The Eurozone banking system is not working properly due to fragmentation between core and peripheral banking systems. In a recent speech, the president of the ECB, Mario Draghi, has acknowledged this, but argues that fixing this problem is someone else’s responsibility. The ECB has the tools to address this crucial flaw in the Eurozone system, and over the medium term horizon there is no other Eurozone institution that can. The ECB should use the tools available to fix this market fragmentation, in particular, the ECB should engage in aggressive, long-term asset refinancing on sufficiently generous terms to encourage bank participation.
The causes of the bank system fragmentation between the Eurozone core and periphery are well understood. The risk of bank runs, capital controls, deposit haircuts or national euro exit pushes bank deposits and other bank funding out of peripheral-nation banking systems and into core states. Peripheral-nation banks are aware of these overhanging risks, and this awareness further limits bank managements’ appetite for new lending. The implicit required return on bank lending in peripheral Eurozone markets has detached from the core (see figure below). This fragmentation of the banking system reflects a deep flaw in the Euro system’s design.
It is useful to compare the current fragmentation in the Eurozone bank lending market to the US market dislocation at the beginning of the 2007-8 credit-liquidity crisis. The flashpoint of that earlier crisis was the freezing of three interlinked securities markets in the USA: the markets for collateralized mortgage obligations (CMOs), credit default swaps on CMOs (CDS-CMOs), and commercial paper (CP). Note that these three markets are not particularly large on the global stage; all three are limited mostly to the USA. The shocks from this US market dislocation spread to the interbank lending market, which is important worldwide, and triggered the worldwide crash and Great Recession. The crisis spread to the U.K. and Europe, where none of these three problem markets are significant, but where the interbank borrowing market is crucial. The US authorities can be faulted for lax regulatory oversight which helped set the stage for the worldwide crash, but at least they took aggressive actions to correct this particular market dislocation. US authorities, both in the US Treasury and Federal Reserve, acted decisively, at considerable risk. They engaged in aggressive quantitative easing to relieve the exorbitant required returns in these markets by direct purchase of assets from banks (see figure below). This is a simplified description of the TARP and QE programs in the USA, but captures the essence.
The bank lending market dislocation in the Eurozone is arguably more severe than the CMO, CMO-CDS, CP market dislocation which sparked the 2007-8 credit-liquidity crisis. The response of the ECB has been hesitant and rule-bound. See Mario Draghi’s recent speech mentioned above. Draghi argues that given the shortage of bank lending for business investment, peripheral economies should instead improve their economic performance by greater focus on competitiveness and structural reform. He argues that national governments need to tighten their fiscal paths to improve investor confidence, which might possibly help to prevent capital flight. National governments are also welcome to inject more equity capital into their banks (within their fiscal constraints), or perhaps some supranational EU institution can do that at some hazy date in the future, after the planned bank resolution system is negotiated, passed by member states, and enacted. The ECB will only provide bank asset refinancing on tightly-controlled terms to ensure that there is no positive value transfer in the transaction. Given the distorted incentives of peripheral area banks, this mean-spirited offer of zero-net-present-value refinancing ensures that the peripheral economies remain starved of credit.
It is true that many banks in peripheral markets have tight equity capital constraints. This is a consequence rather than a cause of unstable credit flows in the Eurozone. It is not clear that publicly-funded equity capital injections will improve outcomes. An equity capital injection into a zombie bank does not automatically change it into a well-functioning bank; it might just become a zombie bank with more equity capital to waste. Asset refinancing by the ECB on generous terms, of good quality loan assets, goes directly to the heart of the problem without wasting taxpayer-funded equity capital.
The ECB has acknowledged that there is a serious flaw in monetary policy transmission in the Eurozone due to the fragmentation between core and periphery banking markets. It argues that fixing the monetary transmission mechanism is some else’s problem; its only responsibility is implementing monetary policy whether it works or not. No other EU body has the tools to deal with banking system fragmentation over the medium term. The ECB cannot hide from its responsibility by an overly legalistic interpretation of its badly-flawed charter. As the central bank of a major world market it has a responsibility to use quickly and aggressively the tools available to it.