ECB Policy for a Fragmented Financial Market

The ECB meets tomorrow and is expected to remain on hold.  Of the 44 market participants surveyed by Bloomberg, only one thought that the ECB would lower interest rates at this week’s meeting.  Markets do seem to hope, and may be pricing in to some extent, a more dovish tone from Governor Draghi, but at a time when the Fed is continuing expansionary policies, and the Bank of Japan is set to join them, the unwillingness of the ECB to do more stands out.

I see the case for a rate cut as powerful.  Weak activity indicators, deflationary pressures, and tightening financial conditions suggest that the euro area will continue to stagnate through 2013 and into 2014.  This lack of euro-area growth, if it persists, represents a bigger threat to the survival of the Eurozone than Greece, Cyprus or the next financing crisis.  A 50 basis point (bp) cut in rates would send a strong message regarding the ECB’s commitment to "do whatever it takes."  It is all the better if it brings about a necessary weakening of the euro.

A threat that the ECB does acknowledge arises from the growing fragmentation of European financial markets.  A small-to-medium sized company in Spain or Italy, especially if it’s normally funded by a second tier bank, will find credit difficult to get and if available, they will pay up to 300 bp more than a similar company in Germany (see chart).  Some portion of the premium is justified by the higher risk of doing business in the periphery, and it’s worth remembering that excessive spread compression during the years following creation of the euro was central to the buildup of imbalances.  But another portion presumably is an “excessive” risk premium that would not exist if European banks and financial markets were functioning smoothly.

For the ECB, this is a job for financial policy, not monetary policy--a separation principle that most major central banks would not see as appropriate in current conditions.  From this perspective a rate cut should not be chosen if the rate is already appropriate for some hyopothetical average.  That said, the case can be made that the first best policy response is a measure targeted directly at the market imperfection that threatens fianncial stability, which in this case is the financial intermediation channel in the periphery.  The question is then how best to create incentives for banks to lend to these firms.  Central banks are understandably skeptical of the directed credit schemes in normal times, but in stress periods such as the present they need to be considered.

It’s worth noting we have two recent models on which the ECB can draw.  The first is the Bank of England’s (BoE) July 2012 Funding for Lending Scheme.  The BoE scheme provides lower cost funding for banks and building societies that increase lending to U.K. households and businesses.  For additional lending up to 5 percent of total loans, participating institutions can receive 0.25 percentage point loans, provided they have sufficient eligible collateral.  While evidence on the effectiveness of the scheme is mixed (we don’t know what lending would have been absent the scheme), the BOE sees the program as successful.  Gavyn Davies is among those recently advocating that this approach get a serious look from the ECB.

When asked whether the ECB would consider such a scheme, Mario Draghi argued that the existence of long-term refinancing operations, or LTROs, coupled with an easing of collateral requirements late last year, in essence replicated the effects of Funding-for-Lending.  That’s true in a sense, but its hard to make the case in current conditions that there isn’t more that can be done.   A targeted easing of collateral requirements for financing for new loans in periphery (for banks in countries where spreads are above some level?) – combined with a new LTRO -- would be a better parallel.

A second recent model is the Term Asset-Backed Securities Loan Facility (TALF) that was created by the Fed in November 2008 to spur consumer lending by supporting the issuance of asset backed securities (ABS). The sharp decline in new ABS issuance in September 2008, coupled with sharply rising spreads, was the basis for the program.  The program extended loans on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. Though the borrower retained the first loss, the program was seen as effective in restarting the ABS market and keeping the flow of loans going.

What both these approaches share is a targeted change in incentives to lend in the periphery.  My suspicion is, if not this week, then soon, the growing fragmentation of euro financial markets will call for a change in policy. It’s worth remembering we have models for what could come next.