Deleverage or Deregulate

Time and again, pundits and pols have proven fairly unaware how financial firms operate—or how upcoming (unwritten) regulation impacts that. No surprise, reactions to the eurozone’s continued fall in private sector lending showed more of the same. But that doesn’t mean markets were caught equally off guard. Falling eurozone lending and the region’s many regulatory issues have been splashed across headlines for a long while—markets are well aware. The current climate is a negative for eurozone Financials and probably partly why growth there remains slow, but it shouldn’t derail growth elsewhere or the bull market’s upward march.

ECB Chief Mario Draghi was among those surprised by January’s -2% m/m (-2.2% y/y) drop in private sector lending—he expected things to turn a corner, thinking banks were done playing it safe in advance of a hefty regulatory review. The ECB takes over as single regulator of big eurozone banks in November, but before that happens, officials want to know what they’re dealing with. Between then and now, every bank falling under the ECB’s purview faces a comprehensive balance sheet audit, starting with the so-called Asset Quality Review (AQR)—an evaluation of the solvency and value of most assets on their balance sheets. Stress tests follow shortly thereafter, and no one wants to fail. To prepare, banks have been bulking up with reserves instead of lending enthusiastically, with businesses bearing the brunt. All of this Draghi and his ECB pals know. But since the ECB already finished collecting necessary AQR data on December 31, they figured banks would hit the gas in January. That banks instead continued deleveraging was a bit confounding.

In our view, though, this isn’t a stumper. Collecting data is simply step one. The actual review is still pending, along with decisions on whether these assets are appropriately valued and adequately capitalized. Then there is the matter of stress tests, whose results aren’t due until October. Ordinarily, we wouldn’t get too hung up on stress tests. They’re arbitrary exercises, political machinations and too hypothetical to give much insight into banks’ true health. But in the eurozone, there is a wrinkle. The ECB has already indicated banks that don’t pass face capital raises at the very least. Consequences could be even tougher, depending on the final details of the Single Resolution Mechanism—the ECB’s procedure for winding down failing banks. Anecdotally, ECB officials have hinted failing a stress test could equal insolvency, triggering resolution proceedings, potentially forcing losses on creditors and large depositors. If there is even a tiny chance banks could get shut down, they’ll likely do whatever it takes not to fail—they don’t want to run the risk of large depositors fleeing. Even though deleveraging weighs on lending profits, banks continue setting reserves aside. It’s better than the alternatives.

Few at the top seem to make this connection, however—they don’t seem to realize the impact their tough words have on banks’ actions. It’s broadly known lending is weak, and most expect it to stay this way, but most also believe quantitative easing (QE) could loosen eurozone credit. The theory: If the ECB bought long-term assets (perhaps including some mortgage-backed assets) from the banks, it would free up their balance sheets a bit, letting them allocate more capital to business lending—and it could lower interest rates, theoretically giving credit demand a boost (sound familiar?). This would lift investment, business activity, money supply and economic growth in one easy step! Sounds dandy, but advocates overlook one very important detail: QE flattens the yield curve and, therefore, banks’ profitability. Banks lend long and borrow short, so long-term rates are their revenues, short-term rates are their costs, and the spread is their gross operating margin. If QE bond purchases pull down long rates while short rates stay at half a point, lending becomes less profitable, which adds another incentive to sit tight.

If the ECB tries QE, the results will likely be similar to the UK. UK QE ran from March 2009 through November 2012. Simultaneously, regulators clamped down, burdening banks with higher capital requirements and tougher standards. Lending fell for QE’s entire existence, and after an initial burst, M4 money supply (the broadest measure of money in an economy) growth was sluggish. Since QE’s end, M4 money supply has accelerated, along with economic growth. But business lending has stayed weak, largely due to continued regulatory headwinds.

That lending would stay weak even with the increased profitability tells you how powerful regulatory uncertainty is. In our view, if the ECB wants more lending, the better solution would be bypassing QE, sparing banks the drag of lower profits, and working with other eurozone officials to address said regulatory uncertainty instead. Clarity on the Single Regulatory Mechanism and what, exactly, would and wouldn’t trigger bank closures and bail-ins would help quite a bit. Even if the rules aren’t terribly flexible, simply knowing them lets banks plan. The same goes for Basel III’s capital requirements, which officials are still debating how and when to implement.

On the bright side, there are some indications of regulatory flexibility. While the ECB likely needs to keep up appearances and conduct a “tough” stress test to keep credibility, policymakers also seem to understand it wouldn’t be good if too many banks failed. The test conditions released last month aren’t terribly onerous—banks will be allowed to draw down capital buffers during the so-called adverse scenario test. Though, what assumptions they use for the test (i.e., the hypothetical market and economic conditions they apply) remains to be seen. As for Basel III, the EU thus far seems to be considering allowing residential mortgage-backed securities and other asset-backed securities to count toward liquidity ratios—a help. The little victories certainly matter but the bigger picture remains: Europe’s plethora of competing, complicated and up-in-the-air financial regulations encourage banks’ constant deleveraging, taking away opportunities for their core business function: lending.

This is a headwind for the eurozone (and its banks) and likely remains for some time—finalizing so many rules between 18 countries with their own agendas is no small task, especially with the European Parliament’s May elections likely disrupting their end of the process. Weak lending is one reason the eurozone recovery likely stays slow. But this is very well known already, and markets have had a while to digest this reality—eurozone Financials likely have a tough time, but on balance, global markets should handle this situation just fine.