24 April 2013

ECB/Mersch: Europe's ills cannot be healed by monetary innovation alone

Calls are becoming louder for the ECB to introduce new tools, swallow ever more risk and start economic fine-tuning. But this would be a diversion. The successful measures taken by the ECB are there to buy time for the political authorities to fix the governance framework and implement reforms. They cannot be a substitute for the repair work.

Action is under way. To break the doom-loop between sovereign and banks, European leaders have decided to establish a European banking union. The ECB will be assigned to create the single supervisory mechanism. This is a necessary element, but not a sufficient one. We also need a single resolution mechanism.

These two reforms are the two sides of the same coin. Supervisors cannot give objective verdicts on the viability of banks if banks can only be closed in a disorderly way that could trigger contagion and put financial stability at risk. If banks cannot be shut down cleanly, necessary liquidity provision could drift into supervisory forbearance, evergreening and zombification.

This raises a question about funding this process. A viable bank that lacks capital ought to seek it first in the market. If it cannot, funding should be warranted from a pot that is funded in advance from private sources. A fund should also help with resolution, for instance to capitalise a bridge bank that is later sold. Only as a last resort, funds could be temporarily drawn from a European fiscal backstop. To ensure fiscal neutrality, a loan to the European resolution fund should be repaid ex-post via levies on banks.

This institutional framework is a prerequisite for the repair of financial markets. The capacity of the banking sector to absorb risk would be increased – currently the Achilles heel of loan provision to the real economy. All this would also help to restore the proper transmission of monetary policy. The current very accommodative monetary policy stance could reach its destinations unhampered. The need for unconventional measures would diminish rather than increase.

To kick-start the flow of credit, a new European asset class of securitised loans to small businesses could be created. European asset-backed securities have been unfairly stigmatised, since they are superficially associated with pools of US sub-prime mortgages. This is despite the fact that the performance of European ABSs has been solid. Funding aid for sound pools of small business loans could be provided by development banks on the national and European level, possibly supported by liquidity from the ECB within its mandate.

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