Can you kick it?
Mario Draghi has given Europe’s banks an adrenaline fix. The European Central Bank’s decision to offer lenders cheap three-year loans has averted a Lehman-style financial system collapse and helped revive markets. But this cure is a far from a panacea.
The ECB’s Longer Term Refinancing Operation has scored several significant successes. To start, the willingness of the central bank to step in has helped calm fears that a dearth of liquidity would cause the sudden failure of a big institution. Investors who fled the bank funding market last summer are slowly returning; European lenders have issued more unsecured bank debt in 2012 than in the entire second half of 2011, according to Morgan Stanley.
Also, banks which can count on three-year funding have more time to shrink their balance sheets. And the central bank’s funding is cheap – an interest rate of just 1 percent. That amounts to an official subsidy of the sector. Suppose lenders draw down another 500 billion euros at the ECB’s next LTRO at the end of February, taking the total to 1 trillion euros. Then each 100 basis points knocked off banks’ funding costs boosts annual income by up to 10 billion euros. The extra earnings should help banks rebuild capital buffers.
Like any emergency medical procedure, however, the ECB’s move may keep the patient alive but not actually make him well. It’s far from clear that banks plan to use their cheap and profitable liquidity to boost longer-term lending to the economy. On the contrary, a recent ECB survey suggests credit conditions in the euro zone are still tightening. Draghi says the medication needs longer to take effect. However, a poll conducted by Goldman Sachs analysts found that just 7 percent of banks plan to use the proceeds of the next LTRO for new loans. By contrast, more than a third expect it to finance purchases of government debt.
The ECB’s intervention also raises more fundamental questions. In effect, the central bank has taken the place of the interbank market. Huge deposits parked with the ECB each night are a reminder that those banks with spare cash are too scared to lend it. Meanwhile, troubled lenders grow ever more dependent on central bank funding.
In effect, the system of private sector credit allocation remains seriously distorted. Banks increasingly don’t judge loans on the basis of risk and return, but by the ease with which they can be exchanged for cash with the central bank.
Indeed, the ECB last week extended that system by giving seven national central banks permission to accept corporate loans as collateral – a move designed to help smaller lenders which were otherwise at risk of running out of eligible assets.
As a result, the ECB has a say about the financing of an ever-growing chunk of the euro zone economy. Since 2007 its balance sheet has doubled to more than 2.5 trillion euros, according to RBC Capital Markets – over a quarter of euro zone GDP. The next LTRO will lift that proportion further.
Draghi is aware of the dangers of large-scale bank support. He hopes that the ECB will be able to withdraw its medication as confidence returns. This has been done before: during 2008, the Bank of England offered UK lenders three-year loans which had to be repaid or refinanced as they matured. This has been achieved. But Britain has the advantage of having been spared a sovereign debt crisis. And the Bank of England simultaneously pushed the country’s banks to build extra capital buffers. The euro zone’s fragmented regulators may prove less steely.
Addiction to cheap money may prompt Europe’s banks to postpone measures required to improve their health, such as issuing longer-dated unsecured debt. They may also struggle to resist the temptation to use recovering earnings as an excuse to pay higher bonuses and bigger dividends.
But unless borrowers share in the benefits of easier credit, public anger with banks is only likely to grow. Taxpayers may ultimately ask whether an industry that is largely dependent on central bank support should be in the private sector at all. In that event, Dr Draghi’s intervention, while a resounding short-term success, may ultimately do more harm than good.