April 26 (IFR) - The European Central Bank is becoming increasingly concerned that troubled loans made before the onset of the financial crisis are clogging the arteries of the region's banking system, with bank officials worried that the problem could hinder the ECB's efforts to boost lending.
Policymakers privately admit that they have become frustrated with the reluctance of national governments, regulators and banks to clean up balance sheets after years of delay. They believe many banks have cut back on lending in order to prop up their growing pools of non-performing loans.
According to KPMG, European banks have about EUR1.5trn of non-performing loans sitting on their balance sheets - about EUR600bn of that belonging to UK, Spanish and Irish banks alone. It said in a recent report that a "wave of deleveraging transactions is yet to materialise", with banks choosing to roll over loans rather than sell and recognise losses.
The ECB governing council has spent the past few weeks examining its options, and could announce a scheme to increase lending at its May 2 meeting. But there is a growing consensus that important factors behind the credit squeeze are beyond the bank's control.
"The ECB does not have a magic wand," said council member Benoit Coeure in a recent speech. "The central bank cannot compensate for a shortage or a mis-allocation of equity. That is something that has to be addressed, in one form or the other, by other stakeholders."
Businesses have been worst hit by the lending slump. ECB data show that European banks have withdrawn EUR365bn of credit facilities to non-financial businesses in the last four years - a 7.5% fall. Spanish lenders have pulled a third of business credit, while Irish banks now lend just half what they once did, the ECB figures show.
Consumer credit has also been badly affected, and is now down by 8.6% from the peak. Central bankers are concerned that the fall in lending could worsen the economic decline in the eurozone, which is already buffeted by record unemployment, ebbing confidence and large cuts to government spending.
One explanation for the fall - often advanced by bankers involved in lending decisions - is that the poor economic backdrop and lack of confidence mean demand for credit has slowed.
"If banks believe they can put loans out safely, they will. But in this recessionary environment neither banks nor businesses feel confident," said Alan Turner, head of debt finance at Barclays corporate banking division.
"SME deposits with us have surged in recent months. That isn't an indication they need credit - it's an indication they have no confidence to invest."
But a recent ECB survey of small and medium enterprises found that such borrowers' need for credit has actually risen since October - and that access has fallen.
The relative impotence of central banks in addressing the issue is clear. The ECB took measures to stabilise the banking system last year when it injected more than EUR1trn of liquidity into the region's banks. But that failed to reverse the decline in lending, with banks preferring to repay the money early rather than lend it out. Some EUR360bn has already been paid back.
The apparent failure of the Bank of England's Funding for Lending Scheme, which was launched last summer, is another indication that liquidity injections from central banks are failing to get lending going. Banks have only taken GBP13.8bn of funding under the scheme - well below the GBP80bn available. In fact, since the scheme began, lending to UK households and non-financial businesses has fallen by GBP1.5bn, or about 0.1%.
"The Bank has made the funds available, with strong economic incentives to support lending to UK households and businesses, but it is up to the banks to deliver," said Paul Fisher, a monetary policy committee member at the Bank of England and head of the scheme, in an interview with IFR.
The Bank of England has tweaked the scheme in recent days, extending the repayment schedule and widening the range of borrowers to whom banks may lend.
Fisher acknowledged that banks' efforts to deal with legacy assets are impeding their ability to make fresh loans.
"Some are still adjusting their balance sheets after lending too cheaply before the crisis - a period when banks mis-priced liquidity and credit risks," said Fisher. "And some are engaged in a process of running down loan portfolios related to commercial property, which grew too rapidly in the run-up to the crisis."
Banks have been delaying the clean-up of their balance sheets, and the regulatory push to force banks to hold more capital in the wake of the crisis has proven to be a major disincentive. Selling off non-performing loans - almost certainly at a discount - would eat into capital, throw capital building plans off-course and unsettle investors.
RBS is one of the few banks to have aggressively cleaned up its legacy loans. Bruce van Saun, financial director at RBS, said that rolling over old loans is a bad use of scarce capital.
"It can be painful to recognise losses in the short term, but cleaning up the balance sheet allows you to start looking forward rather than constantly having to look backwards," van Saun told IFR. "By ignoring reality, you're keeping capital committed unproductively."
RBS was rescued by the UK government in October 2008 and injected with GBP20bn of fresh capital. It has since reduced its balance sheet by almost GBP900bn, selling assets - some of which have caused losses. Although it has reduced the amount it lends to corporate clients, the bank has increased mortgage lending.
"The recapitalisation gave us room for manoeuvre and allowed us to take losses to restructure our balance sheet and risk profile," said van Saun.
"That part of our job is almost complete. In a way, it's more difficult for other banks right now because they haven't got the capacity to aggressively take losses while the market is pressuring banks to increase capital ratios."
Bankers say that the need to raise capital ratios is not just preventing them from cleaning up their balance sheets, but is also acting as a disincentive to lend. New loans would require additional capital be held against them, making the path to meeting capital rules even steeper in the short term.
European regulators have tried to ease that burden by easing capital requirements for SME loans. But that will not remove the need for additional capital - it will only reduce it.
Meanwhile banks are using their excess cash to buy assets such as government bonds, which can be held with zero capital. Eurozone bank holdings of government bonds have risen by 21% since the ECB pumped liquidity into the banking system, and now stand at EUR1.67trn.
"The increase in government bond holdings is a pure capital arbitrage trade," said Roberto Henriques, a credit analyst at JP Morgan. "Banks don't need to hold capital against government bonds, so the return on risk is currently better than lending out to a corporate."
But the ECB is powerless to alter those rules, because such decisions are made at a national level and are beyond its remit. "For the situation to improve, banks need a capital holiday, but the problem is that it isn't in the ECB's power to permit that - at least not under the current regulatory structure," said Henriques.
Stymied by the effects of both the legacy assets and capital requirements, analysts say the ECB will have to be creative to unfreeze lending in the region. One option might be large-scale asset purchases. The ECB has bought more than EUR200bn of government bonds under its securities market programme to bring down yields, and has also launched a covered bond buying programme to ease funding pressures for banks.
Analysts suggest that the bank could buy pools of SME loans. But under so-called "skin in the game" rules, banks would need to keep some of the loans on their books - which in turn means more capital would be required. And even before that, banks would need extra capital to issue the loans before they were packaged and sold.
"Banks need to be originating new loans if they are going to use them in financing transactions, as few people are interested in the vintage loans," said Daniel Pietrzak, co-head of structured credit at Deutsche Bank. "But banks seem challenged to do that in size. They have legacy issues still to clean up, and while funding is not an issue these days, capital remains a large focus."
The ECB's traditionally conservative nature may well limit its willingness to take on credit risk, which buying securities would entail. It could circumvent that by providing funding to the European Investment Bank, which could lend directly out and take on the risk - but the EIB would need more capital to do that. National central banks could also take on credit risks, but that would leave national governments back-stopping losses, which might hurt their credit ratings.
The US offers an example of how such risk-sharing might work. After the collapse of Lehman Brothers, the Federal Reserve agreed to lend money to banks that had made new loans, with the US Treasury offering to take the first losses on any defaulted loans.
"We took the view that the only way to break that loop was if the central bank took the tail risk," said one policymaker in the US directly involved in those decisions. "We felt confident the tail risk wasn't as big as people feared."
But the ECB wouldn't be able to take on the risk alone - it would need its 17 shareholders to stand behind any losses collectively. That might be a sticking point.
A version of this story will appear in the April 27 issue of International Financing Review, a Thomson Reuters publication: www.ifre.com
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