It is now ten years since the 2008 financial crisis and eight years after the sovereign debt crisis. There is no doubt it has been an unusual period from the point of view of the economic cycle, and the ECB response has been unique. In one word, it has been unconventional.
Now that it is very close to the end of quantitative easing (QE), as Mario Draghi implicitly confirmed last month and as can be seen in the chart below, it is interesting to take a look over the past years, to judge whether this monetary policy has been successful or not, and to analyse the potential effects of the QE slowdown.
Why are the demand and supply of credit considered important to evaluate and determine the effectiveness of such measures? The financial structure of the euro area differs mainly from those of other economies, such as the UK and the US, in that banks play a crucial role both in the financing of the economy and in the transmission of the monetary policy measures. Therefore, while in their operational framework the Federal Reserve and the Bank of England mainly buy and sell assets and securities in their open market operations, the European Central Bank operates principally through the lending channel, usually using short-term Repo-Refinancing operations. In addition, in the euro area, SMEs compose almost 99% of all the firms, which mostly rely on bank lending rather than on the market. Thus, the target of the unconventional measures by the ECB has been that of reactivating the traditional channels, namely the credit and the interest rate channel, by which the monetary policy operates in normal times.
Therefore, changes in demand and supply of credit to enterprises are undoubtedly a good variable to consider in order to assess whether the monetary policy has been effectively transmitted to the real economy throughout the banking system. Indeed, the dominant goal of
these non-standard measures is to support the financial intermediation process, the drivers of the credit intermediation sector will be put in the foreground, to eventually determine if the measures have been able to restore the monetary policy transmission mechanism. To do so, it is needed to look at the BLS (Bank Lending Survey) and the ad-hoc questions carried out four times a year by the ECB and addressed to loan officers of a representative sample of euro area banks. Specifically, each unconventional policy implemented by the ECB will be examined and its effectiveness in meeting the target will be assessed in light of the subsequent Bank Lending Survey.
The Financial Crisis and the Great Recession
When trouble started during summer 2007, central banks worldwide intervened by providing liquidity to the markets using the conventional tools of monetary policy. However, simply lowering official interest rates was not enough. The spread between the 3 month
Euribor and the overnight interest rate, EONIA, which normally is around 0.1%, reached a peak of 1.56% on October 13, 2008. Market liquidity reduced tremendously negatively affecting the expectations of the euro area money market.
As the chart about the supply of credit indicates, from the second quarter of 2007 (emphasized with a vertical red line in the chart) there has been a significant increase in the net tightening of credit standards of loans to enterprises. The main factors in this tightening were the expectations regarding future economic activity, and in a secondary manner, the impact of banks’ funding costs. On the contrary, the chart below reports data about changes in net demand for loans to enterprises.
The net demand declined further and remained negative in the third quarter of 2008. A decline in the need for financing for fixed investments, as well as continued negative demand stemming from M&As and corporate restructuring mainly drove this decline.
In this phase, there was a severe banking crisis consisting in an increased instability arising from a marked increase in counterparty risk. If expectations about economic activity and industry outlook require time to be reversed, from the lending channel point of view factors are relatively easier to manipulate. Thus, the first concern of the ECB was to accommodate the funding needs of banks. Using conventional
instruments, it decided to drastically reduce its key interest rates to a value relatively close to zero within a seven-month period (October 2008 to May 2009). Moreover, the ECB decided to complement this measure with ‘Enhanced Credit Support’ (ECB 2010), a set of unconventional and temporary policy measures including the famous 3-month and 6-month Long-Term Refinancing Operations (LTROs).
Specifically, LTROs were implemented to reduce uncertainty on the markets, thus keeping interest rates at low levels and to provide to banks a wider liquidity planning horizon. ECB wanted to stimulate interbank lending and encourage banks to provide credit to enterprises and households.
The April 2009 survey represents the turning point, at least looking at the credit standards applied to loan to enterprises. Despite a further net tightening, this tightening was 21% lower than the previous one, indicating some stabilisation of the tightening cycle. Conversely, net demand continued to decline, mainly reflecting the wider temporal horizon needed by the enterprises to change their expectations.
The Euro Area Sovereign Debt Crisis
In the first half of 2010, the sovereign debt crisis began with market expectations about a possible Greek sovereign default. The entire world realised Greece could default on its debt causing a potential domino effect which could impact Ireland, Portugal and even Italy and Spain. Government bond markets started to dry up and, given their importance, banks and the European Union itself were at risk. Overall, net
tightening of credit standards for loans to the enterprises started again to worry the eurozone, after the stabilisation observed during summer 2010. Specifically, the net tightening of the credit standards observed from summer 2010 was mainly due to renewed constraints in banks’ access to funding, an aspect strictly linked with the deterioration of banks’ balance sheets.
On the contrary, the second phase of the sovereign debt crisis was characterised by the ‘bank-sovereign’ nexus, which amplified the negative movement. During the summer of 2011, the crisis struck Italy and Spain, and the government bond markets of Southern Europe became dysfunctional. Depressed sovereign bond prices weakened bank balance sheets across Europe. Within this framework, the ECB was called to provide not only short-term liquidity support but a commitment to a longer-term solution, to allow the banks to reach a sufficient capital level. It implemented a new set of measures, including two 3-year LTROs, called VLTROs (Very Long Term Refinancing Operations). The first one was launched in December 2011 with an amount of €489bn, with the second launching in February 2012 with an amount of €529bn.
The line that ‘all the unconventional measures are temporary in nature’ proved to be counterproductive. Therefore, the ECB finally committed to acting as a true lender of last resort for the banking system. The most revolutionary measure was the announcement of the Outright Monetary Transaction (OMT), essentially the ECB’s plan to buy bonds issued by eurozone members, in September 2012. The announcement followed the ECB’s commitment to ‘do whatever it takes to preserve the euro’ announced during Draghi’s press conference on the 26th of July 2012 and consisted of the ECB’s potential intervention in secondary sovereign-bond markets of euro area member countries.
Deflationary Risk and a New Phase of Unconventional Measures
During the first half of 2013, banks started to repay in advance the 3-years LTRO loans and both tensions in money markets and bond markets receded. However, instead of reducing risk-weighted assets by raising capital or disposing of non-core assets, banks started to reduce lending, mostly because the return on loans was too low. By mid-2014 it was evident that the recovery had lost momentum. The ECB, therefore, was called to act with new measures. However, with interest rates already very close to zero, the ability to intervene through traditional measures was constrained. In June 2014 a new phase of unconventional measures was launched. The distinguishing features of this extremely unconventional phase were negative rates and the switch to an active steering of the ECB balance sheet. It is necessary to highlight how this phase of the ECB monetary policy perfectly responded to the need to provide loans to the real economy.
As observable in the chart above, from 2013 to 2015 the credit situation in both the supply and demand perspective gradually improved. The impact of the sovereign debt crisis disappeared, lowering the risk perception and gradually decreasing the net tightening of credit standards for loans to enterprises. The turning point for both demand and supply of credit was reached at the beginning of 2014. For the first time since the second quarter of 2007, euro area banks reported a net easing rather than a net tightening of credit standards on loans to enterprises, while net demand returned to positive values for the first time since 2011.
As shown in the chart above, 2015 and 2016 were characterised by a strong recovery in the growth of loans to enterprises. According to the various reports, credit standards eased during this period, mainly inspired by the increased competition in the banking sector partially due to the TLTROs. Despite the short parenthesis of the January 2017 survey, when it registers the first net tightening since 2013 due to specific and temporary developments in the Netherlands, the first half of 2017 shows a general stabilisation of credit supply and an increasing net demand.
The Final Judgement
In the unparalleled complex period analysed, the ECB has taken a series of measures to deliver on its mandate, responding successfully to the financial crisis and sovereign debt crisis at first, and then preventing a prolonged period of low inflation.
In the bank-based euro system, the funding and lending channels are not completely isolated from the key analysis measures such as GDP growth, inflation rate, unemployment rate and government bonds’ spread, but rather it deeply interacts with them because of the transmission role played by the banking sector. It is clear, looking at the lending surveys, that these events have been positive in their ability to partially improve the lending channel and restore the monetary policy transmission mechanism. Interestingly, the ECB proved through the unconventional monetary policies how central banks can remain potent even when the interest rates are close to zero.
It is more difficult to evaluate the measures implemented after the sovereign debt crisis. Lending surveys indicate that ECB’s credit easing and quantitative easing measures have incentivised banks to start competing again for good credit, pushing down rates and putting into reverse the negative lending cycle. This has decreased margins and lending rates have continued to fall, leading to a gradual easing of credit standards and a subsequent impact to the economic recovery. The impact is observable, the first signals of recovery as well, but the question is: is it durable?
The effectiveness is strongly dependent on other policies that put the economic and financial sector in a position to positively react and amplify the monetary impacts. These include new regulations on euro area banks and the structural reforms previously implemented, especially those done so during the financial and sovereign debt crisis. This is a crucial point. As long as the monetary policy and more broadly the ECB remains the only institution providing stimulus, the recovery momentum will not be durable, because the roots of the issues have not been tackled efficiently.
For this reason, the final judgement about the first phase of unconventional monetary policy measures addressed to respond to both the Financial Crisis and the Sovereign Debt Crisis is undoubtedly positive, especially if the seriousness of the periods is considered. The judgement about the new phase of unconventional measures is not unreservedly positive. Despite the new phase of measures providing an impulse to the economy and to expectations, attributing everything to the ECB would be misleading because the overall picture is improving as part of the normal economic cycle. The chart below shows how the level of flows of loans to a non-financial corporation in the euro area is still a long way from pre-crisis levels.
So, what is the next step? With interest rates at zero and the awareness that monetary policy is only one actor in the context, the hope is that new reforms will impact expectations and investments. It could sound contradictory, but if governments and institutions start to implement the structural reforms necessary to fully exploit the central banks’ monetary policy measures, the recognition of the limits of the ECB could become the key factor for the success of the measures. There is only one issue at the moment: QE is stopping and no revolutionary reforms have been realised so far.
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