(Bloomberg Opinion) -- Europe’s banks have often complained about too much regulation hampering their ability to lend. The Covid-19 epidemic shows that when times are bad the real constraint lies elsewhere: in the financial markets.
The European Central Bank has gone to great lengths during the coronavirus crisis to ensure that lenders can keep pumping credit into the economy. It immediately provided flexibility on the treatment of non-performing loans, and allowed banks to make full use of capital and liquidity buffers that were put in place to keep the financial system safe after the 2008 crisis. This relaxation of the rules is to ensure that bankers don’t cut off their customers’ credit lines because of the fear of having to raise new equity. The inevitable risk is that the ECB encourages a dangerous new buildup of bad loans.
Despite all of these actions, there are still complaints that banks aren’t getting money where it’s needed: to the smaller businesses that are the lifeblood of the economy. So what’s stopping them from lending? For sure, there is some fear of what comes next. Supervisors may be understanding today, but they could tighten their standards as soon as growth recovers. Economists call this problem “time inconsistency.” It’s impossible for the ECB to guarantee a future course of action, because its regulatory preferences will be different tomorrow.
Another, perhaps bigger, obstacle comes from the financial markets. Banks are often reluctant to eat into their capital buffers because they know it will upset investors, who will mark down their shares accordingly. The ECB’s Single Supervisory Mechanism has tried to address the problem of lenders prioritizing their shareholders, issuing a strongly worded recommendation for banks not to pay dividends this year. However, the banking industry is equally concerned about its debt holders. Companies don’t even want to get close to the point where they can’t pay the interest on their convertible bonds, as they fear the credit market could turn against them. As a result, they will probably act too prudently in a crisis.
Daniel Tarullo, a professor of regulation at Harvard Law School and a former governor at the U.S. Federal Reserve, outlined this problem in a recent paper. In the good times, supervisors struggle to strengthen the banking system sufficiently because of political resistance. The ECB has been remarkably successful in reducing the mountain of bad loans in the euro-zone banking system, but it faced serious opposition from many politicians and local regulators, especially in Italy.
Then, when a crisis hits, supervisors find it hard to get money moving into the real economy because of resistance from the banks, who are more worried about the market’s perception of their capital strength. “Knowing that investors and counterparties are intensely scrutinizing them for any sign of weakness, the executives of banks and other financial institutions will do all they can to project the soundness of their firms,” Tarullo wrote. This may be happening right now. Banking supervisors hear that lenders are worried about lowering their regulatory capital targets for this year, as they’re fearful of a backlash.
We’re also still seeing the usual regulatory disputes between the finance industry and its supervisors. The ECB has tried to adapt its rules to the extraordinary circumstances of the pandemic, without scrapping them completely. For example, banks still have to use the original criteria for non-performing loans, unless loans are guaranteed by their national authorities. The ECB has relaxed some rules for calculating market risks, but only temporarily. The banks are lobbying for more permanent structural changes, including loosening the new accounting rules (“IFRS9”) that demand tougher standards when making provisions for bad loans.
The ECB’s supervisory body, under its boss Andrea Enria, is sensitive to the huge pressure on the lenders. For example, it is making the case for a European bad bank to help euro-zone members process the non-performing loans that will accumulate after the crisis. This proposal, leaked to the press a few days ago, is unlikely to see the light of the day for now because of opposition from the European Commission. But it’s another sign of leniency from the supervisors.
Still, any supervisory help will be irrelevant if banks are unwilling to worsen the quality of their balance sheets because of the fear of upsetting investors. The only solution may be for governments to keep supporting the economy directly through bigger transfers to citizens and businesses, even though this will pressure public finances and raise questions in the market about sovereign creditworthiness. As with the banks, you can’t simply wish the bond vigilantes away.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ferdinando Giugliano writes columns on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.
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