SUNWAY UNIVERSITY BUSINESS SCHOOL

BACHELOR OF SCIENCE (HONS) ACCOUNTING AND FINANCE

FIN 2024: FINANCIAL INSTITUTIONS AND MARKETS

Group Members:
Chow Eva

12059416

Muhammad Zubair

12018644

Bwale Chisaka

11024874

Samyuktha Manoharan

12057543

(a)
(i)

The Euro zone also known as the euro area, is an economic and monetary union that

consist of 18 different countries in the euro area that have taken up the use of one common
currency known as the euro. Economic and Monetary union involves management of economic
and fiscal policies, common monetary policy and the common currency as the sole legal tender.
The euro zone crisis also referred to as the sovereign debt crisis, its a current crisis that involves
several European countries facing the breakdown of financial institutions, and high government
debt and escalating bond yield in government securities ever since early 2009. There are many
and various reasons that caused the Eurozone crises, some are broad causes to the whole
Eurozone and some are country specific factors. The following part of the report will discuss
some key drivers leading up to the Eurozone crisis:
Monetary Policy - The single currency was initiated in 1999 adopted firstly by only 11
countries increasing to 18 countries to date and this was a major step in European integration, as
a result of this euro members gave control over the monetary policies to the European central
bank which safeguards price stability and setting the interest rates for the entire Eurozone.
Former president of Czech Republic Vaclav Klaus stated that the crisis was created by having
one exchange rate, one interest rate and one monetary policy to govern many diverse economies
in Europe. The crisis taking place in Europe at the moment has proven that the monetary policy
enforced through the various countries isnt efficient. It is over regulated which create a
hindrance for the economy to develop concluded Klaus. Some large countries such as Germany
encountered weak growth this resulting in the central bank setting pretty low interest rates,
conversely this rate was too low for booming economies like Spain and that generated large
market booms. By implementing the one monetary policy and currency, countries with high debt
were restricted to the measures they could use to respond to the crisis as compared to countries
out the Euro could use like the United Kingdom, these include sanctioning higher inflation rates
to decrease the countries liability or directly or indirectly depreciate your currency to stimulate
exports.

Competitive Weakness - As things stand now countries in the euro zone are still
struggling with the competition. The central bank takes measures aiming to boost the demand
and improving the Eurozone export competitiveness, thus far the bank has failed to have positive
results as domestic demand is 5% smaller than it was in 2008 resulting in the European
economies are now more dependent on exports more than ever to improve their economic
growth. Some European countries continue to decline in export competitiveness compared to
their economic rivals and this is due to the shrinking of labor force and the increase in cost in
doing business in certain economies as well as the government inflexibility in many parts of the
Euro zone. Until very recently the euro remained over valued related to the emerging currencies
over the previous years, in result the Eurozone is limited the ability of pulling out of the slumb
because of lower local demands and other competitive factors.
Economic Divergence and Trade Imbalances- Financial times journalist Martin Wolf
declared that one of the major reasons of the crisis was the continuous rise in trade imbalances.
As mentioned in the above paragraphs its clear to see that different economies grow at a different
paces, many of the countries in the zone urgently required bailouts from other countries and
besides that had witnessed the decrease in level of productivity due to high cost relative to the
European average during this period. Paul Krugman stated in 2009 that the problem was the
euros assembly shaped trade alterations within the Eurozone, the chart below shows the major
Eurozone economies by current account as percentage of GDP.
Nation

2010 (%) 2011

(%)
Greece
-11.2
-10.8
Portugal
-10.0
-10.0
Spain
-5.5
-5.2
Italy
-3.2
-2.9
Ireland
-3.0
-2.7
France
-1.9
-1.8
Belgium
0.3
0.5
Finland
1.3
1.4
Austria
2.3
2.3
Germany
4.9
6.1
Netherlands
5.4
5.7
As seen Greece, Portugal, Spain, Italy and Ireland all have been running substantial
current account deficits, the problem present is that the countries are failing to fix these deficits

theyre stuck as trade deficit. When the financial crisis occurred and borrowing cost began to
increase in these countries their ability to pay back liabilities had been questioned. As a single
currency existing in the euro the easy way to regain Balance to devalue the currency wasnt an
option for these countries
Misplaced confidence and assessment of risks - In an interview with Dr Spyros an
economist of the London school of economist stated that he believes the general problem that
caused the Eurozone crisis is the misplaced confidence and assessment of risks. Borrowing cost
for all Eurozone members congregated upon the euros formation, countries such as Greece
beforehand were forced to offer a greater interest rate than say Germany to appeal to investment
were at this time capable of borrow more reasonably. Similarly the private sector borrowing
costs also declined towards German levels, this action lead to an increase in government debt in
countries like Greece and Portugal. The allegations was that financial markets anticipated every
country in the Eurozone to have nearly the same amount of risk of failure to pay their loans
(possibly assuming all Eurozone countries were in it together). As soon as the financial crisis
began in 2008, investors contemplated in pumping in money into the countries in the Eurozone
thus countries with high debt problems and feeble economies, such as Greece shortly saw their
borrowing costs escalate.

(ii)

Contagion risk refers to there being major economic changes in one country, and these

changes effect will spread through to other countries, and it could either be economic booms or
economic deficit through a region. Contagion had become a more noticeable occurrence in the
Eurozone, as all the countries in the Eurozone all become interrelated with one another.
Sovereign debt is commonly known as economic and financial problems initiated by the
observed disability of a country to reimburse its public debt. This regularly transpires when a
country gets to a critically high level of debt and battles the low economic growth. Thus the
Eurozone Debt crisis contagion refers to the potential spread of the current European debt crisis
to other Eurozone countries. This may perhaps make it challenging for countries to settle their
government liability without aid from outsiders. Public Debt in the Eurozone had rose from a
total GDP of 70.2% to an estimated 88.5% between the years 2005 to 2011, through 2008 and
2009 there was miniature to no alarm about the European sovereign debt as the European central
banks focused on addressing the global financial shock. All through this phase countries such as
Ireland and Spain provided some security that these countries could facilitate probable fiscal cost
connected with a medium size banking crisis hence the main focus for the banking system was
stability with specific countries. During the crisis the risk of contagion had increased in
significance and countries with leading involvement in the Securities commission were affected
most by the crisis e.g. (Austria Netherlands and Ireland). Late 2009 the sovereign debt crisis
moved into a new segment, many countries conveyed larger than anticipated escalation in the
deficit of the GDP ratio. In some countries namely Spain and Ireland fiscal revenues declined
much faster than the GDP, resulting in a high indifference of tax revenues and declines in
production activity and asset values. The balance of the recession and escalating approximations
of forthcoming banking sector losses on bad loans in a various countries likewise had adverse
unforeseen effect on sovereign bond values, since then investors realized that countries in the
Eurozone had a declining banking sector positioning themselves vulnerable to fiscal risks.
( Mody and Sandri 2012). The negative changes were revealed in increasing ranges on sovereign
bonds, the yearly range on ten year sovereign bond yields were close to zero before the crisis
between Germany countries like Greece and Ireland. As these countries are all combined by one
common currency, the euro, thus the variances in projected yield chiefly signify professed credit
risks and variances in in instability. (Buiter and Sibert 2006).

(iii)

Euro zone Countries such as Greece, Spain and Ireland grew strongly for the most of

2000s , they all were benefitted from the lower interest rates brought by EMU. Resulting in
stimulating the consumer spending and residential construction, but the boom masked a marked
loss in external competitiveness, which effect in failure to control the wages and unit costs
growth. The European countries are distinguished as closely interdependent and any economic
crisis that impact a single country in the region is highly likely to spread through the whole
region because of financial institution and international trade. As the introduction of the euro as a
single currency in whole Europe eliminated the exchange risk, and it trigger the financial
institutions to lend across the member states. During the global financial crisis in 2007 the
sovereign countries were assumed as safe heaven to invest, resulting heavy investment and
lending from financial institutions. But the default sovereign debts caused sharp widening in
budget deficit among euro zone countries, In 2009 Greece shocked the investors by announcing
that its budget deficit has almost doubled, in early months of 2010 public debt of Greece risk
rose rapidly to the 90 100% of GDP level.
The fiscal deficit of the Greece had a great exposure on the GIIPS countries (Greece,
Italy, Ireland, Portugal and Spain), it aggravated the creditworthiness of these GIIPS countries at
default risk and created instability in financial system and worsened their fiscal deficit. Countries
in the euro zone were obliged to restrict the government deficit ratio below 3%, however Greece
was detected to incurred 12.5% budget deficit ratio which increases to 13% in April 2010. In
respect in May 2011, IMF and EU declared the financial bailout package and European central
bank purchased the government bonds of Greece, Spain and Portugal to reduce the impact of
crisis. The intense effect of sovereign risk across the Europe can be describe by the
disappearance of foreign exchange risk , which triggered the expansion of portfolio and lending
by financial institutions in the core countries. Therefore if few of GIIPS countries went into
bankruptcy , the collision will not only reach to the financial institutions which are lending and
investing in GIIPS countries , but it will also affect the public sector which is suffering from the
instability of financial system. The Sovereign default affected the health of private banking
sector around euro zone countries, which as well as danger the health of public sector as a result,

in Greece since the end of 2009 private sector deposits dropped by 10 % and also a decline in
deposits in Ireland.
Other than that, financial instruction such as banks also suffered greatly due to the default
of sovereign debts. (Allen and Moessner, 2012) As a result of sovereign crisis, in august 2007
bank started to lose confidence in each other banks credit worthiness, and it widely sharpened
margin of interbank deposit rate and the interest rates on sovereign debts. Public start
withdrawing deposits from the banks in countries situated in euro zone as banking system and
public finances were sensed as weak, for some banks the failure was obvious but nobody knew
which banks were exposed to solvency. Banks in euro zone encountered huge losses during mid
2008 to 2011, they faced severe liability pressure and pressure to rebuild their depleted capital.
At the end of 2010 European banks faced gross exposure of Greek sovereign debt of 90 billion
Euros, the risk that the governments will default puts the solvency of commercial banks in
danger around Euro zone especially Greece. The risk of sovereign default result in occurrence of
risk of bank failure, the risk of bank failure was one of the reason for the contraction in interbank
lending after the financial crises in 2008 globally

In addition, According to (Frum, 2012) Europe is facing the euro currency crises because
European countries not only have bumped up against their ability to borrow, but European
countries have bumped up their ability to borrow against Euros. There is possibility for the
countries like Greece to quite the euro and to resume their former currencies as an escape hatch
from the euro zone crises, as quitting the euro would make it less painful for the these countries
as they are facing high depression in unemployment, high taxes etc. it is expressed by many of
the economist that Greece have only one solution to overcome crises is to leave euro, and if
Greece leaves the euro then countries like Ireland, Portugal, Spain might also follow which lead
the banking crises in all the countries.

Moreover, the euro zone crisis, especially current Greece crises put a question on the
survival of the Euro in future (Madhusudhanan, 2012). The current Europe crises are showing
sign of breakdown of euro and soon euro may get dissolved, as the currency unions become

stronger if there is an expansion or boom but it fails when there is a contraction or slum.
Therefore any hint that Euro zone country will default will have an immediate adverse affect on
the euro.
During the worldwide banking crisis, banks encountered phenomenal shocks to their
funding models, as far as both market access and costs are concern. Substantially recognized and
active international banks have developed considerable amount of maturity and currency
mismatches between stakes and liabilities, exposing then on significant vulnerabilities (CGFS
(2010a)). Inparticular, investment banking-oriented institutions had significantly leveraged
uptheir funding structures (FCIC (2011);mainly throughshort-term wholesale funding from repo
and commercial paper (CP) markets. Therefore, solid growth and the development in total assets
were underpinned by low levels of equity.Banks had also opt to other unstable funding sources
on the originate-to distributemodel, for example direct loans sales and securitization
(Brunnermeier, 2009).

In 2007, pressure waves from the US subprime mortgage marketsflew over to banks
short-term wholesale funding markets, resulting certain unavoidable circumstances to decline
tremendously, especially for highly leveraged banks. Contagionthrough the interconnections of
major global banks and financial institutions and theirsubsidizing models prompted to sharp and
phenomenal builds over interbank spreads. European banks faced several severe obstacles in
order to perceive US dollar liquidity. In addition, profoundly leveraged US venture or
investments banks were hit by extreme dislocations in their predominantly short-term obligation
funding businesses and markets (Adrian andShin, 2010).

The failure of Bear Stearns and Lehman Brothers on both March and September 2008
were precipitated when investors lost certainty to their benefits of the business models and the
organizations were shut out of these markets. These issues were not restricted only to the US
venture banks, as illustrated by the dismissal of the Northern Rock in the United Kingdom with
its dependence on the short-term wholesale financing (Shin, 2009). Hence, the banks share
prices plunged across the world due to the inclining solvency concern.

(b)
(i)

The European Monetary Union (EMU) will have a profound impact on the economies,

enterprises and the relationship between social partners, not only of the euro countries, as well as
of the nations staying outside. Particularly, the Euro acquires common alternative or at least
converging fiscal policies of the participating states, the measure to implement budgetary counter
for nations withdrawing from the stability pact and, on a long run point of view, the leap towards
political union (Weiss, 1998).

The main responsibility of the European Central Bank (ECB) is to ensure price stability
within the euro zone, yet the actual policy approach making will be impacted by the evolution of
the cyclical circumstance of the participating nations, the political pressures exerted by
legislatures and pressure groups representing adverse interests (Clarke and Daley, 2010). Hence
will substantially rely upon the co-ordination of national policies, currently positioned towards
prohibitive policies in vary of not participating nations. If the economic inclines in accordance to
the changeover to the Euro, then the level of government funded obligations such as the public
debt may create an opportunity for more expenditure on public investment and venture.

The newly established euro zone works without fiscal compensation to underprivileged
regions or less developed participating countries. The exchange rates, which will be ultimately
settledby prevailing market rates, will lose their function as voluntary stabilizers. This differs
from the solution chosen by the German government for the former East German Mark (Weiss,
1998). In contrast to the component adopted by the German after the reunification, there will be
no automatic financial transfer instruments within the euro zone.

A new approach has to be utilized by the governments to encounter cyclical issues and
eventually understand challenges in order to solve the difficulties arose (Weiss, 1998).In that

setting, it ought to be mulled over that, over the long haul, both financial and budgetary
approaches will be impacted by choices concerning redistribution approach, taken both at the
state level through immediate and indirect taxes and at the enterprise level through wage
settlements.Therefore, the question arises, whether efforts at government level should be
accompanied by agreements between social partners to maintain wage stability (Clarke and
Daley, 2010).
In any case, the prompt effect of the euro on the structure of the economy ought not to be
overestimated, except for the budgetary, banking money and insurance sectors where there will
be a further pattern to consolidating and rebuilding of operations, while a scope of new products
and services may be show cased. In different sectors of the economy, manufacturing industries
and service ventures have long back figured out how to adapt to exchange rate vacillations and
currency risks. While their elimination in the euro zone will be a cost advantage, this is not liable
to generally change the best approach to do business. The euro as such considered will likewise
not change the way that in numerous ranges relevant to business and relations among social
accomplices, there is abundant space for national enactment. Specifically assessment (tax) and
labor law will stay untouched, in any event initially.

(ii)

The first shiver of euro zones financial crisis was in the beginning of year 2010. They

started from rising market concerns where the sustainability of open finances in observation of
debts in Greece, rising government deficits and other secondary euro zone economies. These
damages started before many banks from euro zone had completely taken those impaired assets
out of their balance sheets from the year 2007 to year 2009 financial crisis. Thus, sovereign
concerns will spill over to banks. These harsh market tension incidents, all banks in the euro
zone, no matter how strong or experienced they are, they faced major difficulties in both
admission to funding and cost. Thus sovereign stresses morphed into a banking crisis. Inter-bank
funding costs increased harshly for both euros pounds and others currencies such as sterling and
dollar. Unfortunately, euro zone banks went through tension in US dollar short-term funding
markets once again (Fender and McGuire, 2010). Moreover, International spillovers were also
observable in the frequently harsh declines in UK and US banks stock prices, which fell in
sympathy with those of euro zone banks. In order to worsen, this crisis became gradually tangled
with delays to economic progress in growth and competitiveness. These issues had worsened the
banking crises and the sovereign debt by placing further tension on bank funding.
The strong connection between banks and the sovereigns can be measured by the growth
of a variety of indicators. One of it includes the interconnection between the sovereign and bank
credit default swap (CDS) spreads. For most of the euro zone economies, the 90-day moving
correlations among these spreads have been mostly positive and performing an overall growing
trend as the euro zone crisis developed. Furthermore, the co-movement of sovereign and bank
CDS spreads built up among the euro zone countries after the nationalization of Allied Irish
Bank in January 2009. This is a trend that consequently assisted to send out sovereign risk to
banks even more strongly. It was mainly high for most euro zone countries during crisis episodes
involving a mixture of secondary countries, such as Greece, Ireland and Portugal, joined later in
the crisis by Spain and Italy.
This financial and economic confusion has influenced not only the developed world but
also the euro area. For instance, Greece faced inability to pay off debt which pushed the EU
towards the largest crisis ever, with probable major spill-over effect. If there is no crucial action
taken, a Greek sovereign debt default could possibly start off a huge effect that are able to affect

the main euro zone economies such as Italy and Spain, a harsh impact on France, UK and
Germany as well. Moreover, financial infectivity is one of the effects towards the euro zone
economies. The balance sheet matters of European banks, unstable stock markets and insufficient
investor confidence may rapidly credit lines cuts and deferred investments in the developing
countries. In addition, it also paused growth and fiscal consolidation plans. Thus, strictness
packages brought in by the European governments are to be expected to decrease the demand
for developing countries in exporting and lead to a reduce in spending. Moreover, high
unemployment rates also caused due to the weak economic activity which interpreted into lesser
transfer of funds aimed to developing economies. Besides, the Euros pounds also faced
depreciation against the dollar. With the weaker euro pounds, it may put additional tensions on
those developing countries which reply on dollars for exports and reduce the purchasing power.

The incident in the euro zone has again showed the strong relationship between financial
crises and bank funding. During period of harsh financial market tension which started mainly by
the sovereign stress causes short-term and longer-term general funding markets became tense
even for well rated euro zone banks, they are then forced to alternative funding sources or to
contract their balance sheets. Banks that did keep their market access, funding cost had increased
to much more costly, which reduced banks financial power and eventually decreased capacity in
order to supply financing to both retail clients and the corporate.

REFERENCES

Adrian, T and H-S Shin (2010): The changing nature of financial intermediation and
the financial crisis of 20072009, Annual Review of Economics, vol 2, pp 60318.

Brunnermeier, M (2009): Deciphering the liquidity and credit crunch 2007-2008,

Journal of Economic Perspectives, vol 23(1), pp 77100.

BBC News, (2011). UK unemployment hits 17-year high. [online] Available at:

http://www.bbc.co.uk/news/business-15271800 [Accessed 29 Oct. 2014].

Committee on the Global Financial System (2010a): The functioning and resilience
of cross- border funding markets, CGFS Papers, no 37.

Financial Crisis Inquiry Commission (2011): The financial crisis inquiry report.
International Monetary Fund (2012), Global Financial Stability Report, October.
Pierre, Weiss, 1998. Impact on single currency. The impact of the common currencies on
European economies, enterprises and employees, [Online]. 9, 3-8. Available
at:http://www.efta.int/media/documents/advisory-bodies/consultative-committee/cc-

opinions/impact-of-common-currency.pdf [Accessed 14 October 2014].

Shin, H (2009): Reflections on Northern Rock: The bank run that heralded the
global financial crisis, Journal of Economic Perspectives, vol 23(1), pp 101190.

CIVITAS Institute for the Study of Civil Society 2010. 2010. The euro zone crisis.
[ONLINE] Available
at:http://www.civitas.org.uk/eufacts/download/TheEurozoneCrisis(Oct2010).pdf.
[Accessed 22 October 14].

APPENDICES
Reliance on ECB funding
As a percentage of banking sector assets

The vertical lines correspond to the following dates: 8 August 2011: re-activation by ECB of
SMP to purchase Italian and Spanish sovereign debt; 21 December 2011: first ECB LTRO; 29
February 2012: second ECB LTRO; 6 September 2012: decision by ECBs Governing Council
on the modalities of OMTs.

Sources: ECB; IMF, International Financial Statistics; Bloomberg; national data; authors
calculations.

Indicators of bank stress

Simple average across major banks; for the United States, Bankof America, Citigroup,

JPMorgan Chase, Goldman Sachs, Morgan Stanley;for euro area, Banco Santander, BNP Paribas,
Crdit Agricole, Deutsche Bank, ING Group, Socit Gnrale, UniCredit SpA; for the United
Kingdom, Barclays, Lloyds, HSBC, RBS; for Japan, Mitsubishi UFJ, Mizuho, Sumitomo Mitsui.

Sources: Bloomberg; DataStream; authors calculations.