Benoît Coeuré: Monetary policy transmission and bank deleveraging
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at "The Future of Banking Summit", organised by "The Economist", Paris, 13 March 2014.
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I would like to thank Federic Holm-Hadulla for his contributions. I remain solely responsible for the opinions
contained herein.
Summary
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 Coeuré.
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, Mr. Coeuré 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."
He concludes by explaining why it is important for the banking union to be complete, "Not
moving promptly towards a single resolution mechanism (SRM) and a single resolution fund
(SRF) would prolong financial fragmentation, leave the 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."
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Ladies and Gentlemen,
It is a great pleasure to speak to you at the Economist's "Future of Banking" Summit.
But before turning to the future of banking, let me briefly look back at its recent past. As you
know well, the euro area banking sector is currently undergoing a secular deleveraging
process. The need for deleveraging had its roots in a period of strong bank balance sheet
expansion in the last few years.
From the start of that expansion in 2005 to its peak in 2012, the total assets of monetary
financial institutions rose by more than 60 percentage points of GDP to €33.7 trillion, i.e.
3.55 times euro area GDP. But as the crisis highlighted, this expansion was not necessarily
backed by rising productive capacity in the euro area economy. Instead, it was, at least
partly, channelled to low-productivity activity, as manifest for instance in the overinvestment
in the construction sector in some Member States.
The current adjustment reflects, therefore, the aftermath of a major financial crisis and the
debt overhang that inevitably comes with it. It also reflects the end of the unsustainable
business models and liability structures that many euro area banks had developed before the
crisis. Hence, deleveraging is not a process that policy-makers should seek to avoid; rather,
it needs to take place and be properly managed.
The main point I want to make today is that how this process is managed has important
implications for monetary policy. Deleveraging badly hinders the pass-through of our interest
rates to borrowers. But by the same token, deleveraging well, to the extent that it restores the
transmission of monetary policy, could potentially unleash a pent-up monetary easing.
Achieving the right type of deleveraging depends crucially on the incentives embedded in the
institutional framework in which banks operate. Both monetary policy and prudential
supervision - notably the ECB's ongoing comprehensive assessment - have a key role to
play in this respect.
Three types of deleveraging and their effects
Broadly speaking, there are three different types of bank deleveraging. These are the good,
the bad and the ugly, as The Economist itself stated in a blog a couple of years ago.1
"Good deleveraging" involves banks raising capital and getting rid of impaired assets in a
targeted and rapid manner. This approach recognises and corrects the flaws in legacy
business models and allows for a relatively swift reallocation of credit to more competitive
sectors. This eventually translates into a more dynamic recovery.
"Bad deleveraging" entails an indiscriminate reduction in balance sheet size, regardless of
the quality of assets. The main motivation for such adjustments is to reduce indebtedness.
And in order to "balance the books", this process is accompanied by asset shedding. The
upshot is a potentially prolonged, across-the-board reduction of credit to the real economy.
Finally, "ugly deleveraging" comprises banks specifically discarding good assets while
keeping distressed assets in the banking book and recording them at close to nominal
values. This method can rapidly turn a bank into a "bad bank" that does little to support credit
creation.
These last two types of deleveraging can have significant real economy effects. Financially
weak banks tend to roll over unprofitable loans that do not support growth - which is why
they have sometimes been dubbed "zombie banks".2 There is in fact some evidence that
such evergreening practices have appeared in the euro area as well in the last few years.3
The wrong type of deleveraging also has a further effect, which I want to concentrate on
today: it harms the transmission of monetary policy.
Given the bank-based nature of our financial system, the main channel through which the
ECB's monetary policy impulse reaches the real economy is through bank lending rates. And
this is particularly important for smaller borrowers, as they cannot easily substitute bank
financing for capital market financing such as corporate bond issuance, as larger borrowers
have been able to.
But banks that are deleveraging through a prolonged process of retaining earnings and
rolling-over bad loans tend to block this channel. Regardless of the level of nominal interest
rates, they are likely to demand higher compensation for new exposures that increase
riskweighted assets, including notably loans to non-financial firms. And if they are competing for
new deposits to improve their loan-to-deposit ratios, they will face higher funding costs,
which then have to be incorporated into the interest rate spread for new loans. All this means
that monetary policy starts to lose traction.
Indeed, different deleveraging needs are one explanation for the fragmentation in the
passthrough of interest rates in euro area countries. Those countries that saw the highest
pre-crisis increases in private debt - principally Ireland, Cyprus, Portugal and Spain - and
that therefore have the greatest bank deleveraging needs, are by and large the same
countries where monetary policy transmission has been most impaired. Of course, other
factors such as sovereign risk have also played a role.
Significant progress has already been made with bank deleveraging. Banks have engaged in
a sweeping shrinkage of balance sheets - declining by around 20 percentage points of GDP
in 2013. Loan-to-deposit ratios have also come down, from more than 140% in 2008 to less
than 120% at the end of last year, mainly through higher deposits. And we have observed a
marked increase in banks' risk-weighted capital ratios since the beginning of 2009. Since the
onset of the global financial crisis, euro area banks have issued around €235 billion of equity,
in addition to other forms of capital (e.g. retained earnings, CoCos, etc.). As a result, large
parts of the sector now comply with the minimum capital requirements under Basel III - well
before it becomes binding.
There are already signs, such as the stabilisation of credit conditions,4 that these efforts are
improving the transmission of our easy monetary policy stance. The challenge for
policymakers now is to finish the job: to ensure that deleveraging takes place fast, that it takes
place well, and that it happens everywhere where it is needed.
Monetary policy intervention
Monetary policy itself has a role to play in this process. Our measures have helped ease
pressures on the liability side of bank balance sheets that might have led to "bad" or "ugly"
deleveraging. For example, in the first phase of the crisis after the Lehman Brothers failure,
banks faced a funding crunch which could have led them to fire sales of assets. We helped
avert this by effectively standing in for the interbank market. Our two very long term
refinancing operations (VLTROs) in 2011 and 2012 had an analogous effect in the term
funding market.
It is important to stress, however, that we aimed to prevent a disorderly deleveraging, not the
deleveraging process itself. Bank deleveraging leads to a reduction in inside money, that is
money created by banks, and with fragmented financial markets, liquidity flows within the
euro area were disrupted. By providing an elastic supply of central bank money, we
substituted inside for outside money to support the stabilisation of the banking system.
Indeed, base money - i.e. the total amount of currency in circulation and banks' holdings of
liquid deposits with the Eurosystem - increased by almost 30% following the two VLTROs.
The ECB's forward guidance should also be supportive: the Governing Council of the ECB
expects interest rates to stay at present or lower levels for an extended period of time, while
inflation should rise towards 2% over our projection horizon. This implies that real interest
rates for borrowers will progressively fall as inflation rises.
And we stand ready to act if this scenario does not materialise.
But, nonetheless, broad money and credit expansion by the euro area banking system has
remained anaemic. The annual growth rate of M3 slowed steadily in the aftermath of the
VLTROs and stood at a very low level of 1.2% in January 2014. The monetary policy
impulse, as reflected by the increase of base money, has hardly been transmitted to the real
economy.
Additionally, it is clear that the ingredients of "good deleveraging" cannot be provided by
monetary policy alone. Good deleveraging involves, on the liability side, equity being built up
through outright issuance or as last resort through public interventions. And on the asset
side, it involves writing down and carving out non-performing assets. Indeed, without such
measures there is a risk that low interest rates and ample liquidity provided by the ECB might
delay the restructuring and reallocation that are necessary to escape a debt overhang. For
this reason, prudential measures must also play a key part in the deleveraging process.
Prudential policy in the new banking union framework
For the euro area, the principal tool to steer deleveraging towards its good form is the
ongoing comprehensive assessment of banks' balance sheets. The ECB has recently
released more technical details about an important component of this exercise, the asset
quality review, so I will not repeat its features today. The assessment will shed light on bank
assets and ensure that non-performing exposures are fully recognised, and prompt timely
corrective action in the form of bank restructuring and capital replenishment.
In turn, I expect this to help monetary policy regain traction across the euro area. Actually,
this for me will be a measure of the success of the exercise.
Why do I expect this?
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
passthrough 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.5
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
Let me conclude.
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.
I thank you for your attention.