Draghi’s Deleveraging Dilemma

Fiscal austerity. Too-tight monetary policy. Lowflation. Structural issues. These are just some of the widely cited culprits for the eurozone’s plodding recovery. We’ll save the debate on those four for another day—and instead discuss a legitimate/bigger headwind: bank deleveraging. New data from the ECB show banks are still shedding assets left and right, with a downstream impact on lending, money supply and overall growth. This is a widely known issue—not a glaring market risk—but a headwind to growth all the same, and the latest developments highlight why continued calls for the ECB to just do something are misplaced.

Theories on why banks are deleveraging vary. Some say banks are still correcting for pre-2008 excesses. Others say it’s a byproduct of LTRO unwinding. Perhaps both are true to some degree, though the €715 billion in LTRO repayments to-date are a fraction of the total amount vanishing from bank balance sheets over the same period. In our view, a larger culprit is the ECB’s upcoming stress tests. Banks have been prepping since the ECB telegraphed the exercise last year, attempting to avoid the hefty consequences of failing (ranging from capital raises to possibly forced closures). Last year alone, assets on the balance sheets of Europe’s 50 largest banks fell by €3 trillion. Within the eurozone, assets are down €2.16 trillion since April 2013 and over €4.3 trillion since May 2012—about two and a half Italys or 12% of the total, depending how you’d like to scale it. Banks have also raised capital by roughly €95 billion since July 2013.

When banks bolster balance sheets, it’s darn near guaranteed they aren’t doing much of their core function: lending. That’s a big headwind for many of the region’s businesses—most of which are SMEs, which rely almost entirely on banks for funding (unlike the US, for example, where corporate bond issuance is broader). More broadly, falling lending weighs on money supply—a big reason growth is lackluster and inflation slowing. Loan growth has been negative since August 2012 and clocked in at -1.6% y/y in April. M3 money supply growth has decelerated for the past year, slowing to +0.8% y/y in April—the lowest since September 2010. As we occasionally quip, capitalism doesn’t work without capital. The eurozone, as a predominantly capitalist region (yes, we know, it includes whatever pet socialistic country is coming to mind), can’t grow much if the money supply doesn’t play its part.

While the central bank does have some influence over the money supply, the eurozone’s current headache isn’t a monetary policy problem. It’s a regulatory problem, and the widely suggested solutions like rate cuts, negative central bank deposit rates and quantitative easing (QE) can’t address them. Banks aren’t selling assets and hoarding cash because interest rates are a touch too high, central banks are paying interest on excess reserves or the ECB isn’t flooding the system with excess liquidity. It’s because they don’t want to risk the consequences of failing the stress tests, which have some pretty tough parameters. Shoring up balance sheets as much as possible is in the best interests of the banks and their shareholders, creditors and depositors, who could be on the hook for losses if they fail.

Until the tests are over and the results are out—in October—it’s difficult to envision eurozone banks lending enthusiastically. Even if the ECB does take action at its meeting next week. Charging banks to hold reserves doesn’t provide an incentive to lend—just an incentive to swap reserves for ultra-liquid assets. QE likely weighs further on lending and brings broad monetary contraction, as we saw in the US and UK, exacerbating the problem they’re trying to solve. Dropping the benchmark rate from 0.25% might boost liquidity a tad, but it likely won’t move the needle.

Most observers don’t see it this way, though—many cling to the belief central bankers are the saviors of the financial system. So if the ECB announces something next week, sentiment probably gets a lift—but a quick, short-term sentiment boost doesn’t equal actual, fundamental improvement. In our view, that won’t come to eurozone money markets until after stress tests. The region’s stocks can still do fine over the foreseeable future—deleveraging is a widely known issue—but anyone expecting monetary stimulus to provide a big boost likely ends up disappointed.