Did Mario Draghi bring out “The Big Guns?” Or did he “Wait Too Long?” Those seem to be the two principal camps in the wake of the ECB head rolling out a laundry list of monetary measures intended to boost lending, combat falling inflation and goose the eurozone’s slow recovery. Still others posited recommendations that would likely leave Walter Bagehot scratching his head: Like The ECB Needs to Get Its Crazy On. But in our view, the real question isn’t whether Draghi pulled out enough stops. It’s whether monetary policy is the right prescription, and while some of these steps could slightly help, we think they are largely feckless to change the bigger picture for now. Regulatory overhang seems the biggest headwind to lending.
Whether you believe the ECB’s plan is enough, there is no denying it is officially doing something. A little of (almost) everything it seems. Draghi announced another round of Long Term Refinancing Operations (LTROs) and created a new Targeted-LTRO (TLTRO): Banks can borrow from a €400 billion program at low rates until 2018, but only if they use the funds to lend to small and medium enterprises (SMEs). Funds not lent must be repaid in two years. The ECB also lowered the main refinancing operation rate—at which banks borrow from the ECB—from 0.25% to 0.15%. And it pledged to aggressively research implementing a quantitative easing (QE) program in the asset-backed securities (ABS) market. But the biggest news was the ECB’s decision to lower the main deposit rate to -0.1%—the first time a major central bank has employed negative interest rates.
These measures aim to fix the area’s economic woes—inflation, growth, the whole shebang—by encouraging lending. Fine in theory: More lending would increase money velocity, boosting the supply of money in the real economy, vital to higher inflation and stronger growth. Aside from ever so slightly steepening the yield curve (the cut to the refinancing rate), little suggests these moves will fit the bill—or have much impact at all. Negative rates penalize banks’ keeping excess reserves at the ECB—the idea being, rather than pay to stash cash, banks will push excess funds into the wider economy. But even lending out every cent of eurozone banks’ €91 billion excess reserves is small relative to either the eurozone economy or the €4.3 trillion worth of assets banks have shed in the last two years. But the negative-rate penalty also doesn’t ensure lending-averse euro-banks lend. They could just move reserves into ultra-liquid assets on their own balance sheets. Similarly, it’s unclear what assets QE would buy—we guess that’s what Draghi’s researching—if it were launched. Buying up the area’s €100 billion ABS through QE wouldn’t encourage banks to lend again—having cash on hand isn’t their problem. Then there is the not so little matter of choosing which country’s assets to buy. A potential political firestorm—and very slow process—that may never even materialize. Increasing funds available to banks via LTRO and TLTRO also shouldn’t do much for bank lending. The UK’s Funding for Lending scheme tells us that much. Like TLTRO, it aimed to boost business lending by financially backing banks and encouraging lending. But it didn’t address the core issues, like regulatory uncertainty—hence, UK business lending remains weak.
Thursday’s ECB action makes the same error as Funding for Lending—overlooking the problem in search of solutions. The main reason eurozone banks are deleveraging seems to be preparation for the ECB’s upcoming stress tests. We doubt this or any upcoming European monetary policy can boost lending while the test looms. Banks are continually deleveraging to meet arbitrary parameters with potentially very real negative results. On various occasions, officials have hinted at scenarios ranging from even higher capital ratios to fines to forcefully closing banks that fail the tests. Rather than risk being shuttered, banks are hoarding cash and likely won’t stop until the stress tests are over and other regulatory uncertainties are cleared.
We’d suggest the ECB remember this while it explores potentially implementing QE—which recent history shows also discourages lending. By buying long bonds, QE flattens the yield curve, the difference between short- and long-interest rates. Banks’ traditional practice is to borrow short cheaply and lend long at higher rates, so a flatter yield curve weighs on banks’ profit margins and, therefore, lending. The UK and US experiences show QE weighs on lending even more when implemented alongside regulatory change (think Dodd-Frank, Basel III and all the shifting with new regulators and various and sundry “stimulus” plans). In an uncertain environment, banks probably want bigger profits to make a loan, not smaller. Smaller profits and regulatory issues inhibit lending, in turn restricting the money supply, inflation’s primary driver, and a key forward indicator of economic growth.
No matter how the ECB tries, monetary policy can’t fix the long-term regulatory policy issues causing this. The ECB’s new policies seem well intended, but they do little to change the reality of Europe’s tight credit. These changes are likely insufficient to materially alter Europe’s slow-recovery track. For stocks, a little bit of growth is good enough if expectations are sufficiently low. With the weight folks seem to put (erroneously, in our view) on central bankers doing stuff, the sentiment reaction to Thursday’s announcement will be important to eurozone stocks’ direction moving forward.