Development Centre RESEARCH MEMORANDUM. Banking sector output measurement in the euro area a modified approach. Antonio Colangelo and Robert Inklaar

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1 Universiy of Groningen Groningen Growh and Developmen Cenre Banking secor oupu measuremen in he euro area a modified approach Research Memorandum GD-117 Anonio Colangelo and Rober Inklaar RESEARCH MEMORANDUM

2 Banking secor oupu measuremen in he euro area a modified approach 1 Anonio Colangelo 2 and Rober Inklaar 3 Absrac: Banks do no charge explici fees for many of he services hey provide bu he service paymen is bundled wih he offered ineres raes. This oupu herefore has o be impued using esimaes of he opporuniy cos of funds. We argue ha raher han using he single shor-erm, low-risk ineres rae as in curren official saisics, reference raes should more closely mach he risk characerisics of loans and deposis. For he euro area, impued bank oupu is, on average, 24 o 40 percen lower han according o curren mehodology. This implies an average downward adjusmen of euro area GDP (a curren prices) beween 0.16 and 0.27 percen. JEL No. E01, E44, O47 Key words: Bank oupu, FISIM, risk, loan ineres raes, deposi ineres raes This research was suppored by he European Commission, Research Direcorae General as par of he 7h Framework Programme, Theme 8, "Socio Economic Sciences and Humaniies" and is par of he projec Indicaors for evaluaing inernaional performance in service secors. The views expressed in his paper are solely hose of he auhors and do no necessarily reflec he opinion of he European Cenral Bank. The work has benefied from useful commens and suggesions by Henning Ahner, Giacomo Carboni, Jean- Marc Israël, Seven Keuning, Chrisoffer Kok Sørensen, Reimund Mink and Chrisina Wang. We would also like o hank an anonymous referee for several useful commens; his suggesions have resuled in a much improved version of he paper. European Cenral Bank, Anonio.Colangelo@ecb.in. Universiy of Groningen, R.C.Inklaar@rug.nl.

3 1. Inroducion Banks do no charge explici fees for many of he services hey provide. 4 Insead, he paymen for he services is usually bundled wih he ineres raes charged on loans and paid on deposis. Any complee measure of bank oupu should ake his ino accoun by esimaing wha par of bank ineres raes is a paymen for services and wha par is he cos of funds. In his paper, we argue ha he esimaion mehodology ha is currenly used in he euro area (and in many oher economies) needs o be reviewed o ake ino accoun he risk characerisics of loans and deposis and we presen new euro area esimaes based on our proposed mehodology. 5 The key poin of conenion in esimaing, or impuing, bank oupu is idenifying he opporuniy cos of funds. In curren European Naional Accouns mehodology, he iner-bank rae is used as he cos of funds for all ypes of loans and deposis. 6 However, in recen heoreical work, Wang e al (2008) show ha profi-maximizing banks would no use such an ineres rae as a measure of he opporuniy coss of funds. Insead, hey would use an ineres ha reflecs he (sysemaic) risk associaed wih each loan or deposi, so aking ino accoun he risk of defaul and any erm premium. Recenly, he Wang e al (2008) mehodology has been applied for US commercial banks in Basu e al (2009). They find ha curren mehodologies overesimae US impued bank oupu by 45 percen and US GDP by 0.3 percen. The conribuion of his paper is o apply he Wang e al (2008) mehodology o he euro area o esablish wheher or no he large overesimaion is a common feaure across counries. I is very imporan o have an accurae and appropriae measure for impued bank oupu. Firs of all, i is par of overall banking secor oupu (in addiion o fees and commissions) and insofar as banks serve households, governmen or foreign demand, impued bank oupu conribues o overall GDP. Addiionally, he ineres margin is par of he price of bank oupu, so how his price is measured will affec overall producer and consumer prices. Our resuls are based on a benchmarking exercise ha idenifies opporuniy coss of funds by esimaing pass-hrough equaions in an error-correcion modelling framework. The findings imply ha impued bank oupu is, on average, overesimaed by 24 o 40 percen and euro area GDP (a curren prices) is, on average, overesimaed by beween 12.6bln and 21.4bln or 0.16 o 0.27 percen. The higher numbers are esimaed using he same concepual approach as Basu e al (2009), so we conclude ha euro area bank oupu is overesimaed o he same degree as US bank oupu Where we alk abou banks, we refer o he group of oher Moneary Financial Insiuions (MFIs), which mainly includes credi insiuions and money marke funds (MMFs); for more informaion, see Regulaion ECB/2008/32. As he scope of he analysis is limied o loans and deposis, he bias resuling from he inclusion of MMFs is marginal; in fac, according o ECB esimaes for 2006, deposis held wih MMFs and loans graned by MMFs vis-à-vis non-mfi euro area residens accouned on he average for 0.02% of he corresponding oal oher MFIs loans and deposis. This paper concenraes on esimaes of oupu a curren prices. For deails on he mehodology for FISIM volume measures, see Eurosa s Handbook on price and volume measures in naional accouns (2001), and also Basu and Wang (2006) and Inklaar and Wang (2007). This is consisen wih he recommendaions of he Sysem of Naional Accouns, see 1993 SNA, paragraph

4 The paper is organised as follows. Secion wo describes he curren mehodology for esimaing bank oupu in European saisics; Secion hree deals wih our proposed mehodology, presening boh is concepual framework and he empirical se-up. The esimaes from he new mehodology are presened in Secion four for he euro area 7 as a whole and compared o impued bank oupu derived according o he curren European mehodology. 8 Finally, we offer some concluding remarks. 2. Impued bank oupu curren mehodology Impued bank oupu is commonly referred o as Financial Inermediaion Services Indirecly Measured (FISIM) in official saisics. FISIM are he financial services ha oher MFIs and Oher Financial Inermediaries (excluding insurance corporaions and pension funds, OFIs) 9 provide o heir cusomers bu which are no direcly invoiced. For deposiors, hese services generally include he managemen of he accouns, he provision of accouns saemens and fund ransfers beween accouns. Banks may charge explici fees for deposi accouns, bu in addiion, he ineres rae received on hese accouns is ypically lower han wha cusomers could have obained by lending heir money direcly on he marke. For borrowers, hese financial services include he screening and monioring of heir crediworhiness, financial advice, he smoohing over ime of repaymens, and he recording of he repaymens for accouning purposes. They are paid by an increase of he ineres raes charged by banks. In conras, here is no inermediaion service for deb securiies: o he exen ha a bank was involved in issuing or placing hese securiies, hey will have received an upfron fee and o he exen ha hey bough hese in he secondary marke, hey have no provided services. Paragraph 3.63.J of he 1995 ESA oulines he principles underlying FISIM compilaion 10. In paricular, i saes ha in general financial inermediaion services cover wo pars: (a) financial inermediaion services direcly charged by financial inermediaries o heir cliens and measured as he sum of fees and commission charged; and (b) FISIM. The 1995 ESA idenifies oher MFIs and OFIs as being he only FISIM-producer secors. 11 Their oupu is valued on he basis of he difference beween he acual raes of ineres payable and receivable on loans and deposis vis-à-vis oher secors (including he res of he world) and a reference rae of ineres. For All esimaes in he paper refer o he moving composiion of he euro area, i.e. daa prior o January 2007 do no include Slovenia and similarly, daa prior o January 2008 do no include Cyprus and Mala. The FISIM esimaes presened in his paper according o he mehodology laid down in he Council Regulaion (EC) No 2223/93 of 25 June 1996 on he European Sysem of Naional and Regional Accouns in he Communiy (1995 ESA), amended by Council Regulaions (EC) 448/98 and 1889/2002, are no based on naional official saisics bu have been derived by he ECB simulaing his mehodology. In paricular, whereas naional resuls are only presened for euro area counries, he mehodological framework proposed in he paper could be applied more in general o all EU counries. Oher MFIs, OFIs and insurance corporaions and pension funds are par of he financial corporaions insiuional secor. For a formal definiion of financial corporaions and he relaed sub-classificaion, see Paragraphs 2.32 o 2.67 of 1995 ESA. In he conex of FISIM measuremen 1995 ESA is fully consisen wih he general framework se up in 1993 SNA. The resuls presened in his paper are limied o oher MFIs oupu as a fully consisen and deailed se of saisics on oher financial inermediaries (OFIs) is currenly no available a he ECB for all euro area counries. In addiion, under 1995 ESA insurance corporaions and pension funds are no idenified as producers of FISIM; while his reamen is no quesioned in his paper, i could offer ineresing perspecives for fuure research. 3

5 hose o whom he inermediaries lend funds, boh residen and non-residen, i is measured by he difference beween he effecive ineres charged on loans and he amoun ha would be paid if a reference rae were used. For hose from whom he inermediaries receive funds (under he form of deposis), boh residen and non-residen, i is measured by he difference beween he ineres hey would receive if a reference rae were used and he effecive ineres hey acually receive. In urn, he reference rae is defined as he average ineres rae a which FISIM-producer secors lend money o each oher 12. In paricular, he 1995 ESA disinguishes beween an inernal reference rae, o be used for ransacions among residens, and an exernal reference rae, o be used for he business beween residens and he res of he world, wih he possibiliy of compiling differen exernal reference raes according o currencies of denominaion and counerpar areas. The curren approach has various shorcomings. Essenially, he mehod does no appropriaely capure he differences beween he various ypes of loans and deposis: for insance, whereas he iner-bank business is mainly shor erm wih low defaul risk premium, deposis and loans from/o oher secors may have compleely differen mauriy srucure wih someimes high defaul risk. In summary, wihin he curren mehodological framework compensaion for erm premium and defaul risk is reaed as producive service and leads in many insances o negaive FISIM, boh a he secoral level and in he res-of-he-world accoun The new mehodology 3.1 The concepual framework 14 A measure of bank oupu canno be esimaed wihou a descripion of he financial services ha cusomers buy. This is also he saring poin of he model developed in Wang e al (2008) and his secion is based on heir argumens. I goes oo far in an empirical paper like his o provide a full exposiion of heir general equilibrium model, so his secion will focus on he main feaures and inuiion of heir model. The key conclusion of Wang e al (2008) and he earlier Wang (2003) sudies regarding oupu measuremen is ha implici compensaion for bank services can be inferred from a bank s oal income by neing ou he pure risk-based reurns (i.e., coss of funds) on asses and liabiliies held by he bank. To impue he cos of funds on any such risky financial insrumen, one should use he rae of reurn on (deb) securiies subjec o he same risk, bu wihou any services aached. Toal income ne of he pure coss of funds hen measures he rue value of bank services implicily charged for. This conclusion The reference rae is compued as a weighed average of money marke raes ha reflecs he currency and mauriy composiion of he financial inermediaries lending marke. The posiions vis-à-vis he cenral banks are excluded from his compuaion. I also follows ha when comparing reference raes for differen reference areas, he average iner-bank raes may differ due o he currency and mauriy composiion of he marke. As financial inermediaries include banks and OFIs, he reference rae may also diverge from he average iner-bank rae depending on he relaive size of OFIs. Colangelo and Inklaar (2009) presen wo examples where negaive margins may arise from mismaches beween risk and mauriy srucure of specific insrumens and he reference rae. For a more in deph analysis of he issue of negaive FISIM on impors and expors see S. Fone Sana (2007). This subsecion draws heavily on a similar exposiion in Basu e al (2009). 4

6 is summarized in Figure 1, which shows graphically how we impue he value of bank services relaed o A D loans ( Y ) and deposis ( Y ) using daa on he ineres rae paid on deposis ( r D ), he ineres rae A F M charged on loans ( r ) and marke ineres raes on risk-free securiies ( r ) and risky securiies ( r ). This secion firs oulines he heoreical argumens for choosing hese paricular ineres raes and nex discusses our empirical implemenaion. Figure 1. Decomposiion of a bank s ineres flows (simplified version) r A Noes: r A : (Average) ineres rae received on loans r M : Expeced rae of reurn required on marke securiies wih he same (sysemaic) risk characerisics as he loans r F : Risk-free rae r F : Shor-erm risk-free rae r D : (Average) ineres rae paid on deposis Y A : Nominal oupu of bank services o borrowers Y D : Nominal oupu of bank services o deposiors For a more deailed decomposiion, see Wang (2003) Implici bank services he case of lending 15 Before any aemp o measure, one mus firs define a concep. So, wha is he oupu of banks? Wang (2003) and Wang e al (2008) answer his quesion hrough models ha embed opimal bank operaions wihin he conex of compeiive financial markes. These papers recognize ha he value added of banks lies in resolving informaion problems and processing ransacions, no in generaing reurns on he resuling financial insrumens. These reurns are deermined enirely by he insrumens risk characerisics and marke ineres raes. In paricular, in hese models he value added of bank lending consiss of screening and monioring aciviies o miigae asymmeric informaion problems wih regard 15 For exposiion of he heory, we focus on bank lending services because he measuremen problem is made harder by he fac ha he implici revenue from services is bundled wih risk-based asse (i.e. loan) reurns. See Wang (2003) for deailed accouning of services o deposiors. In he empirical applicaion, we also measure services o deposiors. 5

7 o borrowers crediworhiness. 16 Bank services are analogous o oher professional business services, such as legal, accouning and consuling services, and indeed analogous o all producion in he economy: oupu is generaed hrough a producion process ha uses primary inpus of labour and capial, as well as inermediae inpus (such as office supplies and uiliies). In conras, he purely risk-based reurns ha accrue o he sock of financial insrumens held by banks are wha invesors would demand on any coningen claims wih he same risk profiles, regardless of how hese are creaed. These pure reurns also correspond o he concep of he user cos of funds, defined as he (risky) fuure payoff from invesmen ha compensaes suppliers of funds for heir forgone curren consumpion and for bearing risk, bu no for any aached services. 17 The coss of funds are par of he overall user cos of capial faced by he ulimae users of funds, such as non-financial firms. These are herefore par of hose firms value added, no he value added of he banks ha provide he funds. This paper concenraes on he measuremen of nominal bank oupu, bu o undersand he models of Wang (2003) and Wang e al (2008), i is useful o consider briefly he concep of real oupu implied by hese models. Real bank (lending) oupu consiss of inermediaion services ha cerify borrowers as credi-worhy a loan originaion (screening) and on an on-going basis (monioring). Thus, a naural measure of real bank oupu is he number of loans originaed and moniored, jus as a naural measure of he oupu of a normal service provider, like a barbershop, is he number of haircus i provides. In principle, cerain ypes of loans (for example, small business loans) may require more informaion processing han ohers (such as conforming morgages). Thus, a refined measure of real oupu would augmen he raw ransacions coun wih some noion of quaniy of service, jus as a high-qualiy coiffure by Chrisophe of Los Angeles 18 should be couned as being more haircu oupu han a haircu from he local barber shop. Bu in any measure of real bank oupu, he naural saring poin is he number of ransacions of each ype performed. Inklaar and Wang (2009) coun hese ransacions and aggregae hem ino an index of real bank oupu. The objec of his paper, of course, is o measure nominal bank oupu accuraely. In conjuncion, hese wo papers imply a complee se of naional income measures for banking nominal oupu, real oupu, and an implici price index for banking services Loan ineres rae spread risk vs. implici bank services The key measuremen implicaion of Wang (2003) and Wang e al (2008) is ha he nominal value of bank services ha are no explicily charged for can be impued as oal income ne of he purely risk Banks role in resolving informaion asymmery is well recognized in he financial inermediaion lieraure (e.g., see he survey by Bhaacharya and Thakor, 1993). More recenly, Allen and Sanomero (2001) broaden he scope o recognize inermediaries role as providers of specialized financial experise. This can be inerpreed as a form of ransacion faciliaion and hus encompassed in our definiion of bank value added. This can be viewed as an exension o wha is ofen referred o as he user-cos framework. Diewer (1974) was one of he firs o inroduce his framework and Barne (1978) firs applies i o financial asses, inroducing he concep of user cos of money. The key elemen of our exension is ha i akes accoun of risk, ha is, in he real world where he reward o essenially all invesmen is uncerain, he so-called opporuniy cos of money is comparable across securiies only afer adjusing for risk. Who famously cu Bill Clinon s hair on Air Force One a Los Angeles Inernaional Airpor (LAX). 6

8 based reurns on he financial claims creaed by hose services and held on he bank s book. In he case of lending services, he pure cos of funds on a loan should be inferred using he rae of reurn on a marke deb securiy wih he same risk characerisics (bu wihou any services aached). This mehod of maching risk is of he same naure as a common applicaion of asse-pricing heory o corporae finance he cos of capial for a specific invesmen projec is se o equal he rae of reurn on like marke securiies. Boh of hese applicaions follow he same principle as he Arbirage Pricing Theory in Ross (1976), where he expeced rae of reurn on a porfolio is deermined given he reurns on facor porfolios and he absence of arbirage opporuniies. 19 One obvious implicaion is ha no firm and no bank would use he reurn on risk-free securiies as he appropriae opporuniy cos for an invesmen wih risky payoff. The logic of removing risk-adjused reurns from oal bank income o impue he value of service oupu can be illusraed wih a sylized example of he bank ha does nohing. 20 Specifically, assume fricionless financial markes, so ha firms can borrow direcly from households wihou he need for inermediaries o process informaion or ransacions. The required (ne) rae of reurn on any invesmen beween periods and +1, denoed r % + 1 (wih he ilde emphasizing he random naure of he reurn), is deermined by a sochasic discoun facor, denoed m +1, as follows: E[(1 + r% ) m ] = 1. (1) Assume eniies ha funcion solely as accouning vehicles are se up as follows: 21 households ransfer heir capial o hese eniies in exchange for claims on he eniies, which hen ren he capial o producion firms. By design, hese eniies have balance shees and income saemens ha look like hose of banks, so hey are called banks for shor even hough hey perform no services. For simpliciy of exposiion, we assume hese banks are fully equiy funded. Noe however ha he banks capial srucure is irrelevan for heir cos of capial in his simple model economy since here he Modigliani-Miller (MM, 1958) heorem applies. More generally, Wang (2003) showed ha he cenral message ha he user cos of funds mus ake risk ino accoun does no depend on wheher he MM heorem holds. Wha remains is he pracical maer of finding he marke raes mos commensurae wih he risk of financial insrumens held by banks, as we discuss laer in deail. Now look a he cash flow of a represenaive bank. Households recognize ha a bank here is jus a bookkeeping device and ha hey ulimaely own is asses capial used in producion. So hey require he same rae of reurn on a bank s equiy as on hose asses. The bank mus herefore lend he funds o any firm a a rae se according o (1). Consequenly, producion firms face he same cos of capial as i i hey would have if hey had borrowed direcly from households. Le r E( r % + 1) denoe he expeced These are all examples of he so-called relaive approach o asse pricing: he value of a specific risky invesmen is deermined aking he value of all he oher asses as given. See Cochrane and Saa-Requejo (2000) for oher applicaions of his relaive approach. One prominen example is pricing opions. See Wang e al (2008) for a more deailed illusraion in a general-equilibrium framework. The real-world analogy is a so-called special purpose vehicle, which is a pure financing arrangemen off he balance shee of he sponsoring insiuion. I involves virually no operaional aciviies. 7

9 rae of reurn on he loan o firm i wih balance and he average rae of reurn on he porfolio as can be expressed as A i i (2) r A = Ar, wih A i i i i i A ; furher denoe oal balance of he loan porfolio as A = A and r i A r. Then he expeced ineres income on he porfolio w = A A is he weigh of loan i in he porfolio. Noe ha r A A is also he expeced dividend paymen o he households who own he bank. The correcly impued value of bank service oupu should be zero on average since by design he banks produce no real services. 22 This is exacly he resul if he value of services is impued as he bank s oal A A income ne of is risk-adjused cos of funds, ha is, A ( ˆ r + 1 r ) 0, because A A i i A i rˆ ˆ + 1 r = wi( r 1 r ) 0 i +, where r ˆi + 1 and rˆ ˆ + 1 = wr i i + 1 are he realized rae of reurn on loan i and on he porfolio, respecively. In conras, if he value of services is impued by subracing risk-free reurns from oal income, as in he exising naional income accouning pracices, hen on average he bank will be credied wih producing A F A F posiive oupu of services, since in general he expecaion of rˆ 1 r r + r > 0.23 This resul follows direcly from expanding (1), which applies o i A F r and hence also o r, and subsiuing 1+ r for 1E( m + 1) (which is iself an applicaion of (1) o risk-free asses): A F A (3) r = (1 + r )[1+ cov( r% + 1, m + 1)] 1. F r is he yield on a deb no subjec o any risk 24 (e.g., defaul), nor wih any embedded opions. 25 US Treasury s are he bes example. 26 r F only compensaes invesors for sacrificing curren for fuure consumpion wih cerainy. A securiy wih risky payoff ha canno be diversified away and is (negaively) correlaed wih he sochasic discoun facor, however, mus in expecaion pay a reurn premium cov( r% + 1, m+ 1), o make up for he risk-induced disuiliy. 27 This premium is posiive for almos all risky asses (see any finance ex, e.g. Campbell, Lo and MacKinlay, 1997). This sylized example serves o inuiively highligh he concepual problem of using he risk-free rae o impue bank oupu. Wang (2003) and Wang e al (2008) show ha similar overesimaion of bank oupu A = i wr i i To he exen he porfolio is sufficienly diversified and he persisence in aggregae shocks is accouned for, realized reurns averaged across firms should basically equal he condiional expecaion. The mirror image of his over-couning of bank oupu is he under-couning of borrowing firms oupu reduced on average A F by ( r r ) simply because of he change in accouning mehod. This sylized example refers o a one-period ahead model, so ha mauriy does no really play a role; see also Secion Yields on bonds mus be adjused for he embedded opion o be comparable wih hose on opion-free deb insrumens. Bonds ha allow prepaymen, such as MBS, essenially have an embedded call opion. F They are ypically considered risk-free in ha hey earn a guaraneed reurn, r, if he deb is held ill mauriy. Noe ha even for his ype of deb here is sill ineres rae risk, ha is, he holding-period reurn is almos surely uncerain if one sells i prior o he mauriy dae. In he consumpion-capm model, which can be expressed as a specific case of (1), his means asses wih payoff posiively correlaed wih consumpion growh have o pay a posiive reurn premium. 8

10 arises in he realisic case where banks provide acual services processing informaion and ransacions for which no explici fees are charged bu implici compensaion is earned via an ineres rae spread. To infer he value of such implicily priced services as par of banks ne ineres income, Wang (2003) solves for he opimal ineres rae charged by a value-maximizing bank when making loans wih he same (sysemaic) risk profile as a ype of exising marke deb. The usual firs-order condiion gives rise o he following expression for he rae of reurn (denoed r ) he bank should expec o earn on a loan porfolio: (4) M 1 r = r + r. A M S M r E( r % + ) is he expeced rae of reurn demanded by invesors on he marke deb wih he same risk. S r represens wha we shall call he service spread, which generaes he exra ineres ha compensaes S he bank implicily for processing he loan. The opimal service spread r in (4) saisfies he condiion ha he exra ineres receip, r S A, equals he (weighed average) marginal cos of processing a loan muliplied by he opimal markup. 28 This markup is deermined by compeiion in he loan marke. M In he nomenclaure of he 1993 SNA, r in (4) is called he reference rae serving as reference for he cos of funds on he loan. For a marke rae o be he proper reference, he securiy should no only have similar risk, bu banks should also face he same marginal ax rae and ransacion coss faced by ypical invesors in he reference marke deb. 29 We argue ha his is likely a reasonable assumpion for he reference raes used in our empirical exercise, since mos of he marke securiies chosen as references for bank loans are backed by securiized pools of loans, such as morgage-backed securiies (MBS), and he securiies are rouinely held on bank balance shee along wih hose same caegories of loans. Tha is, by revealed choices of asse allocaion, banks appear o consider hese securiies as offering similar raes of reurn as he corresponding caegories of loans. The reference rae for a porfolio of loans (of varying ypes, mauriies and rae-rese daes) is hen a weighed average of raes on he individual loans. A Impuing he value of implici bank services Derivaions in he previous secion imply ha, on average, a bank s nominal oupu of implici lending S A M A services o borrowers should equal r A = ( r r ) A. Bu neiher of he expeced raes of reurn, r and, is observed. So, for empirical esimaions, we make use of he relaionship ha he expeced rae M r Tha is, he bank charges an implici price for is inermediaion service, equal o a markup on he marginal cos of producing ha service. The cos is deermined by a loan officer s labour inpu in processing a loan, plus he amoun of physical capial and supplies used for ha ask. For banks, addiional disorions are inroduced if deposi insurance is no fully risk sensiive (see Wang, 2003 for a deailed reamen). Here we assume ha deposi insurance is fairly priced for he banking indusry as a whole, and ignore disribuional effecs. 9

11 of reurn on a defaulable deb equals is promised yield o mauriy (ha is, he conracual ineres rae, denoed R ) correced for is expeced loss rae due o defaul (denoed d ): 30 (5) k r = R d, k = M, A. k k k k k d E( d % k M + 1), where d is he (random) defaul loss rae. For marke securiies, R s are generally observed while d M s can be esimaed using ime series daa. 31 Similarly, for loans, d A s can be A esimaed as well, while R s are covered in official saisics (a leas in he euro area). Subsiue (5) ino (4) and we can impue he oupu of lending services as: 32 A S A A M M A M A M (6) Y = r A = [( R d ) ( R d )] A = [( R R ) ( d d )] A k. For he purposes of his paper, due o lack of informaion on expeced defaul raes, we will assume ha A d d M, leaving such measuremen problem for fuure research. ( ) 0 Hence reference raes vary across loan ypes, depending on risk characerisics of he loans or porfolio of loans associaed wih he services considered. In conras, he use of a (nearly) risk-free rae as he reference rae would imply an overesimaion of oupu: A F S P A P r r A = r + r A = Y + r A, (7) ( ) ( ) P M F where r = r r is he reurn premium of he reference risky marke securiies over (mauriymached) risk-free securiies; i equals (1 + r ) cov( r% + 1, m + 1) (see (3) F M above). As described above, he mehodology se up in 1995 ESA goes even furher, proposing he use of a shorerm risk-free rae r as he reference rae, hus including he erm premium as producive service: F ' A F ' S T P A T P (8) ( r r ) A = ( r + r + r ) A = Y + ( r + r ) A, where r T = r r is he erm premium. F F ' The value of oupu impued according o (8) will oversae he acual value of service oupu. According T P o some, he informal jusificaion for (8) is ha r A and r A are regarded as compensaion for rendering so-called mauriy ransformaion and risk-bearing services. The concepual framework presened in his paper argues agains his reamen. Firs, he erm premium enails no service as i simply reflecs he assumpions abou fuure ineres raes as well as he compensaion of he invesors for having heir money ied up for a longer period, including he added risk of he greaer price uncerainy. In urn, Wang and Basu (2007, Secion 3.4) discuss a lengh why risk bearing is no a producive service according o he concepual framework of 1993 SNA. More imporanly, hey show ha he Naional 30 k d equals he produc of he probabiliy of defaul (PD) and he expeced loss rae given defaul. If he laer is near 100%, k hen d is close o he PD. Wang (2003) deails he disincion beween promised yield and expeced rae of reurn. The equaion here is exac only for insananeous reurns, and is used as an approximaion in discree-ime cases. See Duffie and Singleon (2003) for coninuous-ime models of defaulable deb pricing. The condiional esimae of M d, such as KMV s EDF, is procyclical. See Wang e al (2008) for a deailed discussion of how he acual value in each period sill deviaes from his average. 10

12 Accouns impuaion resuls in inconsisen accouning of he oupu of borrowing firms, by making firms measured value added depend on heir sources of funding. Suppose wo firms are idenical, bu one borrows from banks and he oher from he bond marke. Then he firm relying on banks is credied wih producing lower value added han he one issuing bonds, even if heir acual producive aciviies are idenical. 33 The value of implici deposior services can be impued in a similar manner o he new way we impued D he value of implici lending services. Le D denoe he deposi balance, and r he ineres rae paid; R and d M are defined as above (bu he values almos cerainly differ). Then nominal oupu of M deposior services can be impued as: D M M D (9) Y = ( R d ) r D. For insured deposis 34, he relevan reference rae should be he risk-free (Treasury) rae, ha is, M M F P R = r = r, since = M M M F r d = 0. For he remaining, uninsured, deposis, R d > r, because he deposi holders are exposed o some (defaul) risk in bank asse porfolios. In our empirical applicaion, we absrac from his issue and effecively assume ha all deposis are insured, and hence D F D Y = r r D, while he risk-free. Under our working assumpions, equaion (9) hen simplifies o ( ) 1995 ESA mehodology, based on he shor-erm risk free reference rae deposis as F ' D F D T D T (10) ( r r ) D = ( r r r ) D = Y r D where r T F F ', F ' r, compues bank oupu on = r r, as above, represens he erm premium. I hus follows ha he European Naional Accouns underesimae he value of deposior services. 35 Noe ha equaion (6) implies ha if a bank passively holds marke securiies in is invesmen porfolio, here are no services provided o he asse issuers (ha is, Y A = 0), since R A = R M and d A = d M. Likewise, (9) implies zero implici services (ha is, Y D = 0) provided o holders of bank erm liabiliies (commercial paper, marke bonds, and privaely placed bonds), since he ineres rae paid equals he reference rae (R D Defaul risk managemen can be viewed as an insurance conrac where he lender, acing as a guaranor, charges a premium (defaul risk premium) o he borrower in exchange of he risk of his poenial defaul; his premium can hus be viewed as he expeced loss of he loan. See also he secion on loan guaranees in chaper 17 of he 2008 SNA. Drawing a parallel wih he mehodology in use o derive he oupu of non-life insurance corporaions, or specifically, of credi insurance insiuions may be of some ineres in his conex. In his case, oupu is derived as he difference beween he colleced premiums minus he paymens or he calls under he guaranees. This would hen argue in favour of he defaul risk correcion, under he recogniion ha for insurance corporaions he correcion is done ex-pos (discoun of realised defauls) while in he conex of FISIM compilaion i would be performed ex-ane (discoun of expeced defauls). On he oher hand, he risk assessmen is clearly a producive aciviy ha should be incorporaed in FISIM; see also Keuning (2008). See Gropp, and Vesala (2004) for an analysis of he impac of deposi insurance on risk aking of banks. I should be underlined ha before he financial urmoil in Augus 2007 perceived risk on he inerbank marke, measured as he difference beween unsecured and secured inerbank lending raes, was raher minimal. Besides deposi insurance his may hen argue in favour of limied risk premiums on banks deposis. Since he sar of he financial marke urbulence he spreads beween secured and unsecured inerbank lending raes have widened considerably, and hey have been passed hrough on deposis raes o a large exen. While his may jusify he consideraion ha deposis are less secured han before, he impac on oal FISIM calculaion should be minimal as unsecured inerbank lending raes are used as reference raes for mos deposi caegories (accouning, on he average, for abou 90% of oal deposis placed wih oher MFIs by households and non-financial corporaions) hus guaraneeing ha risk premiums are adequaely refleced even in his case. 11

13 = R M and d D = d M ). Also noe ha under virually all circumsances (ha is, whenever here are equiy holders), (r M d M ) in (6) is greaer han is counerpar in (9), because bank asses are ypically riskier han bank liabiliies. In oher words, he reference raes for impuing lending and deposior services almos always differ by a posiive margin. So again, recall ha Figure 1 illusraes he impued nominal oupu value of implici bank services. In he case of loans only par of a bank s ne ineres income consiues nominal oupu of bank services; he M F ' remainder corresponding o he risk and erm premium in he case of loans, ( r r )A, is excluded. Similarly, in he case of deposis a reference rae ha excludes he erm premium underesimaes banking secor oupu by ( r F ' F r )D. The erm and risk premiums, along wih acual ineres expenses on bank liabiliies, consiues a pure ransfer of capial income. I is par of he facor income generaed by he capial used in he borrowing firms producion or in he consumpion of consumers. This facor income is hen ransferred from he end users of funds o he ulimae suppliers of funds he bank shareholders in case of loans, he deposiors in he case of deposis. Only when all invesors are risk neural or all risk is idiosyncraic will his risk premium disappear. Figure 1 illuminaes how our model-based oupu measure differs from he Naional Accouns curren measure, which uses a (nearly) risk-free shor-erm rae as he single reference rae. As we have argued, he Naional Accouns measure incorrecly bank oupu as hey do no reflec erm and risk premiums appropriaely In he remainder of his paper, we discuss how o esimae he quaniaive impac of hese componens on he measured oupu of euro area banks. 3.2 The empirical se up 36 The mehodology developed in his paper o esimae he banking secor oupu on posiions vis-à-vis households and non-financial corporaions is mainly based on he use of MFI ineres rae (MIR) saisics 37. These saisics provide (on a monhly basis and for periods as from 2003) a harmonised and comprehensive coverage of he ineres raes applied by euro area credi insiuions o residen households and non-financial corporaions on euro denominaed loans and deposis. These daa are available and consisen boh a naional and euro area level, and disinguish beween he ineres rae on new business, i.e. newly negoiaed ineres raes during he period, and raes on ousanding amouns. In addiion, deailed breakdowns on deposis are provided boh by mauriy and by insrumen, while for loans he daa are broken down by mauriy/period of fixaion and addiionally, in he case of households, by purpose of he loan, i.e. consumer credi, loans for house purchases and oher credi. While he curren approach implicily relies on MIR raes on ousanding amouns, he mehodology developed in his paper uses saisics on new business. Secion below will discuss some mehodological aspecs underlying his approach Alhough he paper is mainly focused on he derivaion of FISIM esimaes for he euro area as a whole, he empirical se-up of he mehodology could easily be replicaed a naional level. The requiremens for MIR saisics are laid down in Regulaion ECB/2001/18. In paricular, i should be underlined ha he reporing scheme defined in he Regulaion applies only o oher MFIs, hus excluding cenral banks and MMFs. For furher informaion, see hp:// 12

14 As described above, anoher feaure of he curren approach is he use of he iner-bank rae as he reference rae o evaluae ineres margins. The firs proposed improvemen (in he case of households and non-financial corporaions) is o ake ino accoun he mauriy srucure of loans and deposis based on he general governmen bond yield curve 38 and, for shor mauriies, money marke raes; in his paper we use he euro area governmen bond yield curve derived by Thomson Reuers Daasream based on AAA governmen bonds issued in he euro area. 39 In he absence of deailed informaion on he average mauriy/period of rae fixaion for each caegory of loans and deposis for households and non-financial corporaions, he maching wih he relevan reference raes has been conduced via a benchmarking exercise based on he esimaion of a pass-hrough equaion (using an error-correcion modelling framework) agains alernaive marke raes. 40 Table A1 in Appendix 1 describes in deail which rae has been idenified on he basis of sandard model selecion crieria for each loan and deposi caegory under his approach. Overall hough, i should be underlined ha he resuls are no very sensiive o he exac reference raes choices we make. Secondly, while deposis are usually considered as (relaively) risk-free invesmens because of deposi insurance schemes, bank loan raes are higher because of longer mauriies bu also because of higher risk. 41 Daa on he yield on bonds, specifically indices of non-financial corporae bonds and of assebacked and residenial morgage-backed securiies can be used o ake his ino accoun 42. The indices we use are compiled by Merrill Lynch which provides informaion on he average yield of he bonds afer adjusing for opion-like feaures of hese bonds. For hose indices Merrill Lynch also makes available he average residual mauriy of he underlying bonds, hus allowing for a mauriy correcion o ake ino accoun he differen average mauriy srucure of he bond indices compared o he various deposis and loans caegories. Secion describes in deail he use of hese daa in he conex of FISIM measuremen. Table A2 in Appendix 1 reviews he reference raes applied o each ype of loans and deposis for households and non-financial corporaions under his more complex approach The governmen bond yields are based on (noional) zero-coupon bonds, so he duraion of hese bonds is equal o is mauriy. Mos bank loans will have regular ineres paymens, so he duraion of hose loans will be smaller han heir mauriy. For mos mauriies, his disorion is likely o be small. Assuming annual ineres paymens of a 5 percen ineres rae, he duraion will be on average 10% of a year shorer han he mauriy for he bracke of one o five year mauriy. An alernaive approach would be o rely he ineres swap yield curve. Alhough his could offer ineresing perspecives as swap raes reflec banks refinancing coss, i does no fully respec he heoreical framework suggesed in his paper: while reference raes should include only he erm premium, risk componens in swap raes (mainly counerpary risk) are raher high and if hisorically heir spreads on governmen bonds (he so-called swap spreads) were abou 35bp up o Augus 2007, hese have increased considerably afer he sar of he urmoil. Appendix 2 briefly discusses his approach and provides an overview of he resuls of he esimaions. I is imporan o noice ha he dispersion among euro area counries in he level of MFI ineres raes is raher high. This reflecs differences in credi risk and marke srucure bu also insiuional facors like regulaion and axaion; see ECB (2006) for a deailed review of hese aspecs. Focusing on he housing loans marke, Kok Sørensen and Lichenberger (2007) show ha a significan par of he ineres rae differences across he euro area are relaed o counry specific insiuional aspecs such as enforcemen procedures, loan-o-value raios and fiscal arrangemens. Anoher way of indirecly performing he correcion would be o use daa on loan provisions which may be colleced for financial sabiliy purposes by naional auhoriies; in pracice his approach may lead o incomparable resuls due o he lack of harmonisaion of saisics on loan provisions across counries. 13

15 For he oher secors, as well as for cross border posiions, some working assumpions are applied due o lacking basic daa; in Secion below we will argue ha his approach is likely o lead o more sound esimaes compared o he curren framework. Under boh approaches, he margins derived a he level of he breakdowns by mauriy or period of iniial rae fixaion are opporunely averaged on he basis of he new business volumes; he resuling average margins for each loan and deposi caegory are hen applied o he oal amouns ousanding o calculae he corresponding FISIM Ineres raes for households and non-financial corporaions The main aim of our research is o improve he esimaes of ineres margins applied by banks on loans and deposis o reflec he services hey provide. A firs quesion is wheher o use he new business (NB) or ousanding amouns (OA) raes as he basis for comparison. While he esimaed margin should be relevan for he enire porfolio of bank loans in ha caegory hus arguing for OA raes, a drawback of his approach is ha he correc reference rae is difficul o define as many such loans have ineres raes ha were agreed some years before. Ideally, he reference rae should hen be a weighed average of pas bond yields, where he weighs reflec he share of loans from each period in he pas ha are sill on banks balance shees. In addiion, curren definiions of NB and OA ineres raes are no homogeneous for differen mauriies. NB raes are caegorised according o he iniial period of rae fixaion while OA raes are caegorised according o he original ime o mauriy of he loan 44. Hence, for insance, if a loan has an original mauriy of seven years, bu raes are renegoiaed annually, i would be more appropriae o compare he ineres rae on his loan o he yield on a bond wih a ime o mauriy of one year raher he seven years. 45 Given hese consideraions, we will rely on he NB raes o calculae he ineres margins I can be argued ha his approach could lead o overesimaing he oal value of he banking secor oupu as some of he services on loans, for insance, could be provided only a he ime of agreeing on or renegoiaing he erms. This bias should be anyway non-significan for non-financial corporaions as mos hese loans have iniial rae fixaion below one year, bu could be more problemaic for households. Sill, his approach looks more sound han relying on new business volumes only, hus neglecing hose services ha are provided during he enire life span of deposis and loans. For a deailed discussion of he characerisics of MIR saisics, see also he Manual on MFI ineres rae saisics. Following he implemenaion of he new requiremens for MIR saisics as se-up in Regulaion ECB/2009/7, new daa will become available o parly address his limiaion. In paricular, daa will be colleced on new business loans o non-financial corporaions wih period of iniial rae fixaion below one year and original mauriy over one year. In his paper we do no ake ino consideraion ineres rae saisics on bank overdrafs ha are available in he conex of MIR saisics. In fac, his caegory currenly includes negaive balances on curren accouns, revolving loans (including hose obained hrough a line of credi) and, in some counries, also loans wihou fixed mauriy. The difficuly of maching he resuling ineres raes wih reference raes reflecing mauriy and risk characerisics of hese insrumens leads us o leave hem ou of he scope of he paper. I should also be underlined ha in he case of households hese saisics would no be available broken down by purpose of he loans, hus furher complicaing heir usabiliy. All MIR saisics used in his paper relae o so-called annualised agreed raes, i.e. raes individually agreed, convered o an annual basis and covering all ineres paymens bu no oher charges ha may apply; see also he MIR saisics manual cied above. I should also be underlined ha under he MIR Regulaion ineres rae saisics on new business for consumer credi and loans o households for house purchases are also derived reflecing he so-called annual percenage rae of charge (APRC), i.e. he effecive lending rae ha includes oher charges such as adminisraion and legal fees, as well as, in he case of some euro area counries, adverisemen and opening commissions, credi insurance premiums, ec. Those charges hough are no relevan in he conex of FISIM measuremen as hey are ypically direcly invoiced and herefore are already par of he banking secor oupu. 14

16 3.2.2 Reference raes on loans o non-financial corporaions and households: discussion of he daa in case of full adjusmen The proposed mehod requires daa on he curren marke yield of differen ypes of deb securiies wih a broad coverage of he euro area marke. Therefore, bond indices are preferred over individual bonds. The bond indices compiled by Merrill Lynch saisfy hese crieria. 48 In paricular, Merrill Lynch publishes a range of bond indices for non-financial corporaions broken down by raing caegory, bu only heir overall non-financial corporaions bond index, which has an average raing beween BBB and A, is available broken down by mauriy band. Our choice is for he laer as i allows he maching wih he various ineres rae caegories (possibly afer adjusing for he differences in mauriy/fixaion period characerisics). 49 Figure 2 compares he ineres rae on new business loans o non-financial corporaions wih period of rae fixaion beween one and five years wih he corresponding one o five years corporae bond yield adjused o a mauriy of one year and he one year governmen bond yields (see Table A2 in Appendix 1). 50 As expeced, he loan rae is higher han he (adjused) corporae bond yield, which in urn is higher han he governmen bond yield. In June 2008 he spread was slighly negaive, bu oherwise he picure is consisen. As he more complee analysis below will demonsrae, negaive spreads occur in some oher insances as well. There we will discuss possible reasons why margins may become negaive in heory and in pracice. Overall, he Merrill Lynch bond index for non-financial corporaions in he corresponding mauriy bands does capure he main developmens ha also affec loan raes. This may be seen as he financial marke indicaor wih he mos similar characerisics. I is also worh noing ha from he summer of 2007 o (a leas) end-2008, due o he financial marke urmoil he spread of he corporae yield over he governmen bond yield has widened. 51 The spread has peaked a he end of he firs quarer of 2008 when a subsanial fligh o securiy effec pushed down governmen bond yields. Ineres raes on bank loans o non-financial corporaions have also risen hough he risk-adjused ineres margins have been broadly sable, alhough in he course of he second quarer of 2008 he worsening of See for hese daa as well as he bond index rules and definiions. Merrill Lynch does no produce counry-specific bond indices as mos naional deb markes wihin he euro area do no have he characerisics for he derivaion of reliable and meaningful bond indices. This approach is hus implicily based on he assumpion ha he risk characerisics of bank loans are similar, on average, o hose of he corporae bonds included in he overall Merrill Lynch index. This may seem in general raher dispuable. On one side, one may claim ha mos borrowers (a leas by number) are no invesmen grade or anyway unable o obain financing on capial markes, so ha he credi risk of heir bank loans would be ypically higher han on corporae bonds. On he oher side, in many cases banks engage in long-erm relaionships wih heir borrowers and hus obain addiional informaion han wha is available o capial marke paricipans, so ha he price on defaul risk demanded by he bank migh be lower. In paricular, he former facor seems o mosly affec small-sized loans (below 1mln), while he second should be mosly relevan for large-sized loans (above 1mln). While separae ineres rae saisics are available under he MIR framework for hese wo caegories of loans o non-financial corporaions, heir maching wih reference raes ha would address he issues described above is no easy and migh represen an ineresing area for fuure research. One possible approach could rely on he use of Moody s KMV daa ha include saisics on expeced defaul frequencies for a large se of euro area non-financial corporaions, including smaller-sized companies. The ineres rae for non-financial corporaions refers o loans wih an iniial ineres rae fixaion period beween one and five years and is he rae on new business. The corporae bond and governmen bond yields are defined o mach his mauriy band. The spreads of bonds of financial corporaions have widened even more. 15

17 he economic oulook and he consequen lack of liquidiy on euro area bond markes resuled in a sharp increase of NFC bond yields which have converged o ineres raes on business loans. 7.0 Figure 2, Ineres rae on business loans compared o corporae and governmen bonds (%), 2003:1-2008: Jan Apr Jul Oc Jan Apr Jul Oc Jan Apr Jul Oc Jan- Apr Jul Oc Jan- Apr Bank loan rae (NB) Corporae bond yield Governmen bond yield Sources: ECB (MIR ineres raes), Thomson Reuers Daasream (Governmen bonds), Merrill Lynch (Corporae bonds) Noes: All series for he euro area. Bank loan rae refers o loans o non-financial corporaions wih an iniial rae fixaion beween 1 and 5 years. Corporae bond yield is he yield on he Merrill-Lynch bond index for non-financial corporaion bonds wih a remaining mauriy beween 1 and 5 years, adjused using governmen bond yields o a 1-year mauriy. Governmen bond yield is he 1 year consan mauriy bond yield Jul Oc Jan- Apr This illusraes he unappealing choice in roubled financial imes: one could eiher rely on governmen bond yields and see a sharp widening of ineres margins or use corporae bond yields and see a conracing ineres margin. Using governmen bonds probably oversaes margins by more in he recen period: why would loans ha used o require only abou 0.7 percenage poins of service margin require in he curren marke developmens up o 2.5 percenage poins? On he oher hand, a disappearing margin is likewise implausible. For loans o households, i is more challenging o compue ineres-rae margins since households do no generally raise funds direcly from financial markes. Here he mos comparable securiy is securiized deb. Securiizaion is a means for banks o fund furher credis as, in is radiional form, i enables o remove loans from balance shee and hus frees up capial o gran new loans. The main advanage of securiizaion is o enable banks o specialize in wha hey do bes, namely originaing and monioring deb. However, an imporan reason for banks o originae a loan for a household in he firs place is ha he fixed cos of gahering and processing credi informaion on households is oo burdensome for decenralized financial markes. To allow hese loans o be sold in secondary markes in form of asse backed securiies (ABS) or residenial morgage backed securiies (RMBS), a group of similar loans is pooled and usually divided ino ranches. Defauls in his loan pool will firs be borne by he junior ranches and he senior ranches will be affeced las. As a resul, he senior ranches commonly receive an AAA credi raing from raing agencies. The curren financial marke urmoil has raised quesions abou wheher hese raings are a good reflecion of risk, in paricular in he face of high defaul raes on 16

18 morgages of subprime borrowers in he US. However, for our proposed mehod, wha is relevan in principle is he perceived risk by banks a he ime he loan is originaed 52. The limied size of he ABS and RMBS marke in Europe compared o he corporae bond marke also deserves some consideraions. While he overall Merrill Lynch bond index for non-financial corporaions covers around 700 corporae bonds, heir index for ABS and RMBS covers only some 30 bonds. 53 This means ha for Europe we only have a single index ha covers all mauriies and credi raings, wih mos securiies AAA-raed Despie he small number of securiies, he yield spread over governmen bonds is quie sable, highly correlaed wih he yield spread of AAA corporae bonds (0.85) and almos he same size on average As he Merrill Lynch ABS/RMBS index has an average residual mauriy of around six years, he spread over he six-year governmen bond index for each fixaion period band is applied for he maching Recen lieraure has elaboraed on various agency problems raised by securiisaion and resuling in misalignmens beween perceived risks by banks and on he marke. For insance asymmeric informaion may lead o downward biases in ABS/RMBS spreads when he loan qualiy deerioraion is no fully recognised by invesors and raing agencies. In addiion, once he defaul risk is ransferred he bank may have a lile incenive o monior he borrowers and o resrucure he underlying loan porfolios. For a comprehensive review of hese and oher agency problems relaed o securiisaion, see Franke and Krahnen (2008) and references herein. By comparison, similar indices for he US cover around 3000 corporae bonds and 1500 RMBS or collaeralized morgage obligaions (CMOs). Merrill Lynch only provides occasional snapshos of he composiion of he index and hese sugges limied differences beween he componens. Given he scarciy of informaion, his is a enaive finding. As a resul of financial engineering he defaul risk on he mos liquid RMBS and ABS is supposed o be minimal and he main reason for he posiive spread over risk-free governmen bonds is prepaymen risk; see e.g. Rohberg e al (1989). Thus, under normal circumsances he yield from hese RMBS and ABS will be oo low compared o he risk associaed wih he bank loans. However, if he risk is higher, banks will presumably also go o greaer lenghs o gauge he credi worhiness of borrowers, so he service margin for hose ypes of loans is also likely o be higher. One concern in he curren climae is ha he opaciy and heerogeneiy of RMBS and ABS leads o illiquidiy. Also, here is an ongoing reassessmen of he value of credi raings and he defaul risk of hese securiies. As a resul, in curren periods yields on hese securiies are possibly higher han warraned by he underlying defaul risk or he index composiion may have changed o include more lower-raed securiies. The average spread for AAA corporae bonds was 0.33 percenage poins over he period and for he RMBS/ABS bonds i was 0.35 poins. A naural alernaive o ABS/RMBS securiies could be covered bonds. Also in his case, he securiies are backed by a pool of asses (ypically morgages or public deb) bu he issuer mus ensure ha such pool consisenly backs he insrumen. This scheme undermines he linkage beween he risk characerisics of covered bonds and he underlying pool of asses, hus quesioning heir usage in our approach o FISIM measuremen. Oher pahs are being invesigaed o improve his framework. For example, he developmen of new saisics on shor-erm European paper (STEP), which also cover assebacked commercial paper, migh offer some ineresing prospecs. For furher informaion on STEP, see hp:// More in he medium o long erm horizon, he enhancemen of he collecion of securiies saisics on a securiy by securiy basis and he relaed developmen of he so-called Cenralised Securiy Daabase (CSDB) in he euro area could also allow he derivaion of more refined yield curves o be used in he framework of FISIM measuremen as described in his paper. 17

19 6.0 Figure 3, Ineres rae on housing loans compared o ABS/MBS and governmen bonds (%), 2003:1-2008: Jan- Apr Jul Oc Jan- Apr Jul Oc Jan- Apr Jul Oc Jan- Apr Jul Oc Jan- Apr Bank loan rae (NB) ABS/MBS bonds Governmen bond yield Sources: ECB (MIR ineres raes), Thomson Reuers Daasream (Governmen bonds), Merrill Lynch (ABS/MBS) Noes: All series for he euro area. Bank loan rae refers o loans o household for house purchases wih an iniial rae fixaion beween 1 and 5 years. ABS/MBS bonds is he yield on he Merrill-Lynch bond index for asse-back and morgage backed bonds, adjused using governmen bond yields o a 4- year mauriy. Governmen bond yield is he 4 year consan mauriy bond yield Jul Oc Jan- Apr Figure 3 shows he ineres rae on household loans for housing purposes wih period of rae fixaion beween one and five years compared o he ABS/RMBS series on yields adjused o a residual mauriy of four years and he corresponding four year governmen bond yield. The ineres margin for his ype of loans varies more han he corporae margins as he ineria of bank ineres raes seems greaer. On he oher hand, he ineres margin says posiive hroughou he period, wih he excepion of June As for NFCs, periods following he financial urmoil are srongly influenced by he developmens on he financial markes. While he implici risk premium measured by he governmen bond spread of ABS/RMBS securiies index has widened, seemingly in line wih he underlying causes of he credi crisis, his marke has become almos fully illiquid and canno, in he conex prevailing in he second half of 2008, represen a good proxy for he household loans on banks balance shees. For insance, his may be he reason underlying he negaive margin in June The reamen of oher secors Loans and deposis of non-financial corporaions and households represen abou 80 percen of oal ousanding amouns of loans and deposis posiions involving non financial counerparies. For hese secors, he new mehodology proposes o derive ineres margins on each insrumen by comparing he MFI ineres rae on new business wih he corresponding reference rae which represens he yield on marke securiies wih similar characerisics. Loans and deposis of oher domesic secors, i.e. he governmen and insurance companies and pension funds, represen anoher 11 percen while loans and deposis from he res of he world make up he remaining 9 percen. 58 Lile is known abou hese loans and deposis excep heir overall size; especially daa on corresponding ineres raes are no available. 58 These shares are based on he average balance shee composiion over he period from January 2003 o June Loans and deposis of financial insiuions are omied as under he curren FISIM regulaion, a secor can be eiher a FISIM producer or user, no boh. As he focus of his analysis is on differen margin esimaes, we say comparable in he coverage of secors. 18

20 In he case of oher domesic secors, we assume ha he ineres margins are he same as for nonfinancial corporaions. This differs from he curren approach, where he margin is calculaed as a residual of he secoral ineres raes on loans and deposis afer comparison wih he common reference rae. 59 Here we assume consan margins, hus allowing he (implici) reference raes o be differen. Our approach is jusifiable on various grounds. Firs, loans and deposis o non-financial corporaions likely involve similar financial services as hose o he governmen 60 and insurance companies and pension funds. Second, in many counries banks business wih hese secors (mainly insurance corporaions) has a very long mauriy and negaive margins may resul in he framework of he curren FISIM mehodology. Las, given he lack of daa on ineres raes and flows for hese secors, he curren FISIM mehod seems o involve a higher degree of esimaion han he alernaive proposed. When deriving euro area esimaes for residens in he res of he world, we assume ha hey buy he same services as euro area residens. This may be no fully correc as, for example, screening coss incurred by banks migh be higher for non-residen borrowers. Sill, his assumpion seems more plausible han using, for example, foreign margins (if hose were available) as, presumably, foreign cusomers buy financial services from euro area banks raher han heir own banks only if heir cos appears reasonable o hem. As no breakdown by secor is available in MFI balance shee saisics for posiions vis-à-vis residens of he res of he world no belonging o he MFI or governmen secor, we use in his case a weighed average of euro area margins based on he secoral composiion of cross-border balances of loans and deposis wihin he euro area. Applying his logic for individual euro area counries would require using domesic margins for expors from one euro area counry o anoher and foreign margins for impors from anoher euro area counry. For impors 61 from ouside he euro area his is no feasible, so domesic margins will have o be used here as well. This approach o he impor and expor of FISIM also differs from curren mehods. Currenly, he exernal reference rae should be compared o marke ineres raes on cross-border posiions wihin he euro area and for he res of he world. 62 In view of he lack of reliable and deailed secoral daa on ineres raes and margins for he posiions wih exra euro area residens, he proposed mehod has he advanage of concepual clariy and is more appealing from our poin of view since i focuses on he services provided, raher han rying o esimae he service margin as a residual based on For he purpose of simulaing FISIM resuls under he curren mehodology, ineres raes on loans o he general governmen and insurance corporaions and pension funds are esimaed using financial marke daa, while he corresponding ineres raes on deposis are assumed o be he same as for NFCs. For he governmen secor his may no be he case as mos ransacions (a leas hose wih he cenral governmen) are likely o be raher auomaed and involve high volumes, hus implying small service componens. On he oher side his secor has a lile weigh on he overall deposis and loans aciviies of he euro area banking secor, hus implying a small impac on he final esimaes. The paper is focused on he oupu of euro area banks and herefore he reamen of he services impored by euro area residens is no crucial for our discussion. Neverheless is relevance for he compilaion of non-financial accouns leads o include i in our discussion. In our simulaion of he curren FISIM official mehodology, boh he exernal reference rae and he cross-border ineres raes are based on esimaed ineres flows which are respecively derived from iner-bank raes (EURIBOR, LIBOR) for he iner-bank componen, from MIR raes for he inra euro area posiions vis-à-vis non-banks, and from balance of paymen saisics for he posiions vis-à-vis exra euro area non-bank residens. 19