EU falling short on implementing bank capital rules

The BIS Basel Committee has today released its assessment of the EU’s (and the USA’s) implementation of the Basel III rules on bank capital and it does not make good reading for the EU. They key findings of the report are (as detailed in the press release and the graphic below, click to enlarge):

• “Eight of the 14 components meet all minimum provisions of the relevant Basel standards and these were therefore graded as "compliant".”

• “Four of the components were assessed as "largely compliant", reflecting the fact that most but not all provisions of the global standard were satisfied.”

• “One component - the Internal Ratings-based (IRB) approach for credit risk - was assessed "materially non-compliant" and pertained primarily to the treatment of exposures to SMEs, corporates and sovereigns.” In particular, the report notes that exposures to SMEs are given concessionary risk weightings, presumably to try to encourage this specific type of lending, however it is nonetheless not in line with the rules. Furthermore, it finds that banks are given a significant amount of leeway in how to value their sovereign debt holdings, with most across the EU simply applying zero-risk weighting – again this is a deliberate attempt to limit any distortions to the sensitive Eurozone government debt markets.

• “Another component was found to be "non-compliant". This relates to the EU's counterparty credit risk framework, which provides an exemption from the Basel framework's credit valuation adjustment (CVA) capital charge for certain derivatives exposures.” Essentially the current rules allow exemptions for instruments which are not traded on exchanges or the wider market and therefore may be hard to value. Furthermore, this “materially boosts bank capital ratios,” though the report accepts that the EU is considering changes to these specific rules.

• Overall the EU was given the second lowest rating (on a scale of four) of “materially non-compliant”, making it the first jurisdiction to be found on the whole not the be complying with the Basel rules. The assessment is also particularly poor compared to the US, which was found to be “largely compliant” with the rules, in general its failings also seem to be more minor as well as less numerous.

The European Commission’s response can be found here, while there is also a response section following the executive summary in the main report. The EC claims the EU’s approach is “particularly ambitious approach, unique in the world”, which is true to an extent given the diverse nature of national banking systems. The response notes that some changes are already in the pipeline, but largely challenges the interpretation which the Basel Committee makes of the rules. On the whole it is not entirely convincing but then, since the Committee cannot force the EU to change, it seems the Commission is largely happy to ‘agree to disagree’ on a number of areas.

While all of this may seem rather mundane and technical it does have some important implications.

First off, it raises questions about the quality and thoroughness of the recent ECB and European Banking Authority stress tests. We, along with plenty of others, have already raised concerns about this and the report adds further weight to those concerns. Furthermore, the specific problems outlined would certainly have helped present European banks as having higher capital ratios largely by reducing the perceived riskiness of certain assets they hold.

A report by Yalman Onaran for Bloomberg earlier this week highlighted the problems relating to the use of banks internal models to weight risk by contrasting this approach to that of using the pure leverage ratio. As the article notes, under the leverage ratio approach 12 large European banks would need to raise a further €66bn in capital. While neither approach is perfect, the Basel Committee’s indictment of the bank’s internal models and the way a large number of exposures in a number of sectors are valued seems to support such analysis and criticisms.

The second important implication is that is once again clearly highlights that the EU probably remains the more important level of policy making and legislation than international level or international organisations – at least when it comes to how things are structure on the ground.

Despite agreeing to follow the Basel III rules the EU is the one that designs and implements the specific legislation. In this case it has clearly altered the rules significantly to suit its own needs – the gap with the original rules as well as how they are interpreted and implemented in other jurisdictions is clear. Furthermore, while the Basel Committee can issue a damning judgement of the EU’s approach, it cannot force it to change. In this relationship all the hard (legal) power lies with the EU. This also extends beyond just implementation to interpretation. Despite writing the Basel III rules the Basel Committee is not even able to guarantee primacy on how they should be interpreted as the EU’s response to the report clearly shows.

ECB surprises markets with interest rate cut and purchases of private assets: Round-up of reactions from around Europe

As we predicted might happen, the ECB surprised markets yesterday with the announcement of an interest rate cut and the purchases of private assets.

Open Europe’s Raoul Ruparel has a full analysis on his Forbes blog, where he concludes:

“In summation, Draghi surprised the markets with some bullish action. That said, I remain unconvinced that these programmes will do much to boost inflation, growth or even credit supply in the Eurozone. Importantly, the ECB is nearing the end of the actions it can take, and it is very aware of this. The onus has now once again been shifted to governments, with the expectations rising for action. For the first time since 2012, pressure is now really increasing for Eurozone governments to reassess the Eurozone’s institutional structures and take action to pool further sovereignty. Draghi may have come bearing gifts for markets but he came with further warning for governments.”

Needless to say, the fallout from the ECB's announcements has been widespread and varied. Below are some of the best reactions from papers across Europe. As one might expect, the German press was less than impressed with the policies unveiled by Draghi:

Die Welt’s Economics Editor Sebastian Jost describes the announcement as “Draghi’s last roll of the dice”, and claims that the ECB has demonstrated “an unusual passion for experimentation”. He also argues that “the ECB has now done pretty much everything which appears to be economically justifiable. Whoever wants a stable monetary union should hope that it does not go any further.”

Süddeutsche Zeitung’s Economics Editor Ulrich Schäfer describes the ABS as a “highly dubious innovation”, claiming that it resembles many of the financial products that contributed to the initial financial crash “when no-one could ultimately identify who had lent whom how much, and therefore who had assumed what risk.” He concludes that it is “ironic” that the ECB wants to give such products “renewed respectability”.

FAZ’s Economics Editor Holger Steltzner criticises Italy and France for delaying structural reforms in order to get more help from the ECB. He also argues, “Does the purchase of securities, which banks are struggling under the burden of, even come under monetary policy?...How can the ECB eventually return to normal? As soon as it increases interest rates, it will threaten itself with losses.”

Again as many would have predicted, the Mediterranean press took a more sympathetic view of Draghi’s decisions.

An editorial in Spanish daily El País argues that “the ECB hasn’t disappointed…[but] it’s equally necessary that the governments with sound public finances – and notably the German government – intensify investment and temporarily back greater flexibility in the necessary requests for public finances adjustment in the eurozone as a whole.”

The deputy editor of Spanish daily El Mundo, John Müller, makes an interesting point, “The enormous debt – both private and public – that has been amassed, is such a huge burden that it is surprising that no-one is addressing the problem seriously...Yesterday, Draghi only asked for help [from eurozone governments] in the form of fiscal measures and reforms, but not [in the form] of debt restructuring. In short, we don’t know if the monetary sorcerer has correctly identified the reason why we have lost the favour of the gods of growth.”

Columnist Jean-Marc Vittori writes in French business daily Les Echos that “the currency won’t be enough to save Europe”, and argues, “[There’s] no tenable monetary union without budgetary union. In a continent where the temptation to withdraw is growing, this appears to be a challenge. Nonetheless, it’s the condition for the survival of the euro.”

Italian Economics Professor Donato Masciandaro writes in Il Sole 24 Ore, “Draghi couldn’t have been clearer: the later the necessary fiscal and structural policies come, the less effective monetary policy will be…Such a decisive statement should make everyone reflect. The [European] Union is like a bogged-down machine. It has at least four traction wheels – currency, taxation, competition and labour – but only one of them is working. In such a situation, the machine risks going under.”

Italian journalist Danilo Taino writes in Corriere della Sera, “[Italian Prime Minister Matteo] Renzi is a lucky guy, since no [Italian] Prime Minister ever got this sort of help from the ECB. This means, however, that [Renzi] won’t be able to ask for anything else from Draghi. The ECB President has reached the extreme limit – except for a difficult, potential government bond-buying programme. From now on, everything is in the hands of governments.”

One interesting take away, particularly from the articles from around the eurozone periphery, is that there seems to be a renewed push for measures such as further budgetary union and debt-pooling. It looks as though there is a growing acceptance of the limitations of ECB action, and the continued flaws in the Eurozone architecture – something which we have long warned of.

ECB preview - Dovish Draghi to double down on easing?

The European Central Bank (ECB) holds its monthly meeting in Frankfurt today - the day after ECB President Mario Draghi's 67th birthday.

As usual, Open Europe's Head of Economic Research Raoul Ruparel has published a preview on his Forbes blog, explaining what we may expect from today's meeting.

Here goes:

Following ECB President Mario Draghi’s dovish speech at Jackson Hole last month this week’s ECB meeting has taken on new importance. This has been further enhanced by the recent Eurozone inflation data which put annual CPI at 0.3% in August. The headline figure hides some of the story with core inflation actually rising to 0.9% (from 0.8%) but the ECB’s previous inflation forecasts have begun to look increasingly out of line with reality.

However, those expecting a big move are likely to be a bit disappointed. As I pointed out last month, it is almost nonsensical for Draghi to unveil new measures before his previous policies have been implemented. I am thinking specifically of the TLTROs (targeted long term lending operations) the first of which will only be conducted on 18 September. Any big announcement now could undermine the predicted take up of these measures – which clearly remain the ECB’s preferred approach for injecting further liquidity.

That being said, these measures are unlikely to make much difference since the conditions for passing liquidity on to the real economy remain very loose. They are also very unlikely to appease investors and markets which have now come to expect some significant new easing. The two key options which are on the table for this meeting are:

1. A further interest rate cut: Many will validly ask, what is the point in a further cut now? Of course it would have little to no economic impact, however, it would once again signal the dovish bias of the ECB. It would also signal a clear shift in the ECB’s position given that Draghi has previously said rates are unlikely to get any lower than current levels. It becomes another mechanism to express his commitment to further easing. There also remains scope to make the negative deposit rate more negative, although there is a cap on this since, at some point, it will be cheaper for banks to simply hold cash than deposits with the ECB.
    
2. Purchases of private sector assets – specifically Asset Backed Securities (ABS): The ECB has long telegraphed such action and it is the next obvious tool at its disposal. Whether or not it will be announced this month or in the coming months is a bit of a toss-up. It seems the ECB is not quite ready to implement it yet and has made a big song and dance about the need to adjust regulations and definitions of ABS, which are yet to fully take place. Whenever it is announced, implementation is likely to be later this year to allow the negative deposit rate and TLTROs to have time to work. I remain sceptical on the effectiveness of this policy, which I have analysed in detail on the Open Europe blog. Ultimately, the market for the transparent ABS related to SME loans remains very small in Europe and focused in the core countries rather than the periphery (where this money really needs to flow to). For example, in Q1 2014, of the €18.5bn in ABS issued, only €1.6bn used SME loans as collateral. The ECB maintains that it can and will help create the market in this area, yet with this measure having been forecast for some time, you would expect there to have been some market response already.

As with many of Draghi’s press conferences, all of this will be weaved into a dovish speech including a few key trigger words for markets – few other central bankers are as adept in their communication. As for full blow Quantitative Easing on sovereign debt, this remains someway off in my mind and hurdles remain high. Its use will ultimately be tied into developments in the fiscal and political sphere, as hinted at in Draghi’s speech (more detail on this coming in a future post). The ECB will be loath to unveil QE, which it fears can only buy time, without further commitment to reforms, a clearer fiscal approach and developments on the structure of the Eurozone which such changes will entail.

Has the ECB backed German ‘reform contracts’ for the eurozone?

In a speech in London yesterday, ECB President Mario Draghi issued a call for new eurozone rules on structural reform. He discussed it at length in the speech, but the ECB’s summary captures the key points:

The governance of structural reforms deserves as much attention as enforcing fiscal rules and should be done at the euro area level.

Structural reforms need strong domestic ownership since they reach deeply into societal arrangements. But at the same time, the example of the International Monetary Fund shows that there is a convincing case to be made for a supranational body that makes it easier to frame national debates on reform. This can shift the debate from whether to how to implement reforms, Mr Draghi argues.

The outcome of structural reforms – a higher level of productivity and competitiveness – is not merely in a country’s own interest, but in the interest of the monetary union as a whole. 

In the euro area, there is therefore a case for establishing rules on structural reform at the EU-level. While a lack of reform can threaten cohesion of the union, the recovery shows us how decisive reform can strengthen it.

Despite the lack of specific details, this has rightly evoked comparisons to the German proposals for ‘reform contracts’, which were strongly pushed last autumn and which we discussed in detail here. There are lots of overlapping ideas, including the concept that eurozone rules will help encourage ownership of reforms rather than discourage it, and that this is a logical supplement to the existing European Semester.

We have always expected the reform contracts to make a comeback in some form or another, not least given Germany's strong support for the concept, and there are other reasons to think that they may gain some further traction this time around.

While the peripheral countries have previously objected to such sovereignty transfers, Italian Prime Minister Matteo Renzi has been vocally touting the idea that countries should be directly rewarded for reform efforts. The details might differ, but conceptually he has moved closer to the Germans on this point.

There is no doubt the reform contracts will remain a hard political sell, but with the ECB’s backing and the growing desire for a proper negotiation and discussion around the eurozone's fiscal rules, as well as the broader approach to economic reform, now could be the time for the idea to make a comeback in one form or another.

Out of the euro but run by the euro? The UK & ECB prepare to lock horns at the ECJ in what could be the most important case yet...

Could euro clearing be moved from the City to the eurozone?

Tomorrow will see the first hearing of the next in the line of important UK cases at the European Court of Justice (ECJ). The case in question is the UK’s challenge against the ECB’s location policy – and it could be the most important of all the cases. The case is shrouded in technical detail but, fundamentally, is whether we're moving towards a two-tier single market and an EU run by the euro for the euro.

Background
On the 5 July 2011 the ECB published its Eurosystem Oversight Policy Framework, which argued:

As a matter of principle, infrastructures that settle euro-denominated payment transactions should settle these transactions in central bank money and be legally incorporated in the euro area with full managerial and operational control and responsibility over all core functions for processing euro denominated transactions, exercised from within the euro area.

In that paper and future opinions the ECB has stressed that it will not provide central bank liquidity to clearing houses outside the eurozone but that all such institutions should have access to it.

The UK quickly challenged the policy in September 2011, calling for the ECB’s policies to be annulled, and has launched two further challenges at the ECJ, in which it updates its list of complaints, the key points of which are as follows:

• The ECB lacks powers in the specified areas, especially since it did not include the plans in a regulation to be adopted by the Council or by the ECB itself, simply decreed it in a policy paper and opinion.
• “De jure or de facto” the rules will impose a residence requirement on clearing houses which want to clear euros, meaning existing clearing houses will face a choice of moving within the eurozone or changing their business approach.
• The rules offend the principle of equality in the single market since firms incorporated in different EU member states will be viewed differently and the rules will not apply equally.
• There are less onerous methods for achieving the same goals (namely security of the financial system) cited by the ECB.

Why is this case so important?
The case manages to combine two crucially important issues:

1. The question of maintaining the EU single market and whether countries outside the eurozone will be dominated by those inside
2. How to ensure the safety, transparency and security of the modern financial system in Europe to avoid a similar crisis to one we have barely overcome

For the UK, there are additional concerns:

• Firstly, it will once again play a role in setting the boundaries of action the ECB and eurozone can take without the non-euro members. It will also create a clearer boundary on what powers the ECB has. 
• If the ruling goes against the UK, there would be a clear split in the single market and, the precedent set, will make it harder for the UK to stay in the EU
• It would raise further questions about whether the UK can trust the ECJ as a neutral arbiter.
• It would undermine the role of the City of London as a financial centre serving the eurozone (the City remains a trading hub for a single currency of which the UK cannot take part), meaning London could lose business to Paris and/or Frankfurt.

Does the ECB have a point?
From the financial stability perspective it is easy to have some sympathy with the ECB’s stance. More and more transactions are being directed on to exchanges and through central counterparties (clearing houses) therefore it makes sense for them to have access to sufficient liquidity. Then again, the LCH Clearnet clears products in 17 different currencies without the need for central banks backstops in all of them.

Given that, and the huge political stakes, one option would be to establish a permanent swap line between the ECB and the Bank of England (or all non-eurozone central banks). Such swap lines are well tested and were used extensively during the financial crisis. In exchange, the ECB would likely require some greater involvement in terms of supervision of institutions which may receive such cash. The easiest and most practical way to achieve this would be through the existing EU institutions such as the European Systemic Risk Board (ESRB) and the European Securities and Markets Authority (ESMA).

Needless to say, the UK also has a strong case since its hard to say this will not hamper the single market at the very least. In any case, whatever the outcome there will likely need to be changes made to accommodate a new structure, hence the repercussions of the ruling will be widely felt.

On what and how might the ECJ rule?
Trying to second guess the ECJ is a hazardous business. That said, this case is interesting because there are a few different elements which the ECJ could choose to rule on or not.

Whether the ECB has competence or not? The first relates to the UK’s first point of challenge regarding whether the ECB has competence in this area. While the ECB does have control of payment systems and gave an extensive legal grounding in its original policy paper its clear that this is a very political decision. Determining who has competence should be a fairly basic question which the ECJ can rule on.

Which has primacy - ECB policy or EMIR? That said, the matter is complicated by the recent European Market Infrastructure Regulation (EMIR). In the preamble point 47 and 52, as article 85 in the main text, all stress that there must be no “discrimination” with regards to where currencies can be cleared and that nothing should “restrict or impede” clearing houses based in other jurisdictions from clearing foreign currencies. As such, the ECJ may have determine who has primacy in this area, as currently it isn’t clear which set of rules should be adhered to (although given that euros are still being cleared in London one might de facto think EMIR is winning). If the ECJ is swayed by the non-discrimination provisions in EMIR, the UK Treasury should be given some credit for pre-empting the ruling - which Open Europe also has recommended.

Does the ECJ actually have anything to rule on? As with the Financial Transaction Tax decision, the ECJ has shown itself reluctant to rule on issues it sees as hypothetical. Given that the rules that the UK are challenging are actually not in place, the ECJ may rule that the challenge is somewhat premature. Obviously, the risk here is that this would be self-fulfilling and act as a catalyst for changes to happen. It would also leave many questions (not least those above) unanswered.

What happens next?
The oral hearing will take place tomorrow. After that the Advocate General will produce an opinion and a ruling will follow, both most likely in a few months’ time.

It’s possible the ECJ could rule on only part of the UK’s claims or support some and dismiss others. It will also be important to see what happens with regards to the primacy of a regulation over the ECB in this particular area which could itself be an important legal precedent (not least because the ECB is becoming increasingly powerful).

It's also still possible that this will be 'settled out of court', given the stakes involved and the risks of unintended consequences.

We'll watch this one closely.

ECB acts as expected, now the waiting game begins

For anyone following twitter yesterday around the ECB’s announcement and press conference it would seem as if we have just had another ‘whatever it takes’ moment (when ECB President Mario Draghi promised to backstop the eurozone).

However, stepping back for a moment and it becomes clear that the ECB acted more or less as expected and some would argue has done the minimum necessary to retain its credibility and not be labelled an ‘all talk’ institution.

Sure, the package of measures looks more impressive when strung together but as we discussed in detail here and here, few if any of them address the crux of the problems in the eurozone which are depressing inflation and growth (delayed impact of internal devaluation, rebalancing of various economies, recapitalisation of banks and the breakdown of the eurozone’s cross border financial system).

All that said, there were a few more subtle and interesting takeaways from Draghi’s press conference.

Unanimous support is impressive but unlikely to apply to further easing
Draghi stressed that the support for this entire package of measures was unanimous. This is quite surprising given the previous Bundesbank opposition and does add weight to the strength of the decision. That said, just because unanimity was agreed here does not mean it can be easily translated into support for much stronger action such as asset purchases. In fact, Draghi’s hesitancy to talk about such a programme in more depth and the ECB’s willingness to push ahead with one suggests a lack of consensus on the issue. Furthermore, the outcry in Germany has already begun and will likely make central bankers think twice about stronger easing action.

Draghi insists the ECB is not “finished”, but its mighty close
Over the past year, Draghi has waxed lyrical about all the tools at his disposal and we have analysed them all in detail – see here. However, with this package of measures he has come close to emptying his toolkit – he admitted as much on the rate side saying that, for all “practical purposes”, the lower bound has been reached.

True, he has pulled out many of the smaller tools and retains the big sledge hammer of asset purchases (Quantitative Easing through buying either private assets or government bonds) but the bar to take such action remains high and gaining support for it remains a huge challenge. Pushing the deposit rate further into negative territory is also unlikely to work as banks will simply begin hoarding hard cash – this of course has some cost in terms of storage and security but it will not be more than a fraction of a percent. Finally Draghi stressed that this package could take some time to have any impact, between three and four quarters (9 – 12 months), suggesting that the ECB is now in wait and see mode as the emphasis falls on governments and the bank stress tests to help push along the economic recovery.

Impact of long term lending operations relies on cross border lending being revived
As the useful chart to the left shows (from Morgan Stanley via FT Alphaville) the amount which banks can borrow is again limited in countries which need it (the periphery) due to their already underdeveloped markets in lending to small and medium sized businesses. The technical structure for the TLTRO (pronounced Tel-tro) does allow for them to borrow more if they lend more but this will take some time. Ultimately, the target seems to be to encourage banks in the core to lend to banks and businesses in the periphery – this fits with the theory of the negative deposit rate which should encourage a search for yield. Rebuilding the cross border system in the eurozone remains a huge task.

Another potential question which arises is whether the end of sterilising purchases made under the Securities Markets Programme (SMP) will raise any legal issues or challenges in Germany and whether it will impact the judgement of OMT sterilisation.

In the end, the ECB has made its play and will likely now give it time to pan out. It will continue to provide dovish statements and may even talk up asset purchases in the future but it will urge patience in waiting to see if these measures have the desired impact.

ECB to ease policy but impact could be limited

Over on his Forbes blog Open Europe’s Raoul Ruparel provides a preview for tomorrow’s ECB meeting at which some action to ease monetary policy is expected.

In specific terms he sees the ECB taking the following action:

1. Cut the main interest rate to 0.15% (from 0.25% now).
2. Cut the deposit rate to -0.1% (from 0% now). This will be an unprecedented move.
3. Announce a new Long Term Repurchase Operation (LTRO) focused on boosting lending to small and medium sized businesses. The term of the LTRO will be between 3 and 5 years, rates will be reduced if banks provide evidence of a pick-up in lending (see below for a useful Nomura graphic on this).

It could also decide to end the sterilisation of the Securities Market Programme purchases, creating a liquidity injection of €164.5bn and loosen collateral rules further. The ECB will likely keep asset purchases (both of private assets and government debt) in reserve but will likely reiterate that such action remains possible as part of a broader dovish statement from Draghi.

Despite some of these moves being unprecedented Raoul forecasts that the impact could be limited. This is for three reasons. First, much of it has been priced in as the moves have long been expected. Second, the impacts of a negative deposit rate and targeted LTRO are far from certain. Finally because it does not address the key problem, as he notes:

As the chart below shows (courtesy of SocGen) the biggest problem facing the eurozone financial system at the moment remains the discrepancy in lending rates to businesses in different economies. The knock-on impact of this is limiting credit in countries where the economy needs it and where it is needed to help drive inflation and growth.

It’s not clear that the rate cut, negative deposit rate or the LTRO will help close this gap. Fundamentally this gap is driven by a few factors which these issues do not address:

• Banks continue to deleverage and overhaul their balance sheets. The ECB’s Asset Quality Review and the bank stress tests are in the process of trying to put banks on a surer footing but until they are all done and dusted this process will weigh on banks actions.
• Cross border lending system in the eurozone remains fractured. Banks and investors on the whole are still not willing to lend and invest heavily in the peripheral economies. This stops the excess liquidity in the stronger countries filtering in the weaker ones. While negative rates will seek to encourage such movement by pushing a search for yield it is unlikely to override concerns over risk and the desire for safe assets.
• As recent ECB bank lending surveys highlight the problem is not just on the supply side but also the demand side. The economic overhaul, reform and rebalancing on many of the eurozone economies (both in the core and periphery) is an on-going process. Not only does this itself limit demand but it highlights that lending must be to new sectors and new drivers of economic growth rather than helping to simply prop up older sectors (here I am thinking for example in Spain of lending to new services rather than to the old real estate and construction sector).

Spanish banks' bad loans look set to weigh on the economy for some time

The Bank of Spain released its latest data on the level of bad loans held by Spanish banks today. For the first time since January 2013, the value of bad loans has dropped - falling from €195.2bn in Feb to €192.8bn in March. However, it has stayed roughly constant as a percentage of total loans (13.4%).

Symbolically, even a small drop in the headline value of bad loans may be seen as important, especially given that previous declines were down to the transfer of assets to the Spanish bad bank (SAREB), rather than any change in circumstances of the loans. If this is discounted, the value of bad loans has simply continued to rise.

That said, as the graph highlights, these loans remain at very high levels and well above the loss provisions held by banks. This continues to tell us that:

• Spanish banks will continue to deleverage for some time to come. This puts a dampener on any hopes that they will show any rapid increase in willingness to lend and take on more risk to help fuel any form of Spanish recovery. This thereby increases the risk that any recovery will be ‘creditless’, and therefore more likely to be limited and temporary.

• This data is quite timely, as it also highlights the obstacles which the ECB is going up against in these countries when it comes to encouraging banks to begin lending again, particularly to small and medium-sized enterprises (SMEs). With their balance sheets still weighed down by these loans, it seems likely that banks will continue to be reticent to take on significant new lending, even if the ECB does offer them cheaper long-term loans.

• Given that many of these loans still relate to the real estate and construction sector, they will continue to weigh on prices in these markets. This suggests prices could fall further (although this will vary significantly based on location and regional markets), while the political hot topic of evictions could return to the fore again in the future.

Have borrowing costs in the eurozone periphery come down too far, too fast?

Over on his Forbes blog, Open Europe’s Raoul Ruparel asks: is there a bond bubble in peripheral Europe? The thurst of his answer is that, while there are good explanations for why costs have come down so far and so fast, they could certaintly have side effects, not least because people misinterpret the reasons for the move. The full post is here, but below are the key points:

What is driving this and is it a bubble?
There are three key factors at work here:

1. ECB President Mario Draghi’s promise to do “whatever it takes” to protect the euro combined with the unlimited bond buying policy of Outright Monetary Transactions (OMT) has driven borrowing costs down since mid-2012. This effect has been amplified by the expectations of further ECB easing, particularly some form of Quantitative Easing (QE), which would bring yields down even more.
2. There has been some success in terms of eurozone reform, particularly with the successful end to the Irish and Portuguese bailouts as well as these countries’ return to the markets, along with Greece. The eventual agreement on banking union and other aspects of trying to correct the structural flaws in the euro (although I believe it is far short of what is needed) has also contributed to the positive sentiment.
3. Possibly the most important factor though is the very low inflation in the eurozone (and even deflation in some countries). Over the past six months this has pulled the borrowing costs across the eurozone down.

This final point is driven home by looking at the rough and ready version of the ‘real yield’ on ten year debt in Europe (10yr yield minus HICP inflation). As the graph below highlights*, when this is done the UK actually borrows at a real rate which is 2% below Ireland’s.

Could this present a problem? (Hint: Yes)
While the process of collapsing bond yields in peripheral Europe is explainable it does still present some serious causes for concern.

• The huge demand for peripheral bonds does seem to have gone too far with respect to the economic fundamentals of these countries. Debt levels have continued to rise – exacerbated by low inflation – while many countries are barely posting any economic growth.
• More concerning though is that this creates very perverse incentives. Many governments can already be seen professing the success of their policies, citing falling borrowing costs and buoyant financial markets. In reality, these are much more down to the ECB and inflation effects mentioned above.
• The risk is that complacency seeps in (some of which can already be seen) and that the reform process in these countries stalls. Italy and France are prime examples of this. While the European Commission does have additional powers now to encourage further reform, when push comes to shove there is little it can do to force reform on an unwilling political class and population, particularly one with low borrowing costs.
• As detailed here, the banking union looks insufficient to break the sovereign banking loop in the eurozone. The efforts to improve the structure of the eurozone have slowed, the risk is they will grind to a halt until the threat of a crisis returns.
• The performance also looks strange relative to countries such as the US and UK which have always borrowed in their own currency for which they are solely responsible and have clear fiscal and central bank backing. Even with the changes to the euro structure and the ECB promises it’s hard to say that, in another crisis, the same issue wouldn’t arise with regards to a comprehensive lender of last resort (let’s not forget, the OMT comes with plenty of conditions and is limited in scope). Even though accounting for the inflation impact, the difference in risk between peripheral eurozone countries and the likes of the US and UK does seem to be being underestimated.

Ultimately, the crisis highlighted that too much price convergence without economic convergence and reform in the eurozone can actually be a bad thing, with resulting perverse incentives and negative outcomes. While the price action in peripheral bonds might not yet count as a ‘bubble’, investors and politicians would do well to remember these lessons when interpreting the record low borrowing costs.

The ECB gives Portugal a helping hand with its return to the markets

Portugal this morning followed the lead set by Ireland and Greece and issued new debt for the first time since its bailout in 2011.

Portugal managed to sell €750m of 10 year bonds at an average borrowing cost of 3.58% and with demand totalling €2.6bn (3.47 times the desired amount). This is a successful return, albeit not quite as large as Greece’s or Ireland’s issuance.

Again, many people will be asking why a country with uncertain funding conditions over the coming years saw such solid demand for its debt, even before it exited its bailout. As with Greece, we would say many of the factors are more to do with the state of the broader market than specific to Portugal:

• The issue remains small with a decent yield – there will always be demand for this kind of risk and return.
• This is particularly true in the current market where interest rates are at record lows and there is a dearth of safe assets which still yield a decent profit.
• The ECB and the eurozone have shown their commitment to keeping the eurozone together and have shown a renewed aversion to private sector write downs on sovereign debt. This combination provides insurance to investors that, even if the Portuguese economy struggles, the rest of the eurozone will ensure that it continues to pay its debts.
• Of course, all that said, the reforms which Portugal have instituted and which have helped boost exports will play some role in encouraging investors.

One specific point to note though is that, on top of the general support given by the ECB mentioned above, it also gave Portugal a more direct helping hand.

Die Welt reported on this issue today, terming it a “trick”. In reality, the ECB has altered its collateral rules so that, when Portugal exits its bailout, its government bonds will still be eligible as collateral for its lending operations. The change was snuck through as part of a package of changes in ECB/2014/10 ‘amending guidelines for ECB/2011/10’ last month.

The ECB’s line seems to be that this was simply a move to bring all the ratings from different agencies into line for collateral, so they correspond to the correct level in the other agencies. This is a fair point, but the timing seems more than coincidental, especially since these rules have been in place since 2011.

The thinking is that, without this change, demand for Portuguese debt would have been limited since it couldn’t be used to gain liquidity from the ECB (we explained here why ratings are still important for just this reason). As such, the ECB looks to have given Portugal a helping hand.

We have written before about concerns over the ECB’s independence during the crisis, particularly in relation to adjusting its technical rules to aid struggling countries. This seems pretty close to falling into that category and highlights that, even though the crisis has eased somewhat, the ECB still finds itself treading some difficult boundaries with regards to its independence.

All that said, this remains a positive, if small, first step for Portugal. Questions remain about whether it will be able to fully fund itself without a credit line from the EU/IMF and whether export growth will be enough to offset the collapse in domestic demand and investment.

Can the real Super Mario please stand up?

Former Italian Prime Minister Mario Monti may be out of Italian politics, but it's fair to say he still likes to talk - especially when travelling abroad.

In an interview with Belgian daily De Morgen and Dutch daily De Volkskrant, Monti seems to hint at what many Bundesbank-fearing Germans already suspected: that the ECB's pledge to do "whatever it takes" (i.e. the OMT, the new bond-buying scheme) was de facto grounded in a political decision - contrary to what the ECB's mandate dictates.

Here is what Monti said in the interview:

[At the June 2012 European Council], I have used my full negotiating position in order to get a line approved that looks boring at first glance. At 4 am, the signatures of all leaders had been provided, including the ones of [German Chancellor Angela] Merkel, of my good friend the Dutch Prime Minister Mark Rutte, and of Finnish Prime Minister Jyrki Katainen, you can say the monetary firepower from the North [...] The line established, in short, that eurozone countries who did their homework, like Italy, were guaranteed ECB support. That statement – at the highest political level – didn’t impress the markets, because the leaders did have the authority, but no money. One month later, ECB President Mario Draghi came out with his famous statement: the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. That did calm the markets, because Draghi did have the money. 

Monti is clearly trying to claim some credit - and the headline of the interview in De Volkskrant is actually "Mario Monti: the man who saved Europe". However, if Monti is right, it clearly means that the ECB's political independence was seriously compromised, since, strictly speaking, there should be no link whatsoever between a political agreement and ECB action..

Draghi's statement is one of the main reasons behind the fall in borrowing costs for countries in the eurozone periphery - some of which have yet to deliver on real economic reform. Monti may have given Draghi some of the credit - but he has also given fuel to those Germans who fear the ECB's independence is a thing of the past.

Has the ECB actually moved closer to QE?

There has been a cacophony of comments from ECB members and ECB watchers over the past few days. However, the overriding view since ECB President Mario Draghi’s press conference last week is that the ECB has now moved a step closer to unconventional action such as Quantitative Easing (QE).

This is mostly down to two factors. First the following statement from Draghi’s presser:

“The Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation…this statement says that all instruments that fall within the mandate, including QE [Quantitative Easing], are intended to be part of this statement. During the discussion we had today, there was indeed a discussion of QE. It was not neglected in the course of what was actually a very rich and ample discussion.”

Second, the FAZ report over the weekend that the ECB has been modelling the impact of a €1 trillion per year (€80bn per month) QE programme. While it suggested that such a programme would only raise inflation by between 0.2% and 0.8% (not a significant amount given the cost), the simple fact it is being modelled has been enough to give markets hope.

We believe QE or similar measures have become a bit more likely, but mostly because the market now seems to expect action and if the ECB is to maintain its credibility it will need to do more than simply talk.

That said, while there may be ‘unanimous commitment’ to using such measures when needed, it’s still not clear what the criteria are for such action and it is even less clear that all members of the GC agree on when such action would be needed. Draghi was pushed on this on the first question during the Q&A session, however, he never provided a direct answer.

Furthermore, much of the coverage has suggested that QE is in fact closer because the ideological opposition to such a measure at the Governing Council (GC) level has crumbled - although we're not sure that such a clear unified opposition ever really existed.

With this in mind then, it’s worth once again pushing the point that, in fact many of the issues with further easing are practical, political and/or legal rather than ideological at the ECB. We have previously analysed each measure in detail, below is a summary and links to all those posts:

Quantitative Easing (purchasing government debt)
We have detailed the issues extensively here (but also here and here). Draghi has hinted of these practical issues before, highlighting that they need time to design the programme and gather more information. Beyond political opposition in Germany and the legal limits to ECB financing governments, there is a clear problem in that the purchases would need to split according to the ECB capital key, meaning little would flow to the periphery where the deflationary forces are strongest. Add onto this the fact that QE in other countries has not been proven to boost the real economy or even bank lending as well as that it may exacerbate the squeeze on safe assets and it becomes clear that practically and technically this would be a very difficult step for the ECB to take and is not well suited to tackling the problem of low inflation.

Quantitative Easing (purchasing private assets)
See our detailed analysis here. The thrust would be to target purchases of assets which would help promote bank lending – the main one discussed is Asset Backed Securities (ABS), particularly ones made up of loans to the real economy. However, these markets in Europe are small and underdeveloped meaning the level of assets available and suitable for purchase would be minimal. The ECB has suggested it wants this market to grow but it’s tough to force such a move, especially in the short term.

Negative deposit rate
We analysed this option here. Since then the ECB seems to have made progress on the technical implementation of such a move. That said, the impact remains very uncertain. It could further reduce excess liquidity, force money market funds to shutter and force banks to pass costs onto consumers. On the plus side it could help weaken the euro.

A targeted LTRO (similar the Bank of England’s Funding for Lending Scheme)
Discussed, with other measures, here. A fairly simply option to take, however, given that there is already full allotment (unlimited liquidity at low rates) and banks have already repaid a lot of the previous LTROs there is no guarantee there would be any significant take up or that it would filter through to the full economy.

Ending sterilisation of the Securities Markets Programme (SMP)
A smaller measure, discussed in this post. While it would stop liquidity being drawn out of the system on a weekly basis, it’s not clear that this liquidity would flow to the real economy.

Further standard measures such as rate cuts and changing collateral rules
We rounded up such options a while ago here. Given that rates are already so low and that the transmission mechanism remains broken, the impact of such moves is likely to be limited to signalling intent rather than hoping for any significant return.

Overall, nearly all of these measures face quite serious practical, technical and/or legal obstacles.

Furthermore, it is unlikely that there is any consensus at the ECB GC level of when each measure is needed or what the triggers for such action are. The obstacles are also probably viewed to be different sizes by each national central bank. All that is to say, while it may have moved slightly closer, don't yet count on QE being much more than a last resort.

Expectations and pressure mount for ECB action

This could easily be a standard monthly headline. As before the past four or five ECB meetings, the questions of deflation and further easing are once again weighing on the ECB Governing Council and the markets.

Over the past month the market has come full circle from essentially ruling out any further ECB action to almost expecting some purchases of assets (both accompanied by the respective strengthening and then weakening of the euro exchange rate).

This was topped off today with the latest inflation data which showed that inflation in the eurozone has dropped to its lowest level for five years (annual rate of 0.5%).

A couple of points to note on this data:

• While energy prices are still the largest driver of the contraction, unlike some previous months, core inflation (without energy, food prices or tobacco) has also fallen. This may encourage the view that the decreases are not simply due to short term shifts in commodity prices.
• That said, the core inflation rates remain above where they were in November 2013 when the ECB previously cut rates.
• Other national inflation data has been quite weak – Spain moved into outright deflation in March, while German inflation was running at only 1%.
• As Gavyn Davies noted on twitter, the 0.5% rate falls outside of the ECB’s March projections for inflation this year and up to 2016. This raises questions about whether the inflation rate is still on the upward path forecast. Combine this will the volatility and tendency to strengthen of the euro and the ECB’s projections do not seem to be holding up too well.

The other aspect adding weight to expectations has been dovish comments by ECB members, notably by Bundesbank President Jens Weidmann. Many believe this has “opened the door” to significant action by the ECB. Open Europe’s Raoul Ruparel addressed this issue on his Forbes blog on Friday arguing:

“The real issue from a German perspective is not necessarily that the door was ever firmly closed (or open) but that we remain someway from the QE door and to get there would require carefully negotiating some politically and legally explosive obstacles.”

He concludes:

“In the end, I think we find ourselves in a fairly similar position to last month (albeit having gone through a cycle of over scepticism and now over optimism) – further action remains possible but not yet highly likely.”

This meeting will be another one to watch but so far the ECB seems strongly wedded to its new communication and forward guidance policy, which it believes can allow greater control over rates markets, it is not yet clear whether it is willing to abandon this approach or push it over the barrier into full on policy action.

ECB stands firm but looks to wider measures

Over on his new Forbes blog, Open Europe’s Head of Economic Research Raoul Ruparel lays out his take on why the ECB decided to stand firm despite the apparent deflation threat,

“My feeling is that there are two broad reasons. The first being that the flow of data is mostly positive, and the second, more important factor, being that none of its tools are economically, politically or legally suited to tackling the low inflation environment in the eurozone.”

He concludes,

“All in all then, the tools at the ECB’s disposal are far from suited to helping push up inflation in the struggling countries and boosting lending to the real economy to help economic growth. This is not to say the ECB would never use them, but that are better suited to a deeper more acute crisis (such as a break-up threat) than the chronic long term malaise which the eurozone currently finds itself in.”

These are themes we’ve explored plenty of times on this blog so won’t rehash here.

But there were a couple of other interesting points to come out of ECB President Mario Draghi’s press conference though.

The first being his mention of a new dataset which the ECB is looking at, specifically the “the high degree of unutilised capacity” in the eurozone economy. This refers to the ‘output gap’, i.e. the amount by which GDP in the eurozone has fallen below potential GDP. As you might imagine, estimating such a gap is fraught with difficulty and estimates are notoriously revised retrospectively (for example before the crisis few economies were seen performing above potential despite huge financial, real estate and debt bubbles).

Why is this important? Well, it could be the first step towards a more firm GDP target on the part of the ECB. Admittedly, it’s a small step and a full GDP target is unlikely but it could be an interesting shift for the ECB which has traditionally focused more on inflation, money market and private sector survey data (such as the PMIs). As Draghi himself said, it also shows that monetary policy will stay looser for longer, even if the data improves, due to the large gap between actual and potential GDP. It will be interesting to watch how this one develops over the next few meetings and whether the ECB decides to put any more emphasis on this measure.

ECB preview - ECB may take limited action but shy away from serious intervention

As we noted last month, a lot has been pinned on the March ECB meeting, with the release of new data potentially facilitating further easing action.

But on the eve of the meeting, analysts remain split, although the sense is that the pressure for significant action is easing. February’s inflation data came in above expectations, with core inflation (removing the effect of short-term moves in energy and food prices) actually at 1% - still very low but well above expectations. We’ve also seen positive PMIs (indicators of private sector business activity) across the eurozone and in some of the struggling countries, although France remains behind the curve.

With that in mind, it looks as if the ECB will shy away from taking a major decision on Quantitative Easing or a negative deposit rate. These remain drastic actions which the ECB is clearly unsure about, and with good reason. It’s not clear what the side-effects would be of such action or that it would actually feed through to tackling low inflation in the periphery or boosting lending to the real economy (and therefore economic growth).

There are a few other options on the table. Another, more targeted long-term lending operation (LTRO), or purchases of private sector assets, probably packaged bank loans (asset-backed securities). These are possible and more likely than the above, but for reasons discussed before, would also be quite a big step by the ECB.

The most likely options remain a token rate cut (i.e. one without an accompanying cut to the deposit rate), a further extension of the unlimited fixed rate liquidity provision and the end to ECB sterilisation of the Securities Markets Programme (SMP) bond purchases. We have outlined before that, at this stage, a rate cut makes little difference as the transmission mechanism is broken, at least to the areas where the impact of the cut would like to be felt. Extension of the liquidity provision is also broadly inferred and was always expected to go on as long as is needed, in line with the forward guidance given.

We’ve yet to discuss the end to sterilisation, so we lay out a few points below.

As a recap, the SMP was a programme launched in 2010 to purchase government bonds on the secondary market and bring down borrowing costs for certain countries (which were hampering the transmission of monetary policy). The sterilisation process sees the liquidity introduced by these purchases absorbed by the ECB, through the issuance of corresponding amounts of one week fixed-term deposits with an interest rate of 0.25%.

ECB SMP sterilisation total amount (€m)

Why take this measure?

• The idea is that ending the sterilisation would free up the €175bn in liquidity currently pledged to the ECB. This will counteract the recent decrease in excess liquidity in the eurozone and should encourage banks to lend this money out rather than simply posting it with the ECB.
• From a political perspective, this is also one of the least controversial actions since it has been endorsed by the Bundesbank and should be fairly easy to get support for at the ECB Governing Council.

Will it have any impact?

• It is unclear, but we are not overly hopeful. As the chart to the right (courtesy of Commerzbank) highlights, the earlier tensions in money market rates have eased. This means the impact will be limited.
• Ultimately, it depends on what banks decide to do with this money. The ECB deposits were a very safe investment with a decent return given the ultra low rates around at the moment. Our feeling is that banks will want to continue to search for equally safe assets rather than take on much more risk for a similar return over a short period. This could actually acerbate the demand for quality short term assets, particularly core ones, in the eurozone.
• Despite some failings in the sterilisation (shown by sharp deviations in the graph) demand has been fairly solid, although whether this is due to demand for safety or a decent return is unclear.
• The fixed-term deposits are also eligible as collateral for the ECB’s lending operations. It’s not clear if they have been used for this purpose, but if they were, this could further limit the impact in terms of boosting liquidity.

Ultimately, ending SMP sterilisation would be a token compromise measure. Its greatest use is probably as an indicator of an on-going willingness to ease if needed, and of the ability to compromise on the issue from the Bundesbank side. 

German Constitutional Court believes ECB bond buying is illegal, but asks ECJ to rule first

Hanging up their robes? Ball is now in ECJ's court

As has been widely reported this morning there has been some surprising news out of Karlsruhe with regards to the ECB's bond  buying programme and its legality.

Our full take is here, with the summary below:

Summary: The German Constitutional Court (GCC) – Bundesverfassungsgericht – has referred several questions surrounding the ECB’s Outright Monetary Transactions (OMT) programme to the European Court of Justice (ECJ). It is evident that the Court believes the OMT is illegal and incompatible with EU and, therefore, German law. However, the Court only has jurisdiction to rule on matters of German domestic law. It therefore argues that it must refer the key questions to the ECJ – the body which interprets EU law – given that the ECB’s mandate and any overstepping of EU treaties is obviously a question about EU law.

The ECJ is likely to side with the EU institutions and rule that the OMT is compatible with EU law, with the GCC likely to therefore say its hands are tied. Still, the decision throws new uncertainty into the fragile eurozone economy and could hamper the recovery. The GCC may also, in its interpretation of the OMT’s compatibility with German law, insist in new red lines - potentially limiting the level of purchases. This itself would severely restrict the role of the ECB. 

Markets, while briefly spooked, seem to have broadly recovered, whilee the euro remains slightly weaker. This doesn't seem to have had much impact, with many coming round to the view that the OMT will remain practically usable until the ECJ almost inevitably fully approves it.

The broader fallout is interesting, as this case has often been cited as one of the remaining risks in the eurozone. Despite the GCC's strong objections to the OMT, this could end up actually bolstering the ECB's position.

More generally as well, it does raise questions about Germany's role in monetary policy and the GCC's role. On EU related issues it is ultimately bound by the ECJ's interpretation of EU law. Furthermore, we can't help but feel that the Court has tried to somewhat dodge this very difficult and politically sensitive decision. It also suggests Germany may be struggling to fulling impose its will over monetary policy - although it clearly remains very powerful and many would argue continues to hold action such as asset purchases at bay.

Nonetheless, plenty of food for thought and an interesting shift in the dynamic of the eurozone.

BILD up in arms about Greek bailouts once again

This is the front page of Germany’s (and Europe’s) largest  newspaper Bild. The headline reads:

“Greeks richer than us! ...But [the German] government plans new billions of aid.”

Now this is not exactly a surprising or rare occurrence – we have pointed out the tabloid's concern with the bailouts and other eurozone crisis actions before.

The story is based on the ECB wealth survey published last year. But as as we detailed on the blog at the time, the survey is actually quite misleading since it is based on old data and distorted by the much higher home ownership in peripheral Europe than in Germany. It also misses the point that tapping into such ‘wealth’ would be incredibly difficult.

In any case, with Greece continuing to struggle, even while the rest of the eurozone posts some positive results, the chances are that further assistance will be needed at some point. This remains a tricky proposition in Germany (and Greece, given the strings attached, we might add).

Are further falls in inflation putting more pressure on the ECB to act?

Friday saw the release of the flash estimate for annual inflation in the eurozone in January. It dropped further to 0.7% - well below the ECB’s target of 2%.

The initial reaction was that this will increase pressure on the ECB for action at this Thursday’s Governing Council meeting. While that is true on the surface its worth keeping another couple of points in mind.

• As the graph above shows (click to enlarge), much of the recent decline has come from changes in energy and food prices. Core inflation, excluding these two factors, has been relatively stable since October and has been on a gradual decline since spring 2013.
• Now of course, many will point out that energy and food are important components of real world costs and therefore should not be discounted. This is a valid point, but here we are looking for insight into how the ECB takes its decisions. Generally, the ECB will be less concerned over short term moves in energy and food prices and is therefore less likely to take action off the back of this.
• The main part of the decline took place last year and has been happening for some time – this is likely already accounted for in the ECB easing efforts.
• While the inflation data may not push the ECB to act, there are plenty of other concerns. The turmoil in Emerging Markets could push the ECB to provide an additional liquidity buffer against any shocks. While this morning’s PMI manufacturing data was actually very positive for the eurozone, data on lending to the real economy and growth of the money supply is less so.

As we have suggested before, some further easing is looking likely. The real question is when and how? The data suggests to us that the ECB will wait until its March meeting and its updated inflation forecasts to make a judgement – but then again it went a month earlier than expected in November.

As for how, the most likely tools remain some form of targeted LTRO and/or purchases of bank loans but both programmes would require significant work and have numerous shortcomings, as we have already noted.

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?

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.