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Central banks — saviours or distorters?

Central banks have seen their role within the markets evolve and grow rapidly in recent years. The ECB has at times struggled with these changes, loathe to dilute its mandate for ensuring price stability and acutely aware of the risk of further distorting markets in its attempts to save them. Solomon Teague reports.

Traditionally the European Central Bank’s primary focus has been on fighting inflation and maintaining price stability. Recently, with little prospect of an upswing in inflation, its mandate has been to create an environment conducive to growth. Five years ago no appraisal of central bank performance would have considered bank lending to SMEs a relevant metric. It is a mark of the changing role of central banks that today no analysis could be complete without considering this factor.  

This change has been in evidence at all central banks, and is exemplified by the now explicit link between quantitative easing and unemployment in the UK and the US, and a general increase in the politicisation of central banking. The ECB has not been entirely comfortable with this new mandate, and it is in this role that its performance has been weakest — lending in Europe is still very low. But the ECB has been more successful in reducing systemic risk. 

“There is no doubt the central banks’ actions during the crisis were essential and saved the system from unnecessary disruption that would have had permanent negative consequences,” says Anthony Whittaker, head of UK DCM at Natixis. “However, as time has gone on it has stopped being essential, and changed into merely the provision of long term cheap funding to improve interest margins and boost P&L.”

Action by central banks played a key role in stabilising financial markets and creating better conditions for a recovery in economic activity, says Marco Valli, chief eurozone economist at UniCredit. 

“Just think of the huge importance of the ECB long term liquidity provisions and the outright monetary transactions programme: without these moves, the integrity of the euro area would have been in serious danger, with dire consequences also outside the single currency area,” he says. “Obviously, non-conventional monetary policies do imply some kind of market distortion, but this is a price which was worth paying given the highly asymmetric balance of risks.”

Fiscal or monetary policy?

The most dangerous distortion resulting from central bank actions has been the blurring of the line between fiscal and monetary policy, says Christoph Rieger, head of interest rates research at Commerzbank. 

“This was necessary, but dangerous, and central banks must re-establish a clear dividing line between the two as soon as possible, especially in Europe where there is no central fiscal authority.” With market tensions steadily easing, the risk is now that a failure to separate fiscal from monetary policy will create significant problems in future, he says. 

“The ‘Draghi Put’, the idea that the ECB will do ‘whatever it takes’ to protect the eurozone, removes the incentive for governments to push through the reforms they need,” warns Rieger. “There were many factors that caused this crisis but a big one was diverging competitiveness between euro area member states, and this is not being addressed. The longer the ECB supports the market, the longer it will be before politicians tackle this problem.”

Politicians are not the only ones whose actions have been distorted by the ECB. By offering banks cheap money, the long term refinancing operation created the opportunity for a carry trade that encouraged banks to load up on high yielding sovereign debt, strengthening the link between banks and the states in which they are domiciled. In 2009 European banks held on average 3% of their own sovereign’s paper. That has now risen to 10%. Although its primary aim was to avert a funding crisis in Europe, it indirectly recapitalised European banks, serving as a subsidy and increasing profitability too, something that politicians were probably not too dismayed about. 

Unfortunately this has encouraged banks to substitute lending activity with sovereign bond investing, says Rieger. The focus on sovereign tensions has averted financial crises, but the problem has been shifted into the real economy where corporates have reduced access to credit. 

Half way there

According to RBS, European banks are about half way through the deleveraging process, with the bigger banks leading the way. Small and medium sized banks trail and look less healthy, with less capital behind them and less profit being generated, a truth that can be observed in both ailing markets as well as robust ones. 

But after a flurry of better-than-expected economic data from Europe, optimism is in the air. Nearly three quarters (73%) of investors expect a tightening of central bank policy to be “timely and smooth, causing no threat to economic recovery,” according to an investor survey conducted by Fitch.  This is “a surprising number,” admits Monica Insoll, managing director in the credit market research team and author of the survey. 

Conducted around the time of Ben Bernanke’s first comments on tapering, the report did acknowledge potential danger, however, with 68% of respondents describing the withdrawal of quantitative easing as “high risk” to the European credit markets. This represents a significant lurch up from only 19% when the same question was asked in the previous quarterly survey. It makes withdrawal of QE the second biggest perceived risk to European credit, after a prolonged recession, at 71%, and ahead of sovereign debt problems at 65%. 

Attendees at a Fitch conference the same month were more ambivalent. Asked the same question, only 19% of people thought the exit from QE would be “timely and smooth,” representing no economic threat. This time 37% of respondents said the exit would be too slow, leading to asset bubbles and inflation, while 44% said it would trigger a sharp rise in bond yields and volatility. 

“Central banks are navigating difficult times, but overall the survey suggests investors are feeling quite optimistic about their ability to steer us through,” says Insoll. 

Some have asked why the ECB did not implement its own version of the US’s Troubled Asset Relief Program (Tarp), widely credited with facilitating the speedy cleansing of US bank balance sheets. If it had, the charge goes, perhaps Europe’s banks would have made more progress by now. 

But Tarp was unique to the US’s financial landscape. “Europe is not like the US, it does not have any central fiscal authority,” says Rieger. “Central banks can only provide liquidity, not capital.” 

Left to the market’s devices

Tarp was not in the ECB’s toolbox, while European governments lacked the financial firepower to improve the capital ratios of banks on their own. They could only leave it to the markets, offering assistance where necessary. 

The ECB provided abundant liquidity, reduced rates and offered more generous collateral terms to banks. Now, amid hopes of a turnaround, it is back to monitoring the effects of these policies: a rate cut is unlikely, but Europe’’s worries are far from over. Banks are still not lending, especially in the periphery but to some extent in the core too. 

In all, European banks have deleveraged to the tune of €3.2tr in the 15 months following May 2012, a reduction of 8.1%, according to RBS. Yet the sector is still 3.2 times the size of Europe’s economy, and is the largest banking sector in the world. RBS estimates it has a further €2.9tr of deleveraging to go. 

“The system needs to shrink further, in line with the size of the banking sector in Japan, Canada or Australia,” says Alberto Gallo, head of European macro credit research at RBS. 

In those countries, the proportion is closer to two times the size of the economy. “The US banking system, instead, is smaller than its economy, given its high development of bond markets,” says Gallo. “A banking sector more than three times the size of GDP clearly poses a threat to the sovereign in a potential crisis.” 

As European banks continue to shrink, new ways to channel credit to the economy must be found, for example via bond issuance, public funding and increased securitization. Europe also needs to make progress towards banking union before the sector can properly recover, he says. 

“We advocate LTRO3 if things get worse, but more central bank action alone will not fix the problems we currently face,” says Gallo. “Lending more money to banks is not going to increase their own lending. We need more fiscal than monetary action,” including finding new ways to stimulate lending to SMEs. 

Lending programmes from the European Investment Bank will be increased to €60bn a year in 2014, but it needs to rise further, he adds. 

Bring on the stress tests

The European bank stress tests, now scheduled for 2014, will shed greater light on the underlying health of European banks which should boost investor confidence, although there is evidence it is already quite high. Investors responding to Fitch’s survey judged refinancing risk for investment grade financials to be the lowest it has been since before 2010, with only 9% expecting such institutions to face a refinancing challenge. 

Nearly half of respondents expected a decrease in issuance for IG financial institutions, while only 17% expected an increase. “It is possible this could suggest issuers will be locked out of the markets, but it is more likely it means investors expect deleveraging to continue, meaning banks are not raising capital,” says Insoll. 

The stress tests should be sufficiently rigorous to shed real light on the health of bank balance sheets and alleviate investor concerns. The European Banking Authority is a young institution and the stress tests will be one of the first significant tests of its effectiveness: if it gives the all clear, only for problems to arise in subsequent months, its reputation will be undermined — perhaps fatally. That should ensure there is no whitewash. 

Even so, some are optimistic the stress tests will bring positive news. In Spain, among the more troubled corners of Europe, the more digging authorities have done into bank balance sheets the more pleasantly surprised they have been, says Jean-François Robin, head of strategy for economic research at Natixis. 

However, there is downside risk too. The period leading up to the tests will be crucial, with banks becoming more conservative in preparation for scrutiny of their balance sheets. This could increase tensions in the real economy as lending declines even further, says Rieger. 

And the completion of the stress tests is unlikely to bring rapid respite to credit-starved corporates, with banks still mindful of Basel III. But with sovereign yields expected to remain tight, the higher margins available on lending to peripheral SMEs will look increasingly tempting despite the current tight credit and lending conditions, says Rieger. 

The ECB has tried to offset this by making credit available to the economy, providing credit lines to European banks that mirror, in intention if not in execution, the Bank of England’s funding for lending scheme (FLS). 

It’s the SMEs, stupid

“Maybe the ECB should focus a little more on long term liquidity, and on getting the credit to SMEs, which face high borrowing costs in many parts of Europe,” says Robin. “An LTRO explicitly stating that liquidity must be passed on to the real economy, especially in markets like Spain, Portugal and Italy, could be beneficial.”

The ECB could consider a liquidity facility geared towards corporate loans, perhaps using ABS backed by SME loans, modelled on the UK’s FLS, says Rieger. “The ECB could offer three year liquidity at a fixed rate, with the condition it is used for these ABS.”

In the UK, banks’ aversion to joining the FLS indicates they are healthy enough to survive without central bank assistance, says Whittaker. In all, banks have only taken £17bn, well under the amount available, with many shunning the scheme altogether. Others, such as Santander, have paid off their initial loans quicker than necessary. Whittaker says this shows UK banks are being sensible — but it also shows that by providing a lender-of-last-resort backstop, it has made it cheaper for banks to fund in the wholesale markets.

“Markets have been normal in the UK for the last 18 months,” he says. “The government is using the central bank for political ends, to boost lending and direct it to areas of the economy it wishes to help. I think that is wrong. If the government wants to lend to certain sectors it should do that itself, directly — it does own a bank after all. It should not be trying to influence the business of banks it doesn’t own.”

Yet this is a slippery slope, and few are really comfortable with governments running banks, even if they accept they will attempt to influence behaviour with incentives. 

“The ECB has already done a lot to ease monetary conditions and improve the transmission mechanism of its monetary policy,” says Valli. “In case of need, it can still cut the refi rate or provide further long term liquidity to banks, but this will not be a game changer. Ultimately, if banks do not lend it is mostly because demand is not there, or because banks are risk-averse or undercapitalised. There is little the ECB can do on all these fronts, and the ball is now back in the court of governments.”

ECB retreat unlikely soon

An ECB retreat from the market is unlikely for the foreseeable future, says Valli. “The recovery remains weak and subject to downside risks. But note that excess liquidity has been decreasing for some time, as markets normalise and banks repay their long term loans. In a sense, this is already the beginning of the exit.” 

If the exit has already begun, without fanfare or controversy, that suggests the process will be protracted and, if successful, orderly. “I am confident that life support will be withdrawn gradually, because I see no inflation threat anywhere in the developed world,” says Valli. 

“The main central banks are afraid to repeat the mistakes of the past when a premature exit jeopardised the possibility of a recovery,” he says. “The impact of less stimulus on the domestic economies should, therefore, prove manageable. However, those emerging countries that will continue to run a large current account deficit are bound to remain vulnerable to an upward trend of the ‘risk free’ rate.” 

And there is still the possibility of more action to come. The ECB is sensitive to the distorting effect sovereign bond purchases would have in the medium term but regards this as the lesser of two evils, says Robin. If it resorts to activating the OMT it will be fighting a mispricing of the market, effectively restoring fair value. 

“What do we want?” asks Robin. “Sovereign prices that are detached from the true underlying realities, or a more severe adjustment like Greece’s, along with the violent social unrest that comes with it?”

Ultimately central banks will always draw criticism from some quarters, no matter what they do. Some heckle them for increasingly being political agents, others for not doing enough to stimulate lending to the real economy. Most accept their actions have averted the worst possible outcomes of the crisis, including the total collapse of the system. The debate now is how soon markets will be able to stand on their own without that support.

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