The debate over giving the European Stability Mechanism (ESM) a banking licence has generally focused on the efficacy of the mechanism as a buyer of bonds. However, another possibility – mooted by analysts at Royal Bank of Scotland as the real policy game-changer – would be to use a licensed ESM as a vehicle for the purchase of loans from peripheral banks to try to kickstart the transmission of monetary policy.
The argument is that although liquidity solutions play a valuable role in stabilizing funding costs and discouraging capital flight, they don't do enough to encourage lending to corporates, particularly small and medium-sized enterprises. "Liquidity injections are just anaesthesia, not the cure," as an RBS report puts it.
The failure of decently capitalized banks has blighted the eurozone's economic recovery. This problem has been recognized by the Bank of England with its Funding for Lending scheme, following the poor performance of Project Merlin. There has even been talk of fully nationalizing RBS as a means of forcing it to increase lending. RBS’s head of European macro credit research, Alberto Gallo, told a conference call yesterday that the main reasons that banks aren’t lending is to try to preserve capital. Banks need the capital to provision against bad loans – exemplified in BBVA and Santander’s earnings reports. Gallo notes that 85% of variation in bank spreads can be attributed to asset risk.
Gallo argues that lending won’t increase so long as fears over asset quality persist, blighting the quantum of capital that banks feel comfortable lending. Having the ESM purchase performing loans from low-lending banks would give these institutions an injection of capital. The freed-up capital would then, the theory goes, be used for further lending.
However, an asset-purchase scheme would do little to help if – as some theorize – the lack of lending in Europe stems not from nervous banks but from corporates so dismayed at the state of the economy that they are unwilling to borrow.
And while Gallo argues that capitalization through this method rather than more simple capital injections allows public institutions to avoid equity risk, it does expose them to the risk of these assets dropping in quality. Just because the assets are performing at the time of purchase does not necessarily mean that they will continue to do so.
“Why would the ECB want to take on that credit risk?” asks Suki Mann, senior credit strategist at Société Générale. “Checking the quality of these loans would be a laborious process, and perhaps not an efficient use of time and resources. A lot of these loans are unlikely to be rated, and somebody needs to do the donkey work.”
Even if the idea raises some issues that needs to be addressed – and is likely to be stridently opposed by core countries – it seems to be one that deserves more debate since ramped-up credit supply to the real economy is desperately needed to boost growth.