Benoît Coeuré: Financing the economy of the euro area - the European
Central Bank's role
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the Association Française des Tresoriers d'Entreprises (AFTE), Paris, 11 April 2012.
* * *
I wish to thank Simone Manganelli for his contributions to the speech. I remain solely responsible for the opinions
contained herein.
Ladies and gentlemen,
It is a pleasure for me to be here at the Association Française des Trésoriers d'Entreprise.
The topic I have chosen for my address today is the role that the ECB has played - and will
play - in ensuring that the real economy of the euro area continues to receive the funding it
needs to function properly and how this is linked to the ultimate objective of maintaining price
stability in the medium term. I will focus in particular on the latest round of non-standard
measures - the three-year refinancing operations which were conducted in December and
February. I will start by describing the risks that the euro area economy was facing in the last
quarter of 2011. At that time the banking system had funding difficulties, and we were on the
brink of a credit crunch. If a crunch had occurred, it could have had devastating
consequences for many firms and households; their access to financing would have been
restricted. I will then describe how the injection of long-term liquidity has helped to avoid a
sudden curtailment of financing to the private sector by alleviating funding pressures on the
banking system. I will go on to consider some of the challenges the Eurosystem is likely to
face in the near future.
Credit developments to households, non-financial corporations and small and
medium-sized enterprises (SMEs)
During the last quarter of 2011, monetary and credit developments to the private sector were
exceptionally weak. The annual growth rate of monetary aggregates declined significantly in
December, and it was mirrored by similar developments in lending to the private sector,
especially loans to households and non-financial corporations. Clearly, as the sovereign
crisis intensified it impeded banks' support for the real economy.
The annual growth rate of banks' credit to the private sector decreased in the last quarter of
2011, reflecting monthly negative outflows and reaching troughs comparable with those
prevailing in 2008-2009. In particular, the rate of growth of loans to households declined,
reflecting both demand-side factors (such as a deterioration in the prospects for the
economy, and notably the housing market) and supply-side factors (such as increasing
funding difficulties for banks) (Slide 1). Incidentally, these developments masked significant
cross-country heterogeneity, as some countries saw an increase in flows supported by
government measures aimed at the housing market. The annual growth rate of loans to
non-financial corporations declined as well, reflecting particularly weak quarterly flows
(Slide 2). There was considerable cross-country heterogeneity in this case too, with net
redemptions taking place mainly in certain countries and loans to non-financial corporations
continuing to grow in others.
The worrisome picture of monetary developments was confirmed by the results of the Bank
Lending Survey for the fourth quarter of 2011. Euro area banks tightened credit standards
compared with the previous quarter for both loans to non-financial corporations and loans to
households, and to a lesser extent for loans for consumer credit. Furthermore, survey
participants expected a further tightening of credit standards in the first quarter of 2012. Even
if the tightening was slower than during the 2007-2008 financial turmoil, it was starting from
considerably tighter credit standards.
Although it is always tricky to disentangle supply-side from demand-side factors, banks
explained their changes in credit standards mainly by primarily referring to increased funding
costs and balance sheet constraints, which were compounded by a rapidly deteriorating
economic environment. The funding situation of euro area credit institutions worsened
noticeably in the second half of 2011, as shown by the rise in withdrawals of deposits held by
non-euro area residents with euro area banks and difficulties in issuing longer-term debt
securities. This caused banks to make greater recourse to Eurosystem operations.
The decline in credit to the private sector was accompanied by an increasing reluctance on
the part of the euro area private sector to invest in financial assets; it severely hampered
banks' access to financing via the secured money market, due to an increase in haircuts and
a deterioration of the available collateral.
While market-based funding was becoming ever scarcer for banks in the euro area (as
investors were growing increasingly nervous about the escalation of the sovereign crisis),
banks were also facing regulatory and market pressures to strengthen their capital position.
In short, back in December 2011, even though there was significant cross-country
heterogeneity, the overall picture was rather gloomy. There were clear signs that supply-side
factors were making banks less willing to lend to the non-financial private sector, and that
banks may have entered a vicious circle which could compromise their ability to supply credit
to the economy, both in the short and the long run. The additional negative impact on banks'
balance sheets of rapidly declining sovereign bond prices made the situation even worse.
Banks typically have three ways to adjust to pressures on their funding and capital positions:
they can sell assets, raise capital or reduce lending. Let's look at each of these options in
turn.
In an environment of extreme uncertainty and high risk aversion, risky assets can only be
disposed of at very low prices, possibly considerably below their book value. Fire sales would
weigh on profits, further deteriorating banks' capital positions, generating in the process
negative externalities and sub-optimal collective behaviour. Therefore, to be successful,
significant reductions on the assets side of the banks' balance sheet require a stabilisation of
the economic and financial environment.
Raising capital is also challenging in an unstable environment. Uncertainty about the pricing
of the risky assets and the overall risk surrounding the valuation of banks makes it
particularly difficult to attract new equity investors. Raising capital in such circumstances may
not be accepted by shareholders as it may send a negative signal to the markets and lead to
a drop in share prices. And, compared to 2008-2009, credible government support for banks'
capital positions was less available.
This left banks with the third option, namely, to reduce lending. Banks could easily stop
rolling over their loans or granting new ones. This strategy, however, while optimal from an
individual bank's perspective, would lead, if pursued collectively, to a credit crunch, with
significant negative consequences on the real economy and additional strains on the banking
sector.
A credit crunch would have been particularly dangerous for small and medium-sized
enterprises (SMEs), given their heavy reliance on bank funding. It is no exaggeration to say
that SMEs form the backbone of Europe's economy, accounting for approximately two-thirds
of employment. Let me give you a few statistics: SMEs constitute about 99% of all firms in
the euro area, employ 72% of the euro area's labour force and generate around 60% of
value added. They have significantly higher gross job creation (and destruction) rates than
large enterprises. At the same time, SMEs tend to face more stringent financial constraints,
have a higher cost of external finance and exhibit higher debt levels than large firms.
According to the most recent survey on SMEs conducted by the Eurosystem, in the second
and third quarter of 2011 access to finance remained one of their most pressing problems.
To put things into perspective, bear in mind that the number of firms concerned about
financing was actually lower in 2009, a period when economic activity in the euro area was
very weak. According to the survey, bank financing (via overdrafts, credit lines and bank
loans) remained the most important source of external financing for SMEs. In addition, 20%
of the respondents perceived a further decline in banks' willingness to provide loans.
Therefore, after the improvement registered in 2010, SMEs were experiencing once again
significant constraints in obtaining financing.
In the light of this evidence, the concrete risk that the increasing pressures on banks' funding
and capital positions could lead to a significant curtailment of banks' lending activity in some
countries was judged to be extremely high in December 2011. In particular, a dangerous loop
involving low economic activity, funding stress for banks and a reduction in lending had
increased the downside risks to price stability. It was therefore a top priority to break this loop
before it spiralled out of control.
Launch of new non-standard measures and their impact
Faced with this critical situation, the Eurosystem adopted a two-pronged strategy. First, it
offered ample liquidity at very long maturity to prevent funding issues from igniting a
potentially destructive deleveraging process. Second, it widened the eligible collateral to
facilitate access to the liquidity and the provision of credit to SMEs.
Specifically, on 8 December 2011, the ECB announced the following initiatives.
First, the ECB said it would launch two longer-term refinancing operations (LTROs) with a
maturity of 36 months. The LTROs were to be conducted as fixed-rate tender procedures
with full allotment, with the interest rate fixed at the average rate of the main refinancing
operations over the life of the respective operation. To increase the flexibility of the
operations and to cater for different liquidity needs, counterparties were offered the option to
repay after one year any part of the allotted amounts.
Second, the ECB decided to increase collateral availability by allowing national central
banks, among other things, to accept as collateral additional performing credit claims (i.e.
bank loans) that satisfy specific eligibility criteria. As an example, the Banque de France has
accepted real estate residential loans with a mortgage or first-rank privilege, credit claims
denominated in US dollars and export credit claims guaranteed by Coface. Also, in addition
to the ABSs that were already eligible for Eurosystem operations, the ECB would accept as
eligible collateral ABSs with a second best rating at issuance and over the lifetime of A- or
above, the underlying assets of which comprise residential mortgages and loans to SMEs.
Additional credit claims not complying with the regular minimum credit quality threshold
applied to collateral eligible for Eurosystem credit operations are subject to increased
haircuts to aim at achieving risk equivalence with the regular set of eligible collateral.
The Eurosystem allotted €489 billion with the first three-year LTRO on 21 December 2011.
Accounting for other operations that matured and settled within that week, however, the net
liquidity increase was €210 billion. In the second three-year LTRO, on 29 February, the
Eurosystem provided credit institutions with an additional gross amount of €530 billion.
Again, taking into account maturing operations, the net liquidity injection was around
€311 billion. Counterparties bidding in the three-year LTROs can be divided into two groups:
one group consists of many small banks, bidding for comparatively small amounts, while the
other group comprises large banks and accounts for the main share of the overall allotment
amount. A distinctive feature of the second operation was the higher number of bidders, 800,
as opposed to 523 in the first operation. The majority of bidders in the second LTRO were
small banks from euro area countries where the economic conditions are stronger, with more
than half of the bidders bidding for €50 million or less. A reasonable interpretation of this
outcome is that the Eurosystem has also been successful in reaching smaller financial
entities, which had more time to prepare their bids in the second operation than in the first,
and which are essential for providing credit to SMEs.
Analysis of the main determinants of banks' bidding behaviour, combined with anecdotal
information provided by banks, confirms that the funding issues I referred to earlier were of
vital importance. As an illustration, Slide 3 shows a positive relationship between spreads on
bank bonds at issuance and the amounts bid by banks in both three-year LTROs as a
percentage of their total assets. The slide suggests that, for those banks with access to
longer-term funds in the bond market, there was a strong correlation between their cost of
funding and their bidding behaviour. Banks without outstanding debt securities bid on
average even more aggressively. Overall, our internal analysis shows that the most
aggressive bidders were characterised by larger amounts of debt maturing in the next three
years and a shorter average maturity of the outstanding debt. The results of the Bank
Lending Survey further reinforce this interpretation.
This evidence supports the Governing Council's view that banks were facing significant
funding problems and that, by removing impediments to their ability to finance the real
economy, the three-year LTROs helped to avoid a dangerous credit crunch in the euro area.
The large injection of liquidity via the three-year LTROs had an immediate impact on many
market segments. By reducing concerns over the liquidity situation faced by banks and by
cutting banking sector systemic risk (which is reflected, for instance, in a sharp decline in EU
bank CDS premia), the LTROs contributed to reopening funding markets.
In money markets, the EURIBOR-OIS spreads have reversed their widening trend from last
year, by narrowing substantially, thereby suggesting that the operations have successfully
lowered risk premia. More generally, the whole euro money market curve has flattened. In
the secured segment, repo rates in selected euro area government bonds, which had been
progressively increasing since August 2011 compared with those based on collateral from
AAA countries, declined and continued to remain low, indicating that the funding of Italian
and Spanish government bond positions in the repo market has become much cheaper.
Although turnover in the repo market has remained relatively subdued, there are signs of a
moderate pick-up in the volume in Spanish and Italian markets from their levels at the end of
2011. The widespread perception of lower liquidity risk and improved capital adequacy
thanks to the European Banking Authority capital exercise also brought a welcome reduction
in US dollar funding costs via the FX swap market. US prime money market funds increased
their exposure to euro area banks in January 2012 for the first time since April 2011, with an
additional increase of 21% between the end of January and mid-March, and exceeding 12%
of total assets under management.
Euro area banks' issuance of medium and long-term debt picked up in the first two months of
2012 compared with the subdued levels in the second half of 2011. In this period, euro area
banks issued about €50 billion in senior unsecured debt, which is about as much as was
issued in the entire second half of 2011. Banks also issued €35 billion in covered bonds.
While term debt issuance was mostly concentrated in some AAA euro area countries in the
early phase of market reopening, the issuer base broadened thereafter. In particular,
February saw the issuance of senior unsecured debt by some large banks from Italy and
Spain, as well as some increased covered bond issuance by large banks and new issuance
by "second-tier" lenders from these countries.
In another sign of improving funding conditions, the cost of medium and long-term funding
has decreased since December 2011, as illustrated by the drop in European debt yields for
financial and non-financial corporations (Slides 4 and 5). Unsurprisingly, the change in yields
was particularly pronounced for the lower-rated bonds, confirming that the LTROs have
managed to sharply reduce risk premia. The resulting perception that liquidity risks for euro
area banks have diminished and that capital adequacy has improved thanks to the capital
exercise might also have contributed to the recent strong performance of the stock markets
of many euro area countries (Slide 6).
Euro area sovereign bond markets have rebounded dramatically. Yields of shorter-term
notes and bills have declined, with two-year government bond yields of Italy, Ireland and
Portugal declining by over 400 bps since 8 December 2011. Longer-term government yields
have declined as well, although not to the same extent as shorter-term yields (Slide 7). The
positive secondary market developments were accompanied by favourable primary market
activity with sustained demand in auctions of T-bills and shorter bonds in several euro area
countries.
All in all, there is now strong preliminary evidence that the three-year LTROs have helped the
banks to reduce liquidity risk and therefore allowed them to smooth the deleveraging process
over a longer period of time and maintain exposures to SMEs - at least in some cases.
Anecdotal evidence also points to the return of some institutional money market investors,
with quite a number of banks reporting that funds (also unsecured) are becoming available
again at somewhat longer maturities. While banks seem to have used the funds obtained
from the first three-year LTRO mainly for refinancing purposes, when looking forward to the
next six months, they now seem to expect a stronger use of these funds for granting loans.
Whether these expectations will materialise remains an open question and the Governing
Council will closely monitor these developments.
Challenges ahead
A side effect of the three-year LTROs is that the banking system in the euro area is now in a
situation of abundant excess liquidity. "Excess liquidity" (defined as the difference between
outstanding open market operations and the liquidity needs from autonomous factors and
reserve requirements) currently stands at around €800 billion and is expected to remain at
roughly this level at least until the end of January 2013, when banks will be able to exercise
the option of early repayment on the first three-year LTRO. The leeway for a reduction in
outstanding refinancing operations before that date currently amounts to around €100 billion,
and the scale on which banks will exercise early repayment options is difficult to anticipate at
the current juncture. As a consequence, the balance sheet of the Eurosystem has grown to
€3 trillion. This large increase is a symptom of malfunctioning money markets and reflects
the fact that the Eurosystem has replaced much interbank activity. When the situation
stabilises and money markets go back to functioning normally, the balance sheet of the
Eurosystem will also go back to its normal size. To this respect, the Eurosystem is often
compared with other major central banks. Such comparisons however disregard the initial
size of balance sheets, as the Eurosystem holds a large volume of assets that have nothing
to do with monetary policy. In early March, the ratio of monetary policy instruments to
regional GDP was 15% for the Eurosystem, 19% for the Federal Reserve System and 21%
for the Bank of England.
This large amount of excess liquidity has drawn criticism of two different kinds. Some
observers have argued that since banks are re-depositing with the ECB large amounts of
liquidity, the injected liquidity is not circulating within the system and therefore the ECB's
actions will be ineffective in preventing deflationary pressures. Others, however, have
warned that since these large amounts of excess reserves may remain in the system for a
relatively long time, if they are not appropriately absorbed they will hamper the ECB's ability
to keep inflationary pressures in check. These fears are of course contradictory. In order to
dispel them, let's look more closely at the channels of transmission through which the excess
liquidity circulates in the system.
The first criticism - that large-scale use of the deposit facility demonstrates the
ineffectiveness of ECB's measures - reflects a fundamental misunderstanding of the
functioning of the operational framework of the ECB. By an accounting identity, any amount
of liquidity injected in excess of the liquidity needs of the banking system will be necessarily
re-absorbed via the deposit facility. The increase in the deposit facility does not provide any
information whatsoever about how banks use the funds borrowed from the central bank.
For instance, a bank which has borrowed from the ECB can use the funds to grant a
mortgage to a client, who in turn uses that credit to pay construction workers, who in turn
may buy a car, and so on. After each transaction, the buyer transfers the amount from his or
her bank account to the seller's bank account. The liquidity can circulate many times before
eventually appearing on the balance sheet of a bank with a liquidity surplus, which will be
deposited back with the ECB. Of course, at the other extreme is the bank which borrows
from the ECB and immediately deposits the amount with the central bank. In this case, the
liquidity did not circulate at all.
In both cases, the amount deposited with the ECB would be exactly the same and it is
therefore wrong to assume from the large use of the deposit facility that the liquidity is not
circulating. In fact, we know that the banks which are depositing with us are not the same as
those which are borrowing, indicating that the liquidity is somehow circulating within the
banking system before coming back to us. We have no information however (besides
anecdotal evidence) about the speed at which this liquidity is circulating, and through which
channels.
Let me turn now to the second criticism - namely that excess liquidity will generate inflation.
It is important to recall, first, that the three-year LTROs have helped avoid a disorderly
deleveraging which may have led to deflation. Let's analyse now the arguments behind the
fear that the LTROs may have, however, increased the upside risks to price stability. Central
bank reserves represent one of the many assets in the balance sheet of a bank. Up to a
certain amount, banks' demand for central bank reserves is completely inelastic (due to
central bank reserve requirements, internal and external liquidity regulation and other
factors). Beyond this amount, however, the decision to hold excess reserves responds to
risk-return considerations as for any other asset: if a bank decides to hold a certain amount
of excess reserves, it is because their risk-adjusted return dominates that of other assets.
As I mentioned earlier, while an individual bank can decide to hold less excess reserves, in
the short run the banking system as a whole cannot dispose of excess reserves. Since, in
equilibrium, supply must equal demand, if interest rates on central bank deposits (the
riskfree remuneration of excess reserves) are at levels such that demand for reserves exceeds
supply, banks will be willing to hold on to the excess reserves present in the market. This is
likely to be the case in a situation of high risk aversion, where - like today - the risk premia
demanded to hold risky assets are so high that their risk-adjusted return is lower than that
offered by the deposit rate.
If, however, banks become more willing to accept risks, their demand for excess reserves for
a given deposit rate will decrease and they will look for more attractive alternative uses for
these funds: riskier assets and/or loans. Since the banking system as whole cannot return to
equilibrium (after the three-year LTROs, the supply of reserves is inelastic in the short term),
this behaviour will put pressure on asset prices and (as soon as the economy reaches its full
potential) on consumer prices as well, unless an appropriate monetary policy stance is taken.
These effects and the speed at which they may materialise are difficult to quantify as cases
of protracted periods of excess liquidity have been rare in the past. The experience of Japan
does not suggest direct effects on inflation. In the United Sates and United Kingdom, there is
also no clear-cut evidence so far of a pick-up in monetary and credit aggregates spurred by
excess liquidity. However, it is fair to say that in case of a sustained and more robust
recovery in economic activity, excess reserves may have a potential macroeconomic impact
by allowing a build-up of significant asset price misalignments, or by distorting the banks'
incentive to supply funding to the economy. Moreover, in the face of asset market
fragmentation, such asset price misalignments are more likely to build up in countries where
banks have ample liquidity positions.
There is nothing, however, in this reasoning that prevents the ECB from tackling these
effects by increasing policy rates, whenever the Governing Council deems it necessary to do
so. Our operational framework makes it possible to steer a whole range of money market
rates in line with the desired monetary policy stance. In fact, if the ECB decides to the
change its key policy rates, or even hints at it, the indexation of the interest rate charged on
our refinancing operations will immediately affect present and future funding conditions for
banks, favouring inter alia the exit of some of the LTRO bidders. Furthermore, in our corridor
system, the deposit rate puts an effective floor under short-term unsecured money market
interest rates.
Higher interest rates will reduce demand for loans, as the net present value of the project of
the marginal investor becomes negative. Higher interest rates will also decrease the demand
for risky assets, as the remuneration of risk-free assets increases. Eventually, for sufficiently
high interest rates, inflationary pressures will subside and the system will return to
equilibrium.
It can still be argued that there is significant uncertainty as to how an environment of
abundant excess liquidity affects the transmission mechanism of monetary policy. In
particular, heterogeneity in the economic conditions of euro area countries may be magnified
by the excess liquidity, which tends to flow to countries where the economic conditions are
stronger. However, should this uncertainty weaken our ability to maintain price stability, the
ECB has the necessary instruments to absorb the excess liquidity. In this respect, it is worth
recalling that we have been sterilising the liquidity created with the government bond
purchases under the Securities Markets Programme for almost two years. By auctioning
weekly fixed-term deposits, the ECB has been successfully absorbing substantial amounts of
liquidity. In addition, the ECB has the right to issue debt certificates, and, if necessary, we
could also decide to increase banks' reserve requirements again. Reverting to the 2%
reserve requirement ratio that prevailed until December 2011 would reduce excess reserves
by approximately 100 billion euros. So, we are well equipped to cope with any issues arising
from excess liquidity.
There is a third concern which I would like to touch upon, and which I consider to be a
serious one: the risk of moral hazard behaviour triggered by the non-standard measures. The
large liquidity injections have avoided so far a disorderly deleveraging of the banking sector
in the euro area as well as a dangerous credit crunch, but they have not removed the
underlying causes of the turmoil. If governments and banks would stop or slow down their
consolidation efforts and structural reforms, this would undermine the positive effects of the
liquidity operations.
Following the signs of improvement in the financial environment, it is therefore essential for
banks to strengthen their resilience further, even by retaining earnings. The soundness of
banks' balance sheets will be a key factor in facilitating an appropriate provision of credit to
the economy. Very low interest rates and ample liquidity conditions may be disincentives for
banks to avoid recognising the loss by rolling over loans extended to borrowers who are
unable to pay back the principal (the so-called "evergreening" of loans). It is critical that
banks readily exploit the current relatively favourable conditions to meet capital adequacy
objectives and improve their funding profile.
Similarly, to promote sustainable growth and to support confidence and competitiveness,
governments need to continue their efforts towards restoring sound fiscal positions and
improving competitiveness. Many governments have already made significant steps and the
efforts must continue unabated.
Finally, a fourth concern relates to the risk of persistent market fragmentation. The ECB has
used conventional and non-conventional measures to restore the transmission channels of
monetary policy and make sure that the impulse stemming from it is transmitted more
uniformly across the 17 economies of the euro area. The large size of the Eurosystem's
refinancing operations and the resulting expansion in its balance sheet are a reflection of the
impairments which still hamper the proper functioning of capital markets in the euro area.
Today, it is of utmost importance to address these impairments, otherwise we will loose the
benefits of the freedom of capital movements which was why monetary union was needed in
the first place. There will be no lasting recovery of growth if European households and
corporations cannot tap a common pool of savings.
To operate smoothly, be more resilient to crises and better support long-term growth,
Economic and Monetary Union has to become a true financial union. I will list here some of
the key features of the much-needed "Financial Compact". Repairing the single market for
capital is a collective endeavour in which the ECB has a role to play - but to be fully effective
that role needs to be coordinated with the European Commission, European Supervisory
Authorities and market participants themselves. Breaking the feedback loop between bank
and sovereign credit should also be a priority. To this effect, steps should be taken towards a
unified regime for bank resolution and beyond that, towards establishing a single European
banking resolution authority. Finally, the "Financial Compact" should also include the
completion of the single euro payment area.
Payments are at the very heart of a corporate's activity and I am not sure that they always
get the attention they deserve. Nowadays, more than 50% of the trade of the 27 EU
countries takes place within the EU - and that trade is mainly based on cashless payments.
With the introduction of the single currency there could no longer be any differentiation
between national and cross-border euro payments: they should all be "domestic". The Single
Euro Payments Area project, in short "SEPA", came to fill this void; its aim is to establish a
single market for retail cashless euro payments by overcoming technical, legal and market
barriers, so that people can make euro payments throughout Europe as easily, securely and
efficiently as within their own countries.
Using the SEPA payment instruments, companies can make all euro-denominated payments
centrally, from a single account, using the same format. This opens up the possibility of
consolidated payments, of liquidity management in one location and of optimising the cash
flow. The European Commission has stepped in with the Payment Services Directive which,
among other changes, ensures that the full amount of a transaction is transmitted and that
payments are executed more quickly, thus saving time and money. As the transition to SEPA
had to speed up, the European Council adopted in February 2012 a new regulation
establishing 1 February 2014 as the deadline for the migration to SEPA of credit transfers
and direct debits made in euro. This means that users, including corporates, need to migrate
too! SEPA is also about innovation; the project is active in innovative fields such as
einvoicing and e-reconciliation within Europe, which can offer huge savings for corporates in
the handling of payments. The ECB, in its role as a co-chair of the SEPA Council together
with the European Commission, stands ready to pursue a dialogue with all stakeholders on
these important matters.
Conclusion
Let me to bring my rema