6 October 2014 Asset management

The financial crisis was a wake-up call for banks that had grown
too big, and it was also a wake-up call for taxpayers that they were
carrying a lot of the risks when those banks ran into trouble. The
unsurprising reaction was to reduce risks on bank balance sheets
and improve regulation. Now there is a need for another wake-
up call: the realisation that a proper recovery will require credit
creation. But credit creation requires the banks to increase their
loan books and banks cannot do this without taking more risks.
Since the introduction of the euro, the balance sheet of Eurozone
banks has expanded substantially relative to the size of the
economy. Now, the size of the banking sector relative to the
economy varies a lot across the Eurozone: from two and half times
GDP in Italy to more than six times as large in Ireland. These figures
are large compared to Japan (less than two times GDP), and
the US (less than the size of the economy). This reflects the Eurozones
almost exclusive reliance on banks for credit provision. In the US the
credit market is a far more important intermediary. But in Europe,
what happens to banks drives overall credit provision.
Most of the regulation and macro-prudential policy that has
been put in place in recent years was aimed at limiting the
risk exposures on bank balance sheets. Loans to the private
sector are considered far riskier than they were in the past,
which means that banks are now required to hold a larger
capital buffer to protect against those risks. The more
capital that is needed, the less that will be left to provide
protection for new loans. The situation is even worse for
structured financial products such as asset-backed securities
(ABS) or residential mortgage-backed securities (RMBS),
which are penalised even more than their underlying loans
would suggest because they are less liquid.
The new regulations have also changed the risk-weighting
applied to government bonds relative to loans to the
private sector. For a given capital buffer, banks can lend
more to the government than they could to the private
sector. This has incentivised banks to take almost all the
extra liquidity that the ECB injected into the system in
recent years and pump all of it back into government
bonds. Little of that extra money found its way into
additional lending for the private sector (although the ECB
may argue that it prevented a worse shrinkage of credit to
the private sector).
While all these regulations and incentives would not be
a problem for a country like the US that has a dominant
credit market for corporate financing, they are far more
important for the Eurozone where bank financing is key.
The amount of sovereign debt on banks balance sheets
has increased substantially since 2007, especially in the
Eurozone periphery. Most of that increase has come at the
expense of lending to the private sector, especially non-
financial corporates (chart 2).
Joshua McCallum
Head of Fixed Income Economics
UBS Global Asset Management
joshua.mccallum@ubs.com
Gianluca Moretti
Fixed Income Economist
UBS Global Asset Management
gianluca.moretti@ubs.com
Source: ECB
Regulations have incentivised banks to de-risk their
balance sheets and reduce lending to the private sector.
In Europe, the regulatory environment and firms reliance
on bank lending make it unlikely that a fully-fledged QE
programme would have the same expansionary effects
as it has done in the US or UK. The ECB introduced a
programme of ABS purchases but there are obstacles
to implementing this. Government guarantees may be
needed to kick-start the ABS market and prevent credit
growth from stalling.
Economist Insights
Too big to lend
Chart 1: Getting credit
Total assets of monetary fnancial institutions as % of GDP
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400
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600
700
2000 2013
US Canada Japan Australia Italy Germany Spain France UK Ireland
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In such a regulatory environment it appears unlikely that
a fully-fledged quantitative easing (QE) programme that
bought government bonds would achieve the same
expansionary effects as it has done in the US or UK. One of
the most important channels through which QE works is the
so-called portfolio effect: pushing banks and private investors
out of sovereign bonds and into riskier assets. In particular, it
is likely to push them into corporate credit, thereby reducing
the cost of borrowing for firms. Unfortunately, the majority
of firms in the Eurozone are too small to issue bonds in the
credit market. And banks may still feel uncomfortable about
increasing their leverage when they know they could be
punished by the regulator for taking too much risk.
A full-blown QE programme could still have an impact
through other channels. Increasing the money supply should
push the exchange rate down, which would be helpful
for net exports. But the Eurozone already runs a pretty
substantial trade surplus so this may not be the most long-
term beneficial result, although the increase in import prices
would help get inflation back up. But the credit channel
(through the banks) and the portfolio rebalancing channel
(through credit markets) are likely to be disappointing.
The ECB is currently in an awkward position: on one hand
it wants the banks to de-risk their balance sheets and be
more responsible, but on the other hand it wants them to
lend more money to the economy (which is an inherently
risky thing to do). Faced with this contradiction, and having
exhausted all the conventional monetary policy bullets,
the ECB knows it has to do something unusual. Given the
political resistance and the doubtful efficacy of QE, the
ECB decided to target the problem more directly by buying
ABS and covered bonds. The rationale is that since the ECB
cannot force banks to lend more, if it removes these higher
risk-weighted assets from bank balance sheets it will free
up space for new risky lending to the private sector without
increasing total risk. It is a form of credit easing rather
than QE.

The thrust of regulation in the Eurozone, and indeed around
the world, is to shrink the relative importance of the banking
sector. Effectively this means supporting credit markets as an
alternative intermediary. In this context, the ECB efforts to
focus more on purchases that could revitalise securitization
make a lot of sense, and could have more long-lasting effects
than standard QE purchases of government bonds.
Unfortunately, while the process of buying ABS seems
conceptually simple, there are substantial obstacles to the
implementation. The ABS market in Europe is relatively small,
heterogeneous and fragmented (see Economist Insights,
22 April 2014). Furthermore, the amount of new issuance of
ABS in the last few years has been very small. But perhaps
most importantly, since the ECBs own rules mean that it
cannot be exposed to substantial credit risks, it will not be
able to buy all of the ABS (or all the tranches) without some
explicit guarantee from governments or a supra-national
institution such as the European Investment Bank. And if
ultimately the ECB is buying government guarantees, is this
not just a little bit like buying government bonds? For all
these reasons the markets so far have remained relatively
sceptical on the potential implementation and benefits of the
ABS programme, even if the idea is sound.
With the exception of Italy, it seems that the largest European
governments are not inclined to offer such guarantees. It is
easy to understand why the German government does not
want to provide guarantees on Spanish or Irish residential
mortgages. Yet unless the ECB plays its part in kick-starting
the Eurozone ABS market, it is highly unlikely that banks will
go through the effort of creating an asset that so far no one
else has an appetite to buy. So even if guarantees for ABS
might not be the wisest move politically, without them the
ECB cannot revitalise the ABS market and so credit growth
will stall. If credit growth stalls then the economy will stall.
That means the ECB will be forced to try the one thing it
has not tried yet: full-blown QE. And that would mean
Eurozone governments such as Germany providing an implicit
guarantee for another type of security: the government
bonds of their neighbours.
Source: ECB
Chart 2: Rebalancing portfolio
Change in lending to households and non-fnancial corporations,
and holdings of sovereign debt between 2013 and 2007, % of
banks total assets
-15
-10
-5
0
5
10
Change in holding of sovereign bonds
Change in loans to households and non-nancial corporations
Spain Italy France Germany Ireland