A game-changer for Europe
The ECB has achieved some successes over the past two years. Its liquidity injections stopped the bleeding in bank deposits, narrowed the gap in core-periphery bond yields and made markets more resilient to shocks such as Cyprus or Italy’s inconclusive elections.
|Alberto Gallo, Head of European Macro Credit Research, RBS|
Calming markets was the easy part. But outside the trading rooms, Europeans continue to tighten their belts while struggling to find jobs and loans to keep their businesses afloat. A much more complex challenge lies ahead for Europe’s policymakers: getting that liquidity to the real economy. The ECB’s quantitative easing programme may have provided an anaesthetic to bond markets, however the actual cure for Europe’s economy requires a reactivation of lending to small and medium-sized businesses – a sector that creates 85 per cent of the continent’s new jobs.
One way to do that is through securitisations, where banks make loans and then package and sell them to investors. ECB President Mario Draghi and the rest of the board have openly discussed this as well among several new approaches to ease credit conditions. Securitisation could finally be the gamechanger for Europe and its troubled periphery.
Using banks to originate and distribute loans, rather than to hold them, is the only way to quickly re-start lending to small businesses, while at the same time allowing Europe’s oversized banking system to de-leverage. European banks have cut EUR2 trillion from their balance sheets over the past year (including EUR800 billion of loans). But they still hold EUR33 trillion of assets (over three times the size of the eurozone economy and the US banking system). We estimate they will need to cut another EUR3 trillion at the very least.
Bank deleveraging is a long-term positive for financial stability, helping avoid the too-big-to-fail conundrum. But it is happening too quickly in an uneven manner. That is choking funding for companies in the periphery (which rely on loans) and is compounding the recession. Since the start of the year, over 5,500 small firms have defaulted in Italy and bankruptcies are at record-highs elsewhere. To avoid a deeper crunch, policymakers must try to offset this credit contraction.
Loans still sour
The ECB has tried cheap liquidity. Yet loan officers have not re-opened banks’ taps and are unlikely to do so soon. Why? Because more and more of the existing loans continue to sour as companies and households are less able to repay them. In a vicious circle, this hits bank profits, erodes capital and makes them ever more wary of making new loans.
Banks need time to heal themselves, and Europe’s stretched governments can’t fix them all.
Securitisations by contrast allow banks to pool small, illiquid loans to small firms into larger, tradable securities which they can then sell on to investors. This means bank lending is financed by capital markets, without weighing on banks balance sheets for years to come and helping banks focus on new lending. Put differently, making new loans today is, for bankers, like jumping back into a coal mine, getting dirty and risking long-lasting collateral effects.
Securitisations are like renewable energy. They help channel the stream of cash from yield-hungry investors currently flowing into corporate and high yield bonds to where capital is needed most - small businesses.
The benefits of lower funding costs can be substantial: we estimate that a 20 per cent reduction in periphery interest costs can improve their cashflows by up to 10 per cent (on average).
EIB can help
As with most strong medicines, there are some complications.
Firstly, and most importantly, the securitisation market is currently broken. Buying securitised loans is outside the ECB’s remit because of their perceived riskiness. Why would private investors want to lend to small businesses any more than banks? The risk that the loans turn sour is high, and securitisations are a less liquid instrument to trade than regular bonds.
This is where the European Investment Bank (EIB) could help. In the same way that the US Treasury guaranteed Fed purchases of mortgage-backed securities, the EIB could guarantee securitisations to encourage investors to put in money. Agreeing on an EIB plan however will require support from national governments. That will take time.
Second, any stimulus will need to be large. Banks shedding just 1 per cent of their assets means running down loans at the rate of EUR200billion per year. The EIB’s current lending activity is a fraction of that. Unless it is greatly increased, the bank will be trying to bring down an elephant with a pea-shooter.
Third, the operation will have to be more transparent. Securitisation markets vary by type, depth and disclosure across the eurozone and so do bank loan classifications, foreclosure times and legal issues. As Europe’s single bank supervisor, the ECB will have to level the playing field.
These are sizeable obstacles: it may take some time to implement a plan, and it will not be easy. Fortunately the ECB has bought time with the anaesthetic of plentiful liquidity and it has identified a cure. Now it is up to Europe’s governments to get together and use it.
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