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Monday, January 27, 2014

A peek inside the ECB’s toolkit

Despite being barely a month into 2014, there have already been countless column inches written about the ECB and President Mario Draghi’s potential actions during 2014 (mostly to tackle the ‘deflation ogre’).

Is the ECB toolkit empty?
Is the ECB toolkit empty?
As we have noted before, while the ECB has an extensive toolkit in the case of an acute crisis, it has so far struggled to find the right tool (if one exists) to help promote lending to the real economy and therefore economic growth.

The favoured policy, widely cited by commentators and mentioned by Draghi previously, is some form of targeted liquidity scheme linked to lending to the real economy – along the lines of the Bank of England's 'Funding for Lending' scheme.

Such an option remains possible, but as Bundesbank Chief Jens Weidmann has pointed out, difficult to implement. We have noted this before, but, given that the ECB is already running unlimited liquidity at near zero interest rates (on loans up to three months) it’s hard to see that there would be huge demand for longer loans tied to specific lending requirements.

Over the weekend, speaking at the World Economic Forum in Davos, Draghi revealed another potential policy – ECB purchases of bundles of bank loans (aka. securitised bank loans or asset backed securities).

Is this a real option?
  • The ECB has previously purchased covered bonds and government debt on the secondary market. Hence, securitised bank loans should be possible in theory.
  • However, as Draghi himself admitted, the market for such securities remains seriously underdeveloped in the eurozone.
  • The idea seems to be in its early stages, and probably requires a lot more discussion within the ECB.
  • The move would likely face significant opposition within the Bundesbank, and Germany more generally. This would probably be focused on the risks involved in such asset-backed securities, which are often opaque and continue to have a negative connotation due to their role in the financial crisis.
  • These are the reasons why Draghi has previously shied away from direct action in this area, instead suggesting that it is an area for the European Investment Bank (EIB) to act. There have been comments suggesting that work was underway on a joint programme, but nothing ever emerged.
Would it be effective?
  • At the moment, no. The market remains significant underdeveloped. According to the Association for Financial Markets (AFME) the outstanding securitisation market is €1,545bn - only €131bn of which related to small business loans, while the very large majority of which relate to Retail Mortgage Backed Securities (RMBS) probably from the UK and Netherlands. While Draghi is probably right in his suggestion that it would develop in response to any ECB action on this front, it has a long way to go.
  • Data from AFME give some flavour for the securitisation market in Europe. As the tables below show, the market remained small over the past few years, with less than a fifth of last year’s issuance relating to lending to Small and Medium-sized Enterprises (SMEs).
  • Furthermore, in terms of the location of collateral, the markets remain very underdeveloped in the countries which the ECB would likely want to target. The UK and Netherlands account for a large chunk of the European market. Italy and Spain do have some market presence, but it remains small compared to the size of their economies (although this is true for the sector in general).
  • The final point to note is that the structure for such securities remains opaque and undefined. Given that they are bundles of various technical products, they will always be difficult to value, and while credit rating agencies have improved their processes, questions will still be asked as to whether their ratings truly reflect the risk and value of these products.
While this option looks to be some way off then, the fact that Draghi felt the need to bring it up will likely encourage the view that the ECB will take some further action in the coming months.


Rik said...

1. How anybody can think that no deflationpressure and internal devaluation can go together is beyond me.
And mainly in the South which needs the monetary (or any other)stimulus most. These are still seperate markets for the largest part.

You cannot reduce exportprices without reducing local prices at the same time in a monetary union.

So either it is fighting deflation and let the internal devaluation last considerably longer or it is a (for EU and snails) fast internal devaluation and most likely some deflation with that.
People seem to forget as well that this are still largely national economies in a monetary union.

2. Opportunities in the junkbondmarket (as that basically is what it will be) were there, but before any scheme is working they are with near certainty gone.
Products should have been developed much earlier.

3. A proper credit rating will be nearly impossible to make. Unless there is real collateral. But companies with collateral unlikely even now have problems with borrowing.

4. In Spain more than half the cies that have borrowed are unable to pay the interests due from their cash flow (not even to mentione repayments etc). This means 2 things:
a) they will simply not borrow even at favourable conditions;
b) lot of rubbish hidden everywhere. Few will like to have this in the open I presume (reserves/provisions look way too low). Put a credit agency on the job and you likely will get it.

5. Anyway it takes too much time. Investors are now (unlike otherwise) waiting that things start to run again. Which basically means that consumption will pick up. (Not even mentioning unused capacity that has to be filled up first).
It simply doesnot, nowhere near a normalised situation even after 6-7 year.
Consumption or export will start, things up, if ever, not local investment.

Jesper said...

There is a reason why the level of securitisation vary across Europe.

Creditor rights vary a lot across Europe. The explanation is really that simple. If finance professionals had been aware of that fact then the financial crisis might not have been as bad as it turned out to be. Interesting to see that arguments are being made for repeating that mistake.

The difference in creditor rights can be exemplified by how debtors behave:
Sell on credit in a country with strong creditor rights and you might get a call from a debtor asking for a rebate for early settlement of invoice, if payment is late then the debtor will pay late fees.
Sell on credit in a country with weak creditor rights and you might be stuck chasing the debtor for years and in the end you might need to offer a rebate to get any payment whatsoever.

Anonymous said...

What is the point in having a toolkit if you are not allowed to use it?

I would argue that Bob The Builder has a more effective toolkit (even though it is plastic) simply because he is allowed to use it.

You could also argue that he understands finance better than the EU too.


Anonymous said...

Further to my comment above, I see that the German Constitutional Court may well rule that half of the "toolkit" might be illegal from a German perspective.

Roll on the next phase of the Euro sovereign credit crunch.

Welcome to the MananaZone, where nothing has been accomplished since 2008.

Bob The Builder is better placed to deal with all of this than the EU.