Eurozone Subprime Bank Losses To Hurt GDP

Expected subprime-related bank losses in the Euro area are estimated to have a negative impact on economic growth of 0.2 to 0.3 percentage points, according to a new background paper from the International Monetary Fund staff. The paper Euro Area Policies: Selected Issues does not represent official IMF policy. It acknowledges the difficulty in making such estimates, and calculates the potential impact two different ways, with broadly similar results.

The calculations illustrate that there are linkages between the financial sector soundness and real economic developments. They also illustrate the challenges of quantifying the exact relationship, and the uncertainties surrounding the estimates.

Estimates of the total subprime-related losses in euro-area global banks were around $45 billion as of March 2008. Losses for the whole of Europe were much larger (about $121 billion), but substantial chunks of these losses were in global banks based in the United Kingdom and Switzerland. These losses correspond to about 2.0 percent of the euro-area banks’ capital and reserves. If nothing else happened, the ratio of equity to assets for euro area banks would decline from 6.7 percent to 6.5 percent, and the banks’ leverage would increase correspondingly.

Assuming that banks target a certain leverage ratio, absent injecting more capital, assets would have to fall by 2.0 percent to maintain the ratio, so banks would cut down their loan supply by the same amount. The paper assumes a decline in the supply of bank loans by 10 percentage points leads to a decline in real GDP by about 1 percentage point. A loan decline by 2.0 percent therefore corresponds to 0.2 percentage point drop in real GDP.

As a market-based indicator that incorporates market participants’ view on banks’ situation and outlook, distance to default can provide an alternative assessment of the likely impact of the shocks that hit the banks. The average distance to default in January 2008 was 1.9 standard deviations lower than in July 2007. This translates into a decline in real credit by 2.9 percentage points. That in turn translates into a real GDP decline by some 0.3 percentage points.

The IMF says the estimates should be taken with a grain of salt. In particular, they focus only on losses to the euro-area economy stemming from losses in euro-area banks, and do not cover the impact on euro-area residents of losses in, say, Swiss banks. Also, they do not include other financial institutions that could have exposures (such as thrifts, insurance companies, or hedge funds).

The impact of bank losses on lending, and thereby on output, can be lower if banks increase their capital-to-asset ratios (decrease leverage) through capital injections rather than (or in addition to) asset manipulation. The impact can also be bigger if banks aim to decrease their leverage target, “which is quite likely given the overall increase in risk aversion and if they get hit by additional shocks, such as stock price declines.”