You have to admire Mario Draghi’s nonchalance. The president of the European Central Bank, which is about to buy asset-backed securities, said this will be “simple and transparent.”
Mr. Draghi might keep on saying that, but no matter how often he repeats it, it doesn’t make it any truer.
These products are not by their nature simple and transparent; they are complex and opaque. Asset-backed securities are bundles of thousands of loans whose credit-worthiness varies. The only person or institution who knows how likely it is that these loans will be defaulted on is the issuing bank, which is closest to the customers. Neither the rating agency nor the ECB – which doesn’t even have its own valuation method – are able to evaluate the ABS.
That’s why Mr. Drahi’s logic is only briefly appealing: mainly southern European banks are denying their services to the economy; they aren’t giving businesses enough credit mainly due to the banks’ own difficulties, along with lower demand because of the crisis. They don’t have enough capital and they can’t get it from governments which are in debt; they’re not going to get it from private investors who are now more cautious; and the ECB isn’t allowed to give it to them.
Then along comes Mr. Draghi with his good ideas: the ECB won’t hand out capital but it will buy bundled loans from the banks, thereby freeing up some of the banks’ capital that can then be spent on new loans.
On closer inspection, this logic is fatal, for several reasons. For one thing, it’s problematic to force banks in recessive economies to get involved with risky loans.
It’s even more problematic to say right from the start, “go ahead banks, we, the ECB will buy all that off you.” That kind of incentive leads to results like the subprime morgage crisis. The banks stopped looking at their customers’ credit-worthiness because they were going to bundle the mortgages anyway and sell them to investors, first in the United States and then worldwide. Now, eight years later, we are still reaping the results of this development, which brought the global financial system to the edge of the abyss.
Losses are inevitable; they’re part of the plan.
It doesn’t make any difference that the ECB is supposedly only buying high quality ABS. It is still exposed to an enormous risk, because compared to the banks who know their customers, the ECB lacks such information. Economists have long known what such an asymmetrical distribution of information means: the loser is the one with less information. The bank managers are rubbing their hands. They won’t hesitate to offer the ECB the loans that they know to be problematic. Who can blame them? They’re probably required to do that in the interests of their shareholders.
Things get even stranger if you consider that Mr. Draghi would have to hope the banks will do this, if the ABS purchases are to have an enlivening effect on the loan business. If the banks only sell their good loans, they won’t release much equity. No wonder Mr. Draghi is calling for governmental guarantees against losses. He knows such losses are inevitable; they’re part of the plan.
Everyone accepts that Mr. Draghi has a legitimate struggle against credit crunches, deflation and unemployment in the euro zone. But he is fighting the battle with the wrong means. Mr. Draghi’s response would reduce the banks’ responsibility and make them irresponsible when issuing loans. That creates long-term damage to the stability of the system. There is no way out of this dilemma.
Mr. Draghi was right when he said the ECB would not to give credit to zombie banks. But he is wrong if he believes that he can solve this problem by taking on the banks’ toxic assets instead.
The only right way is long and difficult. Weak banks unable to obtain equity have to be systematically closed down as in the United States. Only then can the strong ones be in a position to finance the real economy in the long term.
But Mr. Draghi is choosing a different route. For years he has given zombie banks an artificial lifeline of liquidity, though liquidity can’t be a replacement for capital. And the fear is that even the bank audit and stress tests will only maintain the illusion that the things are not as bad as they seem in the banking sector. In Mr. Draghi’s world, any bad news that could endanger financial stability or opposes the ECB’s monetary policy goals is carefully meted out in bite size chunks. In the short term, this strategy can rescue the system from collapse. But in the long term, this strategy prevents the system from being fixed properly. Mr. Draghi is making the wrong choice.
Jens Münchrath is an editor at Handelsblatt, and leads the newspaper’s economics and monetary policy reporting team. To contact him: firstname.lastname@example.org