In the EU Single Market, companies operate across national borders with branches throughout Europe. This promotes competition and growth. But firm networks across Europe can help banking crises spread, finds a new study by Bertelsmann Stiftung. A banking crisis abroad would hit the UK economy by up to 30 billion euros annually through foreign firms operating in the UK – and a UK banking crisis due to Brexit would hit European economies equally hard.
A new study suggests that a banking crisis triggered by Brexit could hit European economies and in particular the UK economy hard. If banks in the United Kingdom were in crisis (due to Brexit), the associated financial bottlenecks of British subsidiaries could cost the German economy around 13 billion euros in annual sales. At the same time, banking crises originating in the Eurozone would strongly affect the UK through international affiliates operating in the UK. For example, a banking crisis in the US could reduce sales in the UK business economy by around 30 billion euros a year (0.8% of all sales) and a banking crisis in Germany could cost the UK economy about 11 billion euros annually (about 0.27%). These are the results of an analysis by the Bertelsmann Stiftung, for which the authors Kilian Huber (University of Chicago) and Dominic Ponattu (Bertelsmann Stiftung) evaluated data on international corporate relationships in Europe and estimated the impact of banking crises. The analysis covers revenues in the “business economy”, comprising all industries except for the financial sector.
Big economies, big risks – crises states exhibit lower risk
Overall, the UK with its particularly high proportion of foreign companies would be most affected from banking crises originating abroad. Apart from the US and Germany, crises in other euro area members could hit hard the British economy. For instance, a banking crisis in France would set French subsidiaries in the UK under pressure, leading to a sales loss of the British economy amounting to some 7 billion euros. A banking crisis in the Netherlands could spill over to the UK business economy through firm networks and reduce sales by about 3.6 billion euros annually. A banking crisis in Spain would result in a UK sales loss of about 3 billion euros. The impact of banking crises in Italy, Greece and Portugal for the UK economy would much lower, with less than one billion euros of projected sales losses each – thus, the former crises euro area members exhibit a lower risk to the real economy in the UK.
In Germany, the losses would be slightly lower, but still considerable: A banking crisis in the US would hit the German real economy with sales losses of around 21 billion euros (0.35% of total sales), a banking crisis in the UK with more than 13 billion euros per year (around 0.2% of total sales). A banking crisis in France could cost the German economy around 7.5 billion euros a year via French subsidiaries. But the countries hardest hit by the economic and financial crisis would have, again, a much lower impact: In case of a banking crisis in Italy sales losses in Germany would amount to 2 billion euros. In the case of crises in Spain sales losses of 1.5 billion euros would be incurred and a crisis in Ireland would see sales losses of about 1.3 billion euros in the German business economy. In the event of a crisis in Greece, the losses would even be as low as millions.
The susceptibility of an economy – e.g., the UK economy – to crises “imported” through foreign firm networks depends on two factors: Firstly, whether the country the banking crisis originates in has companies with many subsidiaries in the UK. Secondly, the impact on the UK economy depends on the importance of foreign subsidiaries in total sales in the UK. "In the UK, foreign subsidiaries’ sales account for about 2.5 trillion euros or 35% of total sales", explains Dominic Ponattu, co-author of the study. "This makes the UK one of the countries with the highest share of sales by foreign affiliates", says Ponattu. There are many countries in Eastern Europe where Western European and other international companies maintain branches: In Slovakia and Hungary, every second euro of overall sales is attributable to subsidiaries of foreign companies, in the Czech Republic it is 47%. The integration of these countries into transnational value chains such as those of the automotive industry plays a major role in this.
The crisis channel: Financial flows between parents and subsidiaries
How exactly do banking crises unfold through firm networks? First of all, a banking crisis in a country affects companies in the same economy: Firms receive less money from crisis-ridden banks – this leads to job cuts in these companies. Also, the study shows that productivity growth and innovative capacity of those companies whose finances depend on crisis banks decline. As a result, during banking crises many firms shrink and their sales figures collapse. These effects then spread to other countries because firms and their foreign branches lend each other money. "If, for example, a banking crisis breaks out in the UK, subsidiaries of British parents in Germany could get in trouble, too – either because they suddenly no longer receive funds from their parent company or because they have to lend more to their parent as a result of the banking crisis", says Dominic Ponattu.
Eurozone reforms are important – but a hard Brexit poses risk to Eurozone
However, restricting foreign companies to do business in order to reduce the risk of crisis contagion does not make sense. "Trade liberalization and the integration of value chains in the EU Single Market have massively increased the size of the economic pie. Any restriction would likely be harmful and, in the case of many European firms, hardly legally possible in the Single Market framework", Dominic Ponattu says. Instead, it is more important to set in place reforms that prevent the emergence of banking crises in the first place. One element of such reforms could be the completion of the banking union. The measures discussed therein could reduce the risk of national banking crises in the Eurozone and thus protect companies from credit crunches. In implementing such reforms, however, it is important to further reduce systematic differences between European banking systems, such as the proportion of toxic loans per country. Ponattu also points to current macroeconomic risks that can favour banking crises, including Brexit. The aim here should be to prevent a hard Brexit in order to avoid a banking crisis in the UK and, consequently, contagion via British companies in other EU countries.
The study "Banking Crises, Firms and their International Affiliates in the EU" is authored by Kilian Hu-ber (Professor at the University of Chicago) and Dominic Ponattu (Project Manager, Bertelsmann Stiftung). The study evaluates data on firm networks in Europe between parent companies and subsidiaries from the Eurostat database and determines, among other things, the share of international subsidiaries in the individual European countries. The study uses statistical analyses (regression models) on the impact of banking crises on parent and subsidiary companies and uses a back-of-the-envevelop calculation to estimate the sales loss due to crisis-related financial constraints of subsidiaries in European economies. The estimation is based on data on the banking crises and how it affected the real economy during the crisis period between 2008 and 2012 in Europe. All sectors, with the exception of financial services, are included in the analysis (“business economy”).