Eurozone monetary policy transmission is broken. A key aspect of this is the failure of credit to get to small and medium enterprises, and consumers. This column uses the ‘I theory of money’ to diagnosis the problem and propose ‘prudently designed’ asset-backed securitisation as the cure. This would transform illiquid SME and consumer loans into a liquid asset class that would broaden the transmission mechanism while providing a lasting intermediation market for this segment in the Eurozone.
Recent data show a decline in credit to small and medium-sized enterprise (SME) and private loans. Lack of credit growth to productive firms is one of the main obstacles to reignite the European growth engine.
So far, the ECB’s unconventional monetary policy measures benefited primarily government debt. From 2012 onwards the ECB’s communication strategy, which suggested potential interventions in the sovereign debt market, was effective in reducing the funding costs for sovereign governments. This policy has also lowered corporate yields benefitting large enterprises. For example, the Spanish and Italian ten-year yield trade around 3%, the Portuguese around 3.65% and BofA Merrill Lunch Euro High Yield Index fell significantly below 5%. However, the impact of the accommodative monetary policy on SMEs and households has been more limited. In other words, the monetary transmission mechanism is sectorally impaired. Small firms and sectors with many small firms are at a disadvantage compared to large firms.
Our “I theory of money” (Brunnermeier and Sannikov 2012), stresses the sectoral approach. In this framework credit extension by the financial system and money creation are endogenous. Absent any policy intervention, the amplification of negative shocks creates additional endogenous risk and triggers wealth redistribution away from the balance sheets of impaired sectors. Monetary policy can mitigate these adverse effects by identifying the ailing sectors and following the ‘bottleneck approach’. Effective monetary policy changes relative asset prices in such a way that they stem further amplification and avoid undesired redistributive effects hurting productive but balance sheet impaired sectors.
The fundamental problem is when the banking sector is undercapitalised, it hesitates to extend more credit to SME and consumers. There are several approaches to helping the banking sector recapitalise itself. One approach is to grant it temporary monopoly rents. Reduced competition increases banks’ profit margins on new loans, but limits overall credit extension and harms especially the bank-dependent sectors. This hurts overall real economic activity. The opposite approach is to attract new risk bearing capital, by e.g. forcing banks to raise new equity. In addition, the ECB could offer longer term funding exclusively and only to those banks that extend loans to new SME customers.
A third approach is to open credit financing outside the traditional banking channel. Launching a prudently designed asset backed securities market focused on consumer and SME loans could be part of the solution to offset disinflationary pressures. Securitisation badly done during the run up of the crisis in the 2000s spoiled the well for any form of securitisation. However, as any innovation can be harmful or useful depending how it is applied or designed, the same is true for the financial innovation, securitisation.1 Brunnermeier et al. (2011) proposed ESBies (Euro-nomics Group 2011), a European bond securitisation structure for sovereign bonds that does not rely on joint liability.
For relatively illiquid loans to small and medium enterprises (SMEs) a standardised, highly transparent and quality controlled securitisation program can transform these illiquid loans into an asset class with high market liquidity. This is appealing for several reasons.
First, in the short run this could stimulate credit and overcome the ongoing weakness of credit provisioning by banks. Some of the credit risk could be transferred to other financial institutions outside of traditional banking.
Second, this new prudently designed asset class would ensure that any unconventional monetary policy is more ‘sectorally balanced’. Monetary policy should not favour national sovereign debt and large corporate debt issuers over SMEs. With an active SME securitisation market, this problem could be avoided.
Third, securitisation designed on a Eurozone-wide scale would create a new European asset class. It would re-establish cross border financial intermediation inside the Eurozone, with sounder economic fundamentals than wholesale short-term interbank lending. It would also ensure that the monetary transmission channel is not only ‘sectorally’, but also ‘regionally’ more balanced.
Fourth, the senior component of ABS can serve as stable high-quality collateral and take on the role as a European safe asset. It can take on a stabilising function in times of crises when flight to safety capital flows from the periphery to the core of the Eurozone surge.
Fifth, establishing this asset class is an opportunity to launch a truly European market that does not suffer from the diabolic loop, i.e., the link between sovereign and bank credit risk (see https://www.voxeu.org/article/esbies-realistic-reform-europes-financial-architecture)
There exist several technical and legal hurdles. While the statistical properties of default rates for consumer loans, especially for car loans, are by now well understood and stable, the reaction of the value of an SME loan portfolio to various risk factors is less known. As a consequence, tranching of SME loans has to be more conservative. In addition, securitisation has to be designed in a way that minimises asymmetric information problems. Pooling should ideally diversify away any soft informational advantage the initial issuer of the SME loans might have. From a legal perspective, a harmonised bankruptcy law would be desirable but is not necessary.
Advanced standardisation and transparency is essential for the success of the asset class. If the ECB were to embark on a possible private asset purchase programme in the future, it would already have now an opportunity to set the framework for future development and standardisation of securitisation in the Eurozone.
One of the key design issues is whether or not this new prudent securitisation should involve some maturity transformation in addition to pooling and possibly tranching. There are strong arguments in favour of staying away from maturity transformation. The absence of any maturity mismatch limits endogenously created risk of a run. Because there is a large set of natural investors (such as pension funds) that prefer to hold long-dated assets, there is no need to attach the maturity transformation element to this securitisation product. More generally, the fact that a world full of long-term savings and funding needs continues to be served by a financial system that relies mostly on short-term funding remains a paradox.
Monetary policy should not favour national sovereign debt and large corporate debt issuers over small and medium enterprises and consumer loans. Launching a prudently designed asset backed securities market, which transforms illiquid small and medium enterprises and consumer loans into a liquid asset class, could be a way to broaden the transmission mechanism of monetary policy. This would also establish a lasting intermediation market for this segment in the Eurozone.
Adrian T, P Colla and H S Shin (2013) Which Financial Frictions? Parsing the Evidence from the Financial Crisis of 2007-09 Volume 27 edited by Daron Acemoglu, Jonathan Parker, and Michael Woodford, May 2013, pp. 159 – 214.
Brunnermeier, M K, and Y Sannikov (2012), “The I Theory of Money”, working paper, Princeton University.
Brunnermeier, M K, and Y Sannikov (2014a), “A Macroeconomic Model with a Financial Sector”, American Economic Review, Vol. 104, No. 2, pp. 379-421.
Brunnermeier, M K, and Y Sannikov (2014b), “Monetary Analysis: Price and financial stability”, ECB Forum on Central Banking, May.
ECB and Bank of England (2014), “The Impaired EU Securitization Market: Causes, Roadblocks, And How to Deal With Them”, Short paper.
ECB and Bank of England (2014), “The Case for a Better Functioning Securities Market in the European Union”.
Euro-nomics Group (2011), “ESBies: A realistic reform of Europe’s financial architecture“, VoxEU.org, 25 October.
1 One classic example is dynamite. Its invention led to much destruction, but it can also be used wisely for building tunnels and in mining.