Unimpressed by the green shoots on economic activity, central banks have grown increasingly concerned about the risk of a credit crunch. The turn-around has been especially visible for the ECB, which has recently stepped up pressure on banks to lend. All major central banks appear worried that as credit demand starts to recover, credit supply might be unable to keep up—but the moral suasion recently deployed by the ECB has been much stronger and more explicit than, for example, the Fed or the Bank of England. Mr. Trichet has urged banks to be “responsible” and translate ECB liquidity into lending to the real economy, and Mr. Bini Smaghi argued in an interview published today that if banks fail to do so, it would signal that their balance sheets are still too weak and their capital position needs to be bolstered. It is not as easy as that, however. If credit supply starts to fall short of credit demand, this could also largely reflect a more prudent risk assessment in a still very risky environment. If lending truly were a straightforward sign of health, indeed it would be not only responsible but rational for banks to lend more, as this would lead to greater market confidence and easier access to funding. It is tempting to believe in such a virtuous circle. Markets, however, might not see it that way—after the excesses of past years, we cannot rule out the risk that markets would deem as irresponsible an acceleration of credit in a weak macro environment on the back of very visible political pressures. A much better way of strengthening confidence, normalizing access to medium and long term financing and minimizing the risk of adverse feedback loops between financial sector and real economy would be to launch a Eurozone-wide comparable and transparent stress test exercise, something on which Eurozone policymakers still disagree. In other words: banks indeed have a responsibility to do their part to stimulate a recovery, particularly as they have benefited as a sector from considerable and crucial support from policymakers. But as mis-pricing of risk has played a key role in unleashing the crisis, responsible risk assessment must play an important role on the way out of the crisis.
Over the course of this two-year long crisis, the credit crunch has turned from a bogeyman, dismissed by many as an improbable danger, to a Damocle’s sword hanging by a thread over a still ailing real economy. In the early stages of the crisis, central banks could draw some comfort from the fact that rates of credit growth were so high that a correction was needed and healthy. Since early last year, however, credit growth rates have plummeted and they still show no signs of stabilization—and central banks have correspondingly become antsy (see charts next page)
EMU MONEY AND LENDING GROWTH
US LENDING GROWTH
The turnaround has been remarkable for the ECB, which until recently had been particularly explicit in dismissing concerns of a credit crunch, noting that the decline in credit growth rates was entirely demand driven, reflecting a cyclical slowdown in investment. And indeed, the ECB’s initial claim continues to be vindicated by the data: our recent econometric analyses confirm that since credit demand has come crashing down in line with investment, it is impossible to find in the data any hard evidence of supply constraints playing a role. Now, however, the ECB has joined other central banks in acknowledging that credit supply restrictions are probably having an impact.
The ECB has leap-frogged other major central banks with its explicit and public calls on banks to extend more credit. Particularly after the launch of the 1-year refinancing operations, ECB officials have repeatedly called on banks to pass on the liquidity to the real sector. During the latest press conference, President Trichet urged banks to be “responsible”, that is to do their bit to kickstart the recovery through higher lending volumes. Governing Council member Bini Smaghi earlier issued a particularly strong warning, stating that the “appropriate authorities” should ensure that banks pass on the liquidity via increased lending. In an interview published today in an Italian daily, Bini Smaghi noted that as financial markets confidence has not yet been fully restored, banks still find it difficult to raise medium and long term financing, flagging the risk that constraints to credit supply might strangle the recovery once credit demand re-awakens. This is a significantly stronger and more public form of moral suasion than what we have seen from the Fed or the Bank of England, even though the deceleration in credit growth has been equally sharp across the Atlantic and across the Channel.
Bini Smaghi stated in today’s interview that if banks fail to translate the ECB’s liquidity injections into increased lending that would be a sign that their balance sheets are still impaired and their capital position needs to be strengthened. This fits seamlessly with statements made by Trichet at the last press conference, where he exhorted banks to strengthen their capital positions, including where necessary via availing themselves of the support mechanisms made available by governments, for example in the form of recapitalization bonds.
This seems to use a “revealed preference” argument to turn the traditional stress test on its head: if a bank does not lend more, it must be because its balance sheet is too weak. It also echoes recent statements by German Finance Minister Peer Steinbrueck, who complained that banks prefer to invest in fixed income, FX and equity markets rather than extending credit.
It is not as easy as that, however. The deep and prolonged recession we are facing implies a riskier macroeconomic environment, and the natural response for banks is to become more prudent in their lending policy. How much of the perceived reluctance to lend is due to weak balance sheets, and how much to justified concerns about the prospective rise in nonperforming loans? Note that Trichet made it clear at the last press conference that in this macro environment the ECB has no intention of taking on its books additional risk via direct purchases of corporate bonds or commercial paper, and prefers to stick to ultra-safe, “doubleguaranteed” covered bonds.
I am not dismissing the risk of a credit crunch—in fact, I have been flagging it for quite some time. I am arguing that if the supply of credit starts falling short of demand, this might reflect in large part the banks’ prudent risk assessment. This is a time-honored, if unfortunately procyclical, feature of lending, famously encapsulated in the definition of a banker as someone who gives you an umbrella when the sun shines and takes it back when it starts raining.
