26 May 2014

ECB/Mersch: Finance in an environment of downsizing banks

Yves Mersch, Member of the Executive Board of the ECB, spoke on how financing of the real economy in the euro area has historically taken place through the large banking sector. The crisis brought those business models to an end and triggered a process of structural change in the banking sector.

Financing of the real economy in the euro area has historically taken place through banks. The euro area therefore requires and has a large banking sector. The aggregate balance sheet of euro area banks is around 270 per cent of GDP, whereas in the US, where capital markets are deeper, it is only around 70 per cent of GDP.

The euro area banking sector, however, expanded rapidly in the years before the crisis from already high levels. From the start of the expansion in 2005 to its peak in 2012, banks assets increased by more than 60 percentage points of GDP. This was associated with the development of unsustainable bank business models. Banks relied too much on debt to finance their lending, and that debt depended too much on wholesale market funding and too little on deposits.

 The crisis has brought those business models to an end and triggered a process of structural change in the banking sector. European banks have entered a period of secular deleveraging and restructuring. Bank balance sheets declined by around 20 percentage points of GDP in 2013 alone. Loan-to-deposit ratios fell from 142 per cent in the first quarter of 2008 to 117 per cent at the end of last year, and I expect these ratios to continue to fall. Credit growth has consequently been very weak.

This trend towards a downsizing of the banking sector has both positive and negative aspects.

The negative aspects are mainly cyclical and relate to the current situation. A deleveraging banking sector implies lower credit supply, which is problematic for a recovering euro area economy. While the early stages of recoveries do not depend on credit as firms tend to draw down internal funds, when credit demand picks up it needs to be matched by credit supply for a sustainable recovery to take hold. The typical lag between credit growth and the economic cycle is around 3 to 4 quarters.

The recovery in the euro area began not yet a year ago, and we are seeing tentative signs from survey data that credit demand in the euro area is starting to pick up. The latest euro area Bank Lending Survey (April 2014) shows that net loan demand has turned positive for all loan categories. So, we need to make sure that the banking sector is strong enough to meet that demand. A car can run on low fuel for a while, but at some point it needs to fill up otherwise the engine will stall. At this stage of the recovery it is clear: There needs to be sufficient fuel to rev up the engine.

This is one reason why the ECB has been putting so much emphasis on its on-going comprehensive assessment of bank balance sheets in the euro area. Our aim is to ensure that banks are sufficiently capitalised to once more start originating loans and taking risk. So far, the mere "shadow" of the exercise has had a catalytic effect on banks' asset valuations, provisioning and capital raising. That is not to say that we expect a surge in aggregate credit growth as the exercise reaches its completion with the publication of the results later this year. Rather, our expectation is that new finance should be available for firms that need it. 

The positive aspects of a downsized banking sector are mainly structural.

Some research suggests there is a threshold beyond which the positive effect of finance on growth diminishes. For example, information rents in the financial sector might be generated by complex financial products or opaque banking organisations, allowing - at least temporarily - for higher salaries and bonuses to be paid. This attracts talented individuals away from productive sectors. Structurally, a smaller banking sector could - at least in theory - help to avoid negative effects on growth and insulate the euro area from some of these risks.

Still, a smaller or downsized banking sector is no guarantee for lower overall risk. The business models, risk attitudes and profitability of the banks need to be taken into account as well. Likewise does geographical expansion into foreign markets when it is not accompanied by local knowledge. 

Another aspect is that a downsized banking sector provides impetus for capital market development in Europe - after all, if savings are not being intermediated through banks, they must be being intermediated through capital markets. I see this as central to a more balanced and contested financing mix in the euro area.

Full speech

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