03 October 2017

EC: Quarterly Report on the Euro Area (QREA), Vol. 16, No. 2 (2017)

In this edition of the QREA, European Commission staff looks at the importance of sequencing and packaging structural economic reforms; the ease of doing business in the euro area; the determinants of trend TFP growth; and the macroeconomic implications of bank lending constraints.

Section IV (Bank lending constraints in the EA and their macroeconomic implications) presents stylised scenarios highlighting how low bank profitability, reluctance to issue bank equity and increases in target capital ratios can temporarily constrain bank lending in the current economic context. In connection with this, the article also reviews the main potential and actual sources of increases in minimum capital requirements at euro area level.

An increase in bank capital ratios is expected to improve financial stability by lowering the probability and cost of a financial crisis. Beyond this important benefit, the combination of the three factors mentioned has the potential to significantly constrain bank lending during the period of transition to higher capital ratios. According to DSGE model simulations, this could reduce growth and investment levels in the short run. As such, restoring bank profitability, implementing conservative dividend payout policies and promoting equity issuance can have particularly positive macroeconomic implications in the current context

An increase in bank capital ratios can improve financial stability by lowering the probability and costs of a financial crisis. However, the period of transition to a higher bank capital base can imply a short-term drag on the economy if banks try to achieve the new target ratios by compressing loan growth rather than increasing their equity levels. Such a situation is made more likely if raising equity on capital markets is deemed unattractive for current shareholders due to depressed bank valuations, or if bank profitability is low, as this constrains the possibility of building up capital buffers through retained earnings.

The 2008 financial crisis saw the profitability of the banking sector of most EU Member States plunge to negative or very low levels. This was the result of several factors, including asset valuation losses springing both from a recognition of existing asset quality problems, as well as from an unfavourable macroeconomic environment. The latter also meant reduced banking activity and has progressively led to a low-yield environment, which has put pressure on interest rate margins. While the post-crisis period saw the need for more stringent regulatory requirements, including a larger capital base, in order to prevent and increase the resilience of the banking sector to future crises, this has also contributed to lower banks' return on equity, at least in the short-run. As both low valuations and low profitability continue to characterise the euro area banking sector, this section seeks to assess in a stylised manner the role of these two factors in constraining current and prospective bank lending dynamics in a context of increasing target capital ratios. The broader macroeconomic implications of these bank lending constraints are subsequently simulated in a general equilibrium model, allowing for an assessment of their short-term impact on GDP and investment levels.

As a first step, sub-section V.2 provides stylised projections for bank profitability, dividend payouts and equity issuance. Based on these variables, on an equation for the evolution of risk-weighted assets over time and on some assumptions, a projection for the growth rate of bank lending can be run. As this projection is dependent on changes in capital ratios over time, sub-sections V.3 and V.4 discuss how both minimum and target capital ratios may evolve over the next few years. On the basis of this, three possible scenarios are defined, ranging from a scenario of no changes in target ratios to a scenario consistent with a sizeable increase. The implications of these scenarios for aggregate bank lending in the euro area are then shown in subsection V.5. Sub-section V.6 assesses the short-term macroeconomic effects of these bank lending constraints in a general equilibrium context and sub-section V.7 concludes.

Quarterly report

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