This article is part of a series of analyses on the challenges facing banking this decade, written by Dr Andrei Radulescu, Director of Macroeconomic Analysis, Banca Transilvania, and published on the BT Blog.

Macro‑financial developments, endogenous shocks (the Great Recession) and exogenous shocks (the coronavirus pandemic), together with the economic policies implemented over recent decades, have led to structural changes in the banking system, both globally and in Europe.

The impact of the Great Recession was severe in terms of non‑performing loan ratios, which rose sharply and stayed high for longer, especially in Romania, with consequences for lending activity.

At the same time, following the onset of the most severe economic and financial crisis since the end of the Second World War, central banks focused their activity on core lending, in an environment marked by an unprecedented degree of prudence.

Moreover, the significant increase in public debt and an environment dominated by unconventional monetary policies implemented by central banks to counter market fragmentation — including risks to the continuity of the European Monetary Union — have pushed banks’ exposure to government debt instruments to record highs in recent years.

In fact, the Great Recession exposed the vulnerabilities of the euro area’s imperfect architecture, with financial markets repeatedly pricing in the fact that countries borrow in a currency they do not control.

Among the factors that contributed to the marked increase in banks’ exposure to public debt instruments were:

• the low risk profile and the opportunity to invest in interest‑bearing securities rather than hold cash (which pays no interest);
• the lack of more profitable alternatives at a similar level of risk;
• asset diversification;
• the shorter post‑crisis business cycle in Europe (as the Great Recession produced a two‑wave crisis) and challenges around loan portfolio quality (weighing on the supply of credit);
• difficulties in the corporate sector (weighing on credit demand, despite very low real financing costs).

By contrast, the increase in euro area banks’ exposure to public debt could pose future risks to financial stability. That said, representatives of the Banque de France have stressed that the rise in banks’ exposure to government debt instruments played a fundamental role in absorbing the financial shocks the region faced (the Great Recession and the coronavirus pandemic).

The Banque de France also notes that the euro area banking sector is much stronger today, not least thanks to progress on the European Banking Union across multiple dimensions.

This article aims to do just that: present the main structural changes in the euro area banking system — Romania’s main economic partner — over recent decades.

Romania’s banking system has largely mirrored developments in the euro area in recent years.

Broadly speaking, the occurrence of endogenous (the Great Recession) and exogenous (the coronavirus pandemic) shocks, together with policy responses, increased banks’ exposure to public debt across the region and reduced exposure to non‑government lending.

According to European Central Bank data, between end‑2006 and end‑H1 2021 the share of banks’ exposure to public debt rose by 8.4 percentage points to 20.1% (a record high).

Conversely, the share of banks’ exposure to non‑government lending declined by 6.9 percentage points between 2006 and end‑H1 2021, to 39.5%, an all‑time low.

In this context, the traditionally strong link between European companies and the banking sector has weakened. It is well known that European companies rely on bank financing, unlike in the US, where companies predominantly raise funding on the capital markets.

Share of non‑government credit and government credit in total assets of euro area banks

Source: BT, based on European Central Bank data

Before the euro area economy felt the impact of the Great Recession, the asset structure of the banking sector was dominated by non‑government lending (to companies and households), at 50% of the total. Foreign assets accounted for 26% of euro area bank assets in 2007.

By contrast, banks’ exposure to the government sector in the euro area was just 12%, ranking third among asset classes.

Asset structure of the euro area banking sector in 2007

Source: European Central Bank

After the onset of the Great Recession in Europe (a two‑wave crisis for the euro area — first private debt, then public debt), banks increased their exposure to government assets amid large‑scale programmes rolled out by the authorities to counter the crisis, and the share of non‑government lending fell given the severe impact on the real economy, as well as the deterioration in loan portfolio quality. Thus, in 2012 banks’ exposure to government assets was 13%, while the share of non‑government lending was just 42% (down from 50% in 2007), according to the European Central Bank.

Asset structure of the euro area banking sector in 2012

Source: European Central Bank

In 2019, euro area banks’ exposure to the government component stood at 16.2%. By contrast, the share of exposure to the non‑government segment was 41% in the year before the health crisis.

In other words, over the post‑crisis business cycle (2012–2019) the share of exposure to government credit increased from 13% to 16% of euro area banks’ total assets, based on European Central Bank data.

Meanwhile, over the same period, the share of exposure to non‑government credit fell by just one percentage point to 41%.

Asset structure of the euro area banking sector in 2019

Source: European Central Bank

The coronavirus pandemic extended this trend, taking banks’ exposure to the government sector to 20.1% in H1 2021.

Immediately after the most severe global health crisis in a century hit, the European Union and national governments rolled out large programmes (including grants and highly favourable loans) to support the real economy (companies and households) during the pandemic. The implementation of these programmes substituted for bank lending, which is heavily regulated.

At the same time, these government programmes weakened public finances; the state’s financing needs were met through bank funding, with banks keen to place their excess liquidity at low risk.

Conversely, banks’ exposure to non‑government lending (as a % of total assets) fell to 39.5%, an all‑time low, as shown in the chart below.

Asset structure of the euro area banking sector in H1 2021

Source: European Central Bank

This series also includes:

• A paradigm shift in monetary policy
• Excess liquidity accumulating in the banking sector
• Structural developments in Romania’s banking sector after the Global Financial Crisis
• Outlook for the banking sector