Mario Draghi: Bank restructuring and the economic recovery
Speech by Mr Mario Draghi, President of the European Central Bank, at the presentation
ceremony of the Schumpeter Award, Central Bank of the Republic of Austria, Vienna,
13 March 2014.
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Summary
On accepting the Schumpeter Award in Vienna, ECB President Mario Draghi said 2014 and
2015 were set to be a period of recovery after two years of stabilisation and a return of
confidence in the euro area. But the recovery "remains conditional on our pursuing the very
policies that have brought about the return of confidence," including growth-friendly fiscal
consolidation, structural reforms and a committed monetary policy.
In his speech, Mr Draghi drew a parallel between the policies applied in the euro area with
the ideas of economist Joseph Schumpeter, who spoke of "creative destruction" driving
innovation and productivity growth. By cleaning up and repairing banks' balance sheets, the
ECB's comprehensive assessment helps create the necessary conditions for resources
again to flow to the productive economy. "By encouraging creative destruction in the banking
sector, we can facilitate creative destruction in the wider economy and support the recovery."
Deleveraging in the financial system was necessary, since too much debt has been built up
in the run up to the crisis, but the question is what form this deleveraging should take, and at
what speed it should be allowed, or encouraged, to take place. What we want to achieve, Mr
Draghi said, is a "good" form of bank deleveraging, where equity is built up, where deposits
rise and where balance sheet reduction takes the form of swift asset clean-up, rather than a
slow scaling back of the loan book while rolling over bad loans.
The ECB's monetary policy is helping this process. As the recovery proceeds and inflation
gradually increases towards levels closer to 2%, the ECB's forward guidance, firmly
reiterated by the Governing Council in its last meeting, creates a de facto loosening of policy
stance, and real interest rates are set to fall over the projection horizon. At the same time,
the real interest rate spread between the euro area and the rest of the world will probably fall,
thus putting downward pressure on the exchange rate, everything else being equal. The
strengthening of the effective euro exchange over the past one and a half years has certainly
had a significant impact on our low rate of inflation, and, given current levels of inflation, is
therefore becoming increasingly relevant in our assessment of price stability.
The risk of deflation, which would make deleveraging harder, is quite limited. But the longer
inflation remains low, the higher the probability of such risks emerging. That is why the ECB
has been preparing additional non-standard monetary policy measures to guard against such
a contingency and why it stands ready to take further decisive action if needed, Mr Draghi
said.
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Ladies and Gentlemen,
Let me start by expressing how grateful I am, but also how humbled I feel, to speak before
you today as the recipient of the Schumpeter Preis.
It would be tempting to see the honour that you are bestowing upon me today as a reward for
a job well done. I prefer, however, to regard it as encouragement and inspiration to continue
to pursue our task with the determination and single-mindedness that we have shown over
the past few years.
After five years of crisis and uncertainty, 2012 and 2013 have been years of stabilisation for
the euro area. They have seen a return of confidence in the prospects of our union.
2014 and 2015 will be a period of recovery. But that recovery remains conditional. It remains
conditional on our pursuing the very policies that have brought about the return of
confidence: growth-friendly fiscal consolidation; structural reforms aimed at enhancing
investment and productivity; a committed monetary policy guarding against all threats to the
integrity of our money - in particular, the risk of both too high and, currently more relevant,
too low inflation.
But the recovery is also conditional on another set of policies, to which it is appropriate that I
devote my remarks tonight, because those policies draw significantly on the teachings and
ideas of Joseph Schumpeter. I refer here to the actions being undertaken to "reboot" the
financial system, in particular the so-called comprehensive assessment, the current health
check of the euro area banking system, which precedes the start of the Single Supervisory
Mechanism (SSM) in November this year.
The rationale for what we are doing actually connects two of Schumpeter's most important
and better known insights. First, it acknowledges the importance of a well-functioning
financial sector for the efficient allocation of capital and credit. And second, it contributes to
the Schumpeterian notion of "creative destruction" which drives innovation and productivity
growth.
In short, by "cleaning up" and repairing bank balance sheets, we are creating the conditions
necessary for resources to flow once more to the firms that use them most productively. And
in this sense, by encouraging creative destruction in the banking sector, we can facilitate
creative destruction in the wider economy and support the recovery.
Deleveraging and the real economy
Let me begin by outlining the challenge facing policy-makers in repairing the banking sector.
Looking back, there is no doubt that the business models and liability structure of euro area
banks had to evolve. Before the crisis, numerous banks funded their activities with too much
debt and not enough equity; and that debt involved wholesale financing that was too high
relative to deposits.
This model was only able to develop because of the perception of an implicit state guarantee
for bank debt - a perception that is perhaps the most pervasive component of the link
between sovereign and bank risks. The deterioration of sovereign credit, on one side, and
the clarification of the rules regarding bail-in of bank debt, on the other, have both contributed
to putting an end to a funding model that was neither desirable nor sustainable. As a result,
the euro area banking system has begun a secular process of restructuring and
deleveraging.
From a policy perspective, the question presented to us is not whether we can avoid this
deleveraging. It is universally accepted that too much debt had been built up in the run up to
the crisis, by governments, non-financial firms, households and banks, and that we now have
to work through the effect of the subsequent debt overhang.
The correct question, in my view, is what form this deleveraging should take, and at what
speed it should be allowed, or encouraged, to take place.
Clearly, we do not want any excessively rapid deleveraging that involves disorderly fire sales
of assets. This is why two years ago, in the context of a bank funding squeeze, the ECB
implemented longer-term refinancing operations. Borrowing from Schumpeter's terminology,
it would have been "destructive destruction".
At the same time, we do not want any excessively prolonged deleveraging, where banks
reduce their loan book by curtailing new lending, while hoping that the underperforming
assets they hold recover in value.
Put bluntly, this would create "zombie" banks that do not lend, and the longer this persists,
the longer credit conditions will interfere with the process of creative destruction described by
Schumpeter. The "churn" process between firms entering and exiting the market that is a
crucial driver of productivity would be disrupted.
There is some evidence that such credit misallocation is already occurring in the euro area,
and it is creating an undesirable, even if only temporary, distortion to the detriment of small
firms. Unlike large firms, small and medium-sized enterprises (SMEs) cannot easily replace
bank funding with capital market financing. Banks perform a key role in reducing information
asymmetries with respect to the creditworthiness of smaller borrowers.
If small, innovative firms cannot access finance, it has an important impact on employment
and investment. Studies from the United States show that the bulk of net new job creation
comes from young firms. At the same time, young firms have been shown to be much more
sensitive to changes in investment opportunities than older firms, meaning that fewer
startups would probably lead to lower trend productivity growth.
Achieving a "good deleveraging": the comprehensive assessment
What we want to achieve is a "good" form of bank deleveraging, where equity is built up,
either through retained earnings or through outright issuance, where deposits rise and where
balance sheet reduction takes the form of an asset carve-out, rather than of credit attrition.
Our comprehensive assessment of bank balance sheets is, in my view, creating the setting
and incentives for achieving this. The assessment will shed light on bank assets, ensure that
problematic assets are fully recognised and prompt timely corrective action in the form of
bank restructuring and capital replenishment.
Frontloading banking sector repairs in this way should in turn facilitate the Schumpeterian
process of creative destruction in the economy at large - and not only by helping credit flow
to younger firms, but also by facilitating debt resolution for older ones.
Firms that no longer have a viable business model should go into insolvency. But there also
appear to be corporates in the euro area that cannot invest in new growth opportunities
because of an excessive level of debt. Well-capitalised banks are better able to end or
restructure loans to firms with bad credit standing. This in turn ought to facilitate the process
of selection of the firms that deserve to survive because they can thrive.
Of course, credit conditions are not the only obstacle to innovation, and it is important to
emphasise the role of structural and tax reforms in creating a business climate that is
conducive to investment and job creation. Cleaning-up banks is not a sufficient condition for
a return to sustained growth - but it is a necessary condition.
There is a second incentive for frontloading bank restructuring and balance sheet
adjustment, which has to do more directly with monetary policy. Banks that need to
recapitalise typically do not pass the low level of our policy rates through to their lending
rates. This has shown up for some time in the dispersion of bank lending rates across the
euro area, and in the muted reaction, especially in the stressed countries, of lending rates to
our successive steps of monetary easing.
As bank balance sheet deleveraging progresses, one should expect to see - and we are in
fact starting to witness - an improved transmission of our currently loose monetary policy
stance, in particular as deposit rates converge to lower levels. And we expect the effect of
this improved transmission to become gradually more visible throughout the current year.
The role of monetary policy
In this context, last Thursday the Governing Council firmly reiterated its forward guidance to
keep key ECB interest rates at present or lower levels for an extended period of time. The
intention to maintain an accommodative policy stance for as long as necessary is based on
an overall subdued outlook for inflation extending into the medium term. This accommodative
stance supports the deleveraging process through various balance sheet channels.
But our forward guidance also has a further effect. As the on-going recovery proceeds in line
with our projections, the significant slack in the economy will begin to be absorbed, and
inflation will gradually increase towards levels closer to 2%. Our forward guidance therefore
creates a de facto loosening of policy stance, as real interest rates are set to fall over the
projection horizon. This is recognised, for example, in lower forward real interest rates
embedded in the term structure of nominal interest rates and inflation swaps.
How does this help? While the process of repairing the banking sector should improve the
credit supply, falling real interest rates should support demand for credit by encouraging
higher business investment, thus fostering a virtuous circle of higher spending, growth and
inflation. At the same time, the real interest rate spread between the euro area and the rest
of the world will probably fall, thus putting downward pressure on the exchange rate,
everything else being equal. The strengthening of the effective euro exchange over the past
one and a half years has certainly had a significant impact on our low rate of inflation and,
given current levels of inflation, is therefore becoming increasingly relevant in our
assessment of price stability.
At present, risks of deflation, which would of course make the deleveraging process harder,
are quite limited. In fact, inflation excluding energy and food started to increase slightly from
0.7% in December to 0.8% in January and to 1.0% in February. And medium to long-term
inflation expectations remain anchored to our objective of an inflation rate of close to, but
below 2%. But the longer inflation remains low, the higher the probability of such risks
emerging. That is why the ECB has been preparing additional non-standard monetary policy
measures to guard against such a contingency and why it stands ready to take further
decisive action if needed. Any material risk of inflation expectations becoming unanchored
will be countered with additional monetary policy measures.
In other words, the ECB's accommodative monetary policy stance and its strong symmetric
commitment to price stability will help the deleveraging process. At the same time, the
healing of the banking sector will accelerate the transmission of our policy stance and firm its
grip on the economy. Together, they will support the on-going recovery.
Conclusion
Ladies and gentlemen,
I can summarise what I said tonight in a few words: the comprehensive assessment of bank
balance sheets, which we initiated last year, is a bank-level supervisory exercise ahead of
the start of the operations of the Single Supervisory Mechanism. But it also has significant
macroeconomic consequences and, as such, forms an integral part of the strategy for the
recovery of the euro area.
In fact, just the prospect of the comprehensive assessment has already caused banks to
raise new capital and to shed non-core or non-profitable exposures. This is very welcome:
corrective action does not need to wait until the end of our comprehensive assessment. It is
to everybody's benefit that it takes place pre-emptively.
In this way, I believe that we are already starting to witness some of the positive effects of
frontloading bank balance sheet adjustment. I expect that we will see those effects gradually
strengthen over the year, including in the form of a better transmission of our monetary policy
impulse. In turn, I expect the necessary process of creative destruction to gain pace.
I think we can now say of the euro area economy what Galileo said of the earth: eppur si
muove - and yet, it moves!
The job is by no means complete. But as evidence accumulates that we are on the right
track, I am hopeful that, eventually, we will have deserved the prize that you have generously
awarded to me tonight.