September 14th, 2014
in Op Ed
by Charles Wyplosz
Appeared originally at Voxeu.org 12 September 2014.
Last week, the ECB announced that it would begin purchasing securities backed by bank lending to households and firms. Whereas markets and the media have generally greeted this announcement with enthusiasm, this column identifies reasons for caution. Other central banks' quantitative easing programmes have involved purchasing fixed amounts of securities according to a published schedule. In contrast, the ECB's new policy is demand-driven, and will only be effective if it breaks the vicious circle of recession and negative credit growth.
The 4 September announcement by Chairman Mario Draghi has been greeted with enthusiasm by the markets and the media. It has been long awaited, and many believe that the ECB has finally delivered. This is not sure. The ECB intends to buy large amounts of securities backed by bank lending to households (mortgages) and to firms.
- Traditional quantitative easing (QE) is demand-driven since the central bank buys assets in predetermined amounts.
- The ECB's version is supply-driven.
This means that it is not certain that the liquidity injections of "hundreds of billions" will materialise.
Size of the operation
The ECB has announced its intention to boost liquidity. With traditional QE, as practiced by the US Federal Reserve, the Bank of England, and the Bank of Japan, the central bank buys securities - mostly public debt instruments - in pre-announced amounts according to a published schedule. As a result, the amount of liquidity creation is known ex ante and certain to happen.
In the case of the ECB, this will require market participants to securitise existing or new loans. The existing amounts of Eurozone asset-backed securities is presently believed to be of the order of €1 trillion, to be compared with the $2.4 trillion created by the Fed through its various QEs.1 Not all of it will be accepted by the ECB for quality reasons. A rough guess of the outstanding amount of Eurozone covered bonds is €2 trillion, much of which was issued by German institutions.2 Over 2009-2010, the previous covered bond purchase programme of the ECB led to purchases of €60 billion.
This demand-driven process means that no one knows how much liquidity the ECB will be able to create. Its signalling power, therefore, is limited relative to traditional QE. One can already anticipate financial markets debating the size and timing of the programme. In the US, doubts only surfaced when the Fed started in 2013 to send warnings that QE was not forever. The 'taper tantrum' is an indication of how poorly markets deal with uncertainty (Feroli et al. 2014, Neely 2014).
The hope is that the existence of the ECB programme will encourage lenders to lend more under the assumption that these loans will then be sold to the central bank. Two assumptions come into play here.
- First, that current bank lending, which has been negative in net for several years, is restrained by a lack of liquidity.
- Second, that securitisation of these new loans will develop.
The first assumption is contradicted by the fact that banks hold some €100 billion in excess reserves, for which they receive a negative interest rate. Lack of liquidity cannot explain negative credit growth. The alternative explanation is that there is not enough demand, which is plausible in the midst of a recession. If so, the programme will not have any impact. Yet another explanation is that banks do not lend because they are too risk averse. The ECB programme will succeed if the securitisation process allows them to pass the risk on to the ECB.
Risk-taking by the ECB
The ECB programme will encourage securitisation. By selling their loans to securitisation agents, banks will get rid of the associated risks.3 Thus, the best hope is that risk-averse banks will start peddling large amounts of loans, and convince their customers to take them, because they will not bear potential losses.
The ECB considers that European asset-backed securities will not be as risky as their toxic US counterparts of 2008 because they will not rely on the infamous subprime loans. Indeed, subprime loans cannot really exist in Europe because consumer protection laws effectively ban them. In addition, Mario Draghi insists that the asset-backed securities will be fully transparent so that subprime loans can be detected. He rightly notes that loan delinquency levels are much smaller in Europe than in the US. All this is true, but one still has to explain why banks are so afraid to lend.
- One reason is that banks are busy repairing their balance sheets through deleveraging because of new regulation and stricter stress tests.
- Another reason is that the on-going recession cuts into corporate rates of return, and that high unemployment rates mean that lending to households is inherently risky.
The first reason may evaporate later this year as the result of the Asset Quality Review and tough stress tests that will force weak banks to recapitalise. It may also mean that banks will have one more argument to delay, or possibly even roll back, the new regulation designed to make them less fragile and costlier to bail out. That would be a disaster.
The second reason describes a vicious circle. The ECB must hope to break it. Yet, it is hard to see how the process starts other than through more risk-taking by banks, passed on to the ECB. The bet, then, is that loans that now appear risky will turn out to have been safe because the process will have triggered a recovery. In that view, in the end of it all, the ECB will not suffer significant losses. Maybe, but the ECB will have to take the risky bet.
Why not traditional QE?
The ECB programme is more complex, less certain to work and riskier than traditional QE. There must be good reasons for the ECB to have chosen such a convoluted route. To start with, the European banking system remains fragmented. That means that the normal channels through which liquidity trickles down throughout the Eurozone are not operating well (Al-Eyd and Berkmen 2013). The ECB programme is designed to lend to lenders, indirectly through securities, thus bypassing the broken channels.
In addition, traditional QE involves buying large amounts of public debt. In the Eurozone, this is highly contentious. Ideologues will be prompt to describe QE as the backdoor for debt monetisation. To be effective, the ECB would have to choose public debts of countries in bad shape, since national bonds are now concentrated on the balance sheets of the respective national banks. That will reinforce the debt monetisation syndrome. Furthermore, if one believes that many countries face unsustainable public debt levels, this means that some restructuring is unavoidable.4 It could well be that public bonds are riskier than the loans that will be created under the new ECB programme.
A virtuous circle?
No one should believe that the ECB's task is an easy one. With inflation way below its definition of price stability, the ECB must 'do something'. Indeed, had 'something' effective been done a year ago, the situation today would be less pathetic. Its version of QE, however, is both uncertain and risky. It all comes down to a bet that easier lending conditions will restart the Eurozone economy. Is the bet likely to pay off?
One can only wish so, even though it rests on many dubious assumptions, as described above. The main source of optimism may lie elsewhere. If liquidity does increase by a few hundred billion euros, the euro will depreciate. A sizeable and early depreciation is really the best that can happen. Rising exports will trigger the recovery, which will encourage borrowing. Lending will follow as risk aversion declines, leading to more liquidity creation and yet more depreciation.
Maybe this "hundred billion" debt is the best that the ECB can do given the Eurozone's complex political situation. But it remains a bet, with a highly risky downside. Traditional QE, on the other hand, may not produce wonder, but certainty of liquidity creation seems to work and it can provoke the desired depreciation that is the key to success (Krishnamurthy and Vissing-Jorgensen 2011).
- Al-Eyd, A and S P Berkmen (2013), "Fragmentation and Monetary Policy in the Euro Area", IMF Working Paper 13/208.
- Feroli, M, A K Kashyap, K Schoenholtz, and H S Shin (2014), "Market Tantrums and Monetary Policy", mimeo, University of Chicago.
- Krishnamurthy, A and A Vissing-Jorgensen (2011), "The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy", Brookings Papers on Economic Activity, 43(2): 215-287.
- Neely, C J (2014), "Lessons from the Taper Tantrum", Economic Synopses, 2014(2), Federal Reserve Bank of Saint Louis.
- Pâris, P and C Wyplosz (2014), "PADRE: A politically acceptable debt restructuring in Europe", Geneva Reports on the World Economy Special Report 3, ICMB and CEPR.
- Source: Securities Industry and Financial Markets Association (SIFMA).
- Based on data from the European Covered Bond Council.
- This is only true for asset-backed securities. Covered bonds do not remove the risks.
- See Pâris and Wyplosz (2014).
About The Author
Charles Wyplosz is Professor of International Economics at the Graduate Institute, Geneva, where he is Director of the International Centre for Money and Banking Studies. Previously, he has served as Associate Dean for Research and Development at INSEAD and Director of the PhD program in Economics at the Ecole des Hautes Etudes en Science Sociales in Paris. He is a CEPR Research Fellow and has served as Director of the International Macroeconomics Programme at CEPR.