Procyclical Effects of the banking System during the financial and economic Crisis 2007-2009: the Case of Europe

This paper examines the relationship between adverse shocks to the banking system and their effect on the general economy in Europe. This topic was brought to the spotlight during the 2007-2009 financial and economic crisis, when the relatively healthy, at that time, European economy was severely hit by the spread of the US sub-prime mortgage problems. This interbanking contagion may have been one of the main, if not the primary, reasons why the region entered into a recession during the period. If significant evidence can be found to support this theory, it will make the need for more regulations on the financial system and stricter capital requirements even more apparent. The research includes comprehensive literature survey on past and recent financial crises, procyclical banking practices and their impact on the economy. Then it goes on to developing a theoretical model of the transmission of negative economic shocks from the financial system to the rest of the economy. The theoretical model is empirically tested on a range of banking specific and macroeconomic variables. The results show that a loss of confidence in the financial system and banking losses are followed by a significant decrease in the new loans to non-financial companies and subsequent economic contraction. Moreover, countries with better capitalized banks experienced smaller declines during the crisis and in general Tier 1 capital is correlated positively with economic growth.