The usually staid world of British banking has been titillated in recent days by revelations about the drug-taking of the Co-operative Bank’s former chairman, Paul Flowers. Crystal meth, it seems, was the reverend’s drug of choice. There are lessons for the co-operative movement to learn, mostly concerning governance. But there may be a more instructive parallel to draw with eurozone bank funding.
Any respectable drug-users’ dictionary will tell you that crystal meth delivers a long-lasting high with feelings of exhilaration and alertness, though often with secondary effects of agitation and confusion. These descriptions could equally apply to the after-effects of the more extreme market interventions of the European Central Bank. The time has come to get off the drugs.
It is two years since Mario Draghi launched his first big policy initiative as ECB president, with the longer-term refinancing operation gratefully taken up by about 1,000 banks across the eurozone. Many desperately needed the three-year money – scares about the stability of eurozone government finances, banks’ exposure to consequently riskier-looking government debt and the integrity of the euro project itself had scared off investors in droves.
The €1 trillion flood of cheap money extended under the scheme has served three vital purposes.
First, it ensured governments had ready buyers for the debt they needed to keep issuing. Even as banks have derisked since the crisis, cutting loans to companies and individuals, they have amplified their investment in sovereign bonds. Italian banks, the most enthusiastic sovereign bond investors, today hold more than 10 per cent of their total assets in government debt, up from 6 per cent a couple of years ago.
Second, the LTRO’s low interest rate, now just 0.25 per cent, inflated banks’ profit margins, allowing weaker institutions to build up capital reserves. That in turn has been key to boosting investor confidence in the robustness of the eurozone banking system.
Third, it levelled the playing field for banks across the region, albeit artificially. For the first time in an age, Portuguese banks were borrowing money at the same price as their German counterparts.
Given the benefits, it has been unsurprisingly popular. Though more than a third of the money has been repaid early as banks have sought to prove their newfound strength, €630 billion is outstanding and Mr Draghi has been lobbied to extend the programme when it expires in a year. Last month he suggested he might well heed the cry, saying the ECB was ready to renew the scheme “if needed”.
Doing so would be tantamount to forcing a recovering addict back on to class A drugs.
The truth is that the very existence of the LTRO is stopping the markets operating normally.
Securitisation, the practice of packaging multiple loans and reselling portions to investors, is a case in point. Despite seemingly rampant demand, particularly from US funds, the supply of new eurozone securitisations has been anaemic. Given the choice between funding lending through a market-rate securitisation or with super-cheap LTRO money, it is hardly surprising that few banks are choosing the former. According to the Association for Financial Markets in Europe, a trade body, new securitisation volumes are at 11-year lows. Interbank lending, which has traditionally greased the wheels of finance, has seized up for similar reasons.
Without the distortions that result from special schemes such as LTRO, many bankers reckon that nearly normal service would resume across funding markets. Already, just about any bank with a sustainable business model can issue debt in the bond markets at reasonable rates. It will still cost a southern eurozone bank more to fund itself than a northern eurozone one, but the differential is a fraction of what it was in 2011 at the height of the eurozone crisis.
By the time the LTRO is due to end – between November 2014 and January 2015 – investors should feel even more comfortable about European banks. The ECB’s forthcoming asset quality review and the follow-on stress test of banks’ balance sheets by regulators at the European Banking Authority are both due to be completed by October next year. And unless there are glitches, the transparency they provide should be heartening.
Whether the LTRO ends in a year, or is extended, withdrawal symptoms are inevitable, especially given the fundamental flaws in the make-up of the eurozone. Without further movement towards fiscal union, combined with pre-funded cross-border backstops for failing lenders and a credible system of “living wills” to help wind down those institutions in an orderly way, investors will continue to distinguish between the relative risk of Portuguese banks and German ones.
Given the political and economic sensitivities of all those issues, the ECB may need to come up with a gradual way to wean banks off the LTRO drug. A redesigned, far smaller scheme targeted at today’s emerging priority – the weak supply of credit to smaller businesses – could be the answer. Financiers and central bankers have apparently been discussing the idea in recent weeks, drawing on the lessons of the Bank of England’s Funding for Lending Scheme. To date, the FLS has hardly been a resounding success but there is emerging evidence of promise. The £17.6bn scheme helped to fuel positive lending overall in the second quarter of the year and that trend is expected to accelerate in the second half. It is not exactly clean living. But it feels like a healthier way of life for the eurozone’s banks.