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The large dollar balance sheet of Europe’s banks

by Brad Setser
April 14, 2009

Tyler Durden/ Zero Hedge’s analysis of the aggregate balance sheet of the US commercial banks attracted a lot of attention last week, for good reason (h/t Felix Salmon).

American taxpayers are – in various ways – stabilized the US financial system by putting equity into a host of troubled banks, lending liquidity constrained banks a lot of money and guaranteeing a decent fraction of the banking system’s liabilities. And there is still a lot of uncertainly about the ultimate cost to the taxpayer of all these policies, as the “true” state of the banks’ balance sheet isn’t yet known – and in some sense cannot be known, as the cash flows underlying a host of financial assets themselves are a function of the economy.*

I though was struck my something else. Data on the US banks seems to miss a large chunk of the US banking system.

Total liabilities of US banks, according to Zero hedge, are close to $12 trillion.

The dollar liabilities of Europe’s banks are – according to the BIS — about $8 trillion. UK banks alone had a gross dollar balance sheet of close to $2 trillion. For details, see the charts on p. 2 and p. 51 of the latest BIS quarterly.

There may be some double counting. And European banks make dollar loans to non-US borrowers, so they aren’t just lending in dollars to the US. But the data – on face value, without any adjustment – suggests that US banks might only account for only about 60% of the aggregate dollar balance sheet of the world’s commercial banks.

But the Fed’s flow of funds data suggests that there isn’t a lot of double counting. The liabilities of US-charted banks at the end of q4 totaled $9.9 trillion, with US bank holding companies accounting for an additional trillion dollars of debt. Foreign banking offices in the US had by contrast $1.6 trillion in liabilities (see tables L 110-112), far less than the $8 trillion in dollar balance sheet of the European banks.** There is little doubt that many of the world’s large dollar balance sheets aren’t regulated by the US – and aren’t going to be bailed out by the US taxpayer.

At least not directly.

The US did, though the Fed’s swap lines, provide Europe’s banks with dollar liquidity. But it did so by providing Europe’s central banks with dollars, dollars that were then onlent to European banks. US provided the dollar liquidity, but all the downside risk resided with European governments.

And the US also indirectly bailed out some European banks by bailing out AIG, and thus assuring that AIG would be able to honor the insurance it sold to the world’s banks. But European governments have also bailed out a host of European banks that made bad bets on “toxic” US assets. Absent those bailouts, European banks would have had to dump a lot of US debt – driving the price of that debt down and threatening the health of a host of US financial institutions that hold similar stuff on their balance sheets. Europeans taxpayers have indirectly helped to bail out American banks too.

The FT – more than most – has recognized the challenges created by a global banking system and national regulation. A recent leader argued: “The current mismatch of globalised finance and national governance is unsustainable. Either governance becomes more globalised or finance less globalised.“

My guess is that finance will necessarily become a bit more national. The current crisis has shown than highly leveraged intermediaries require a government backstop, and for now there is no global taxpayer willing to bailout global banks that go bad.

* Gillian Tett’s analysis of the difficulties (a Sisyphean task ) of removing “toxic’ assets from banks’ balance sheets is worth reading.
** The BIS data is through q3, while the Fed’s flow of funds data is through q4. At the end of q3 foreign banking offices in the US only had $1.24 trillion in US liabilities. They clearly dramatically increased their “onshore” borrowing during the crisis, as they lost access to “offshore” dollar liquidity. I haven’t spent enough time with the BIS data to know whether the $1.24 trillion in onshore liabilities should be subtracted from the $8 trillion (or if the $1.17 trillion in onshore assets of foreign banking offices should be subtracted from the $8 trillion) to avoid double counting. Help on this would be appreciated.

29 Comments

  • Posted by Thomas

    The numbers are somewhat bigger than I thought, but apart from the exact quantification, this isn’t news to anyone in Europe:

    The big problem of most European banks is precisely their US exposure. In Germany, just about every major bank (and several not-so-major ones) has written off several billion US$ of the US exposure. Considering that write-offs are only a fraction of total exposure, I wouldn’t be surprised if German banks make up 1 tr $ or more of the 4 tr $ total exposure the BIS allocates to “Euro-area banks”.

  • Posted by jonathan

    That’s the best explanation of why the Fed let (encouraged?) AIG to pay without a discount.

    The word “toxic” is a problem for me because it implies more than it has historically meant. Loans actually in default, loans in jeopardy, obligations which can’t be traded versus those whose values have suffered as the economy has worsened, etc. aren’t all of the same toxicity. One of the things that makes this meltdown so fascinating – if you’re an emotionless Vulcan – is the new forms of bad assets; the old categories were usually loans made on collateral that became worth less and to borrowers whose business deteriorated (or did not materialize). We now have casino bets gone bad.

    Anyway, the maturity of most of these European dollar assets can’t be that long; I thought they were more short-term funding dollars. Am I wrong? I would think the problem would become much more worrying as the maturities lengthen. That is, the dollar is still the world’s reserve currency.

  • Posted by guest

    Whilst reading the story of Sisyphus coupled with the Danaides,it came to my mind that regulatory issues may as well explain for future or existing offshore booking of dollar assets.
    Central banks do not encourage funds mistmatching (borrow short term funds for funding long term assets and they are now legacy)Liquidity ratios may explain for the European banks increasing their assets in usd whilst helping their subsidiaries to meet with the US CB regulations.

  • Posted by CapVandal

    There is a really good reason that AIG paid off on the credit default swaps.

    The companies already had the money by virtue of collateral. They had 50 cents on the dollar in cash and realized losses to date were a small fraction — the remainder being so called mark to market losses.

    There is a fairly decent chance that the ultimate losses on the underlying CDO’s will be less than the collateral held at the time the decision was made.

    This is a question that can only be answered in retrospect, like any question involving cash flows with credit risk.

  • Posted by CapVandal

    There is no “true state” of bank balance sheets. There is no way that current accounting can deal with the uncertainty in both interest rates and default rates.
    People tend to be severely overestimating the impact of default and underestimating the impact of the increased interest rates implicit in asset prices.
    The only solution is to subsidize interest rates, which the Fed/Treasury are doing to the extent possible. Maybe more than is possible.

  • Posted by anon1

    “Data on the US banks seems to miss a large chunk of the US banking system.”

    “But the data – on face value, without any adjustment – suggests that US banks might only account for only about 60% of the aggregate dollar balance sheet of the world’s commercial banks.”

    What’s the problem? I’m not following your concern or line of thinking here.

  • Posted by bsetser

    concerns:

    a) Tighter US regulation wouldn’t have avoided the crisis if European banks kept on borrowing from us money market funds to buy US securities; ergo the challenge of global markets for crisis prevention.

    b) as discussed in an earlier post, the reliance of european banks on us money market funds and cross -currency costs for short-term funding (plus central bank deposits) became a transmission channel for the crisis. the fed fought the shock by providing $ liquidity to a set of European institutions it didn’t regulate (a process that worked fairly well, as the fed was able to lend to european central banks that either were the banks regulator or were connected to the banks regulator). but conceptually, it could have been a problem …

    c) European taxpayers will end up covering euroepan banks losses on their $ books, which may not be exactly what they bargained for. E.g. global banks impose undue costs of national taxpayers, or put differently there is a cost of being the home country of a global bank in a global crisis.

    More generally, I was a bit surprised by the share of the say a $20 trillion agggregate dollar balance sheet that came from european institutions, and largely offshore European institutions.

  • Posted by Twofish

    bsetser: My guess is that finance will necessarily become a bit more national.

    I don’t think so. Once you allow cross border financial transactions, then the horse has left the barn. I don’t so how you could make finance more national, even if you wanted to.

    bsetser: The current crisis has shown than highly leveraged intermediaries require a government backstop, and for now there is no global taxpayer willing to bailout global banks that go bad.

    US taxpayers aren’t particularly willing to bailout US banks either. It’s the (perfectly justified) idea that not doing so would cause the world to fall apart that gets the US doing want they are doing.

    But that hasn’t prevented global banks from getting bailed out. If you have a global firm whose destruction would destroy the world, then you are going to have a national government try to save that firm because if the world falls apart, then a particular nation will fall apart.

  • Posted by anon1

    OK. I understand your concerns.

    But I’m surprised at your surprise at the size of the Eurodollar balance sheet globally.

    I think somewhere there’s a chart on the growth of the offshore dollar balance sheet over the past 10 years or so. I thought it was on your blog. The growth has been hyperbolic, as you might guess anyway.

  • Posted by Twofish

    bsetser: E.g. global banks impose undue costs of national taxpayers, or put differently there is a cost of being the home country of a global bank in a global crisis.

    True but there also huge benefits people from your country have a huge impact on where capital goes and where it doesn’t. You don’t have huge problems when you have big banks in big countries that can do a bailout/cleanup when things go bad. However, if you have a big bank in a small country, then you are going to have some very serious problems. Witness Iceland.

    The fact that only big countries can support big banks makes things easier, since it means that you just have about a half dozen countries whose opinions on global financial regulation really matter, and so it won’t be hugely difficult to come up with some consensus.

    Also there one other reason that the European banks are huge and that is that European banks typically play a much larger role in Europe than American banks play in the United States.

    US banks can’t own stock, which means that some thing that are done by European banks are done by other institutions (such as mutual funds, hedge funds, and private equity) in the US.

    In the US if you want to invest in an index fund, you go to someone like Fidelity or Vanguard and invest in shares of a mutual fund. In Europe, if you want to invest in an index fund, you go to a bank and buy a derivatives contract. The big German and French banks are also industrial management companies which is something that US banks cannot do.

  • Posted by bsetser

    surprise is perhaps the wrong word. I knew that offshore “euro dollar” balance sheets were large, and had grown fast. I hadn’t grasped that they were 2/3s the size of the US commercial banking system tho. my sense of scale was off.

  • Posted by don

    bsetser responds:
    “surprise is perhaps the wrong word. I knew that offshore ‘euro dollar’ balance sheets were large, and had grown fast. I hadn’t grasped that they were 2/3s the size of the US commercial banking system tho. my sense of scale was off.”
    So, apparently, is mine. What could account for such huge dollar holdings in Europe? I could see the U.K., but what’s with the rest of Europe?

  • Posted by don

    Do we have any clues as to who is holding these deposits?

  • Posted by bsetser

    the big rise in Europe’s dollar balance sheet wasn’t financed heavily out of deposit growth. the european banks were big borrowers from us money market funds/ big users of cross currency swaps (see the BIS papers). but at least some of the deposit growth came from large deposits the the world’s central banks … which then decided that banks weren’t as safe as treasuries and moved funds out of the european banking system post lehman.

  • Posted by anon1

    The scale of the Eurodollar market puts a different slant on the nature of the global credit crisis.

    While it wasn’t entirely US generated, much of it was US dollar generated.

  • Posted by John Booke

    Is it possible that the large spike in the US monetary base has alot more room to move higher? Most of the US dollar cash (a chunk of the monetary base)is held by foreigners. With lots of US dollar assets still in foreign banks could stressed out foreigners shift to cash? Could this partially explain the recent US dollar strength?

  • Posted by euro

    @vbrief,

    because it’s impossible for the Fed/Treasury and U.S. Taxpayers to prevent a massive synthetic CDO setoff…In the U.S. alone there’s still 100+Trillion of CDS sitting in the banks…

    That’s my opinion. It’s one deep dark black hole, and just when they think the problem has been solved a new one arrives.

    Anyone has thoughts/comments on the stress test?

    I heard OBama’s speech today and it sure sounded in his voice as some of them didn’t pass…

  • Posted by purple

    Bears repeat : “The current mismatch of globalised finance and national governance is unsustainable. Either governance becomes more globalised or finance less globalised.“

    It is probably the FT’s dream to further globalize finance, but that’s politically impossible. What that means in the medium term is that globalization – and therefore, international capitalism as we know it – is at a roadblock.

  • Posted by R Hadden

    1) I’m not sure if it is relevant (and I cannot remember the details) but I remember learning that the Eurodollar system arose in the 1960′s (or possibly 70′s) when the US levied some sort of tax (withholding tax on bond income?) and drove a very large amount of USD-denominated business off-shore to the waiting arms of London.

    2) I am also surprised at the relative size of the European dollar holdings but steady growth for three decades may explain them as much as a recent binge – is there any data on the growth rate?

    3) Also, the Eurozone is a significant part of world trade and the USD is the world’s reserve currency (and a significant part of Eurozone exports are invoiced in USD) so perhaps it is even natural for there to be a major Eurodollar market (even if not 40% of the total).

  • Posted by D Gross

    Interesting point about global institutions and national problems.

    As a US taxpayer I was beginning to wonder whether the US should be bailing out an institution like Citibank when its traditional US banking arm is really just a small part of what it does (or rather, did) as a global firm. Fortunately, the US had the funds (or at least the borrowing capacity) to help Citibank and even allowed firms like Goldman (irrelevant to the US consumer and voter) to re-charter as banks and receive TARP money. I think Mr. Setser’s point is most obvious in countries like the UK and Austria where international activities of the country’s banks as a % of national GDP are huge. If the global downturn worsens we may yet see large European countries go the way of Iceland Their banks could literally be too big to rescue rather than too big to fail.

    However, I believe the problem with European banks is on the Dollar asset side, not the liability side.

    Central bank reserve diversification and currency speculation against the Dollar created a flood of demand for Euro-denominated bank deposits and short term Euro government securities in the 2004-2008 period. However, there was not a corresponding need for Euro-denominated loans (assets), particularly the AAA-rated assets that European banks prefer due to BIS capital rules. European banks, instead, purchased AAA-rated Dollar assets (as Dollar loans were in great supply), the US investment banks dutifully manufactured more AAA assets to meet this demand, and the European banks then used the FX swap market (essentially a part of the interbank lending market) to hedge these “AAA” Dollar assets back into Euros. Hence, Euro deposits were matched with synthetic “AAA” Euro assets (really Dollar assets which were either hedged with FX swaps or funded via interbank cross-currency lending).

    As the value of the toxic Dollar assets fell, the currency hedge (or Dollar funding) needed to be reduced in tandem, creating a need for these banks to buy Dollars. A European bank that fails due to toxic Dollar assets would also fail on its currency hedges with other large banks (which, like AIG’s “credit insurance” are collateralized) or on its interbank borrowing (not collateralized). Hence, the “European” problem would also be a problem for many major US institutions.

    It is interesting how so many factors came together to create the current crisis. The US Federal government increased the activity of FNMA and the GSEs, driving the profitability of traditional bank mortgage lending toward zero while mortgage brokers undercut traditional banks in origination. Traditional banks moved toward loans without government-subsidized competitors (home equity, subprime, option ARM, commercial real estate). Meanwhile, easy monetary policy by Greenspan and demand by China and other central banks for govt and govt agency paper kept those yields low (in Europe, the lack of a large, deep AAA-rated govt securities market also created disproportionate demand for Euro and GBP bank deposits). European and US banks needed to find other forms of AAA paper (due to favorable BIS capital treatment) that yielded “just a bit more”, and so AAA-rated residential and commercial mortgage paper was manufactured to meet the demand. The supply of Dollar loans and the demand for Euro-denominated deposits (by central banks and speculators) was balanced through currency swaps and interbank cross-currency lending.

    In the BIS’s 2007 FX survey (http://www.bis.org/publ/rpfxf07t.pdf) , they noted that the volume in FX swaps had grown by 80% (to $1.7 trillion per day) since 2004 despite FX spot trading volume growing only by 59%. To me, evidence that cross-border financing spilled over into the FX swap markets.

    The BIS also has a relevant paper on the “global dollar shortage” in its most recent quarterly review

    http://www.bis.org/publ/qtrpdf/r_qt0903f.pdf

  • Posted by DJC

    From Asia Times,

    The World Economy needs to be decoupled from US Dollar hegemony

    http://www.atimes.com/atimes/Global_Economy/KD16Dj03.html

    It is clear that this is no ordinary recession. While an emphasis on reviving banks and an injection of public spending are both important, the trouble is that neither one directly addresses the main source of global deflation, which is that global imbalances are no longer being recycled effectively. Because US households and banks are now bankrupt, the United States has lost much of its capacity to absorb and recycle foreign trade surpluses. That, in a nutshell, is the driving force behind the global deflationary trend.

    Substituting massive public spending for private consumption and putting banks on life support are at best stopgap measures, and it is unlikely that they will bring back the ability to recycle trade surpluses.

    The advantage the US enjoys in being able to issue its liabilities in its own currency can turn into a liability for the rest of the world. The US has been spared the worst ravages of this financial crisis because of this ability.

  • Posted by bsetser

    dgross — thanks for your insightful comment. you did a nice job of pulling a lot of the threads that led to the crisis/ led european banks into synthetic USD triple AAA assets.

    I though would argue that there also have been problems on the liabilities side — per the (excellent) BIS paper: european banks were also financing their $ book by borrowing from money market funds and by taking large $ deposits from CBanks, and both funding sources withdrew from the market last fall.

    the main question i have is who supplied the cross currency swaps, i.e. effectively going long euros v the dollar (by swapping dollars for the European banks euros)? Who was the natural seller of dollars for EUR in GBP in the size needed to match the European banks book? (I think the BIS estimated a gap of over $500b … that was being met by cross currency swaps)

  • Posted by Twofish

    bsetser: Who was the natural seller of dollars for EUR in GBP in the size needed to match the European banks book? (I think the BIS estimated a gap of over $500b … that was being met by cross currency swaps)

    By process of elimination, I’d say it was the Arabs. There are four big players in the world. The US, Europe, China, and the Middle East. It’s not the US and Europe. China is heavily dollar exposed, so that leaves the Arabs.

    There’s no one else I can think of with with large dollar holdings that want euros. It makes sense if you have Arabs with dollars that want to invest in Europe, and then Europeans with euros that want to invest in the United States, and the United States with large trade deficits due to oil that were paying the Arabs.

  • Posted by Twofish

    Also I suspect that international finance is going to follow the “post office” model of funding. If you mail a letter from US to Germany, you only pay the US post office, on the theory that for every letter to Germany there is a letter from Germany to the US, and everything balances.

    Europe indirectly benefits when the US bails out AIG, but then the US benefits when Europe bails out RBS, so I think in the end, everyone is more or less even.

    D Gross: It is interesting how so many factors came together to create the current crisis.

    Yes and no. If you light a match in a room full of dynamite, it’s interesting to watch which particular sticks go off first, but tracking down exactly what explodes may make you lose track of the big picture.

    The basic cause of all this is that you had a complex coupled system that was highly leveraged, in which a failure at one point would cause a domino effect.

  • Posted by Twofish

    euro: because it’s impossible for the Fed/Treasury and U.S. Taxpayers to prevent a massive synthetic CDO setoff…In the U.S. alone there’s still 100+Trillion of CDS sitting in the banks

    No there isn’t. The banks exposures to CDS’s is a few billion, and it’s not the big problem. At this point CDS’s and derivatives are minor problems. Going back to the forest fire analogy, CDS’s and derivatives are what set off the forest fire, but now that everything else is burning, it’s not too useful to focus on what started the fire except for historical reasons.

    Also the place that started the fire is the first place that got burned to ashes. CDS’s and synthetic CDO’s have been written down to the point that they are a minor problem right now.

    The big problem are ordinary loans. Also I think everyone “passed” the stress tests. But there is still a huge difference between the picture of health and barely alive.

  • Posted by Rien Huizer

    Brad,

    The eurodollar market (that is the market in US instruments without a US resident actually borrowing or lending) has been around for some 40 years now and was once the unintended consequence of US regulation. The lower interest rates are, the lower the US political risk (of confiscation) and the less not quite legal money is held in USD, the more USD is held at home.

    Were you surprised by the existence of a large stash, or about the size of the stash? (assuming the numbers have any meaning). If you believe the US should have control, promote regulation (and get smuggling plus other forms of crime). If you do not, pay no attention.

  • Posted by Rien Huizer

    D Gross,

    Yes. Still, what’s new? Since some European banks did all this almost riskless arbitrage and got badly burnt, we have come down to earth, This looks like a hornet’s nest where desparate banks will not be looking for honey temporarily. There were (and still are) far too many financial institutions and too little capital to keep them all solvent while their industry is going through a shakeout.

    The thing about shake outs is that it eliminates the weak. Where is that happening now, when every bank gets bailed out? Financial services where firms act as principals with the tacit backing of the government (too big to fail) are still around and we have just witnessed yet another instance of political impotence to tame this stupid industry. The eurodollar market was once the typical example of an unconstrained deposit multiplier system. Then Basle I came along, the banks found ways around it, governments looked the other way while the investment banks sold yield machines to German public sector banks
    (uncontsrianed again, off balance sheet) consiting of a conduit, toxic assets and commercial paper placement facilities. NOw there is a bit of a problem, some shake out but also a lot of real economy shrinking. Our political system cannot afford to antagonize major constituencies so the sore is bandaged and deodorized for a while.

  • Posted by Twofish

    Rien: The eurodollar market (that is the market in US instruments without a US resident actually borrowing or lending) has been around for some 40 years now and was once the unintended consequence of US regulation.

    It was an unintended side effect of the Cold War. The Marshall Plan ended up with Europe having lots of dollars some of which ended up in the Soviet Union. For obvious reasons, the Soviets were worried about holding dollars in American banks.

    The huge amount of dollar-euro swaps may have something to do with the “dollar hegemony conspiracy theory.” Suppose you are a Spanish oil company, you want to buy crude oil in six months, but you want to do it in euros. What do you do to avoid currency fluctuations? You buy a dollar-euro swap.

  • Posted by MakeMeTreasurySecretary

    Off topic but I hope of interest to this community. I found the following article quite interesting:

    The politics of the Maastricht convergence criteria

    http://www.voxeu.org/index.php?q=node/3454

    Some countries “got in” just because of political considerations (what a shock!). Same countries better be careful as public attitudes and politics change in good old Europe. Ireland, Greece, and Austria, are you listening?

    Of course, politics may change again. Even Germany is expected this year to violate the 3% limit on public deficit to GDP. Nevertheless, repeat offenders better prepare themselves for a trip to the woodshed.

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