Yves Mersch: Finance in an environment of downsizing banks
Keynote speech by Mr Yves Mersch, Member of the Executive Board of the European
Central Bank, at the Shanghai Forum 2014 "Asia Transforms: Identifying New Dynamics",
Shanghai, 24 May 2014.
* * *
Ladies and gentlemen,
Thank you very much for inviting me to speak today.
Europe and Asia have an increasingly symbiotic relationship. In 2013 total EU trade with Asia
reached €1.25 trillion, almost double the value recorded a decade ago and representing over
one-third of total EU trade. At the same time, the EU accounted for almost 30% of Asian
trade last year, far ahead of any other trading partner, including the United States. The EU is
also a major investor in Asia, and vice versa. Around 20% of EU outward investment goes to
Asia, while 20% of inward investment originates in the region.
In other words, the economic situation in Europe today has important consequences for the
growth trajectory of Asia - and this is a relationship that will likely only increase in strength in
the future. I would therefore like to use my remarks to discuss developments in Europe as
part of the growth equation for Asia. Asian policy-makers know best the domestic challenges
that face them and the types of solutions that are needed.
The European situation is no doubt a complex one, but if there is a common factor in the
crisis and its persistence, it is the difficulties of the euro area banking sector. The sector is in
a phase of downsizing and structural change that will inevitably affect financial intermediation
going forward. To think about how this will impact European and global growth, I think it is
useful to recall an ancient Chinese fable.
The fable is about a boy who lived near China's northern borders, and whose horse one day
wandered off into the territory of the northern tribes. Everyone commiserated with him for his
misfortune. But not his father, a well-practiced Taoist. "Perhaps this will soon turn out to be a
blessing," he said.
Then, a few months later, his horse returned, accompanied by a fine horse from the north.
Everyone congratulated him for his luck, but his father was more sanguine. He remarked,
"Perhaps this will soon turn out to be a curse". The boy quickly became fond of riding the fine
new horse, then one day out riding, he broke his leg in a nasty fall. Everyone again
commiserated with him. But once more his father disagreed. "Perhaps this will soon turn out
to be a blessing," he said.
Soon after, the northern tribes invaded the border regions. All able-bodied young men took
up arms to fight the invaders, and nine out of ten died. Due to his broken leg, however, the
boy did not join in the fighting. He and his father therefore survived.
This fable, known as "blessing or curse", is essentially about how the true significance of
developments is often not immediately apparent - and how the wise observer therefore pays
due attention to unintended consequences, both positive and negative. In my view this
describes rather well the situation in the euro area financial sector today.
The euro area banking sector has suffered a substantial shock that has triggered widespread
deleveraging, and on the face of it this is a negative development: it harms economic growth
and constrains access to finance. Yet, it is also clear that before the crisis the European
banking system had become unhealthily large. It was too leveraged, too big relative to the
size of national economies, and perhaps too dominant relative to capital markets. Thus, the
effect of a downsizing banking sector might in fact be a blessing in disguise - that is, a shift
towards safer banks and a more balanced financing mix.
Yet, we have to be careful that this too does not turn out to create problems. For example,
the transition to a new financing mix may favour some jurisdictions over others, thus
reinforcing imbalances. A shift from bank to non-bank financing may create new sources of
systemic risk in less transparent sectors. In other words, the challenge for policy-makers in
Europe today is to capitalise on the potential positives from the situation that has befallen us,
while making sure that we do not simply end up creating new problems for the future.
Let me begin my discussion on how to achieve that by looking at the current trend towards
bank downsizing in the euro area.
The trend towards downsizing banks
Financing of the real economy in the euro area has historically taken place through banks.
The euro area therefore requires and has a large banking sector. The aggregate balance
sheet of euro area banks is around 270% of GDP, whereas in the US, where capital markets
are deeper, it is only around 70% of GDP.
The euro area banking sector, however, expanded rapidly in the years before the crisis from
already high levels. From the start of the expansion in 2005 to its peak in 2012, banks assets
increased by more than 60 percentage points of GDP. This was associated with the
development of unsustainable bank business models. Banks relied too much on debt to
finance their lending, and that debt depended too much on wholesale market funding and too
little on deposits.
The crisis has brought those business models to an end and triggered a process of structural
change in the banking sector. European banks have entered a period of secular
deleveraging and restructuring. Bank balance sheets declined by around 20 percentage
points of GDP in 2013 alone. Loan-to-deposit ratios fell from 142% in the first quarter of 2008
to 117% at the end of last year, and I expect these ratios to continue to fall. Credit growth
has consequently been very weak.
This trend towards a downsizing of the banking sector has both positive and negative
aspects.
The negative aspects are mainly cyclical and relate to the current situation. A deleveraging
banking sector implies lower credit supply, which is problematic for a recovering euro area
economy. While the early stages of recoveries do not depend on credit as firms tend to draw
down internal funds, when credit demand picks up it needs to be matched by credit supply
for a sustainable recovery to take hold. The typical lag between credit growth and the
economic cycle is around 3 to 4 quarters.
The recovery in the euro area began not yet a year ago, and we are seeing tentative signs
from survey data that credit demand in the euro area is starting to pick up. The latest euro
area Bank Lending Survey (April 2014) shows that net loan demand has turned positive for
all loan categories. So, we need to make sure that the banking sector is strong enough to
meet that demand. A car can run on low fuel for a while, but at some point it needs to fill up
otherwise the engine will stall. At this stage of the recovery it is clear: There needs to be
sufficient fuel to rev up the engine.
This is one reason why the ECB has been putting so much emphasis on its on-going
comprehensive assessment of bank balance sheets in the euro area. Our aim is to ensure
that banks are sufficiently capitalised to once more start originating loans and taking risk. So
far, the mere "shadow" of the exercise has had a catalytic effect on banks' asset valuations,
provisioning and capital raising.
That is not to say that we expect a surge in aggregate credit growth as the exercise reaches
its completion with the publication of the results later this year. Rather, our expectation is that
new finance should be available for firms that need it. In Spain, for example, the banking
sector restructuring programme since 2012 has not yet led to an increase in overall credit.
But loans of less than €1 million to non-financial corporations - which are associated mainly
with small- and medium-sized enterprises (SMEs) - have shown a notable recovery in recent
months.
The positive aspects of a downsized banking sector are mainly structural.
Some research suggests there is a threshold beyond which the positive effect of finance on
growth diminishes.1 For example, information rents in the financial sector might be generated
by complex financial products or opaque banking organizations, allowing - at least
temporarily - for higher salaries and bonuses to be paid. This attracts talented individuals
away from productive sectors.
Alternatively, too-large banks may start expanding into less productive types of lending. If a
housing bubble is fuelled by aggressive lending, it is often the residential construction
industry that initially benefits. But the construction sector is typically characterised by low
productivity growth compared to manufacturing. Indeed, the proportion of housing loans as a
percentage of total loans in the euro area increased from around 50% in 1990 to more than
70% today, which is a type of lending that tends to be associated with lower growth.2
Structurally, a smaller banking sector could - at least in theory - help to avoid those negative
effects on growth and insulate the euro area from some of these risks.
Still, a smaller or downsized banking sector is no guarantee for lower overall risk. The
business models, risk attitudes and profitability of the banks need to be taken into account as
well. Likewise does geographical expansion into foreign markets when it is not accompanied
by local knowledge.
Another aspect is that a downsized banking sector provides impetus for capital market
development in Europe - after all, if savings are not being intermediated through banks, they
must be being intermediated through capital markets. I see this as central to a more
balanced and contested financing mix in the euro area.
Contrary to the trend in most advanced economies, the relative importance of bank versus
non-bank financing in the euro area has actually increased in the last two decades - from
already high levels - and this may have given banks excessive market power. Recent
research looking at the pre-crisis period suggests that where banks face limited competition
in their domestic markets, and firms are more dependent on them, financing constraints for
SMEs have been higher.3]
Matching credit supply and demand
We are already seeing signs in the euro area that a rebalancing towards capital market
financing is taking place: as bank credit to corporates has fallen, it has been approximately
matched by issuance of corporate bonds. It would nonetheless be naïve to expect this
transition towards a new financing mix to occur seamlessly. While on aggregate, euro area
credit supply might be sufficient to meet credit demand, I see two factors that might lead to
an imperfect match between supply and demand for certain firms. They are the location of
those firms and their size.
Location
In terms of location, the cost of and access to finance in the euro area remains strongly
based on national conditions. For example, the average cost of borrowing for non-financial
firms in Portugal is more than 5% per year, whereas the equivalent for French firms is around
2% per year.
One would imagine in this situation that a Portuguese firm would seek out a French bank, but
the euro area banking market does not facilitate such arbitrage. Direct cross-border loans to
firms account for just 7.5% of total loans to firms. And local affiliates of foreign banks
represent on average only around 20% of national markets, and much less in larger
countries. Thus, firms depend heavily on the health of their domestic banks.
Moreover, while corporate bond issuance has partially substituted for bank lending, it is
strongly concentrated in non-distressed countries where there has been no decrease in the
net flow of bank loans. The net issuance of debt securities, quoted shares and bank loans in
non-distressed countries was plus €66 billion in 2013, whereas it was minus €93 billion in
distressed countries.
Of course, in principle firms from distressed countries can issue securities in non-distressed
countries. In practice, however, it is legally complicated due to issues of different governing
law, especially when securities are traded along a chain of financial intermediaries.
This analysis points to two missing pieces in the euro area financial market: lack of retail
banking integration and lack of capital market integration.
The low level of retail banking integration reflects several factors, but diverging approaches
to supervision and resolution are certainly among them. For one, the persistence of national
borders in a European financial market has in the past created compliance costs and
reduced the synergies of banking integration. A European Commission survey in 2005 found
that opaque supervisory approval procedures were a major deterrent to cross-border banking
M&As.4
Moreover, national considerations may have reinforced the fragmentation of retail markets
during the crisis. For example, some commentators have argued that supervisors erected
de facto "internal capital controls"5 within the euro area, which restricted the flow of funds
between banks and within cross-border banks.
A similar pattern can be observed in how national authorities in the euro area have dealt with
failing banks. In general, non-viable banks were merged with other national banks, rather
than being wound down or broken up and sold off. Thus, what could have been an
opportunity to increase foreign competition in domestic markets, and indeed to work through
the crisis more quickly, in some cases ended up increasing national concentration. To give a
comparison with the US, the FDIC has resolved around 500 banks since 2008, mainly by
selling parts of banks to other banks, whereas the equivalent figure for the euro area is
around 50.6
All this suggests that the move towards a genuine Banking Union in the euro area could help
create the conditions for deeper retail banking integration. A Single Supervisory Mechanism
(SSM) should lead to harmonisation of rules and standards, and also remove distortions
created by national borders. And a Single Resolution Mechanism (SRM) should ensure that
banks are resolved from a European perspective and according to least-cost principles,
which should in principle open the door for cross-border resolution strategies.
In this way, even though the banking sector on aggregate is downsizing, credit allocation
across the euro area may become more efficient. Banking Union is key part in ensuring that
location becomes a diminishing factor in access to bank finance.
While Europe is and will remain a bank-based economy, adding the second missing piece of
the euro area financial market - deeper capital market integration - is key to ensure that
firms in all jurisdictions can use capital markets as a "spare tyre" when banks are not lending
- and not only those in larger countries with more developed bond markets. Within a single
currency area, there is no reason in principle why firms should not be able to tap a European
pool of savings. What prevents this in practice, however, is regulatory heterogeneity across
the euro area.
Europe has made some good progress in tackling this issue in recent years, in particular in
harmonising the rules needed for the transparency and integrity of securities markets.
Nonetheless, obstacles remain.
One is legal uncertainty for cross-border holding and issuance of debt and equity securities -
for example, different national definitions of securities ownership.7 Another is differences in
national insolvency laws, which make it difficult for investors to properly evaluate the risks
they assume when investing in securities in other jurisdictions. Still another is the transaction
costs that investors face when engaging in cross-border securities trading due to divergent
corporate governance and tax regimes.8
In other words, building a truly integrated capital market in Europe requires further efforts and
new legislation extending far beyond Banking Union. It is essential that the progress we have
made on the banking side does not cause us to lose reform momentum here. And this is not
a case of politics directing markets; it is about policy creating the pre-conditions for markets
function properly.
Firm size
The effects of location on access to finance are exacerbated by firm size. While firms are in
general more credit-constrained in some jurisdictions than others, this phenomenon is
particularly apparent for SMEs. For example, the percentage of financially constrained but
viable SMEs - defined to be those with positive turnover in the last six months seeking a
bank loan - varies from a minimum of 1% in Germany and Austria to a quarter of the total
population in Spain and even a third in Portugal.
There are two reasons for this.
First, bank lending to SMEs is concentrated in a handful of large banks as only they have the
capacity to diversify idiosyncratic risks by lending to a broad enough range of firms. The
three biggest originators in each euro area country represent on average 80% of the
outstanding amount of the SME loans. This makes SMEs particularly vulnerable to any
shocks to the banking sector and reduces their ability to switch between banks.
Second, as smaller firms tend to be less transparent than larger firms, it is more costly for
investors to obtain adequate information. This makes it harder for SMEs to substitute capital
market finance for bank finance if the latter dries up.
This is far from a trivial issue. The ability of SMEs to consistently access finance has vital
macroeconomic importance for Europe. Between 2002 and 2010, 85% of total employment
growth in the EU was attributable to SMEs, and SMEs have a much higher employment
growth rate (1% annually) than large enterprises (0.5% a year). And within the SME class,
most employment growth takes place within young firms9, for whom external financing is
particularly important as they cannot draw much on internal funds. Recent research from the
US has shown that these firms also tend to be more sensitive to changes in investment
opportunities.10
So what is the solution here? There are many schemes underway in Europe to address this
problem that I will not try and cover today. But one unifying theme that I see as critical is to
better match the needs of SMEs with the funds of non-bank investors, thus providing more
diversification for SMEs.
One way in which non-banks provide this diversification is in terms of counter-cyclical access
to credit. When banks contract credit, less risk-averse investors such as private debt funds or
peer-to-peer lenders can fill the gap and thus help smooth the credit cycle.
Another way is in terms of maturities. While regulatory changes have made commercial
banks less willing to make long-term loans, some large institutional investors - for example
pension funds and insurance companies - need assets with maturities and returns that
match their liability profiles. SME lending can provide this, especially while long-term safe
assets exhibit low rates of return.
The size of this "shadow banking" system - which in my view is a misleading term11 - has
increased considerably in the euro area since the crisis, rising by almost 20% since 2008. It
has also taken on a greater role in financing the real economy. At end-2013, outstanding
amounts of loans from euro area non-bank financial intermediaries to euro area non-financial
firms amounted to €1.2 trillion. But the key challenge from a policy perspective is to ensure
that these funds make their way to the most credit-starved SMEs.
Here I see two initiatives as particularly important.
The first is to increase their capacity to lend directly to SMEs via loans or bond purchases.
Here improving the information available for non-bank investors is key. A possible solution,
proposed in the recent report of a high level expert group12 on finance for growth in Europe,
is for European institutions to work with the private sector to establish a consolidated
database on SME credit risk performance. Actions are also possible at the level of Member
States. In Italy, for example, "mini bonds" for SMEs are guaranteed by the Italian state up to
70% of principal, and the results are promising so far.
The second initiative is to increase the capacity for non-bank investors to lend indirectly to
SMEs via securitisation. This requires a concerted effort to revive the flagging market for high
quality securitisation in Europe, which the ECB and the Bank of England have been jointly
pushing.13 Securitisation has the double benefit that it not only encourages existing
originators to extend more SME loans, but to the extent that it partially removes credit risk
from bank balance sheets, it may also help smaller, less diversified originators to enter the
SME loan market. In this way, it could also mean that SME lending is less dependent on a
few large banks in each country.
It is worth reflecting, however, on what the new normal should be once the credit cycle picks
up. On the one hand, there clearly benefits to having a more balanced financing mix. It is
useful not only to provide a cyclical cushion in bad times, but also to increase market
contestability and reduce over-banking in normal times. On the other hand, if what we are
seeing is the beginning of a structural shift from bank to non-bank financial intermediation,
we have to keep a close eye on the potential risks that might be building up. Indeed, there
may be little long-term value in shifting risk from a highly regulated sector to a lightly
regulated one, particularly if more and more lending is taken up entities that fall outside the
regulatory reach.
Conclusion
Let me conclude.
My message today is simple: the euro area financial system has been hit by a major shock,
which few of us foresaw, but through good policy choices it is possible to steer this
development towards a positive outcome, while avoiding unintended negative
consequences. And looking at the developments across the euro area today, in my view the
right choices are being made.
Banks are already strengthening their capital as a result of the comprehensive assessment.
The European supervisor will be fully operational in November this year. From next year we
will start building up a single fund for European bank resolution. And initiatives are underway
to strengthen access to finance for SMEs, especially through securitisation.
For Asia, there is every reason to be confident that the euro area is addressing the structural
problems in its financial system, which should in turn support more sustainable growth in
Europe and for the world economy. We still have a long way to go, to be sure, but I am
confident that Europe has now moved from being a risk to the global economy to a partner in
global growth.
Thank you for your attention.