Beyond the AQR, a recipe for a broader push to successful Banking Union should include a network of bad banks set up with ECB-backed liquidity, writes Frieda in this FT article.
First, a network of bad banks should be established with resources set aside as national backstops ahead of the AQR. Good banks that have carved out bad assets should find it easy to raise capital from the market where needed. Second, the ECB should establish a special liquidity facility to fund the bad banks. To avoid the ECB falling into the trap of monetary financing, the new liquidity facility would be outside the monetary policy framework. The funding would come from the ECB but be guaranteed by national governments.
With stable, low-cost funding, bad banks could then be structured to avoid the need to transfer assets at rock-bottom prices (since the net present value of these assets rises as the discount factor – the cost of funding – falls) and/or to run off the assets more rapidly in a way that depresses prices needlessly. Access to the special liquidity facility would be conditional on performance targets specified by the bank regulator.
Bad banks can serve a dual purpose: to formally cleanse the banks’ balance sheet and to accelerate the corporate debt restructuring process. The AQR can identify the bad and non-core assets to be transferred to the bad banks. Properly set up, they can also serve to delink the issue of toxic assets from domestic politics. Beyond subjecting these institutions to normal state aid rules, the ECB would impose an additional layer of conditionality associated with their recourse to cheap and stable funding.
This is not to downplay the significance of the ECB’s forthcoming exercise. But complementary action to incentivise asset segregation and corporate debt restructuring would reduce the potential cost to governments of bank restructuring and resolution efforts over time through a positive feedback loop between banks, governments and private borrowers.
Ironically, the greatest risk of a return of the sovereign-bank doom loop now relates to a failure to address the bank-corporate feedback loop. In that sense, the AQR must be used as a forward-looking catalyst rather than a backward-looking beauty contest.
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