike the previously reviewed

studies. It is highly likely that these emerging markets have in place, a far less robust

regulatory framework compared to developed countries previously analysed such as

the UK, Germany and France. For that reason, the fragility of regulatory frameworks in

developing countries could be a major cause of competitive distortions in the banking

sector over and above any distortions created by the government interventions

themselves.

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4. Theoretical Analysis

This chapter will begin by discussing the theoretical framework behind European

integration and the Single Market. ‘BE-COMP’ theory will be analysed specifically,

paying close attention to the implications that state aid can have on European

integration. The chapter will then provide an overview of EU competition and state aid

policy during the recent crisis, with the aim of establishing whether this has caused any

distortions to competition in European Banking sector.

4.1 ‘BE-COMP’ Theoretical Framework

BE-COMP theory examines the influence of integration in Europe on the number of

firms operational in the market, the efficiency and size of these firms, and the price

and output in the market. (Wyplosz, 2012) BE-COMP comprises of the ‘competition’

(COMP) and ‘break-even’ (BE) curves. The equilibrium in the market is determined by

the intersection of these curves.

The COMP curve demonstrates how the number of competitors in the market can

influence the variation between price and marginal cost (MC). (Lelovská, 2009) In a

market with imperfect competition, a firm will charge a price above MC to maximise

profits. The gap between price and MC is the ‘mark-up’ (µ). A higher mark-up indicates

a less competitive market. If more firms are able to enter the market and compete

with incumbent firms this will drive down the mark-up, reflected by a downward

sloping competition curve. All firms are able to alter their prices instantaneously when

the number of firms in the market changes; hence, all firms lie on the COMP curve. The

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BE curve illustrates the relationship between the number of firms in the market and

the mark-up. (Lelovská, 2009) A higher mark-up will enable more firms to remain

operational. This is due to the fact that if increasing returns to scale are present in a

specific sized market, only a certain number of firms will be able to operate. The BE

curve is represented by an upward sloping function illustrating that a higher mark-up

enables more firms to ‘break even’ and cover their fixed costs.

Figure 2: BE-COMP Equilibrium

Source: (Wyplosz, 2012: 175)

Figure 2 illustrates the market equilibrium from the intersection of the BE and COMP

curves. The left hand diagram shows a firm’s average cost (AC) and marginal cost (MC)

curve which determine the equilibrium size of the firm, represented by (X’). A firm

within a competitive market will have an equilibrium price (P’) equal to AC, earning

zero profit at the equilibrium. The price equilibrium (P’) is determined by the firms MC

and the mark-up equilibrium (µ’). (Wyplosz, 2012) The middle diagram shows the

demand curve for the home market which determines the total consumption level (C’)

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according to the equilibrium price. Finally, the right hand diagram shows the

intersection point of the BE and COMP curve outlining the number of firms in the long

run and the mark-up equilibrium. The BE curve illustrates the number of firms (n’) that

are able to break even at a mark-up of (µ’). The COMP curve demonstrates that in a

market with (n’) number of firms, a mark-up of (µ’) is charged by the firm.

4.2 BE-COMP – ‘No Collusion’

According to EU law, price collusion among firms who face competitive pressure is

illegal. Incumbent firms are required to restructure in order to reduce costs and

improve efficiency when faced with competitive pressure. However, restructuring can

be avoided if there is price collusion as firms charge higher prices in order to offset the

lack of efficiency. (Green, 1995)

Figure 3: BE-COMP – Economic Integration with ‘No Collusion’

Source: (Wyplosz, 2012: 304)

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Figure 3 illustrates the BE COMP framework in the absence of price collusion. The

middle diagram assumes there are two identical countries where the demand for the

home market in a closed economy is represented by the downward sloping demand

function. In this case, long run price and total consumption are initially at (P’) and (C’),

respectively. The left hand diagram assumes that profits diminish and price eventually

falls to equal the firms AC, due increased competition. The average cost measures the

efficiency and size (X’) of a typical firm. In this instance, the long run price equilibrium

(P’) determines the long run equilibrium size of the firm (X’). The right hand diagram

demonstrates the relationship between the number of firms (n) and the mark-up (µ).

Assuming perfect competition in the market, the COMP curve shows the optimal

combinations of mark-up and the number of firms. (Wyplosz, 2012)

Economic integration in Europe is modelled as a ‘no trade to free trade’ liberalization

between two equal countries. (Pelkmans, 2001) The equilibrium position between

these two countries with ‘no trade’ and ‘free trade’ are denoted by E’ and E’’ in figure

3, respectively. Liberalization can directly influence the competitiveness and size of the

market. Once integration has occurred, each firm can access a second equally sized

market, causing the BE curve to shift to point 1. Furthermore, there are twice as many

competitors faced by each firm in the market. Upon integration, the number of firms

operating in the market is denoted by (2n’). Provided that price collusion does not

occur, a firm will lower its mark-up to point A in both markets due to the new rise in

competition, causing a fall in price to (PA). As the new break even line (BEFT) is above

the lower mark-up at point A, all firms begin to make a loss. The number of firms in the

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market will then fall to a new long run equilibrium point (n’’), as a result of firms being

forced to restructure. (Wyplosz, 2012) Once restructuring has taken place, average

costs fall to (P’’) and sales per firm rise to (X’’) as firms improve efficiency by exploiting

economies of scale. The greater degree of competition firms now face, post

liberalization, drives the mark-up down to (µ’’).

4.3 State Aid to All Firms

The loss of jobs that occur as a result of a firms exit from the market during the

process of integration can be damaging for an economy. Governments may attempt to

prevent this by providing subsidies to these firms in the form of non-repayable grants.

Before liberalization, a total of (C’) units were sold at a price (P’) in order for the

industry to break even and earn a profit equivalent to area (A+B), shown in figure 3.

Post liberalization, the new profit area corresponds to area (B+C) due to the fall in

price to (PA) and increase in total sales to (CA). If governments in both countries

prevent restructuring by granting annual subsidies to cover the losses of all firms

(equivalent to area A+B+C) in the market, the number of firms will remain at (2n’).

Therefore, the economy will remain at point A in the short run as no firms will enter

the market, due to lack of abnormal profits being generated. As a result, taxpayers

now bear the burden for the inefficiency of these small firms. Prior to integration,

higher price levels meant that consumers paid for a firm’s inefficiency. The subsidy

therefore prevents integration and the improvement of a firm’s efficiency as they

remain functioning at a small scale. (Kinsella, n.d.) The ‘too many too small firms’

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problem will persist as all firms within the market continue to operate due to the

prevention of integration.

4.4 State Aid to Some Firms

The restructuring process can be unfair if only certain governments provide subsidies.

A firm that gains competitive advantages from the subsidy would not need to

restructure, unlike other firms in nations without a subsidy. (Blondiau, 2012) This

scenario was examined in the literature review whereby banks who were granted state

aid from their governments gained an unfair advantage over other banks in EU

member states that failed to provide such aid.

For example, assuming that there are 30 firms in total before liberalization, 15 Home

(e.g. Germany) and 15 Foreign (e.g. France), equivalent to (2n’) in figure 3, and 20 firms

after restructuring (n’’). Additionally, Germany provides a 2 year subsidy covering

losses for all 15 firms. France, on the other hand, is unable to subsidize their firms due

to a lack of finance and allows market forces to determine which firms remain

operational. As a result, only 5 French firms survive whilst all 15 German firms continue

to function. The exit of French firms helps restore profitability to the German firms

remaining in operation. The German government would then withdraw the subsidy

after the 2 year period.

Overall, the subsidy policy is purely beneficial in the short term preventing inefficient

firms from failing; along with preventing them to adapt to competitive pressure. The

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issue of moral hazard becomes apparent if firms lack the incentive to adapt. This has

been observed in the European Banking sector in recent years. Inefficient banks that

were reckless in their risk-taking and lending activities, prior to the crisis, were able to

cover their losses due to the an assurance of a state guarantee. The expectation by

banks deemed, ‘too big to fail’, of an implicit government guarantee has amplified the

problem of moral hazard in the banking sector.

4.5 EU State Aid and Competition Policy

The analysis above has demonstrated that long run integration in Europe can enhance

the efficiency of firms due to greater competition. However, restructuring by firms can

be avoided with government aid. In order to prevent such competitive distortions, the

Treaty of Rome was introduced in 1957. The treaty sets out laws to regulate and

prohibit state aid that has the potential to distort competition in the European Union.

According to Article 107 (1) of the treaty:

Any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between member states, be incompatible with the internal market.

(European Commission, 2014: 16)

The European Commission is responsible for regulating competition policy in the EU,

including the control on state aid. The commission will make the final judgement on

the legality of aid provided by EU member states. If state aid is granted illegally the

commission has, according to Article 108(2), the power to enforce an alteration or

abolition of aid:

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If, after giving notice to the parties concerned to submit their comments, the Commission finds that aid granted by a State or through State resources is not compatible with the internal market having regard to Article 107, or that such aid is being misused, it shall decide that the State concerned shall abolish or alter such aid within a period of time to be determined by the Commission.

(European Commission, 2014: 17)

According the Article 107 (3b), state aid is compatible with the single market if used in

the event of severe economic distress:

Aid to promote the execution of an important project of common European interest or to remedy a serious disturbance in the economy of a Member State.

(European Commission, 2014: 16)

4.6 An Assessment of Temporary State Aid Rules

Due to the unprecedented nature of the recent financial crisis, the EU commission

adopted temporary state aid rules. These included six Crisis Communications providing

additional guidelines outlining the compatibility of state aid. These communications

were put in place to limit any distortions to competition between financial institutions

across EU member states, as well as ensuring greater stability in financial markets.

The communications include the requirement by distressed banks to present a plan for

restructuring before the approval of aid. (European Commission, 2011) Aid would then

be granted to the bank in question, provided that this restructuring plan was approved

by the commission. Furthermore, the communications included a rise of the minimum

threshold of burden sharing by banks in relation to amount of aid received. Aid would

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then be granted subject to an adequate level of burden sharing by the banks

shareholders. Specifically, banks were required to utilise any available capital in order

to absorb losses incurred during the crisis, contribute to its restructuring costs and

provide compensation to the state. (European Commission, 2011)

These requirements were put in place to address moral hazard, minimize government

intervention where possible and to ensure aid was better targeted. However, the EU

sovereign debt crisis has weakened the fiscal credibility of a number of EU member

states due to a rise in the number and cost of government interventions.

Consequently, minimum burden sharing requirements have been exceeded by certain

member states. States that have exceeded this threshold have resorted to ‘bail-ins’ via

bondholders. (European Commission, 2013) Dissimilarities between burden sharing

across member states, from countries who abided by the minimum threshold to others

who exceeded it, have triggered a variation between a number of banks’ cost of

funding subject to the probability of a bail in by bondholders. This demonstrates that,

despite the laws in place to regulate state aid and the modifications made during the

crisis in order to attach conditions to aid, distortions to competition in the European

banking sector have arisen. (European Commission, 2013) Heimler (2012) shares this

view suggesting that the commission failed to establish whether there had been any

competitive distortions prior to state aid being deemed incompatible with EU law. It

goes on to suggest that the conditions attached to aid were merely in place to reduce

moral hazard and the reduction of a bank’s fragility was the last objective.

Nevertheless, moral hazard can only truly be eliminated by not granting state aid to

26

any banks in distress. In the short term, this could lead to significant repercussions to

the economies of member states. However, in the long run European banks could

become more risk prudent due to the assumption that if they were to become

distressed, the state would not intervene to prevent the bank from failing. This could

potentially eliminate moral hazard all together. (Shoenmaekers, 2012)

Overall, it is clear to see that during the recent crisis state aid policy within the

European Union was relaxed. This was made apparent by the commission approving

state aid on the premise of Article 107 (3b) despite it being incompatible with the

single market (according to Article 107 (1)). In this case, the actions taken by the

commission created competitive distortions in the European banking sector. (Heimler,

2012) Recent policy developments in Europe, however, have led to the agreement of a

new ‘Banking Union Framework’ for dealing with distressed banks in need of support.

This framework is scheduled to be fully implemented by 2015-16 and aims to create a

€55 billion ‘Single Resolution fund’. This fund will be financed by the banking industry

over the next decade in order to avoid the use of taxpayer’s money for bailouts and

minimise moral hazard. (Gros, 2014)

27

5. Analysis of Funding Advantage Models

5.1 Background of the Size and Ratings Based Approaches

Funding advantage models can be used to measure a reduction in funding costs for a

bank as a result of obtaining an implicit guarantee from the state. These models

compare the higher costs a bank would incur without government support to a bank’s

ability to issue debt at lower costs due to receiving an implicit guarantee. (Sowerbutts,

2012) Typically, the two main estimation methods consist of the ‘Sized Based

Approach’ and the ‘Ratings Based Approach.

The Sized Based approach is based on the assumption that the government will

provide aid to larger banks only; thus, enabling them to benefit from lower funding

costs compared to smaller banks. (Sowerbutts, 2012)

The Ratings Based approach analyses the difference between the higher funding costs

a bank would incur without an implicit guarantee, reflected by a ‘stand-alone’ rating,

and the actual funding costs faced, reflected by a ‘support’ rating. (Kloeck, 2014) A

credit rating agency, such as Moody’s, assigns both a stand-alone and a support rating

to a bank in order to assess its risk of default. However, the higher support rating

further takes into account the prospect of that bank receiving support from the state.

The difference between these two credit ratings is known to as the ‘ratings uplift’. The

variance between the ‘artificial’ and ‘actual’ funding costs will represent the implicit

guarantee for both types of approach.

5.2 Review of Testing Literature

28

Sowerbutts (2012) adopts the ratings based approach in order to quantify the implicit

subsidy for four major UK banks using Moody’s credit ratings. The average annual

ratings uplift is estimated for the four banks using the difference between the higher

support rating and the stand-alone rating. A bank’s funding cost is then shown to fall

as a result of ratings uplift. The size of the implicit subsidy is then found by multiplying

the risk sensitive liabilities of a bank by the variation between the costs of funding for

that bank in the presence and absence of support. Overall, the paper approximates a

funding advantage of £5bn, £25bn, £125bn, and £40bn from the years 2007-2010

respectively, for the four UK banks.

Bijlsma (2013) develops the work carried out by Sowerbutts (2012) and uses a data

sample from 2008-2012 for 151 European Banks in order to find the funding

advantage. More specifically, credit ratings including a measure for implicit and explicit

guarantees are used in order to estimate a bank’s cost of funding advantage. For

example, bank ‘X’ may be given an Aa1 (Moody’s Long Term Deposit (LTD)) rating with

government support and a Baa1 (Moody’s Bank Financial Strength (BFS)) rating

without government support, which is equivalent to a stand-alone rating. This method

assumes that the bank assigned a Baa1 rating with support pays a level of interest

equivalent to the counterfactual level of interest that it would pay with an Aa1 rating,

without government support. The variation between these interest rate levels is

classified as the funding advantage. Bijlsma (2013) ran a regression in order to

estimate the connection between the Moody’s LTD rating and the daily bond yield for

a bank. A measure of a bank’s funding advantage is reflected by the value of the

29

decline in yield. Finally, the level of outstanding debt for a bank was obtained and then

multiplied by the reduction in yield to calculate the funding advantage. The testing

found that, on average, a bank experienced a rating’s uplift at the start of the crisis

which then rose further during the crisis. It was also found that banks holding a higher

LTD rating have lower funding costs; and while this rating remained high, the BFS

ratings for banks fell. The characteristics of a particular country, from which a bank is

originated, is also found to have an implication for the funding advantage of that bank.

The greater the creditworthiness of a country, the higher the funding advantage is for

a bank classified as ‘too big to fail’ situated in that particular country. Finally, in

economies with higher sovereign ratings banks experience greater uplifts in their

rating.

Feldman (2010) demonstrates that banks considered ‘too big to fail’ (TBTF) enjoy cost

of funding advantages. If there is an expectation by debt investors that a bank will

receive government support in the event of failure; they will demand a lower risk

premium resulting in a lower cost of funding. Hughes (1993) supports this with the

premise that, providing the quality of assets and risk of default are held constant, the

price of uninsured deposits for larger banks is lower compared to that of smaller

banks.

Hughes and Mester (2011) also examine whether economies of scale in banking exist

due to any TBTF factors. This study finds economies of scale grow in line with the size

of a bank. However, it fails to clearly establish characteristics for a TBTF bank and

instead adopts a threshold for banks holding assets in excess of $100 billion. In order

30

to overcome this issue, Davies (2012) suggests the use of a measure for the ‘implicit

funding subsidy’ that the state provides to a bank. Davies (2012) argues for an

improved set of guidelines in which to determine whether banks are TBTF. In addition,

it advocates for improved measurements for cost of funding advantages with the aim

of determining the exact effect on economies of scale.

As mentioned previously, if there is a belief that in the event of failure a bank classified

as TBTF will be bailed out by the state; this can reduce that banks’ cost of funding. As a

result, the bank is deceptively regarded as being more cost efficient. This would imply

that economies of scale in banking are likely to be affected by TBTF factors to the

degree that they reduce a banks cost of funding. Davies (2012) suggests that the

degree to which funding costs are reduced can be defined as the ‘implicit funding

subsidy’. The paper uses the ‘ratings based approach’ previously adopted by Haldane

(2010) and Schich (2012) in order to estimate the implicit funding subsidy. Haldane

(2010) estimated that in 2009, 13 UK banks experienced a fall in their costs of funding

in excess of £100 billion. In order to find the implicit funding subsidy, the value of

credit rating sensitive liabilities is multiplied by the fall in a bank’s cost of funding due

to the presumption of state support (i.e. the ratings uplift), as shown below:

“Implicit Funding Subsidyb,t = (Ib,t SUR - Ib,t BFSR) x Ratings Sensitive Liabilitiesb,t”(Davies, 2012: 11)

This shows the difference in index spread taken for both the support and standalone

credit ratings for bank ‘b’ at time ‘t’. The difference between these ratings is significant

due to the fact that, at the standalone rating, banks are required to fund themselves

without state aid.

31

Davies (2012) uses an augmented bank production model, without adjusting for cost of

funding advantages held by TBTF banks, with the aim of approximating economies of

scale. This model then alters the input price of debt via the funding subsidy. The

altered debt price gives an estimate from the price of debt that banks would be

required to pay in the absence of lower costs of funding. If banks face debt prices

which are not influenced by the TBTF policy, the altered debt price can be used to

establish whether these banks are producing an efficiently optimal level of output. The

implicit funding subsidy can then be used to calculate the ‘total underlying funding

cost’ as follows:

“Total Underlying Funding Costb,t = Total Interest Expenseb,t + Implicit Funding Subsidyb,t”

(Davies, 2012: 11)

This total funding cost is then divided by the total sum of deposits in order to find the

altered input debt price. Finally, in order to establish whether economies of scale for

larger banks is attributable to TBTF cost of funding advantages, the altered debt price

is used in a recalibration of the bank production model. As a result of the altered debt

price, these large banks may be producing an inefficient level of output. Overall, the

test results suggest that when controlled for the implicit subsidy, economies of scale

are non-existent for banks. This would imply that larger banks appear more efficient

due to TBTF cost of funding advantages. The results are supported in previous studies

by Wheelock (2012) and Hughes (2011) in the fact that if banks become excessively

large in size, improvements in efficiency owing to economies of scale can be

32

counterbalanced to some extent by diseconomies of scale. Finally, the results show

that, on average, the implicit funding subsidy grew during the recent crisis which is

further supported by Schich (2012). This is predominantly due to the fact that the size

of the subsidy was influenced by the widening of credit spreads as investors attempted

to minimize their exposure to risk. Additionally, an overwhelming percentage of

sampled banks experienced an increase in their ratings uplift owing to an alteration in

their standalone credit ratings during this period.

In summary, the various empirical tests have shown that implicit government

guarantees are characteristically associated with banks deemed as being ‘too big to

fail’. Furthermore, over the course of the recent crisis the amount of guarantees

granted to a high majority of the banks sampled rose across the various studies.

Finally, there is a general consensus amongst the studies mentioned above that banks

gain substantial cost of funding advantages as a result of being granted an implicit

guarantee, hence, generating competitive distortions in the financial sector. It is

important to note, however, that the empirical studies analysed do not present results

with a comparable and identical metric. Approximations for the implicit funding

subsidy have been expressed in the form of a monetary value and ratings uplift. For

that reason, in addition to use of different time periods, the true extent of the cost

advantages enjoyed by particular banks is likely to differ across studies.

6. Conclusion

33

This paper was set out to explore whether government bailouts have distorted

competition in the European banking sector following the recent financial crisis. The

review of literature identified that bank liability guarantees were the main method of

intervention used over the crisis period. A general consensus amongst the literature

was reached indicating that state aid can in fact generate competitive distortions in the

banking sector, in the form of lower marginal costs. The moral hazard problem and

‘too big to fail’ policy were found to have a direct influence on this. Due to the

interconnectedness of global interbank lending markets during the crisis and the

potential implications a failure of a large bank could have had on the rest of the

banking sector, governments felt compelled to bailout distressed banks. The

distortions to competition were found to be greater if the competitors of bailed out

banks were not granted the same level of support, as to be expected.

The analysis of European integration theory, despite its acknowledged simplicity,

demonstrated that state aid can prevent integration and the enhancement of a firm’s

efficiency. Inefficient firms granted aid are able to remain operational and do not need

to restructure in the event of increased market competition. These firms gain a

competitive advantage over other firms who are required to restructure and adapt to

market changes. After assessing the EU Commission’s temporary state aid rules

adopted during the crisis, it is evident that these were ineffective in preventing

competition distortions to the European banking sector. Examined literature suggested

that state aid rules had in fact been relaxed during the crisis with aid being approved

34

despite its incompatibility with EU law. Additionally, the commission failed to identify

any potential competitive distortions before incompatible aid had been granted.

The assessment of Funding Advantage model testing literature highlighted that implicit

government guarantees are associated with TBTF banks. These banks appear artificially

more efficient owing to size and cost advantages achieved from economies of scale.

This accompanied by increases in the ratings uplift that these banks experienced,

meant that they gained significant cost of funding advantages due to being granted the

implicit subsidy.

It is clear that the findings from the literature review and Funding analysis are

consistent with the theoretical framework explored and answer the research question.

Nevertheless, empirical studies are likely to be developed further due to the continued

fragility of the European banking sector with some bailed out banks remaining under

state ownership. New empirical work could be developed in the future which could

improve upon this research. Furthermore, the newly agreed Banking Union Framework

could significantly impact banks funding costs once implemented fully in 2015-16. The

Single Resolution Mechanism that will be used to assist distressed banks in the future

will be funded by an annual bank levy. This attempts to solve moral hazard as banks

would in effect be contributing towards their own potential future bailout. In light of

this, more conclusive results from empirical testing could be achieved once this

framework is fully in place. It can then be determined whether bailed out banks

experience funding advantages to the extent that is enjoyed at present.

35

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