Financing the Recovery in Europe
Pedro Santa Clara
Nova School of Business and Economics
Banco de Portugal – European Investment Bank
September 2014
Banks are the critical source of funds in Europe
Taken from DB Research
-2-
Taken from DB Research
Too much leverage and slow deleveraging
Taken from DB Research
Reluctance to raise equity
Taken from DB Research
Taken from DB Research
Leads to shrinkage instead
Taken from DB Research
Incentives and policy
Banks as options: highly leveraged entities best seen as a call
option on assets – Merton (1976, 1977)
•  Don’t raise equity, as the benefits accrue to bondholders and
deposit insurers
•  Invest in assets that pay off in the good state of nature
–  Roll bad loans, slow write-offs, keep zombies alive
–  Invest in your own government’s debt
Differences in policy vs the US:
•  Treasury and Fed buying assets from banks thus reducing
overhang
•  Sovereign and bank risks still linked in Europe through ineffective
deposit insurance and bank resolution
•  Only now are we making progress in common regulation and
supervision
What to do?
Ex-post
•  Force banks to recapitalize and restructure
•  Get supervision right – this time is for real!
Ex-ante
•  Give incentives for write-offs and asset sales
•  Give incentives to raise equity, swap debt for equity
•  Deposit insurance and resolution at EZ level, not the sovereigns
Improve financial “technology”
•  Europe needs a diverse ecosystem of financing institutions, not
just banks – from angel investors to capital markets
Blowing bubbles is not enough!