Blog Post

Boosting the resilience of Europe’s financial system in the coronavirus crisis

Europe has a heavily bank-based financial structure, but bank-based financial structures are associated with higher systemic risk than market-based financial structures. The higher level of systemic risk in Europe suggests caution when pursuing policies that stimulate risk taking and debt creation by banks, especially in the wake of COVID-19. Priority should be given to financial diversification and equity finance.

By: , and Date: July 17, 2020 Topic: Banking and capital markets

Bank-based and market-based financial structures mobilise savings, allocate capital, price risks and absorb shocks in different ways. While banks conduct financial intermediation and bear risks on their balance sheets, markets channel resources directly from savers to borrowers, serving as platforms via which equity and debt securities are priced, distributed and traded. A key question is whether differences in financial structure are associated with systemic risk, which has implications for public policy efforts to sustain real economic activity.

The literature published after the Great Financial Crisis of 2008 generally speaks in favour of market-based financial systems. This is because financial crises are more severe in bank-based than in market-based financial structures (see eg Gambacorta et al, 2014). In bank-based structures, systemic risk may be greater because banks are highly leveraged and interconnected institutions, with sizable maturity mismatches on their balance sheets and direct linkages to the payments infrastructure. By contrast, systemic risk may be lower in market-based financial structures since markets channel resources straight from savers to borrowers, and are less dependent on intermediation through highly leveraged and interconnected institutions with large balance-sheet mismatches and links to payments systems. Moreover, market financing recovers quickly during banking crises and, if well-developed, functions as an alternative to financial intermediation by banks (Becker and Ivashina, 2014; Crouzet, 2018). This reduces disruption to the flow of financial services and thus serves to protect the real economy.

Differences in countries’ financial structures correspond to differences in the short-term dynamics of the probability of default of banking systems (Figure 1). During the financial crisis (indicated by the shaded area in Figure 1), the banking system’s default probability increased only a little in the United States, which has a relatively market-based financing system. But it increased substantially in Germany and Japan, which have relatively bank-based financial structures. This suggests that differences between countries in terms of their financial structures indeed help explain differences in financial stability.

Figure 1: Banking system default probabilities in bank- and market-based financial structures

Source: Bruegel based on World Bank Global Financial Development Database (GFDD; July 2018 version). Notes: This figure shows two time-plots of, respectively, a country’s financial structure and the default probability of its banking system. Financial structure is represented by the ratio of a country’s outstanding bank credit over the sum of non-financial sector debt and stock market capitalisation. The banking system’s probability of default is measured by the reciprocal of the Z-score of a country’s banking system, indexed at 2000. The shaded area represents the Global Financial Crisis.

To empirically explore the relationship between financial structure and systemic risk, we estimated linear and non-linear regression models for a panel of 22 Organisation for Economic Cooperation and Development countries (Bats and Houben, 2020). The financial structure indicator represents the ratio of bank credit to total non-financial debt and stock market capitalisation. The systemic risk indicator measures the nominal amount of the expected equity capital shortfall of stock-listed financial institutions, including non-banks. Two other systemic risk indicators are used for separate robustness checks.

Our analysis has four key conclusions. First, the results confirm that bank-based financial structures are associated with greater systemic risk than market-based financial structures. Systemic risk rises more than proportionately when bank financing rises relative to market financing. Second, the relationship is found to be non-linear (Figure 2). Systemic risk is minimised when the financial structure is relatively market-based. Third, bank financing no longer contributes to systemic risk in relatively market-based financial structures. A diversified financial structure is thus important. Separate threshold regressions show that in relatively bank-based financial structures, such as in Europe, bank financing increases systemic risk, while market financing decreases systemic risk. By contrast, in relatively market-based financial structures such as the United States, bank and market financing do not significantly impact systemic risk. Fourth, from a systemic perspective, stock market financing is preferable to debt finance, whether market or bank debt finance. This reflects how equity finance increases loss absorption capacity and thereby reduces systemic risk.

Figure 2: Non-linear relationship between financial structure and systemic risk

Source: Bats and Houben (2020). Notes: This figure shows the non-linear relationship between financial structure and the predicted value of systemic risk as estimated by Bats and Houben (2020). The vertical axis represents the predicted value of systemic risk as a percentage of financial institutions’ total assets. The horizontal axis is the ratio of bank credit to non-financial debt and stock market capitalization.

Policy implications in the context of COVID-19

The COVID-19 pandemic and related behavioural restrictions have caused an unprecedentedly sharp economic downturn. To mitigate the downturn, monetary and prudential policies aim to sustain financing flows to the real economy. In delivering this policy stimulus, financial structure matters. Indeed, the different designs of these policies reflect differences in financial structure. In particular, while the expansion of the Federal Reserve’s balance sheet has predominantly been driven by large-scale purchases of debt securities and funding facilities for a host of market participants, the expansion of the Eurosystem’s balance sheet relates mostly to increased lending to banks. These Eurosystem lending operations are aimed at the supply of credit from banks to the real economy (Figure 3). In addition, European authorities have eased financial sector policies to further support the lending capacity of banks, including through the release of macroprudential buffers and greater flexibility in microprudential requirements. Meanwhile, banks have provided debt service holidays and new credit to help customers through what is assumed to be a temporary crisis.

Figure 3: Eurosystem and Federal Reserve lending and securities holdings before and after the COVID-19 outbreak (in % GDP)

Source: Bruegel based on Federal Reserve and Eurosystem. Notes: This figure shows the amounts of securities holdings and loans for monetary policy purposes by the Fed and Eurosystem as a ratio of GDP (Q4 2019). The shaded area represents the total amount of claims at the start of the corona crisis (end-February 2020). The diagonal lines indicate the total amount of claims by mid-May 2020.

Stimulating capital markets in Europe

While the objective of COVID-19 policy measures is to sustain bank lending to the real economy, our results highlight another consideration. The greater level of systemic risk in Europe calls for caution when stimulating debt creation and risk taking by banks, because this can lead to financial instability. Put differently, what started as a crisis in the real economy must not lead to systemic stress in the financial sector, ultimately making the crisis much more severe. To safeguard the functioning of the financial system in times of stress, two aspects of financial structure deserve special attention in Europe.

First, Europe needs more diversity in its financial sector. Disruption to the flow of finance is less when more financing sources exist alongside each other. More financing through markets will also serve to reduce systemic risks posed by the sovereign-bank nexus and to spread credit risks privately, beyond national borders. There is a structural force at work in the European financial system that is already contributing to more market-based finance. Fuelled by increasing pension savings, the rise of institutional investment is spurring the development of European capital markets. This is because institutional investors prefer to invest in marketable securities such as bonds and equities (Darvas and Schoenmaker, 2018). Professional institutional investment also brings about a declining home bias in bond and equity portfolios, which improves risk sharing and fosters capital-market integration.

However, Figure 4 shows that the increase in the relative share of market debt and equity financing stagnated after 2015. Ironically, progress in diversifying the financial structure of the euro area has slowed since the start of the EU capital markets union (CMU). This contrasts with the sustained decline in the dominance of banks in the seven years after the Great Financial Crisis, reflecting inter alia the waterbed effects of higher prudential requirements for banks (Cizel et al, 2018). To increase the relative share of market-based finance in Europe, the policy efforts to underpin CMU thus need to be substantially stepped up.

Figure 4: The structure of financing to private non-financial companies

Source: Bruegel based on Credit Statistics of the BIS, Statistical Data Warehouse of the ECB and Economic Data of the Federal Reserve Bank of St. Louis. Notes: This figure shows the evolution of bank credit to private non-financial corporates in the euro area and the United States as a ratio of: 1) total credit to private non-financial companies; 2) the sum of total credit to private non-financial companies and listed equities issued by private non-financial companies. All data represent closing balance sheet positions (ie stocks), such that share buybacks are accounted for. GFC = Great Financial Crisis.

Reinvigorating CMU requires measures across a broad range of policy areas (see Sapir et al, 2018; CEPS-ECMI, 2019). In particular, on the institutional front, creating a strong supervisory body at the centre of the EU is needed to foster the integration of capital markets. This has become urgent. Brexit has caused London capital market activities that require a passport to operate in the EU to move to the EU27 countries. The European Securities and Markets Authority (ESMA) should grow from its role as a coordinator of national supervisors to a supervisory body with direct powers. ESMA would then become the central supervisor (in a hub-and-spokes model with national supervisors) of the EU capital market, similarly to the Securities and Exchange Commission in the US capital markets (Sapir et al, 2017). Other policy areas can also contribute. For instance, European Central Bank purchases of corporate bonds are found to contribute to a more diversified financial structure by reducing larger companies’ dependence on banks (Bats, 2020).

The second aspect is that Europe should buttress the resilience of its financial sector by increasing the share of businesses’ risk-bearing funding. More equity financing is the first best way to reduce systemic risk in Europe. Schemes to support businesses with equity can strengthen transition incentives to deal with the COVID-19 challenges, while boosting the economy’s loss-bearing capacity (Boot et al, 2020). Regulation and procedures for equity issuance should be streamlined accordingly. More fundamentally, the time is ripe to tackle the fiscal bias favouring debt over equity finance.

Recommended citation
Bats, J., A. Houben and D. Schoenmaker (2020) ‘Boosting the resilience of Europe’s financial system in the coronavirus crisis’, Bruegel Blog, 17 July, available at


Bats, J. (2020) ‘Corporates’ dependence on banks: The impact of ECB corporate sector purchases’, DNB Working Papers 667, De Nederlandsche Bank

Bats, J. and A. Houben (2020) ‘Bank-based versus market-based financing: Implications for systemic risk’, Journal of Banking & Finance 114, 105776

Becker, B. and V. Ivashina (2014) ‘Cyclicality of credit supply: firm level evidence’, Journal of Monetary Economics 62: 76-93

Boot, A., E. Carletti, H.-H. Kotz, J.-P. Krahnen, L. Pelizzon and M. Subrahmanyam (2020) ‘Corona and Financial Stability 3.0: Try Equity – Risk sharing for companies, large and small’, SAFE Policy Letter 81, Frankfurt

CEPS-ECMI Task Force (2019) Rebranding Capital Markets Union – A market finance action plan

Cizel, J., J. Frost, A. Houben and P. Wierts (2019) ‘Effective macroprudential policy: Cross-sector substitution from price and quantity measures’, Journal of Money, Credit and Banking 51 (5): 1209-1235

Crouzet, N. (2018) ‘Aggregate implications of corporate debt choices’, Review of Economic Studies, 85 (3): 1635-1682

Darvas, Z. and D. Schoenmaker (2018) ‘Institutional Investors and Development of Europe’s Capital Markets’, in D. Busch, E. Avgouleas and G. Ferrarini (eds) Capital Markets Union in Europe, Oxford University Press

Gambacorta, L., J. Yang and K. Tsatsaronis (2014) ‘Financial structure and growth’, BIS Quarterly Review, March: 21-35

Sapir, A., D. Schoenmaker and N. Véron (2017) ‘Making the best of Brexit for the EU27 financial system’, Policy Brief 2017/1, Bruegel

Sapir, A., N. Véron and G. Wolff (2018) ‘Making a reality of Europe’s Capital Markets Union’, Policy Brief 2018/8, Bruegel

Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article More by this author

Blog Post

Owning up to sustainability risks: the EU should champion international standards

To keep European Union capital markets open and integrated, new international standards should be reflected in future European law and accounting practice to provide further incentives for a reallocation of capital, reflecting in particular climate risks.

By: Alexander Lehmann Topic: Banking and capital markets, Green economy Date: April 26, 2022
Read article More on this topic More by this author


China’s Covid policy to be year’s largest economic shock

Beijing’s ‘dynamic zero-Covid’ policy could devastate the domestic economy, but the effects will also be felt globally.

By: Alicia García-Herrero Topic: Global economy and trade Date: April 26, 2022
Read article More on this topic

Blog Post

Venture capital: a new breath of life for European entrepreneurship?

Whether the dynamism of European venture capital of the past two years can be sustained and kick start a credible alternative to bank finance in the European Union remains to be seen.

By: Maria Demertzis and Lionel Guetta-Jeanrenaud Topic: Banking and capital markets Date: February 10, 2022
Read article

Blog Post

European governanceInclusive growth

12 Charts for 21

A selection of charts from Bruegel’s weekly newsletter, analysis of the year and what it meant for the economy in Europe and the world.

By: Hèctor Badenes, Henry Naylor, Giuseppe Porcaro and Yuyun Zhan Topic: Banking and capital markets, Digital economy and innovation, European governance, Global economy and trade, Green economy, Inclusive growth, Macroeconomic policy Date: December 21, 2021
Read article

External Publication

European Parliament

Don't let up - The EU needs to maintain high standards for its banking sector as the European economy emerges from the COVID-19 pandemic

In-depth analysis prepared for the European Parliament's Committee on Economic and Monetary Affairs (ECON).

By: Rebecca Christie and Monika Grzegorczyk Topic: Banking and capital markets, European Parliament Date: October 21, 2021
Read article More on this topic More by this author

Blog Post

Better sustainability data is still needed to accelerate the low-carbon transition in capital markets

Investors need more trustworthy sustainability data. Regulators should leave space for better products to emerge, while remaining alert to well-known patterns of misconduct in capital markets.

By: Alexander Lehmann Topic: Banking and capital markets Date: October 18, 2021
Read article Download PDF More by this author

External Publication

European Parliament

What Are the Effects of the ECB’s Negative Interest Rate Policy?

This paper explores the potential effects (and side effects) of negative rates in theory and examines the evidence to determine what these effects have been in practice in the euro area.

By: Grégory Claeys Topic: Banking and capital markets, European Parliament, Testimonies Date: June 9, 2021
Read article Download PDF More on this topic

Policy Contribution

Europe should not neglect its capital markets union

The European Union’s capital markets remain very underdeveloped compared to the United States. The market for equity, as measured as the size of the total market capitalisation of listed domestic firms relative to GDP, is much larger in the US and in Japan than in Europe.

By: Maria Demertzis, Marta Domínguez-Jiménez and Lionel Guetta-Jeanrenaud Topic: Banking and capital markets Date: June 7, 2021
Read article More on this topic More by this author

Blog Post

Confronting the risks: corporate debt in the wake of the pandemic

As European economies emerge from lockdowns, it is becoming clearer that corporate debt has reached critical levels. A new French scheme, in which the state guarantees portfolios of subordinated debt, shows how financial support could be targeted better.

By: Alexander Lehmann Topic: Banking and capital markets Date: April 28, 2021
Read article

Blog Post

European governance

Urgent reform of the EU resolution framework is needed

In this blog, the authors argue that two aspects of the European resolution framework are particularly in need of reform – the bail-in regime and the resolution mechanism for cross-border banks – and propose a reform of both.

By: Mathias Dewatripont, Lucrezia Reichlin and André Sapir Topic: Banking and capital markets, European governance, Macroeconomic policy Date: April 16, 2021
Read article More on this topic

Blog Post

The impact of COVID-19 on artificial intelligence in banking

COVID-19 has not dampened the appetite of European banks for machine learning and data science, but may in the short term have limited their artificial-intelligence investment capacity.

By: Julia Anderson, David Bholat, Mohammed Gharbawi and Oliver Thew Topic: Banking and capital markets Date: April 15, 2021
Read about event More on this topic

Past Event

Past Event

Presentation of the Euro Yearbook 2021

Join us for the launch of the eighth edition of the 'Euro Yearbook'

Speakers: Maria Demertzis, Fernando Fernández, Fiona Maharg-Bravo, Antonio Roldán and Jorge Yzaguirre Topic: Macroeconomic policy Date: March 12, 2021
Load more posts