The two hands of the ECB: a case of mutual ignorance?

In the Gospel (Mathew. 6:3), it is a virtue when one hand does not know what the other hand is doing: “But when thou doest alms, let not thy left hand know what thy right hand doeth”.

This does not apply, in the view of some observers, to the ECB. Indeed the ECB is accused of inconsistency: while its monetary policy hand is pushing banks to lend more, its supervisory hand is doing the opposite, as it continues asking higher capitalization from banks 1)In a February interview given to the FT, Daniele Nouy stated some banks would need to raise capital as a result of efforts to harmonise the definition of capital across the European banking system after having already required higher capital ratios in its Comprehensive Balance Sheet Assessment at the end of last year.

In this post I want to examine the validity of this criticism. This I will do, though, from the limited perspective of monetary policy. This means, in particular, that I will not look at financial stability issues that could justify higher capital ratios even if they would create disincentives for bank lending in a situation where there is not enough of it.

The criticism is sometime formulated as if the only way to increase capital ratios was to deleverage by reducing lending.

It is, instead, obviously true that there are other tools to increase the capital ratio: a bank can reduce dividends, issue equity, increase income, reduce the share of risky assets in total assets. 2)The importance of the tool used by banks to increase their capital ratios has been stressed by Coeure, who splits the deleveraging process in 3 types: the good (raising capital); the bad (reduction of assets); the ugly (reduction of good assets while keeping the bad ones on the book) and concludes: “Depending on how it materialises, bank deleveraging has a potential to impede the recovery and make it more difficult for central banks to engineer an appropriate degree of monetary accommodation or, to the contrary, to support the transmission of monetary policy. Therefore, policy-makers need to set proper incentives to promote “good” deleveraging and to steer clear of “bad” or “ugly” deleveraging.”

In their thorough analysis of how banks have adjusted to higher capital requirements between 2009 and 2012, Cohen and Scatigna show that banks reacted to higher capital requirements by raising their capital ratios. In the sample of 94 banks from both advanced and emerging countries that they examine, though, the most important factor leading to higher capital ratios was not deleveraging but rather additional capital, in particular because of lower dividends. Indeed banks overall did increase rather than reduce their assets between 2009 and 2012. This was particularly the case for emerging economies, but also applied to advanced economies. European banks, instead, slightly reduced their assets and, specifically, lending. The different behaviour of European banks may be due to the fact that the regulatory action to recognize losses was delayed in Europe with respect to the United States. The results of Cohen and Scatigna are confirmed by the data reported in the Annual report of the BIS for 2014 (Chapter VI) and by the Monitoring Report of the Basel Committee on Banking Supervision of March 2015, which made the analysis more precise by using confidential supervisory data and a definition of “fully phased-in minimum and target capital requirements” in its analysis. In order to better interpret the macroeconomic consequences of the behaviour of European Banks it should be recalled, however, that they disproportionately deleveraged on foreign lending, as they privileged their domestic activities.

A zoom on lending by €-area banks (see Table 1) confirms that indeed they somewhat reduced their lending between the beginning of 2009 and March 2015, while keeping total assets practically unchanged. It is also noteworthy that the reduction was concentrated in lending to corporations and other borrowers, while lending to households increased during the period. My previous post on bank lending showed that the signs of a recovery in the supply of bank loans, in particular to corporations, are fairly recent, dating only from Autumn of 2014. 3)Bank credit supply is improving in the €-area

Table 1: Change in total assets and loans, breakdown by borrowers ( Jan 2009-Mar 2015)

Total assets Total loans Households Corporations Other borrowers
EUR bn 236.9 -1056 328.3 -566.1 -818.2
% 0.01 -5.80 6.70 -11.61 -9.70

Source: ECB SDW

So, the conclusion so far is that, while there are more tools other than deleveraging to increase the capital ratios of banks and these other tools were predominantly used by banks at a global level, the story about European, and in particular €-area banks, is somewhat different and some deleveraging indeed took place in this area.

We therefore have something of an ambiguous result about the effect of higher capital ratios on lending. While many studies, including Bridges et al, Brun et al and Martynova, estimate that higher capital requirements reduce lending and lead to higher spreads, this effect is far from universal. The uncertainty about the link between capital ratios and lending is also reflected in different estimates of the elasticity of bank lending to increases of capital requirements. Taking into account that the range of possible changes in capital requirements is in practice limited to a few percentage points, it is only elasticities at the high side of the range of estimates that are macro-economically relevant.

The ambiguity in the relationship between capital ratios and lending is reinforced by the empirical finding, again noted by Cohen and Scatigna, that banks with higher capital ratios in 2009 expanded their lending more than banks with lower capital ratios. This is confirmed by Martynova`s, conclusion that “undercapitalized banks reduce their lending more than well-capitalized ones. …… Also, during the recent financial crisis, banks with strong balance sheets were better able to maintain their lending. [And] better capitalized banks (with lower leverage ratio) that were exposed to the financial market shocks decreased their supply of loans less than other banks. In conclusion, all studies …… suggest that higher capital makes the provision of credit more stable and robust even in economic downturns.“ (page 5) Overall, one can characterize the empirical evidence about the relationship between capital ratios and bank lending by saying that the relationship is positive on a cross-section basis at a certain point of time but negative on a time series basis.

The complex relationship between capital ratios and bank lending can be better understood when distinguishing, at least conceptually, between capital resources and capital requirements, as stressed by Bridges et al. Capital resources are represented by the equity of a bank at a given point in time and give it solidity. Capital requirements are the result of regulation and can lead to the need to increase the capital ratio. The effect of higher capital resources on lending is positive, that of higher capital requirements, which require an adjustment, can be negative. One can thus conclude that the possible impact of higher capital requirements is a disequilibrium effect lasting until actual capital ratios are increased along the higher capital requirements, as shown by Bridges et al. Consistently, the possible negative impact of higher capital requirements is estimated to mostly dissipate within three year. So, over time, more lending follows the imposition of higher capital requirements, since they lead to higher capital resources.

Seen in this perspective, the overall conclusion is that the two ECB hands are not fighting each other: the monetary policy hand is assigned to the short and medium term through the Targeted Longer Term Refinancing Operations and QE, the supervisory hand takes care of the longer horizon to put the €-area banking system better able to assist economic growth. Indeed it is possible to find this kind of reasoning in a statement by Draghi. 4) ” It is pretty clear, ……, that banks, in view of the AQR, had carried out some deleveraging, also in some cases significant deleveraging. And so the short-term consequences of the AQR are that banks have to clean up their balance sheets; they know that we will shed light on what is in their balance sheets, so they want to be presenting balance sheets that are clean, and this has a negative effect on credit. But, in the medium to long term, ……, the AQR will be positive for lending……. “ Draghi, Press Conference February 2014

In charitable actions mutual ignorance and modesty can be virtues, in monetary policy consistency and a “two handed” approach are better.

References:

1. Bank for International Settlement Annual Report, 2014.
2. Basel Committee on Banking Supervision, Basel III Monitoring Report, March 2015.
3. Jonathan Bridges, David Gregory, Mette Nielsen, Silvia Pezzini, Amar Radia, Marco Spaltro; The impact of capital requirements on bank lending; Bank of England Working Paper; 2014
4. Benjamin H Cohen, Michela Scatigna; Banks and capital requirements: channels of adjustment; BIS working paper, 2014
5. Natalya Martynova; Effect of bank capital requirements on economic growth: a survey; De Nederlandsche Bank, 2015
6. Matthieu Brun, Henri Fraiss, David Thesmar, The Real Effects of Bank Capital Requirements, Banque de France, 2013


This post was written with the assistance of Madalina Norocea. Benjamin Cohen provided very useful insights.

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References

↩ 1. In a February interview given to the FT, Daniele Nouy stated some banks would need to raise capital as a result of efforts to harmonise the definition of capital across the European banking system
↩ 2. The importance of the tool used by banks to increase their capital ratios has been stressed by Coeure, who splits the deleveraging process in 3 types: the good (raising capital); the bad (reduction of assets); the ugly (reduction of good assets while keeping the bad ones on the book) and concludes: “Depending on how it materialises, bank deleveraging has a potential to impede the recovery and make it more difficult for central banks to engineer an appropriate degree of monetary accommodation or, to the contrary, to support the transmission of monetary policy. Therefore, policy-makers need to set proper incentives to promote “good” deleveraging and to steer clear of “bad” or “ugly” deleveraging.”
↩ 3. Bank credit supply is improving in the €-area
↩ 4. ” It is pretty clear, ……, that banks, in view of the AQR, had carried out some deleveraging, also in some cases significant deleveraging. And so the short-term consequences of the AQR are that banks have to clean up their balance sheets; they know that we will shed light on what is in their balance sheets, so they want to be presenting balance sheets that are clean, and this has a negative effect on credit. But, in the medium to long term, ……, the AQR will be positive for lending……. “ Draghi, Press Conference February 2014