The EU Financial System under the Global Financial Crisis

Abstract

The severe recession in the EU economy after the September 2008 Lehman shock was caused by vulnerability in the EU financial systems. Why did the problems in the US mortgage market explode throughout Europe? Were there any deficiencies in the EU financial regulatory and supervisory system? These problems should be solved within the framework of the EU integration studies.To tackle these problems, sections I and II of this paper consider these issues by focusing on problems the EU financial institutions faced prior to the financial crisis. The present regime of EU financial institutions was established through (1) domestic consolidation during the 1992 Internal Market period, (2) cross-border consolidation during the 1999 Monetary Integration period and (3) the one way entry into emerging markets through EU enlargements in 2004 and 2007. This paper focuses on how the financial institutions reacted to the new environment of historically low profitability in the first half of the 2000s, and divides the banks into two groups according to their business strategy for higher profitability: (1) Some banks attached greater importance to the so called “trading book” business, which is associated with the “Shadow Banking System” in the US. (2) Other banking groups expanded their branch network, i.e. “banking book”, throughout the new EU member states.Sections III and IV describe the global financial crisis by distinguishing between its two phases. PhaseIwas the “trading book crisis” period when risks that had accumulated during the worldwide “excess liquidity” environment gradually materialized after 2006 and finally exploded in September 2008. In the current post-Lehman shock Phase II, the EU economy faces a traditional “banking book crisis” due to the accumulation of non-performing loans.The issues concerning the EU financial regulation and supervision are reviewed in section V. The present crisis can be described as the first truly pan-European financial crisis since the decentralized system of EU financial regulation and supervision was established in 1992. In the face of such a challenging environment, there has been significant progress in EU financial regulation laws. Also concerning financial supervision, both the ESFS (European System of Financial Supervisors) and the ESRB (European Systemic Risk Board) have been established. The global financial crisis has thus urged the EU to establish a more integrated financial regulatory and supervisory system.