LeveragedBuyout
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My commentary: The gist of the article is that economic growth in Europe has been stagnant because banks have not been lending to businesses, so businesses are unable to invest in new projects, hire employees, etc. The banks are afraid to lend because the regulators continually scrutinize the banks' balance sheets to make sure they have enough capital reserves vs. the loans outstanding, so the easiest way to make the bank look good to the regulators is to cut down on lending activities.
Several analysts hope that now that the regulator's tests are over, banks will be more willing to lend to businesses, and help the economies of Europe start growing. Bank lending is critical, since the other source of funds--investments--have thus far been flowing into less productive sectors of the economy (I am guessing they are referring to real estate) instead of high-productivity areas (i.e. the sectors that export). Bank lending is more likely to flow to more productive sectors, and thus increase overall productivity (and growth). Therefore, we can be optimistic that Europe may now start to recover.
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http://ftalphaville.ft.com/2014/10/28/2020672/now-that-thats-over/
Now that that’s over…
Matthew C Klein | Oct 28 18:02
Mario Draghi probably wasn’t expecting that his July 2012 comment that “the ECB is ready to do whatever it takes to preserve the euro” would coincide with the start of a relentless drop in bank lending to nonfinancial businesses far worse than what occurred during the first wave of the recession:
At least some of this decline can be explained by the lack of demand for credit in an environment of stagnant growth and relatively high real interest rates. But the robust growth of the euro-denominated corporate bond market — up by more than halfsince the start of 2009 — suggests that problems within the banks are also to blame.
Since the euro area’s financial system is dominated by a few big lenders, their dysfunction has prevented needed monetary stimulus from reaching households and businesses. Despite the incredible growth of the corporate bond market, total credit to euro area nonfinancial corporations was barely flat between the start of 2009 and “whatever it takes”. Despite the end of the acute phase of the sovereign crisis, the sum of bonds and loans outstanding has since plunged by a little more than 4 per cent:
We’ve already written about the ECB’s modest efforts to get around this problem by nudging the euro area towards greater use of capital market funding through the commitment to buy a large amount of asset-backed securities (and maybe corporate bonds too) — and while we think those will be helpful, we wonder how much can be accomplished by bond-buying when spreads are so tight and the rest of the financial system remains impaired.
This is where the just-completed stress tests from the European Banking Authorityand European Central Bank could come into play. Nearly all of the banks (by assets) passed! And that is despite the fact that some of the Italian banks may have been treated more harshly than they deserved.
True, one-fifth (by assets) barely made it. And one wonders how rigourous the Asset Quality Review must have been if lenders with a total of €22 trillion on their books only overstated their holdings by €47.5 billion (0.2 per cent). Similarly, the adverse scenarios were relatively benign in their forecasts of inflation and unemployment. Nor was there any consideration of the possibility that sovereign debt could be meaningfully restructured.
Even so, Daniel Davies, a semi-retired European banking analyst, thinks that simply ending the testing process could encourage nervous loan officers to become more aggressive:
By this logic, the actual results of the test were much less important than the fact that it encouraged European banks to increase their capital ratios after Draghi’s soothing words had effectively ended the sovereign debt crisis and lowered funding costs. Now, presumably, the real work of recovery can begin as the ECB unleashes its bond-buying at the same time that the banks feel empowered to lend again.
We have no view on whether this is right or wrong, since Europe has plenty of other problems beyond a lack of credit from the banks. These include, but are not limited to, a dysfunctional currency union, an overhang of bad debt, insufficient inflation, and stagnant productivity growth.
Suppose, however, that Davies’s optimistic interpretation is the correct one. How good could things get?
One clue is to look at the UK, which has puzzled observers for years with its odd combination of (relatively) rapid inflation, robust employment growth, and plummeting productivity. A recent paper from economists at the Bank of England and the Institute for Fiscal Studies suggested that these behaviours would be consistent with an economy on the receiving end of massive monetary stimulus, but whose faster growth is retarded by a broken banking system that has prevented resources from being efficiently reallocated from unproductive sectors to more productive ones.
(The euro area, of course, managed to get the broken banks without the palliative of the monetary stimulus.)
The result was that the UK ended up looking a little bit like much poorer countries, where a lack of trust prevents well-run firms from growing and displacing badly-run companies. (See here for more on this.) You can see how the recent recession and recovery in the UK were unusual by looking at the dramatic increase in the difference between the most productive and least productive sectors of the economy:
One explanation for the growth of these differences is that capital was not able to move across the economy to the places where it would earn the highest return. In a study of thousands of individual businesses, the researchers found that, since 2007, the gap between the rates of return on capital earned by the best firms and the rates earned by the worst firms has widened into a chasm. Yet capital has failed to chase these returns, since the distribution of resources across the economy is about the same as it was before the crisis:
As they put it:
Economists at Goldman think that the UK’s difficulty moving resources to where they perform best could explain why the current account deficit didn’t improve as much as it should have initially given the decline in the currency:
First, inflation has slowed down significantly both relative to where it was and relative to the US and Europe, even though domestic demand and employment have been growing faster in the UK than in either. And second, the UK’s trade deficit has held steady as a share of GDP when a simple model combining the real trade-weighted exchange rate with relative domestic demand growth of the UK and its trading partners would have predicted the deficit would widen by about 1.5 percentage points of GDP:
Both of those developments could be explained by an uptick in productivity caused by an improvement in the financial system’s ability to properly allocate capital.
If the end of the stress tests and AQR means that the euro area’s banks can get back to nudging resources where they will earn superior returns (and that’s a big if), it’s possible that the ECB’s bond-buying, combined with the latest Targeted Long-Term Refinancing Operations, could make more of an impact than sceptics currently assume. Something to keep an eye out for.
Several analysts hope that now that the regulator's tests are over, banks will be more willing to lend to businesses, and help the economies of Europe start growing. Bank lending is critical, since the other source of funds--investments--have thus far been flowing into less productive sectors of the economy (I am guessing they are referring to real estate) instead of high-productivity areas (i.e. the sectors that export). Bank lending is more likely to flow to more productive sectors, and thus increase overall productivity (and growth). Therefore, we can be optimistic that Europe may now start to recover.
---
http://ftalphaville.ft.com/2014/10/28/2020672/now-that-thats-over/
Now that that’s over…
Matthew C Klein | Oct 28 18:02
Mario Draghi probably wasn’t expecting that his July 2012 comment that “the ECB is ready to do whatever it takes to preserve the euro” would coincide with the start of a relentless drop in bank lending to nonfinancial businesses far worse than what occurred during the first wave of the recession:
At least some of this decline can be explained by the lack of demand for credit in an environment of stagnant growth and relatively high real interest rates. But the robust growth of the euro-denominated corporate bond market — up by more than halfsince the start of 2009 — suggests that problems within the banks are also to blame.
Since the euro area’s financial system is dominated by a few big lenders, their dysfunction has prevented needed monetary stimulus from reaching households and businesses. Despite the incredible growth of the corporate bond market, total credit to euro area nonfinancial corporations was barely flat between the start of 2009 and “whatever it takes”. Despite the end of the acute phase of the sovereign crisis, the sum of bonds and loans outstanding has since plunged by a little more than 4 per cent:
We’ve already written about the ECB’s modest efforts to get around this problem by nudging the euro area towards greater use of capital market funding through the commitment to buy a large amount of asset-backed securities (and maybe corporate bonds too) — and while we think those will be helpful, we wonder how much can be accomplished by bond-buying when spreads are so tight and the rest of the financial system remains impaired.
This is where the just-completed stress tests from the European Banking Authorityand European Central Bank could come into play. Nearly all of the banks (by assets) passed! And that is despite the fact that some of the Italian banks may have been treated more harshly than they deserved.
True, one-fifth (by assets) barely made it. And one wonders how rigourous the Asset Quality Review must have been if lenders with a total of €22 trillion on their books only overstated their holdings by €47.5 billion (0.2 per cent). Similarly, the adverse scenarios were relatively benign in their forecasts of inflation and unemployment. Nor was there any consideration of the possibility that sovereign debt could be meaningfully restructured.
Even so, Daniel Davies, a semi-retired European banking analyst, thinks that simply ending the testing process could encourage nervous loan officers to become more aggressive:
For the whole of 2014, there has been a sword of Damocles hanging over top management at nearly every Eurozone bank, because they have known that they are taking a test where failure has really bad consequences, and where the pass/fail mark was really quite opaque. And this wasn’t just the case at the small or marginal institutions – right up into the last week before the stress test, people were talking about Deutsche Bank as potential fail, and although I didn’t agree with this, I couldn’t definitively gainsay it (because nobody knew what the treatment of Level 3 assets might be).
In an environment like that, it’s very hard to manage the normal deposit-and-loans business of a bank, particularly the lending side. After all, as the bank CEO, one of the only things you know about this test is that it’s going to be based on a ratio and that risk-weighted assets are in the denominator of that ratio. So anyone who increases the denominator of that ratio is making your problem worse. So, there are no “employee of the month” awards going to branch mangers who make a load of loans, and Group Treasury (who are always alert to the emotional weather around head office) are going to be particularly cautious in allocating capital out to the divisions.
Now that Sword of Damocles has been lifted away. Not only do 137 out of 150 large European banks have a certificate of capital adequacy for the year, but they also have an idea of what their margin of safety is – in other words, the capital budgeting process can begin. That capital budgeting process hasn’t been possible in 2014, and since this the necessary first step in any bank’s planning cycle, it’s not surprising that the underlying business hasn’t been done either.
I think there is a potentially very large pent-up supply of credit which could come on stream in Euroland in 2015, representing all the number of times during 2014 when a bank manger has told a borrowing prospect “we’d love to do this deal, but we can’t, because of all the work we’re doing on the AQR”. If I’m right, I’d expect to see a big step-change in the ECB’s Lending Survey, in Q1 2015 or potentially even for the last quarter of this year.
In an environment like that, it’s very hard to manage the normal deposit-and-loans business of a bank, particularly the lending side. After all, as the bank CEO, one of the only things you know about this test is that it’s going to be based on a ratio and that risk-weighted assets are in the denominator of that ratio. So anyone who increases the denominator of that ratio is making your problem worse. So, there are no “employee of the month” awards going to branch mangers who make a load of loans, and Group Treasury (who are always alert to the emotional weather around head office) are going to be particularly cautious in allocating capital out to the divisions.
Now that Sword of Damocles has been lifted away. Not only do 137 out of 150 large European banks have a certificate of capital adequacy for the year, but they also have an idea of what their margin of safety is – in other words, the capital budgeting process can begin. That capital budgeting process hasn’t been possible in 2014, and since this the necessary first step in any bank’s planning cycle, it’s not surprising that the underlying business hasn’t been done either.
I think there is a potentially very large pent-up supply of credit which could come on stream in Euroland in 2015, representing all the number of times during 2014 when a bank manger has told a borrowing prospect “we’d love to do this deal, but we can’t, because of all the work we’re doing on the AQR”. If I’m right, I’d expect to see a big step-change in the ECB’s Lending Survey, in Q1 2015 or potentially even for the last quarter of this year.
By this logic, the actual results of the test were much less important than the fact that it encouraged European banks to increase their capital ratios after Draghi’s soothing words had effectively ended the sovereign debt crisis and lowered funding costs. Now, presumably, the real work of recovery can begin as the ECB unleashes its bond-buying at the same time that the banks feel empowered to lend again.
We have no view on whether this is right or wrong, since Europe has plenty of other problems beyond a lack of credit from the banks. These include, but are not limited to, a dysfunctional currency union, an overhang of bad debt, insufficient inflation, and stagnant productivity growth.
Suppose, however, that Davies’s optimistic interpretation is the correct one. How good could things get?
One clue is to look at the UK, which has puzzled observers for years with its odd combination of (relatively) rapid inflation, robust employment growth, and plummeting productivity. A recent paper from economists at the Bank of England and the Institute for Fiscal Studies suggested that these behaviours would be consistent with an economy on the receiving end of massive monetary stimulus, but whose faster growth is retarded by a broken banking system that has prevented resources from being efficiently reallocated from unproductive sectors to more productive ones.
(The euro area, of course, managed to get the broken banks without the palliative of the monetary stimulus.)
The result was that the UK ended up looking a little bit like much poorer countries, where a lack of trust prevents well-run firms from growing and displacing badly-run companies. (See here for more on this.) You can see how the recent recession and recovery in the UK were unusual by looking at the dramatic increase in the difference between the most productive and least productive sectors of the economy:
One explanation for the growth of these differences is that capital was not able to move across the economy to the places where it would earn the highest return. In a study of thousands of individual businesses, the researchers found that, since 2007, the gap between the rates of return on capital earned by the best firms and the rates earned by the worst firms has widened into a chasm. Yet capital has failed to chase these returns, since the distribution of resources across the economy is about the same as it was before the crisis:
As they put it:
The positive relationship between the average rate of return to capital and subsequent investment has broken down since 2008, which is suggestive of increased frictions to the allocation of capital. Although there is a large degree of uncertainty around our estimates, our results suggest that frictions to the allocation of capital are likely to be one of the factors that can help to explain the persistent weakness of UK productivity.
Economists at Goldman think that the UK’s difficulty moving resources to where they perform best could explain why the current account deficit didn’t improve as much as it should have initially given the decline in the currency:
Much as problems with reallocating resources from “old” sectors and firms to “new” sectors and firms helps to account for the weakness of productivity, it can also help to explain why the UK’s trade balance was relatively unresponsive to the 25 per cent fall in sterling’s real trade-weighted exchange rate that took place between August 2007 and January 2009. The size of the exchange rate adjustment required to rebalance the economy depends (in part) on the ease with which resources can be reallocated from non-tradable to tradable sectors.
If the reallocation of resources required to meet the shift in demand from foreign-produced output to UK-produced output is impeded by impairments in the financial system, the decline in sterling required to rebalance the economy will be larger.
However, the Goldman note goes on to argue that the easing of lending conditions since 2013 may have already begun to boost productivity even if the results haven’t yet shown up in the official productivity statistics.If the reallocation of resources required to meet the shift in demand from foreign-produced output to UK-produced output is impeded by impairments in the financial system, the decline in sterling required to rebalance the economy will be larger.
First, inflation has slowed down significantly both relative to where it was and relative to the US and Europe, even though domestic demand and employment have been growing faster in the UK than in either. And second, the UK’s trade deficit has held steady as a share of GDP when a simple model combining the real trade-weighted exchange rate with relative domestic demand growth of the UK and its trading partners would have predicted the deficit would widen by about 1.5 percentage points of GDP:
Both of those developments could be explained by an uptick in productivity caused by an improvement in the financial system’s ability to properly allocate capital.
If the end of the stress tests and AQR means that the euro area’s banks can get back to nudging resources where they will earn superior returns (and that’s a big if), it’s possible that the ECB’s bond-buying, combined with the latest Targeted Long-Term Refinancing Operations, could make more of an impact than sceptics currently assume. Something to keep an eye out for.
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