13 March 2014

ECB/Cœuré: Monetary policy transmission and bank deleveraging

Cœuré spoke on the necessity of properly managed deleveraging processes, highlighting that "both monetary policy and prudential supervision – notably the ECB's ongoing comprehensive assessment – have a key role to play".

Deleveraging is not a process that policy-makers should seek to avoid; rather, it needs to take place and be properly managed, explained ECB Executive Board member Benoît Cœuré. Describing the good, the bad and the ugly deleveraging at the Future of Banking Summit organised by "The Economist" in Paris, he emphasised how the wrong type of deleveraging could impede recovery and make it more difficult for central banks to engineer an appropriate degree of monetary accommodation.

Broadly speaking, there were three different types of bank deleveraging, he said:

1. "Good deleveraging" involves banks raising capital and getting rid of impaired assets in a targeted and rapid manner. This approach recognises and corrects the flaws in legacy business models and allows for a relatively swift reallocation of credit to more competitive sectors. This eventually translates into a more dynamic recovery.
2. "Bad deleveraging" entails an indiscriminate reduction in balance sheet size, regardless of the quality of assets. The main motivation for such adjustments is to reduce indebtedness. And in order to "balance the books", this process is accompanied by asset shedding. The upshot is a potentially prolonged, across-the-board reduction of credit to the real economy.
3. Finally, "ugly deleveraging" comprises banks specifically discarding good assets while keeping distressed assets in the banking book and recording them at close to nominal values. This method can rapidly turn a bank into a "bad bank" that does little to support credit creation.

These last two types of deleveraging can have significant real economy effects. Financially weak banks tend to roll over unprofitable loans that do not support growth – which is why they have sometimes been dubbed "zombie banks". There is in fact some evidence that such evergreening practices have appeared in the euro area as well in the last few years. The wrong type of deleveraging also has a further effect in being harmful to the transmission of monetary policy.

To ensure the right type of deleveraging is achieved, Mr. Cœuré highlighted, "both monetary policy and prudential supervision – notably the ECB’s ongoing comprehensive assessment – have a key role to play". According to him, the comprehensive assessment of banks’ balance sheets and the steps taken towards the banking union are crucial to establish the conditions necessary for a transparent, competitive and stable banking sector. He added, "and they will help monetary policy to regain traction across the euro area". Insofar as it leads to bank lending rates converging between the core and the periphery, it will allow a significant additional easing of monetary policy in some jurisdictions. And insofar as it leads to better access to finance, higher growth and rising inflation, it will support our expectation that real interest rates will gradually ease over the projection horizon.

He concluded by explaining why it is important for the Banking Union to be complete, "not moving promptly towards a single resolution mechanism (SRM) and a single resolution fund (SRF) would prolong financial fragmentation, leave the financial system exposed to systemic fragility, and, ultimately, be harmful for growth and jobs. This would in particular be the case if the SRF is only slowly mutualised, and if it cannot resort to a common European backstop from the outset."

Full speech

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