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Euro area bank bailout policies after the global financial crisis sowed seeds of the next crisis

During the 2008/09 global financial crisis, European governments bailed out a large number of banks that were severely affected by the crisis. This column documents how the design of the bailout policy was determined by the fiscal capacity of the respective country. Fiscally weak countries recapitalised banks insufficiently, causing undercapitalised banks to shift their assets from loans to risky sovereign debt and engage in zombie lending, resulting in weaker overall credit supply, elevated risk in the banking sector, and, eventually, greater reliance on liquidity support from the ECB. Kicking the can down the road in 2008/09 thus sowed the seeds of the future banking crisis. These results have potential implications for the ongoing COVID-19 pandemic as, if the economic situation further deteriorates, banking sector stability is likely to be adversely affected.

When considering interventions in the banking sector during crises, governments can either use system-wide or bank-specific measures (Farhi and Tirole 2012). Bank-specific measures can be grouped into three categories (Pazarbasioglu et al. 2011) – (1) guarantees, (2) capital injections, and (3) asset restructuring/resolution – the implementation of which induces different fiscal costs (Stavrakeva 2020).

In a new paper (Acharya et al., 2020), we investigate government interventions in the context of the global financial crisis using a novel, hand-collected dataset of all aid measures granted to euro area banks during the 2007 to 2009 period. While banks across all European countries were in distress, bailout decisions were subject to the discretion and the fiscal constraints of national governments. Key measures of fiscal capacity (inversely, constraints) are, among others, government revenues (as percentage of GDP) and the total debt of the country (as percentage of GDP).

Figure 1 shows the average development of these fiscal capacity measures for GIIPS countries (Greece, Ireland, Italy, Portugal, and Spain) and non-GIIPS euro area countries. Evidently, GIIPS countries appear more fiscally constrained based on both measures throughout the two decades from 1998 to 2018.

Figure 1 Fiscal capacity of GIIPS vs. non-GIIPS countries

We find that countries with a higher fiscal capacity were more likely to recapitalise their banks in the immediate aftermath of the global financial crisis. Moreover, these countries linked their bailout decisions more closely to observable metrics such as the banks’ size, capitalisation, or profitability, while fiscally weaker countries applied more discretion (i.e. forbearance).

Consequences of an undercapitalised banking sector: Bank-level evidence

Next, we document a number of consequences from leaving banks undercapitalised:

  • Undercapitalised banks lost further equity capital and reduced lending, but increased their loan loss provisions compared to their better-capitalised peers during the 2010 to 2012 period. 
  • Undercapitalised banks also increased their short-term borrowing from the ECB. 
  • Moreover, undercapitalised banks shifted their assets from loans to risky sovereign debt and engage in zombie lending (i.e. lending to highly distressed firms at subsidised rates), resulting in weaker credit supply to other healthier firms and elevated risk in the banking sector. 

The top panel of Figure 2 shows how the lending behaviour of undercapitalised banks changed from 2009 to 2012 depending on the borrower category. While lending to risky borrowers fell by more than 20%, lending to zombie firms increased by more than 30%.1 This implied an overall reduction in credit supply of about 8%, since signigicant bank capital was tied up in lending to zombie firms. Banks have an incentive to evergreen loans to borrowers at the brink of default to (at least) postpone the default of the firm and thereby avoid the materialization of losses on their balance sheet.

The bottom panel of Figure 2 shows how the balance sheet composition of undercapitalised banks evolved between 2009 and 2012 compared to their better-capitalised peers. While better-capitalised banks increased the share of outstanding loans to assets, undercapitalised decreased it. More strikingly, better-capitalised banks did not significantly change their security exposure, while undercapitalised banks heavily increased it, mostly driven by the purchase of GIIPS government bonds.2 Overall, these developments, which were a consequence of the undercapitalisation of banks in some euro area countries, contributed to the severity of the sovereign debt crisis and the anemic and asymmetric economic recovery across the euro area afterwards (Acharya et al. 2018, Schmidt et al. 2020).

Figure 2 Consequences of undercapitalisation

This micro-evidence on the consequences of an undercapitalized banking sector is consistent with that at the macro level. Recent research by Jordà et al. (2020) confirms the importance of adequate banking sector capitalisation levels for the recovery from large economic shocks. The left panel of Figure 3 shows that economies with a weakly capitalised banking system take considerably longer to regain previous output levels (green vs. red line). The  right panel speaks to a likely channel for the observed differences: bank lending takes considerably longer to recover when initial capital ratios are low. Our evidence shows further that bank lending not just takes longer to recover when banks are undercapitalised, but that these banks become increasingly dependent on the central bank for liquidity support.

Figure 3 Financial crises and economic recovery 

Source: Jordà et al. (2020).
Note: Vertical axis in left panel shows changes in output level; vertical axis in right panel shows changes in bank lending

Implications for the COVID-19 pandemic

These results from the 2008 to 2009 financial crisis seem quite germane to today’s context. The banking sector will be key in the recovery from the economic consequences of the COVID-19 pandemic. Government fiscal support measures that have been implemented early as we entered the pandemic will eventually wear off, and the recovery will require intermediated credit support from the banking sector across Europe.  An important role of banks is to provide credit and insurance against liquidity shocks to healthy borrowers in the real economy. While non-bank financial institutions (collateralised loan obligations, hedge funds, private debt funds, etc.) have taken over some share of corporate financing over the past years, particularly of highly leveraged firms (so-called ‘term loan funding’), banks remain the main providers of overall corporate liquidity in Europe. 

A key lesson from the global financial crisis is that banks must be well-capitalized to allocate credit efficiently and support the recovery.  Indeed, the COVID-19 pandemic has already impacted the global banking system. For example, banks faced liquidity drawdowns (‘runs’) from their borrowers at the outset of the pandemic (Acharya and Steffen forthcoming) and bank debt and equity values are severely depressed (Aldasoro et al. 2020) which led the Single Supervisory Mechanism (SSM) to issue a recommendation to suspend payouts until the end of 2021. 

In our analysis of bank bailouts during the 2007-2009 period, we show that decisive recapitalisations by governments address two issues simultaneously. Recapitalisations boost banks’ capital position and prevent them from gambling-for-resurrection, for example by shifting assets in their portfolios towards high risk investments and instead focusing on credit-worthy healthier borrowers. 

Overall, the importance of fiscal capacity for government interventions at the national level as we show in our paper highlights the need for an integrated fiscal support scheme at the European level. The decision of the European Commission to fund its €750 billion Next Generation EU recovery plan by borrowing from financial markets directly (backed by all EU countries) and distribute those resources to individual countries without increasing their fiscal burden is an important step in this direction. A fully-fledged banking union for the EU countries with clearly laid-out burden-sharing rules for deposit insurance and resolution funds seems an important natural next step.


Acharya, V V, L Borchert, M Jager and S Steffen (2020), “Kicking the can down the road: government interventions in the European banking sector”, NBER Working Paper No. 27537.

Acharya, V V, T Eisert, C Eufinger and C Hirsch (2018), “Real effects of the sovereign debt crisis in Europe: Evidence from syndicated loans”, The Review of Financial Studies 31(8): 2855-2896.

Acharya, V V and S Steffen (2015), “The “greatest” carry trade ever? Understanding eurozone bank risks”, Journal of Financial Economics 115(2): 215-236.

Acharya, V V and S Steffen (forthcoming), “The risk of being a fallen angel and the corporate dash for cash in the midst of COVID”, Review of Corporate Finance Studies.

Aldasoro, I, I Fender, B Hardy and N Tarashev (2020), “Effects of Covid-19 on the banking sector: the market's assessment”, BIS Bulletin No. 12.

Bruche, M and G Llobet (2014), “Preventing zombie lending”, The Review of Financial Studies 27(3): 923-956.

Drehmann, M, M Farag, N Tarashev and K Tsatsaronis (2020), “Buffering Covid-19 losses-the role of prudential policy”, BIS Bulletin No. 9.

EBA – European Banking Authority (2020), “The EU banking sector: first insights into the COVID-19 impacts”,Thematic Note EBA/REP/2020/17.

Farhi, E and J Tirole (2012), “Collective moral hazard, maturity mismatch, and systemic bailouts”, American Economic Review 102(1): 60-93.

Jordà, Ò, B Richter, M Schularick and A M Taylor (forthcoming), “Bank Capital Redux: Solvency, Liquidity, and Crisis”, Review of Economic Studies.

Kirschenmann, K, J Korte and S Steffen (forthcoming), “The zero risk fallacy? banks’ sovereign exposure and sovereign risk spillovers”, Journal of Financial Stability.

Kleinnijenhuis, A, L Kodres and T Wetzer (2020), “Usable bank capital”,, 30 June 2020.

Pazarbasioglu, C, M L Laeven, O M Nedelescu, S Claessens, F Valencia, M Dobler, and K Seal (2011), “Crisis management and resolution: Early lessons from the financial crisis”, International Monetary Fund.

Schmidt, D, Y Schneider, D Streitz, and S Steffen (2020), “Capital Miscallocation and Innovation”, Working Paper.

Stavrakeva, V (2020), “Optimal bank regulation and fiscal capacity”, The Review of Economic Studies 87(2): 1034-1089.


1 Zombie firms are defined as firms in the high-risk segment (a rating of BB or lower) who reiceve subsidised credit from banks, i.e. have to pay an interest rate that is below the average interest rate of AAA-rated firms in the same industry.

2 The European framework of banking regulation offers a zero risk exemption for euro area government bond holdings. As already shown by Acharya and Steffen (2015), weak banks massively used this exemption to gamble for resurrection, which has adverse consequences for financial stability domestically and cross-border through risk spillovers (Kirschenmann et al. 2020).

3 Drehmann et al. (2020) and Kleinnijenhuis et al. (2020) highlight the importance of sufficient usable capital (buffers) forNthe banking sector to maintain its role in credit supply. Moreover, the European Banking Authority (EBA 2020) has emphasised the deteriorating asset quality as a key concern for banks.

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