Gael de Boissard
After three years of market turbulence, Europe is laying the foundations to address the euro crisis and restart growth. Two big steps announced over the past 10 days give grounds for this hope.
First, the European Central Bank unveiled its plan to buy – in unlimited amounts – bonds of troubled euro states that are prepared to meet its conditions. While not quite turning the ECB into a fully-fledged lender of last resort, this move promises at least to provide a back-stop to ward off the spectres of default and euro break-up that have had the markets so worried.
Then the European Commission unveiled the first part of a plan to create a banking union, with unified supervision arrangements under the ECB. This, too, is a welcome development, offering as it does the prospect of a more coherent and decisive approach to the problems plaguing Europe’s financial system. Implementation of a banking union is a complex and difficult undertaking. But it is a key policy initiative to start dismantling the negative feedback loop between sovereigns and banks, addressing the financial fragmentation that is undermining the euro from within, and the other issues that weigh heavily on confidence and inhibit growth.
These initiatives will provide the European Union with the firepower to deal with immediate market concerns, and establish a road-map towards a structural solution.
While this is a long way from heralding the end of concerns about the euro, or even guaranteeing that proposed solutions will stick, it does at least provide an opportunity to look beyond the crisis and ask some searching questions about the broader issues shaping Europe’s economy.
Policy-makers and industry agree that a key focus for debates about the future is “growth.” How are we going to get the European economy growing again and, as importantly, how will we finance investment and job creation when it does?
The health of banks is inextricably bound up with that of the wider economy. And as a discussion paper for meeting makes clear, in today’s Europe that is a sobering thought.
Macro-economic policy, it suggests, is at or near the limit in terms of its ability to regenerate confidence – and new financial regulations together with restrictive fiscal policy may be increasing recessionary forces.
Meanwhile, a wave of deleveraging and restructuring, driven in part by tougher regulation, means Europe’s banking sector is ill-equipped to play its traditional role as a motor of investment. On the contrary, there is a strong risk that much of the necessary deleveraging will take place through reduced lending.
The IMF suggests euro-area credit could drop by anywhere between $100bn (£62bn) and $400bn in the coming years, with the axe falling especially hard on countries already struggling with relatively high interest rates, such as Spain and Italy. What makes this problem acute is that Europe traditionally depends far more than, say, the US, on bank lending to fuel growth, and Europe’s banks, with their relatively high loan-to-deposit ratios, depend heavily on capital markets for funding.
In the US, deep and liquid bond and stock markets provide significant financing for corporations, whereas in Europe intermediated finance through the securities markets is much less well developed. Of total non-financial corporate debt outstanding in the euro area and the UK in 2011, bank loans and other advances accounted for 85pc; with non-financial corporate bonds just 15%.
Moreover, corporate bond and stock issuance face headwinds in current conditions, and securitisation activity in the euro area – another potential source of funding – has fallen sharply since 2008.
As a result, in the short term Europe, faces a corporate funding gap. According to Standard & Poor’s, in the next five years, the euro area and UK have $8.6 trillion of corporate debt to be refinanced and will also need $1.9 trillion to $2.3 trillion in new finance. Even assuming – as S&P does – that sufficient liquidity will be available to help companies refinance maturing debt, those figures could imply a requirement for net new corporate-bond issuance on a scale at least double the highest level Europe has seen in the past 10 years.
While large, global companies will have no problem accessing the bond markets, small and medium-sized companies – that generate most of the jobs – will struggle for funding.
The UK’s recently completed Breedon Review focused on improving access by SMEs to sources of finance other than the banking system. Other European countries are worrying about the same issue, and it is bound to feature in the EC’s deliberations on long-term investment later this year. In the longer term, the problem is even more serious. Prolonged deleveraging could severely curtail economic growth, as happened in Japan over the past 20 years as its banks restructured their balance sheets and reduced lending.
What will be needed is a banking system sound enough to fund investment and jobs. But we know that the formal banking sector will be constrained by the burden of new regulation and the need to deleverage.
Two questions therefore arise. First, in the wave of regulatory reform prompted by the financial crisis, has the right balance been struck between growth and financial stability, and are there better ways of managing the trade-offs? Change was needed: at issue is its pace, volume and cumulative impact. Policy-makers need to consider the effect of multiple layers of new regulation and ask whether this has added to pro-cyclical tendencies and, if so, how to undertake a course correction.
Second, we need to consider urgently how to develop alternative ways of channelling Europe’s savings into long-term investment. Our economic model needs to change, from reliance on the big banks to fund investment to a greater focus on capital markets. The development of a broader corporate debt market would be a welcome development for corporates and investors.
It is time to refocus the conversation between regulators and the regulated. We must address not only making the financial system safer, but also how that whole system and individual institutions can best meet the longer-term needs of the real economy.
Gael de Boissard wrote this commentary in his role as chairman of the Association for Financial Markets in Europe (AFME). Gael is also Co-Head of Global Securities at Credit Suisse.
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