What this page is about: From November 2014 on the ECB will be responsible for the supervision of the main European banks. It is evident that the ECB’s monetary policy will impact banks’ asset and liability management. This page highlights topics that show a close link between the ECB’s supervisory task and its monetary policy.

 

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April 2014: Mario Draghi Announces Unconventional Monetary Measures 

Europe’s inflation rate further decreased over the last three quarters. Though the central bank interest rate is at a low level of 0.25%, banks’ lending to corporate entities does not increase. If private and corporate consumption continues to go south, a deflation period similar to that which can be observed in Japan may occur. This may result  in high sovereign debt rates combined with limited economic growth.

To address this issue, Mario Draghi announced: “All instruments that fall within the mandate, including Quantitative Easing, are intended to be part of this statement.” QE means, that the ECB buys government bonds. As a direct investment is not allowed, the ECB would have to trade on the secondary markets, buying from private persons, banks or others. The purchase results in additional funds, which are pumped into the European financial system. In an optimal world, this would have two effects:  to lower interest rates and increase the money supply. The goal is to stimulate the demand for credits/investments of corporates as well as the supply of lending by the banks. This mechanism is meant to stimulate economic growth.

The link between the ECB’s bank supervision and its monetary policy is the following: Current bank regulation supports increasing investments in government bonds. Supervising the banks from November 2014 on, the ECB will stress banks’  liquidity and capital. On the other side, the idea of Quantitative Easing is that, among others, banks sell their government bonds and reinvest in corporate lending.

Even if banks could sell some of their government bonds it remains questionable if they would reinvest the money by lending it to corporates.  The main reason why banks may operate this way has to do with the ongoing regulation. Numerous new regulations are being currently designed, such as the Net Stable Funding Ratio, the Fundamental Review of the Trading Book, the Interest Rate and Credit Spread Risk Monitoring for Banking Book positions, IFRS 9 and others. As a consequence, banks are not yet in a position to forecast the impact of future credit migrations on their profit, capital and funding position.

In summary: having ECB’s Banking Supervision focusing on stable banks on one side of the table and ECB’s Monetary Policy Division, which focuses on economic growth on the other side, the current situation resembles a Remise in a game of chess. Actually, it would not look very different from the FED’s chess table, though the US has a more market-based corporate financing scheme which should support QE goals. As a follower states: “The european economy is much more bank finance oriented than that of the US or the UK. Therefore bond purchases of the Fed style would be even less likely to trickle down to the small and medium companies whose finances are squeezed and who make up a large part of the market. Therefore the schemes that Draghi et al are envisaging will have to work through increased bank financing.” This brings us back to bank regulation.

For an enjoyable explanation what QE is, click here (not to be taken too seriously)

For further information on EU QE, click here

For an analysis on QE in Japan, click here

 

 

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