15/3/2013: IMF Assessment of the Euro Area Banking Sector Risks - part 4

This is the fourth post on today's release by the IMF of the 2013 Financial System Stability Assessment Report for European Union report, and probably last.

The first post - summarising top-line conclusion from the Technical Note on Progress with Bank Restructuring and Resolution in Europe is available here: http://trueeconomics.blogspot.ie/2013/03/1532013-imf-assessment-of-euro-area.html

The second post dealt with the Technical Note coverage of the Non-Performing Loans issues: http://trueeconomics.blogspot.ie/2013/03/1532013-imf-assessment-of-euro-area_15.html

The third part focused on the real economy side of the banking sector risks within the euro area: http://trueeconomics.blogspot.ie/2013/03/1532013-imf-assessment-of-euro-area_5878.html

And related Country Risk Survey study for Q1 2013 covering euro area banking sector risks is available here: http://trueeconomics.blogspot.ie/2013/03/1532013-irish-banks-still-second.html .


This note is focusing on the actual report itself: European Union: Financial Sector Stability Assessment.


Top-level assessment:

Per IMF: "Much has been achieved to address the recent financial crisis in Europe, but vulnerabilities remain and intensified efforts are needed across a wide front:

• "Bank balance sheet repair. Progress toward strong capital buffers needs to be secured and disclosures enhanced. To reinforce the process, selective asset quality reviews should be conducted by national authorities, coordinated at the EU level." [In Irish context, the real review should be carried out, imo, across the quality of capital claimed to be present on banks balance sheets. Rating agencies have highlighted the Ponzi-like risk scheme whereby contingent capital measures are provided by the Sovereign supports whereby neither the Sovereign, nor the banking system can actually sustain a call on capital of any appreciable volume. Asset quality reviews are also needed, as Irish banks are carrying large exposures to unsustainable and already defaulting mortgages.]
• "Fast and sustained progress toward an effective Single Supervisory Mechanism (SSM) and the banking union (BU). This is needed to anchor financial stability in the euro area (EA) and for ongoing crisis management. The European Stability Mechanism (ESM) is to take up its role to directly recapitalize banks as soon as the SSM becomes effective." [It is pretty much clear now that ESM is not going to be deployed unless significant pressure rises on Italy and/or Spain. In this context, calling for 'effective' ESM is like calling for a 'real' Santa Claus. Meanwhile, neither the SSM nor BU can be expected to become functional any time soon. The institutions behind both are yet to be defined, let alone fully legislated. And from legislation line, it's a long distance still to functionality.]

"Restoring financial stability in the EU has been a major challenge. The initial policy response to the crisis was handicapped by the absence of robust national, EU-wide and EA-wide crisis management frameworks. In a low-growth environment,
several EU countries are still struggling to regain competitiveness, fiscal sustainability, and sound private sector balance sheets. Their financial systems are facing funding pressures as a result of excessive leverage, risky business models, and an adverse feedback loop with sovereigns and the real economy."
[This is significant across a number of points. Firstly, in contrast to the European leadership claimed wisdom, the IMF clearly links banking crisis not just to sovereign crisis, but to the real economy, and these links follow not just balance sheet line, but the line of private sector debts. Secondly, the IMF clearly believes that private sector debt overhang is a core structural problem and has contagion implications across the entire system. EU leaders, even in countries heavily impacted by debt overhang, like Ireland, are solely obsessed with banks balance sheets (less) and sovereign finances (more).]

"Much has been done to address these challenges… Nevertheless, financial stability has not been assured. Recent Financial Sector Assessment Program (FSAP) assessments of individual EU member states have noted remaining vulnerabilities to:

• stresses and dislocations in wholesale funding markets; 
• a loss of market confidence in sovereign debt; 
• further downward movements in asset prices; and 
• downward shocks to growth." 

"These vulnerabilities are exacerbated by

• the high degree of concentration in the banking sector; 
• regulatory and policy uncertainty; and 
• the major gaps in the policy framework that still need to be filled."

"The SSM—while critically important––represents only one of a number of crucial steps that need to be taken to fill key gaps in the EU’s financial oversight framework.

• "As crisis tensions abate, it is important that the implicit unlimited sovereign guarantees in place for the last several years be effectively removed through affirmation and implementation of the principle that institutions with solvency problems must be resolved." [Note: in Ireland's case once again there is a departure from this principle - we are, simply put, not resolving insolvent institutions presence in the market. Instead, we are continuing to deleverage and consolidate the insolvent banking sector at the expense of its future viability and current borrowers and non-financial companies requiring credit. Resolving insolvency - especially after 4.5 years of supports - requires shutting down insolvent banks. That would de facto mean survival of the Bank of Ireland and significantly slimmed down AIB. And that's all. None else. We are far, far away from the Government even considering such an action, which means that the zombified banking sector will continue extract excessive rents out of stressed borrowers and businesses in this country for years to come all to dress up the banking sector 'stabilisation' whilst achieving no structural resolution of the crisis.]
• "The Single Resolution Mechanism (SRM) should become operational at around the same time as the SSM becomes effective. Resolution should aim to minimize costs to taxpayers, as well as to deposit insurance and resolution funds, without disrupting financial stability." [The sheer nonsense of this statement is exposed by the core EU authorities insistence that ESM will not apply retrospectively. In other words, the ESM will be a promise of a miracle cure to the dying patient contingent of the patient surviving for a number of years required to devise the cure. And the same applies to the last two points below.]
• "This should be accompanied by agreement on a time-bound roadmap to set up a single resolution authority, and common deposit guarantee scheme (DGS), with common backstops." 
• "Guidelines for the ESM to directly recapitalize banks need to be clarified as soon as possible, so that it becomes operational as soon as the SSM is effective."

So here you go, folks, per IMF, there's an ambulance to help the injured, but currently it exists only on the paper and even as such it is still pretty much unworkable. Good luck with setting up that triage, mates.

15/3/2013: IMF Assessment of the Euro Area Banking Sector Risks - part 3

This is the third post on today's release by the IMF of the 2013 Financial System Stability Assessment Report for European Union report.


The first post - summarising top-line conclusion from the Technical Note on Progress with Bank Restructuring and Resolution in Europe is available here: http://trueeconomics.blogspot.ie/2013/03/1532013-imf-assessment-of-euro-area.html

The second post dealt with the Technical Note coverage of the Non-Performing Loans issues: http://trueeconomics.blogspot.ie/2013/03/1532013-imf-assessment-of-euro-area_15.html

And related Euromoney Country Risk Survey study for Q1 2013 covering euro area banking sector risks is available here: http://trueeconomics.blogspot.ie/2013/03/1532013-irish-banks-still-second.html .

This note is focusing on the Technical Note on Financial Integration and Fragmentation in the European Union.


Let's start with a fascinating chart showing the sources of financing for the real economy in the EU compared to the US:

The scary bit here is the overall significant imbalances built in the system of financing in the EA17, compared to Denmark, and to the US:

• Thin bond markets across ALL euro area states
• Inexistent private credit markets
• Imbalanced over-reliance on bank credit
• In the case of Ireland, Netherlands, Spain, Cyprus, Portugal, Austria, Italy, Germany, Malta, Finland and Greece - mature markets were characterised with exceptionally thin or thin equity markets

And as chart below shows, euro area is also suffering from extreme over-concentration of the banking credit markets in the hands of the 'globally systemically important banks' (G-SIBs):

Per IMF: "The main EU banking systems are dominated by a set of globally systemically important banks (G-SIBs). These European G-SIBs have grown in size and importance and are highly interconnected with the rest of the global financial system (see Annex 1). Their assets more than tripled since 2000, amounting to US $27 trillion in 2010. As key players in global derivatives and cross-border interbank markets, they are also among the most interconnected GSIBs. European G-SIBs tend to be larger and more leveraged than their peers. In particular, they are very large relative to home country GDP, and in many EU countries, their size may dwarf the capacity of the home government to raise revenues."

Per footnote, this over-concentration is driven by the legacy models of banking in the euro area: "In part this is because European banks tend to follow the universal banking model, which combines a range of retail, corporate, and investment banking activities under one roof. There are some accounting differences that would make the balance sheets of the IFRS-reporting banks appear more “inflated” than the balance sheets of banks reporting under the U.S. GAAP (e.g., netting of derivative and other trading items is only rarely possible under IFRS, but netting is applied whenever counterparty netting agreements are in place under U.S. GAAP)."

Not surprisingly, banking sector stress directly links to the real economy and even more so to the sovereign positions:

And, within the real economy, the crisis is hitting the hardest the SMEs: "The deleveraging process raises concerns about a credit crunch that would particularly affect SMEs. SMEs in peripheral Europe are particularly hard hit by the deleveraging process, as deposit outflows and capital shortages at banks limit the availability and raise the cost of bank loans. Data from the European Commission and European Central Bank Survey on the Access to Finance of SMEs show that the availability of external finance from banks has decreased since 2009 while the demand for external finance has increased.

"However, there is much cross-country variation, with the availability of external finance having deteriorated markedly since 2009 in Greece and Ireland and having remained fairly stable in countries like Finland and Germany. Regression analysis suggests that the deterioration in the supply of credit to SMEs is partly driven by the financial dis-integration process, as measured by the decline in cross-border BIS claims."

Which, of course, is not surprising - Big Banks Dominance = Closer Links to the Governments and Big Business via the Social Partnership / Corporatist models for governance.

So, great stuff, Messr Kenny & Noonan - Irish banks (duopoly-modeled super-concentration with above average links to sovereigns and some of the most aggressive delveraging plans on the books within the EA17) offer as much hope of restarting lending to SMEs as that of sustaining viable rice growing industry in Sahara.


The next post will continue with my analysis of the IMF report and technical notes. Stay tuned for more later tonight.

15/3/2013: IMF Assessment of the Euro Area Banking Sector Risks - part 2

This is the second post on today's release by the IMF of the 2013 Financial System Stability Assessment Report for European Union report.

The first post - summarising top-line conclusion from the Technical Note on Progress with Bank Restructuring and Resolution in Europe is available here:


And related Euromoney Country Risk Survey study for Q1 2013 covering euro area banking sector risks is available here: http://trueeconomics.blogspot.ie/2013/03/1532013-irish-banks-still-second.html .

Some beef on the Non-Performing Loans (NPLs):

"NPLs in EU banks continue to rise, outpacing loan growth (Figure 4). Since 2007, loans to the economy have decreased by 3 percent while NPLs increased by almost 150 percent, i.e., €308 billion in absolute terms. And, this trend shows no sign of reversal, reflecting the continued macro deterioration in parts of the EU and the absence of restructuring."

"When NPLs remain on balance sheets, they absorb management capacity, and continued losses can weaken banks’ profitability. They can also foster forbearance, thereby deterring new investors by impairing transparency. In several countries, independent asset quality reviews and stress tests have facilitated a diagnosis of the quality of banks’ assets, supporting prospects for private recapitalization."

Per IMF note: NPLs have jumped from 2.6 percent in December 2007 to 8.4 percent of total loans in June 2012

Euro area periphery is worst-hit, for obvious reasons: "NPLs across EU banks differ largely, with those in the “peripheral” countries (Greece, Ireland, Italy, Portugal and Spain) witnessing the largest increases. For instance, from December 2007 to June 2012, the NPL ratio for Italy increased by 2.5 times, while in Spain, the increase was seven times (Figure 5). Ireland stands out with average NPLs of around 30 percent, followed by Hungary and Greece. However, definitions in this area remain non-harmonized and impair comparability across the EU".

Now, note that 'turned-the-corner' Ireland is in the league of its own when it comes to NPLs ratio to total loans. Taken to the average ratio of total loans to GDP, Irish NPLs must be absolutely stratospheric.


And now, onto IMF view of the NPL resolution processes in the euro area (again, italics are mine and all quotes are directly from the IMF note):

"Borrower restructuring needs to be facilitated, with legal hurdles lifted. The legal framework should facilitate the restructuring of NPLs and maximize asset recovery. In several EU countries, including Italy, Greece and Portugal, the IMF is involved in bankruptcy/insolvency law reform, including by introducing fast track restructuring tools and out-of-court restructuring process. For instance, repossession of the collateral backing a retail mortgage may take several years in Italy versus few months in Scandinavia and United Kingdom. The asset recovery process is also very prolonged in many EEE countries."

[Do note absence of IMF input in the case of Ireland and that is a general gist of the Note - it simply passes no assessment of the Irish personal insolvency regime 'reforms', which is strange given the prominence of these reforms and the fact that these are the first comprehensive reforms in the euro area periphery. Personally, I read this lack of analysis as the IMF reluctance to endorse the Irish Government approach to the NPLs resolution when it relates to mortgages.]

"An efficient framework for handling NPLs is key to rehabilitate viable borrowers and provide the exit of non-viable borrowers."

[Note the IMF emphasis on rehabilitating viable borrowers AND providing the exit for non-viable borrowers. These twin objectives strike contrast with the Irish Government approach to resolving the personal insolvencies and mortgages crises. Instead of rehabilitating viable borrowers, the Irish Government is pursuing an approach of giving the banks full power to avoid any writedowns of the loans, even when such writedowns can define the difference between rehabilitation and insolvency. When it comes to providing exit for non-viable borrowers, the Irish Government has adopted the approach of reforming the personal insolvency regime from 12 years bankruptcy duration to 3 years, but then extended the process of availing of the bankruptcy from few months to up to 3 years. The pre-bankruptcy period of up to 3 years under the new regime is a period during which the banks have full power to extract all resources out of the households with little protection for the household, in contrast with the previous bankruptcy regime. Thus, in terms of life-cycle financial health, Irish households going through the new reformed personal insolvency process are unlikely to gain any meaningful relief compared to the previous regime.]

"Active management of NPLs is needed. In principle, NPLs can either be:

1. retained and managed by banks themselves at appropriately written-down values, while the banks receive financial assistance from the government for recapitalization; or
2. relocated or sold to one or more decentralized “bad banks,” loan recovery companies, or Asset Management Companies (AMCs) that specialize in the management of impaired assets; 
3. sold to a centralized AMC set up for public policy purposes (possibly when the size of NPLs reaches systemic proportions)."

IMF also notes that: "The European Banking Coordination “Vienna” Initiative (2012) in a working group focused on NPL issues in Central, Eastern and Southeastern Europe. Recommendations, among others, focused on establishing a conducive legal framework for NPL resolution, removing tax impediments and regulatory obstacles, as well as enabling out-of-court settlements."


Stay tuned for the third and subsequent posts covering other technical notes released by the IMF.

15/3/2013: IMF Assessment of the Euro Area Banking Sector Risks - part 1

Today's releases of the horror flicks starring Irish financial sector are up and running, folks.

As noted in the previous note - premiering Q1 2013 article on euro area banking sector analysis from Euromoney Country Risk surveys (link: http://trueeconomics.blogspot.ie/2013/03/1532013-irish-banks-still-second.html) - the IMF has released today 2013 Financial System Stability Assessment Report for European Union report.


This is the first blog post on the report and associated technical papers, and it covers the Technical Note on Progress with Bank Restructuring and Resolution in Europe.


From the top-line conclusions by the IMF (all quotes marked, italics within quotes are mine):

1. "The European Union (EU) banking system restructuring is under way, but is far from complete. Some bank restructuring has started, and the level Tier 1 capital ratios of EU banks have been substantially increased."
2. "But system-wide, capital ratios have been met partly by deleveraging or recalibrations of the risk weights on activities."
3. "Consolidation in the banking sector has been slow, with banks rarely closed."
4. "Nonperforming loans are building up in banks’ balance sheets, and addiction to central bank liquidity remains high especially for banks in peripheral countries."
5. "Despite the EBA recapitalization exercise having led to €200 billion of new capital or reduction of capital needs by European banks, fresh capital is difficult to attract in an environment where prospects for profitability are uncertain."
6. "Several hurdles impair restructuring and resolution in Europe, and urgent progress needs to be made:

• "First, EU bank resolution tools need to be strengthened, aligning them with the Financial Stability Board Key Attributes for Effective Resolution. Fast adoption of the EU resolution directive is welcome, but enhancements are warranted. Swift transposition should follow." [We are still ages away from having any effective resolution tools and any sort of functional regulatory consolidation, let alone functional and effective supervisory consolidation.]
• "Second, restructuring of nonperforming loans (NPLs) should be facilitated [more on this below]. The legal framework should not slow down restructuring and maximize asset recovery. In several EU countries, such as Italy, Greece and in Eastern Europe, bankruptcy reforms lag behind in that, for instance, current practice does not allow the seizure of collateral in a reasonable timeframe. Banks should also manage more actively their NPLs, possibly allowing a market for distress assets to emerge in Europe." [Note the absence of Ireland in the list of laggards above. It is generally strange that the IMF is avoiding passing any judgement on the only case of actual reforms that has impacted only one of the peripheral countries.] 
• "Third, further evolution of the General Directorate for Competition’s (DG COMP) practices will be needed in systemic cases to ensure consistency with a country’s macro-financial framework and support viability of weak banks, recovery of market access, and credit provision. Increased transparency would give added credibility and accountability." [Again, we are ages away from delivering on these.]
• "Fourth, disclosure should be significantly enhanced and harmonized by the EBA, to restore market confidence. In particular, interpretable metrics regarding the quality of banks’ assets, in terms of NPLs, collateral, probability of defaults (PD) and loan recovery rates (LGD) are key for assessing the strength of banks and restoring confidence in the banking system." [see comment above]

Summary: what needs to be done is, largely, nowhere to be seen, yet...

Update:


And when it comes to much of hope of the forthcoming regulatory changes altering the status quo of the dysfunctional regulatory system, don't hold your breath, folks.

The Big Hope is on the forthcoming EU resolution directive aiming to create coordinated system of responses to any future structural financial crises. Here's IMF view on that one:

• First, polite stuff: "A critical new EU resolution directive is in preparation. As a national approach to resolution may well not be appropriate in the EU given the importance of cross-border banking, and the failure of existing cross-country coordination mechanisms, the European Commission (EC) has taken steps to harmonize and strengthen domestic resolution regimes. This should help avoid regulatory arbitrage and make orderly resolution effective and efficient for cross-border banks. In June 2012, the Commission issued a draft directive for harmonized crisis management and resolution framework in all EU countries. The Irish Presidency will make the adoption of the resolution framework a top priority and plans to adopt it during the first part of 2013. The new national resolution regimes endow EU countries with strong early intervention powers and resolution tools. The transposition of the directive into national laws should be accelerated relative to the current deadlines (01/2015, and 01/2018 for bail-ins)."

I wrote about this Directive recently (http://trueeconomics.blogspot.ie/2013/02/2422013-eus-banking-union-plan-can.html) and was not too enthusiastic. Alas, here's IMF's less pleasing assessment, although dressed up in polite language of 'suggestions':

• "Box 1. Proposed Resolution Directive––Risks and Areas for Enhancements

1. Resolution of banks is undermined by the absence of a more effective EU-wide framework to fund resolution. Binding mediation powers for the EBA and mutual borrowing arrangements between national funds face inherent constraints (in particular, the EBA cannot impinge on the fiscal responsibilities of EU member states).
2. Passage of the directive will substantially enhance the range of tools available to resolution agencies in the EU. But the scope of the directive should be widened to include systemic insurance companies and financial market infrastructures. The European Commission launched a consultation at the end of 2012 on this issue. All banks should be subject to the regime, without the possibility of ordinary corporate insolvency proceedings.
3. The breadth and timing of the triggers for resolution should be enhanced by providing the authority with sufficient flexibility to determine the non-viability of the financial institution (including breaches of liquidity requirements and other serious regulatory failings, not just capital/asset shortfalls). There should be provision for mandatory intervention in the event a specified solvency trigger is crossed.
4. The directive affords less flexibility for using certain resolution powers than the key attributes. For instance, it does not permit exercising the mandatory recapitalization power and the asset separation tool on a standalone basis. Also, bail-in safeguards should not prevent departure from pari passu treatment where necessary on grounds of financial stability or to maximize value for creditors as a whole.
5. Depositor preference should be established for insured depositors2, with the right of subrogation for the DGS."

Thus, to sum up the best-hope response of the EU - it is useless, largely toothless and predominantly weak. And to add to this - it will only be fully functions in 2018! You might as well think we live in a Natural History museum, where urgency of response is differentiated by months, rather than minutes.




Next post will cover the issue of Non-Performing Loans.

15/3/2013: Irish banks - still the second sickest of the sick euro area banking sector

In anticipation of the today's release (16:00 GMT) by the IMF of the 2013 Financial System Stability Assessment Report for European Union, Euromoney Country Risk analysts have published an interesting article Country Risk: Five years on, banks still inflict chronic pain on eurozone. Here are some of the very insightful charts - including an update on the previously covered banks stability scores (see here for January 2013 post and here for Q3 2012 data).

Let's start with the aforementioned chart on banks stability scores:

Pretty poor showing here for Ireland. Unlike the rest of the economy, we clearly have not 'decoupled' from the peripherals in terms of banking sector health and that is given:

1. Unprecedented and incomparable by the rest of the EZ standards levels of support for banks in Ireland;
2. Lack of any progress on mortgages crisis; and
3. Longer duration of the banking crisis in Ireland than in any other peripheral state.

We had the second weakest banking sector in the EZ throughout 2011-2012 and we still do. So much for the theory that Irish banks are 'lending into the economy' or 'have been repaired' and so much real support for the body of economic knowledge that says the deeper the debt overhang crisis, the longer and the deeper the required deleveraging crisis...

Now, something that shows that despite the consensus in Ireland and in the bonds markets, we are not quite due an upgrade as risks are still favouring continuation of the banking crisis (note, my view is that we are due an upgrade, but a single notch one, to reflect economic decoupling from the peripherals):

And the sovereign-banks links? Well, they are still there and still nasty for Ireland:

And here are few sobering words from the ECR:

"While some observers might still be convinced the worst of the banking crisis is over, the [Euromoney’s Country Risk] survey provides compelling evidence that bank stability risks are as concerning, if not worse now, for many European countries than at the beginning of last year, according to its contributing experts. More than five years on from the catastrophic events of 2007/08, the resolution of the region’s banking sector problems is still firmly at the top of policymakers’ to-do list, but with plans seemingly stalling, the implications of failing to act could prove critical."

Just in case you are in the 'green jersey' 'we've-turned-the-corner' camp, here's ECR quote putting Irish gains in the above scores into perspective:

"Across the eurozone, bank stability risks were unchanged last year in four countries – Austria, Belgium, Cyprus and Slovakia; with Cyprus the lowest of the group – and improved in four more: Malta, Italy, Ireland and Portugal. However, for the latter three, the rebounds were small and their scores remained at low levels of 5.5, 4.3 and 3.3 out of 10 respectively, illustrating heightened levels of risk."

So how bad are things in the euro periphery and in Ireland? Well:  "And the banks are just as problematic across the periphery. Taken as a whole, the seven riskiest eurozone countries (Greece, Portugal, Spain, Ireland, Italy, Cyprus and Slovenia) had an average bank stability score below that of most other regions, worse even than Mena or Latin America – see chart (below)." Keep in mind, that is for the average and Ireland is way worse than the average.

So next time you see Irish 'banks' adds claiming they are 'open for business' and 'doing our bit to help the economy' etc, just check these charts once again. They are, by all international comparatives, graveyard zombies, still holding this island at ransom.

29/8/2012: Slovenia & Ireland lead in banks-related risks

According to latest data from the Euromoney, Slovenia now leads the rise in bank-related risks in Europe. Here's a chart mapping declines in scores across Europe (lower score implies higher risk):

It is worth noting that Ireland shows the second largest risk increase  after Slovenia in absolute level terms, but the largest in percentage terms.

Economics 19/01/2010: Irish banks - a rational model of risky strategies

I just came across a very interesting paper, written back in November 2007 and published by the Bank for International Settlements as a Working Paper No 238. Authored by Ryan Stever and titled “Bank size, credit and the sources of bank market risk” the paper “…examines bank risk by investigating the equity and loan portfolio characteristics of publicly-traded bank holding companies.” The study is based on the US banks, with sample being a panel of ‘at least 339 publicly trades BHCs at each point in time” for the period of 1986-2003. “These range in size from American Bancorporation at $31 million in book assets (200 employees) to Citigroup at $1.26 trillion (over 280,000 employees).”

“Unlike the pattern for non-financial firms, equity betas of large banks are two to five times greater than those of small banks. In explaining this, we note that regulation imposes an effective cap on banks’ equity volatility. Because the portfolios of small banks are less diversified, this cap has a greater effect on small banks than large banks.”

In other words, there is plenty of evidence that even when effective, regulators can induce some unintended consequences onto the banking system and that these consequences, if unaddressed can lead to systemic failures.

Here is how it works:

• Regulators (and/or shareholders through exercise of their voting rights) place a limit on the total volatility of each bank’s assets regardless of size, which tends to minimize bank risk; however
• Small banks have more idiosyncratic risk inherent in their loan portfolio “because they cannot diversify away idiosyncratic volatility as well as large bank” (practically – smaller banks are more specialized, making their loans books more exposed to idiosyncratic strategy risk).
• Smaller banks inability to diversify comes about in “a number of different ways – for example; less total loans held, less diversity in borrower type (they do not have access to large borrowers) and geographic restrictions (small banks tend to be more localized);

 Because their total equity volatility is limited by regulation smaller banks must then find a way to eliminate their idiosyncratic volatility that is in excess of larger banks’ idiosyncratic volatility. To do this, small banks do not necessarily pursue higher levels of equity capitalization or lending to different sectors in the economy – in other words, they do not strive to become like larger banks, but instead they either:

•  make loans with less credit risk than large banks (Swiss private banks, for example). This has the effect of reducing idiosyncratic volatility (as desired) and also reducing the beta of each loan (and thus the equity beta of small banks); or
• demand more collateral (e.g. Irish banks).
  

Of course, the problem with selecting the latter path (beefing up collateral) as opposed to the penultimate pathway (more conservative, risk-sensitive lending) – as Irish banks should have learned from the current crisis – leads to additional problem, not highlighted in the study. This problem is manifested in the selection bias induced onto collateral – smaller banks opting for higher collateral requirements will take on less diversified collateral that is more likely to be positively correlated with their own (risk-skewed) loans books. Thus collateral risk becomes positively correlated with loans risk.

Just think of what type of collateral Liam Carroll was supplying for his property development loans? You’ve guessed it – property-based collateral.

In fact, the study does find that small banks did not lower their equity volatility through lower leverage. Instead, “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.”