ECB Doubles Down on Financial Repression

We just posted a comment on the situation in the EU, where financial repression is still increasing.  Big concern from my perspective is that negative rates and central bank market intervention seem to be frightening investors and convincing savers to abandon the financial system.  Look at the earnings reports from UBS and the other large EU banks.  Banks are 80% of the EU balance sheet and virtually all are shrinking.  It is hard to envision how this situation does not end in tears for the nations of Europe given the policy mix.  Or to put it another way, should we worry about Brexit or Gexit?

The economic policy debate seems comprised of a binary choice. On the one hand, we are offered radical action by global central banks including the forced transfer of value from savers to debtors, and on the other, increased fiscal spending funded via either more debt or higher taxes. We believe that there is a third choice, namely to make public policy pro-growth as well as pro-consumer, with a balanced approach that is constructive rather than punitive.  Good luck getting the current cast of characters in the global central banking community to start talking about growth. But if we don't see a change in policy by the ECB, there could be a German-led political crisis in Europe before end of the year. 



Achieving Stability & Growth in Europe

Kroll Bond Rating Agency

May 2, 2016


Since the 2008 financial crisis, the fastest growing economic indicator in many industrial nations has been public sector debt. The Group of Twenty nations have seen a double digit increase in total indebtedness by a number of member nations. Japan and the European Union have driven short-term interest rates negative so as to lighten the fiscal load on cash-strapped governments. As Kroll Bond Rating Agency (KBRA) previously noted, faced with the reality of public and private debts that cannot be repaid, a number of nations have embraced negative rates, an explicit transfer from savers to debtors. In setting zero or even negative interest rates, the Federal Reserve, the European Central Bank (ECB), and Bank of Japan (BOJ) have created a fourth phase of the historical progression of public indebtedness which is widely known as “financial repression.”  Negative interest rates are essentially a tax on investors and have profoundly negative implications for economic and fiscal planning, personal saving, capital investments, banking, insurance, pensions and health care schemes. 

As government debt has grown, the nations of Europe have very deliberately avoided dealing with an equally pressing problem, namely the state of Europe’s banks. The total assets of the EU banking sector declined from €33 trillion in 2008 to about €28 trillion in 2014. The ECB reports that the total number of credit institutions in the euro area fell to 5,614 at the end of 2014 (down 17% from 6,774 in 2008). The largest reductions in the value of total bank assets since 2008 were recorded in Ireland, Estonia and Cyprus, amounting to drops of 69%, 40.7%, and 39.8% respectively. Yet many EU nations still have banking sectors that are larger than their economies.

The European community’s banks still report over €1 trillion in bad assets, as noted in KBRA’s research report on the ECB referenced above. KBRA believes that the actual number of problem loans held by EU banks is significantly higher and is masked by the relatively liberal International Financial Reporting System rules on the recognition of bad assets. The key message is that the capacity of EU banks to originate and support new credit creation is falling, part of the reason why KBRA believes job creation and economic growth in the EU remain muted. That said, in Q1 2016 the EU reported a growth rate higher than the U.S. or the UK, begging the question as to why the ECB feels the need to embrace negative rates, open market asset purchases and other radical expedients at this time.

The retreat of EU banks manifested by the shrinkage in total assets has caused an increase in non-bank financial intermediation, albeit far smaller than the decline in the traditional banking system. Regulators and pundits fret about the “risks” of the so-called shadow banking sector, suggesting that somehow regulated commercial banks are superior business models (and less risky from a public, systemic perspective) than are private sector companies. It is useful to recall that commercial banks are, by definition, government sponsored enterprises that enjoy a variety of public subsidies, explicit and hidden. Non-banks, on the other hand, represent the private sector and generally have little impact on markets or cost to taxpayers when they fail. In fact, KBRA argues that the non-bank appendages of the largest universal banks actually did the greatest damage during the 2008 market collapse. 

Public Anxiety Over Negative Rates

Credit conditions in the U.S. are relatively strong, banks in KBRA’s rated universe are more than adequately capitalized and the financial system has largely dealt with all significant asset quality problems. Yet both in the U.S. and the EU, the public at large remains profoundly unhappy with the economic situation and continues to focus critical attention on the banking sector. Former Federal Reserve Governor Kevin Warsh noted last month at a conference sponsored by Grant’s Interest Rate Observer that negative interest rates only impact financial assets and markets. There is no trickle-down effect that is helpful to consumers, thus three quarters of people in the U.S. believe that the economy is on the wrong path. Yet, Governor Warsh notes, in Washington most observers believe that things are fine and that the economy is at full employment.

In Europe, however, the issue of negative interest rates is causing political contention. Senior members of the German government are openly blaming the policies followed by the European Central Bank for the rise of political populism in Europe. Whereas in the past central bankers had to endure scolding from politicians when they increased interest rates to protect their nations from inflation, today central bankers like Mario Draghi are castigated for easy money policies that are increasingly viewed as counter-productive, even reckless by some observers. The independence of agencies like the Federal Reserve and ECB are less threatened by the criticism of politicians than by a stunning lack of public support. 

A large part of the public antipathy for central banks is due to the impact of zero interest rates on savers. Bavarian finance minister Markus Soder told Der Spiegel: “The zero interest [rate] policy is an attack on the assets of millions of Germans who have placed their money in savings accounts and life insurance policies.”

At its most recent meeting, the ECB opted to leave its benchmark rate unchanged at zero, maintain the deposit rate at -0.4%, and leave unchanged the current size of its bond-buying program (~$90 billion a month). Significantly, the ECB remains willing to “do more” for an “extended” period of time even though there is growing public unease at the ECB’s policy mix of negative interest rates and debt purchases.

Both the Fed and ECB have tried to compensate for a lack of action by elected officials to deal with structural issues such as debt and unemployment, but in so doing have only weakened their political position. In Europe in particular, the Weimar-era German social imperative of a balanced budget has come into a direct collision with the accommodative polices of the ECB. German Finance Minister Wolfgang Schäuble went so far as to blame the ECB’s “money-for-nothing” polices on the rise of Alternative for Germany, the right-wing, Euroskeptic, anti-immigrant party that did well in the last regional elections.  

Focusing on Growth

Now, eight years since the financial crisis, the ECB has embarked upon a radical policy of debt purchases and outright subsidies for banks. ECB Governor Mario Draghi seeks to do via monetary policy what Angela Merkel and other elected officials in the EU cannot or will not do, namely deal directly with the asset quality problems festering inside the EU banking system by writing down bad debts and converting debt to equity. The latest ECB policy move is effectively a work-around for a political system that has not been able to deal effectively with the uncollectible debts on the books of EU banks as well as the public and private debts of a number of EU member states.

KBRA notes that today’s economic policy debate seems comprised of a binary choice. On the one hand, we are offered radical action by global central banks including the forced transfer of value from savers to debtors, and on the other, increased fiscal spending funded via either more debt or higher taxes. So far, political leaders have not been inclined to accelerate borrowing or spending. Indeed, combined with increased regulation on financial institutions and markets, through inaction our political leaders have done their best to kill the economies of Europe and the U.S. – and thankfully they have failed, to paraphrase Governor Warsh. 

There is a third choice to help provide an answer to the common problems of employment and growth. We believe policy makers need to make policy pro-growth as well as pro-consumer, with a balanced approach that is constructive rather than punitive. Those observers who say that Europe and the U.S. cannot grow at more than 2% per year without greater fiscal action give too little credit to the qualities which make these societies great. Democracy and the rule of law, an educated and highly skilled workforce and world-leading infrastructure are the basis for stable, sustainable growth that can be achieved in the proper political environment. KBRA believes that policy makers ought to stop demonizing private businesses and banks, and instead find a more reasonable path to achieve common goals of growth and jobs. 

Rather than tolerate further the use of mechanisms such as negative interest rates and overt debt monetization by central banks, we submit that our political leaders should direct Mr. Draghi and his counterparts on the U.S. Federal Open Market Committee to return to more conventional policies. The quid pro quo, however, is that the political leaders of Europe and the U.S. must be willing to engage on some difficult issues, including debt reduction and recapitalization of banks in Europe, as well as other policy changes to stimulate private sector credit creation and thus growth and jobs. Simply increasing public spending, KBRA submits, is insufficient to really address the challenge of stimulating growth. 

As the EU tackles the twin tasks of reducing debt and recapitalizing the banks, it should modify some of the more draconian regulations put in place after the 2008 crisis, restrictions which are causing many banks in Europe and U.S. banks to stop taking risk altogether. Institutions across the EU are migrating to a “capital light” business model that emphasizes asset management over consumer lending, private placements instead of trading and capital markets. 

Because of the importance of banks as providers of liquidity in the EU, the strictures placed upon lenders and securities firms has a direct connection to reduced business activity and job creation. The decrease in the effective leverage on bank capital on both sides of the Atlantic, we believe, is one of the key reasons for sub-standard job and income growth. Only by adjusting public policy to encourage credit creation and private sector investment, can the nations of Europe achieve sustainable financial stability and acceptable levels of economic growth.