Loan appeal

Cleaner Banks Mean Cleaner Lending

Maybe I could count these banknotes a bit more slowly.
  • Why it matters

    Why it matters

    Cleaning up banks’ balance sheets is key to reviving the euro zone’s struggling economy.

  • Facts


    • The ECB’s efforts to encourage bank lending have fallen short of expectations.
    • There is no one reason for sluggish lending, and no easy remedy, the author argues.
    • The ECB will release the results of a comprehensive assessment of banks in mid-October.
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The economy in the euro zone is faltering. Part of the blame lies with sluggish lending, even though the European Central Bank has taken several steps to make lending more appealing to banks – and borrowers. Rarely have interest rates been this low and the availability of inexpensive, long-term central bank liquidity been as ample as it is today.

But the results of the most recent monetary policy measures have been disappointing. The use of targeted longer-term refinancing operations (TLTRO), in which the provision of liquidity is partly tied to bank lending, has remained well below expectations. Whether the liquidity taken up by the banks will be converted into actual loans is uncertain. But why isn’t lending getting underway?

There are three answers to this question, and they are not mutually exclusive. First, businesses and households don’t want to borrow; second, banks don’t want to lend; third, the banks are unable to lend. In the first case, the limiting factor would be the demand for credit, and in the second and third cases it would be the availability of credit. The recommended treatment varies, depending on the diagnosis.

If demand for credit is the limiting factor, we should focus our attention on investment conditions in the euro zone and not as much on the banks. It is difficult to contain uncertainty over geopolitical risks, but a flexible labor market, social welfare systems capable of withstanding future challenges and a functioning and digital infrastructure are the key underlying conditions for a favorable investment climate.

Why isn’t lending getting underway? First, businesses and households don't want to borrow; second, banks don't want to lend; third, banks are unable to lend.

But this is where governments come in, not the ECB.

If banks are unwilling to lend because borrowers are not sufficiently creditworthy, it wouldn’t be advisable to convince banks to lend anyway. It would be fatal to convince them by promising to buy up their receivables, or money owed to them. Even before the financial crisis, the only reason lenders approved many bad loans was that they knew they could sell them again later on.

A third explanation is that the banks, especially those in the crisis-hit countries of the euro zone, would like to lend more but are not in a position to do so. This is why investment projects that make sense economically are not materializing. It certainly isn’t for lack of liquidity.

What the banks lack is equity capital, because not even their current risks are adequately covered. Making liquidity available at attractive rates and buying up collateralized debt could gradually clean up bank balance sheets. But this isn’t a task for monetary policy.

The ECB’s ongoing comprehensive assessment creates a great opportunity. Its objective is to uncover latent risks in bank balance sheets through a series of stress tests. The banks will have to close any capital caps that are discovered by procuring new equity capital. If the market is unwilling to provide equity capital, this raises the question of whether the institution is even sustainable or would be better off being shut down.

The ECB's ongoing comprehensive assessment creates a great opportunity.

It remains to be seen whether the political will to shut down banks exists. A complicating factor is that the new European mechanisms for winding down ailing banks haven’t even been put into place yet.

If the ECB misses the opportunity to bluntly expose problems in the banking sector and to achieve either recapitalization or the shuttering of weak banks, lending – and probably the economy along with it – will not get off the ground again anytime soon. Weak banks will still be kept artificially afloat by the central bank.

Additional monetary policy measures, including those in the form of quantitative easing that involves bond purchases, would hardly stimulate lending. Instead, these measures only reduce the pressure on countries to implement structural reforms, and they tend to reduce the demand for credit.

Buying up packaged loans of dubious quality – with or without government guarantees – could increase the availability of credit, but certainly not in the desired way. Only if the banking sector is finally cleaned up can we hope for a revival of lending in the euro zone. That is what the European Central Bank can and should do.


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