Irish banks need to further strengthen and improve their capital levels given the risk of contagion across the eurozone banking sector, which remains as underestimated as it was prior to the financial crash of 2008.
New research has found that banks across Europe are as vulnerable to failing now as they were seven years ago, in the period directly preceding the banking collapse.
The most vulnerable banks to systemic risk are in southern European states such as Spain, Italy, and France, according to the research published in the Journal of Banking and Finance.
While the Irish banking sector fares much better in the report than its southern equivalents, risks still exist, according to lead researcher Dr Nikos Paltalidis of the University of Portsmouth.
“The Irish banking system seems to be quite well-capitalised and resilient; the financial system seems to be OK in Ireland. However, there is a need to strengthen and improve capital levels,” he said.
“The results give a vivid picture of financial contagion and the domino effect in the banking sector. The risks are still substantial and a repeat of the last financial crisis is feasible.”
The collapse of Lehman Brothers and the subsequent crash brought the world’s financial system to its knees. The report describes this as the canary in the mine which exposed its fragility.
In the aftershock, the effects of both interconnectedness and contagion manifested themselves, while systemic risk emerged as one of the most challenging aspects.
Reducing the risk of contagion was held up as the biggest reason for introducing the bank guarantee in Ireland.
Despite the scale of the collapse, systemic risk is again being enormously underestimated.
Efforts to strengthen the eurozone banking sector have been successful to a degree but, in reality, do not provide the intended protection against systemic shocks, according to the study.
“In theory, the new capital rules adopted by ‘systemically important’ banks should be able to endure a 10% fall in the value of their assets before placing panicky calls to the central bank. Also, the euro area banking system seems to be fundamentally solvent, according to several stress tests,” Dr Paltalidis said.
“However, our study provides ample evidence that this hypothesis does not hold in practice, indicating that, similar to the pre-2009 period, systemic risk is enormously underestimated once again.”
The researchers used three independent channels of systemic risk — the interbank loan market, the sovereign credit risk market, and the asset-backed loan market — to test which banks were resilient and to track how shocks spread between domestic and international banks.
The findings show that although a shock in the interbank loan market triggers the highest expected losses, a shock in sovereign debt risk transmits fastest and causes a cascade of losses for other banks. The results reveal that a sharp rise in government borrowing costs would have a destructive ripple effect across the region.
Dr Paltalidis warned the “too big to fail puzzle” is not over and that further policies need to be implemented. Among these is the suggestion by Bank of England governor Mark Carney that banks ringfence routine retail operations from riskier investment banking activities.
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