Central Bank, bank regulators and politicians are frustrating each other’s efforts
On Thursday 5 June, the European Central Bank cut its official rates to the lowest level ever and the deposit interest rate is now actually negative. Granted, the drop was only 0.10%, but it still represents an important move into uncharted territory.
Appeared as an opinion piece in the Financieele Dagblad, 2 July 2014
What it chiefly demonstrates is the impotence of current monetary policy, with the ECB failing to hit its inflation target of around 2%. While monetary policy traditionally aims to curb inflation, we now find ourselves in a situation where the actual inflation rate is too low. Parts of the eurozone are already experiencing deflation and although the eurozone as a whole is not yet affected, we are awfully close to that point. Along with the interest rate cut, the ECB also introduced what it refers to as the Targeted Long Term Refinancing Operation (TLTRO) - an initiative for stimulating credit provision to the Small and Medium-sized Enterprises (SME) sector.
It could be argued that the ECB is doing everything within its mandate to boost economic growth and prevent deflation. At the same time however, for those willing to look at the situation realistically it is increasingly clear that the current policy mix lacks coherence. In this instance, I’m not referring the ECB’s policy as such, but to the lack of coherence between this monetary policy and the measures taken by regulatory authorities and governments.
Banks are required to comply with the BIS 3 regulatory regime implemented in Europe under the CRD IV directive. This comprehensive package of measures includes requirements for bank liquidity by which banks are required to maintain large reserves. Considering that a significant portion of these reserves are held in the ECB’s deposit facility, this means that these banks are now being ‘rewarded’ with a negative interest rate. The ECB hopes that this will encourage banks to reduce liquidity levels and grant more credit, but this in turn causes problems for the banks due to regulatory requirements relating to liquidity. In all likelihood, they will be more inclined to increase their inventory of short-term government loans, and by doing so they will further augment the financial ties between banks and governments. In terms of stability, it would actually be much better if banks were to hold less not more government notes.
This demonstrates how ECB monetary policy is working against the banking regulators. At the same time, political measures are working against ECB policy, specifically the TLTRO. The TLTRO provides banks with cheap long-term funding to grant loans to the SME sector. These must be new loans however - the TLTRO is not intended for use by banks to repay existing, more expensive loans. But the problem here is that increased credit provision leads to an increase in balance sheet totals, and that is exactly what is making many banks unhappy at the moment. This is because, according to BIS 3, banks are required to maintain a minimum capital buffer of 3% relative to their unweighted balance sheet total. This presents significant problems for many banks, not so much in terms of attaining the 3% but because the definition of this so-called leverage ratio could still change. For instance, the exact calculation of the term ‘capital buffer’ is still not fixed. Additionally, banks have to add part of their off-balance activities to their balance sheet, but this too remains unclear. Another current issue is what is referred to as the Asset Quality Review and the stress test, where the results of either could have major consequences for some banks. This is causing uncertainty on all sides. Unfortunately, this uncertainty is further compounded by politicians and a number of academics who continue to call for a rapid rise in the leverage ratio. At the same time, governments are drafting poorly thought-out punitive measures such as the bank tax, that make it even more difficult for banks to reinforce their balance sheets. Taken in this context, not many banks will be willing to make use of the TLTRO.
What we are seeing here are banking regulatory authorities who want to see more liquidity in banks and an ECB that punishes them for compliance. We are seeing an ECB attempting to prevent a credit crunch and politicians who - no doubt unintentionally - are undermining those efforts. Taken separately, many if not most of these measures can certainly be justified, but taken as a whole they make for inconsistent policy. The underlying problem is the lack of a coherent vision on the role to be played by the financial system. Much work remains to be done.
Wim Boonstra is chief economist of Rabobank Nederland, Utrecht, Professor of Monetary and Economic Policy at VU University, Amsterdam and President of the Monetary Commission of the European league for Economic Cooperation (ELEC), Brussels.