13 March 2014

ECB/Cœuré: Monetary policy transmission and bank deleveraging

Deleveraging is not a process that policy-makers should seek to avoid; rather, it needs to take place and be properly managed, explains ECB Executive Board member Benoît Cœuré. Describing the good, the bad and the ugly deleveraging at the Future of Banking Summit organised by “The Economist” in Paris, he emphasises how the wrong type of deleveraging could impede recovery and make it more difficult for central banks to engineer an appropriate degree of monetary accommodation.

To ensure the right type of deleveraging is achieved, Cœuré highlights, “both monetary policy and prudential supervision – notably the ECB’s ongoing comprehensive assessment – have a key role to play". According to him, the comprehensive assessment of banks’ balance sheets and the steps taken towards the Banking Union are crucial to establish the conditions necessary for a transparent, competitive and stable banking sector. He adds, “and they will help monetary policy to regain traction across the euro area".

Comprehensive assessment

For banks that are found to be healthy by the assessment, the price mechanism will no longer be obscured by uncertainty about asset valuation and bank funding models. This should be reflected in higher share prices and cheaper funding costs, supporting the pass-through of our interest rates.

For banks that are restructured and recapitalised, lending rates should also become more responsive to our monetary policy impulses. There will no longer be a need for such banks to rebuild capital, and hence their incentive to reduce loans that carry higher risk weights, like those to non-financial corporations, will disappear. When loans are repaid, banks can opt to lend again rather than to shrink their balance sheets.

At the same time, spreads on loans should come down. Funding pressures are likely to attenuate as banks reach their target loan-to-deposit ratios and as interest rates on deposits converge. And as more banks free up balance sheet space for new lending, competition among banks for borrowers should start to increase, putting further downward pressure on new lending rates. We have already seen some of these dynamics playing out in Spain since mid-2012.

By identifying weaker and stronger banks, and putting a price on bank assets, the comprehensive assessment may also have a further effect: the results could present an opportunity for a revival of M&A activity, which has been very weak since the crisis, with the overall value of deals decreasing fourfold from 2008 to 2012. A rationalisation of the euro area banking sector will increase efficiency, and hence be conducive to a smoother transmission of monetary policy.

In short, a strict and credible comprehensive assessment will significantly support monetary policy. Insofar as it leads to bank lending rates converging between the core and the periphery, it will allow a significant additional easing of monetary policy in some jurisdictions. And insofar as it leads to better access to finance, higher growth and rising inflation, it will support our expectation that real interest rates will gradually ease over the projection horizon.

One final point: looking further ahead, I expect the downsizing of the banking sector to accelerate the development of alternative, capital market-based sources of finance, especially for smaller firms. We are already seeing this playing out in some jurisdictions – for example, the “mini bonds” scheme in Italy – and through initiatives, which the ECB supports, to revive European ABS markets.

This matters for monetary policy for two reasons. First, it provides a spare tyre, i.e. an additional channel through which monetary policy can be transmitted if the bank lending channel becomes impaired again in the future. Second, it reduces banks’ market power, which may tend to make bank lending rates more responsive to monetary policy. Indeed, recent research has shown that where banks in Europe face limited competition, and firms depend on them, financing constraints for SMEs have been found to be higher.

Such a rebalancing of the financing mix of the euro area economy probably requires further regulatory action to acknowledge the emergence of new, high-quality capital market instruments, such as simpler and more transparent ABSs.

Conclusion

Depending on how it materialises, bank deleveraging has a potential to impede the recovery and make it more difficult for central banks to engineer an appropriate degree of monetary accommodation or, to the contrary, to support the transmission of monetary policy. Therefore, policy-makers need to set proper incentives to promote “good” deleveraging and to steer clear of “bad” or “ugly” deleveraging.

Monetary policy has a vital role to play here, notably by providing the necessary liquidity support. But ultimately, it is up to policy-makers in other domains to ensure that the banking system is restored to health, and becomes fit for supporting the recovery and the reallocation of production factors in the euro area. Here, the steps being taken towards a banking union and the comprehensive assessment of banks’ balance sheets are crucial. They will establish the conditions necessary for a transparent, competitive and stable banking sector. And they will help monetary policy to regain traction across the euro area.

“One final remark: for all this to work, the Banking Union needs to be complete.  We need not only a single supervisory mechanism, but also a single resolution mechanism (SRM) and single resolution fund (SRF) and, at a later stage, a single deposit insurance scheme. If we fail to establish the SRM and SRF, bank resolution will remain a national task, resulting in a misalignment of responsibilities, and entrenching the link between banks and sovereigns. Not moving promptly towards the SRM and SRF would prolong uselessly financial fragmentation, leave the euro area financial system exposed to systemic fragility, and, ultimately, be harmful for growth and jobs. This would in particular be the case if the SRF is only slowly mutualised, and if it cannot resort to a common European backstop from the outset.“

Full speech

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