Before Mario Draghi became its President, the ECB was widely regarded as just another dysfunctional European institution: overly focused on an illusory inflation demon, indifferent to anaemic economic growth in the Eurozone and in any case too impotent in terms of unconventional policy tools at its disposal. Whilst debate in the US and the UK has moved to the timing of exit from unconventional monetary policy, the recent announcement that the ECB would embark on an unsterilized programme of private sector asset purchases heralds the beginning of Quantitative Easing (QE) in the Eurozone. Moreover, whilst the market is concerned about Eurozone banks “passing” the forthcoming Asset Quality Review (AQR), of much greater significance is the progress made by the ECB in delivering a recapitalised, functioning commercial banking system after six years of crisis. This achievement of the ECB should see the future debate over Eurozone growth move away from the supply of credit being a constraining factor to a focus on economic liberalisation and structural reforms.
There is a common misperception that QE – in terms of both semantics and effectiveness - must involve the large scale purchase of government bonds. Whilst the Bank of England decided to focus almost entirely on gilt purchases, the Federal Reserve and the Bank of Japan have purchased a variety of different asset classes.1 QE is in fact any asset purchase from a central bank funded by new money creation. Whereas previously the ECB sterilised its asset purchases, funding the Securities and Markets Programme (SMP) with commercial bank excess reserves, the non-sterilisation of the recently announced Asset Backed Securities Purchase Programme (ABSPP) is key in terms of the semantics of QE2: this creation of new money heralds the beginning of QE in the Eurozone.
The main purpose of central bank purchases of sovereign bonds (so-called “full-scale QE”) has been to drive down interest rates across the yield curve. The ECB has already achieved this through other policy tools: allowing commercial banks to pawn loans at the ECB for record cheap funding (now 15bps3) that can be used to purchase higher yielding sovereign bonds in an attractive carry-trade4 and more recently imposing a penal negative rate (now -20bps6) for commercial banks wishing to deposit their excess cash at the ECB. As a result liquidity has pushed out into riskier, higher yielding assets, to the extent that half of the Eurozone has negative yields on their 2-year sovereign bonds. Irrespective of any political or constitutional considerations, it is unclear what any programme of large-scale purchases of Eurozone sovereign bonds would achieve in addition to the current policy. Criticism of the ECB for not also buying government bonds is therefore somewhat misguided.
Of course, negative yields can also be viewed as fitting the Eurozone Japanese-style-deflation obsession of many financial commentators. But if negative rates were solely a function of risk aversion then it is difficult to square the current interest rate curve with higher rates throughout financial and sovereign crisis. Economic growth is currently disappointingly slow in Europe but it is not logical to be more risk averse today than in the days of real crisis in 2008/9 when Europe experienced a proper deflationary bust. It is therefore arguable whether the 10-year German bund trading below a 1% yield for the first time ever last month (see Fig 1) was more reflective of a worsening economic outlook or had a more simple explanation: the increasing absence of low-risk, positive yielding assets.
Figure 1: German 10-year Bund Yield vs Eurozone Economic Growth
Source: Bloomberg, August 2014
Whilst this “hunt for yield” (see Fig 2) should have a multiplier effect on all financial assets and highlight the attractions of equity dividend yields, the worry is that economic growth is still being held back by availability of capital in the real economy, particularly in Europe’s periphery. This is precisely why the ECB has specifically targeted the purchase of Asset Backed Securities (ABS) composed of loans to small and medium sized businesses. Assuming the ECB is willing to bid aggressively for ABS, lending to SMEs potentially disintermediates bank balance sheets – though the bank remains as originator - and the ECB is able to transmit low interest rates directly to the businesses for whom capital is most constrained. This also potentially frees up capital on commercial bank balance sheets for new lending.
Figure 2: The Hunt for Yield
There are, however, a number of practical difficulties the ECB will need to overcome for the ABSPP to be effective. First, the ECB could succeed in driving down yields on ABS but if volumes are too small, the transmission effect on the real economy will be negligible. We do not yet know the size of the ABSPP: an initial figure of €500bn was leaked but is yet to be confirmed. To put this into perspective, the European ABS market is currently worth just €1.5 trillion (one tenth of the size of the same market in the US).7 This compares with €39trillion8 in outstanding loans under ECB supervision. So €500bn would be a third of the ABS market, but just 2% Eurozone bank loans. So the ECB could succeed in reflating the ABS market without necessarily meaningfully increasing bank lending and the availability of cheaper capital in the real economy.
It is therefore crucial that banks are incentivised to issue more ABS, given current annual issuance of just €200bn.9 An important factor will be the capital relief to a bank of removing the loans from its balance sheet through the sale of ABS without recourse to its risk absorbing capital.10 If the ECB chooses to buy only senior tranches of ABS and leave most of the credit risk with the originating bank, this may help reduce on balance sheet assets of banks without actually reducing their risk weighted assets, thus giving no capital relief that might free up capacity for new lending. Importantly, however, the ECB has also stated that it would be prepare to purchase mezzanine tranches of ABS, but only with some form of credit risk guarantee (presumably given by an institution like the European Investment Bank or Eurozone governments).11 Moreover, although the ECB has potentially unlimited balance sheet and no requirement to make a profit, this is different from an aversion to losses. So for banks to meaningfully raise their new issuance, it is crucial that the credit risk is also transferred: initially to the ECB with this sovereign guarantee but longer term to institutional investors and insurance companies, many of whom currently face regulatory restrictions investing in the asset class. All of this clearly runs contrary to all post-financial crisis regulatory instincts. Further details of the ABSPP will be released at the next ECB meeting on October 2nd.
Recent monetary policy initiatives from the ECB should also be viewed in conjunction with the current Asset Quality Review (AQR) (concluded mid-October) and the ECB becoming the sole Eurozone bank regulator (Single Supervisor Mechanism) on November 4th. Although we expect nearly all quoted Eurozone banks to “pass” the AQR test, particularly in view of the amount of capital raised in the sector since 2007,12 the real importance of the process is to harmonise accounting standards across the industry. Currently, there are inconsistent definitions of Non-Performing Loans (NPLs) which makes cross-border comparisons difficult and leads to suspicions that national regulators are complicit in hiding poor asset quality. There are also inconsistencies in how much capital banks should hold as loan loss provisions against sub-standard loans, particularly when these loans have been restructured but are still performing or are not considered impaired owing to collateral. It is also appropriate that risk weightings of assets (the important number against which Basle III regulatory capital is held) are uniform across the Eurozone, which is again another potential source of abuse. A single regulator with clear and consistent accounting rules would therefore be a significant step forward. In addition, banks that have been cautious taking on risky assets on their balance sheet for fear of being penalised under AQR should see animal spirits rekindled. Although remedial action for individual banks cannot be ruled out, overall the AQR should be cathartic and help rebuild confidence across the industry.
It should also be noted that for the first time in six years bank lending surveys are already indicating expansion in bank credit (Fig 3).
Figure 3: Eurozone Bank Lending Survey
Source: UBS, August 2014
So whilst the economic momentum has recently slowed, in part owing to seasonal factors and external conflict, we continue to be believe the underlying trends are more encouraging and that the six-year crisis in peripheral Europe and the Eurozone banking sector is at an end. Although in the short-term a reacceleration in economic activity over the coming months is now probable, not least owing to the recent depreciation of the Euro13 and a diminution of conflict in the Ukraine, the delivery of a recapitalised, fully functional Eurozone banking system by the ECB will be of greater longer-term importance. For if the Eurozone banking system can no longer be blamed for anaemic economic growth, this will place greater pressure on those sovereign states that have yet to fully embrace economic liberalisation. As such Draghi will have proven beyond doubt that the ECB is Europe’s least dysfunctional organisation.
1 The Federal Reserve has split its purchases between Treasuries and MBS, the Bank of Japan has bought mostly government bonds but also a small amount of corporate bonds, ETFs and REITs. The BoE also made tiny purchases of corporate bonds and commercial paper. Source: Bloomberg, Credit Suisse, Sept 2014
2 Arguably, the ECB began QE when it stopped sterilising the legacy assets from the SMP programme earlier this year, though this decision was in probably owing to the diminishing commercial bank excess reserves with the ECB (ECBLDEPO Index on Bloomberg) that had previously funded the sterilisation, itself a function of negative deposit rates
3 Source: Bloomberg, Sept 2014
4 Through LTRO and forthcoming TLTROs in Sept and Dec 2014. The trade is attractive not only because of the yield differential and the low risk of default but also owing to sovereign bonds having negligible risk weightings (against which regulatory capital is held)
5 Source: Bloomberg, Sept 2014
6 2-year government yields are currently negative in Germany, France, Netherlands, Finland, Belgium, Austria and Ireland. Source: Bloomberg, Sept 2014
7 Source Credit Suisse September 2014
8 Source Credit Suisse September 2014
9 Source Credit Suisse September 2014
10 This is why the inclusion of Covered Bonds is somewhat bizarre given the credit risk stays with the originating bank and therefore the capital relief is negligible. The CB market is also predominantly composed of residential mortgages and public sector loans. If the ECB wanted to support residential property prices in peripheral Europe, it would be better purchasing Residential Mortgage Backed Securities (RMBS) where the risk of capital loss didn’t fall back onto the originating bank.
11 This is a somewhat circular argument given that post the Outright Monetary Transactions (OMT) announcement, the ECB now is supposed to back-stop the sovereigns. However, this probably means that should the ECB make theoretical losses on its equity capital (only possible if the case of default or sale before maturity) the sovereigns agree to make additional equity contributions.
12 Since 2007, European banks have raised €400bn of equity and a total of €524bn of loss absorbing capital. Source: Credit Suisse, September 2014
13 Negative short term interest rates increase the attraction of using the Euro as a funding currency. As such the Euro has depreciated 4% against the dollar since Draghi’s Jackson Hole speech and 7% since April. According to the ECB a 10% depreciation of the Euro will boost GDP by 40-50bps.
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