Credit for Growth: The Future Role of Traditional Banking and Capital Markets – Comparing the United States to Europe
Alexander Privitera a Geoeconomics Non-Resident Senior Fellow at AICGS. He is the head of European affairs at Commerzbank AG. He focuses primarily on Germany’s European policies and their impact on relations between the United States and Europe. Previously, Mr. Privitera was the Washington-based correspondent for the leading German news channel, N24. As a journalist, over the past two decades he has been posted to Berlin, Bonn, Brussels, and Rome. Mr. Privitera was born in Rome, Italy, and holds a degree in Political Science (International Relations and Economics) from La Sapienza University in Rome.
Six years after the worst financial crisis in more than fifty years, the banking sector is still undergoing profound changes. Regulators on both sides of the Atlantic are tightening the rules for those credit institutions deemed to be systemically important. Public authorities in both the European Union (EU) and the United States are trying to fulfill their promise to end the “too big to fail” syndrome. Bailing out banks with taxpayers’ money should become the exception. Bailing in shareholders and creditors of banks in distress should finally become the new norm.
Regulators are trying to make their respective credit systems more shock resistant. Higher capital requirements as well as restrictions on certain activities, such as the ban on proprietary trading that will be imposed on U.S. banks, represent significant moves in this direction.
The purpose of this analysis is to compare some aspects of credit intermediation in the U.S. and Europe, and to highlight why in the emerging regulatory environment a preference for traditional forms of lending intermediated through banks, coupled with a significantly smaller size and strength of European capital markets, could put the European Union at a competitive disadvantage vis-à-vis the U.S. and cause transatlantic economies to diverge in the future.
The Cost of Providing Credit
In a tougher regulatory environment, the cost of holding securities, loans, and trading exposures will rise. As a consequence, traditional lending will become more expensive. At the same time, banks will increasingly try to shift away from “originating and holding” securities to an approach more focused on “originating and distributing,” resulting in more activities intermediated through the capital markets. These complement traditional lending activities by allowing companies to access alternative forms of funding through the issuance of equity and debt securities.
Yet, notable differences in the size and role of capital markets remain between the U.S. and Europe.
In the U.S., the shift from bank-based to market-based lending had already taken place well before the crisis erupted, while in the EU, albeit with some differences among member countries, the development of capital markets still has a long way to go.
More developed capital markets played an important role in spreading the financial crisis in 2007-2008, which was triggered by asset-backed securities that suddenly became illiquid. However, strong capital markets also helped the financial system and economy in the U.S. to recover much more quickly than Europe once credit market liquidity was restored.
Efforts by regulators to address some of the structural weaknesses of capital markets are ongoing, such as enhancing transparency and limiting some of the riskier activities. In Europe, the European Securities and Markets Authority (ESMA) was created to harmonize EU member states’ capital markets. The primary objective of the new regulator is to protect investors. ESMA’s “safety first” approach to capital markets may well help boost demand, but it does little to stimulate the supply of securities. Furthermore, the structure and size of many small and medium-sized enterprises (SMEs) in European countries discourages alternative forms of funding for those companies. They are often simply too small to gain direct access to capital markets. More demanding reporting requirements can also deter companies with poor or incomplete corporate governance from pursuing non-bank forms of funding. Finally, in many EU member states, including Germany, capital markets are still viewed with deep suspicion.
All these factors help to explain why the role of banks is much greater in Europe than in the U.S. In the euro area alone, bank loans account for most household borrowing and around half of all non-financial firms’ external financing. In the U.S., 75 percent of firms’ financing is channeled through capital markets. This explains why the banking sector in the euro area is so big—270 percent of GDP—while in the U.S. this figure is only 72 percent.
In the wake of the crisis, traditional bank lending suffered both in the U.S. and in Europe. Indeed, despite very easy monetary policies, bank lending to households has not yet fully recovered. Attempts by central banks to revive the traditional credit supply through generous liquidity injections have been frustrated by the reluctance of well-funded institutions to pass on their abundant liquidity to the real economy. This forced the Federal Reserve to activate unconventional monetary policies by intervening directly in capital markets. The various rounds of asset purchases, in particular mortgage-backed securities, have helped drive down interest rates as well as risk premiums on a wide range of financial assets. This helped the housing sector to rebound. Non-bank lending to consumers and companies has grown more robustly than the traditional financial intermediation through banks. As a result of these efforts, many corporations and households were able to tap alternative forms of funding, and therefore managed to avoid a prolonged phase of credit scarcity. How effective so-called quantitative easing programs have been for the real economy is the object of an ongoing debate. But, it is hard to argue that these programs have not had an effect on stimulating the economy.
The European Central Bank (ECB) has sought to achieve similar results by injecting liquidity into banks. The goal here was two-fold: to stabilize credit institutions that were losing access to funding in order to reverse the fragmentation of the euro area financial system, and at the same time to revive credit flows to the real economy, in particular to consumers and SMEs. The central bank achieved its first objective but failed to spur lending. Experts within the ECB have been asked by the central bank’s leadership to explore alternative options aimed at fully restoring the monetary transmission channel—i.e., encourage lending activities to the real economy. Some are advocating emulating the approach of the Federal Reserve by activating a massive asset purchases program. But, given the much smaller size of capital markets in Europe, and stiff German resistance within the ECB, the central bank has shied away from undertaking such a dramatic step thus far. The ECB had almost no choice but to concentrate all of its firepower on banks.
As a result of this one-sided approach, lending to households and non-financial corporations is still contracting, and parts of the monetary union are experiencing a credit crunch. Weak lending activity is primarily driven by uncertainty about the European recovery and by a legacy of past misallocation of investment across various sectors of the economy and EU member states. At the same time, the sharp drop has made a bad situation worse. Indeed, while the sovereign debt crisis appears to have been largely contained and the tail risk of a sudden breakup of the euro zone has receded, the recovery of lending and investment activity across Europe has failed to materialize. According to recent findings published by the European Investment Bank (EIB), the continent is experiencing an ongoing investment crisis. The uncertainties that continue to surround the very future of traditional forms of lending in Europe are certainly not helping to stimulate investments.
Banking on Europe?
It is unclear what the current regulatory drive and the implementation of the so-called banking union will do to the size of the euro area banking system and to lending activities. Ideally, it should create the conditions for a healthier, well-capitalized, and smaller banking sector; encourage the development of capital markets; and decouple growth from its over-reliance on traditional bank loans. However, attempts to build a full banking union, comprised of a single supervisor, a central resolution mechanism and fund, and a common deposit insurance scheme, are far from complete. The current focus on the single supervisor—the European Central Bank—and an effective resolution mechanism for failing banks, reveals how, for many European politicians, a safer banking system and a punitive regime for big banks go hand in hand.
But restricting big banks’ activities without actively encouraging the securitization of loans could have a net negative effect on credit supply and growth. If banks remain the primary loan originator in most European countries for the foreseeable future—and that may well be the case—they need to become more profitable. Banks are currently attempting to address this problem by reducing the size of their balance sheets. The need to strengthen capital cushions in anticipation of the comprehensive balance sheet assessment and stress tests that the ECB is undertaking with the European Banking Authority (EBA) is understandable. But it may well end up having a negative impact on lending, especially if the banks’ push to deleverage is not complemented by a stronger reliance on capital markets for credit intermediation. Advancing the securitization of assets—as suggested in the October 2013 Financial Stability Report by the International Monetary Fund (IMF)—would therefore have several short and long-term beneficial effects, including:
- boosting banks’ profitability;
- helping revive lending to consumers and non-financial companies, particularly SMEs across the euro area; and
- strengthening the role of capital markets in supporting the real economy.
In order to spur loan securitization during a time of weak recovery, the origination of some classes of asset-backed securities may need to be guaranteed by fiscal authorities—either directly by member states or indirectly through the EIB. The EIB has already increased its lending activity dramatically, but much more needs to be done. The ECB could ease collateral requirements for asset-backed securities. Alternatively, a significant amount of these securities could be purchased directly by the central bank.
Europe certainly needs a smaller banking sector, but in order to help non-financial corporations, in particular SMEs, to take full advantage of capital markets, it still needs a full range of credit institutions, including investment banks and big universal banks.
There is a growing risk that regulators will choose a different path—one that makes credit provision even more dependent on traditional lending and therefore more difficult and potentially more expensive to obtain. So far at least, the overhaul of the banking sector has had the effect of exposing bigger banks to increasing controls while shielding small savings banks from the all-powerful reach of the new central supervisor. In the public narrative, particularly in Germany, small has become synonymous with safe.
However, smaller banks are not necessarily safer. True, they tend to have closer ties to their clients. They tend to resist the impulse to cut and run if economic conditions deteriorate. Thus, they can have a stabilizing effect in a downturn. At the same time, by keeping poor quality loans on their books for too long, smaller savings or community banks can become an impediment to a more efficient allocation of capital. Current monetary policies are exposing further structural problems at smaller banks. In a loose monetary policy regime—and the weak recovery will force the ECB to remain accommodating for some time to come—smaller banks’ revenues and profits are further eroded. They are structurally less profitable than investment or universal banks, and therefore in a more precarious position. Furthermore, by being overexposed to local economies, smaller banks are likely to suffer disproportionately in a downturn. The so-called “cajas” in Spain were far more exposed to the Spanish housing bubble than bigger credit institutions. They were also far more vulnerable to political pressure during the boom years. Even in Germany, many of the problems for banks shaken by the crisis were caused by smaller banks and an often all too cozy relationship of banks’ managements with local politicians that contributed to making bad investment decisions. In Italy it is mainly smaller banks that were placed in conservatorship by the Italian central bank (Banca d’ Italia).
Finally, a preference for smaller, locally rooted banks could make it harder to create a truly integrated euro area banking system. Indeed, it could cement the financial fragmentation along national lines in the euro area. The unintended consequence of an excessive, one-sided focus on removing the “too big to fail” problem posed by big banks could even have a destabilizing effect on the monetary union.
Indeed, there is a growing danger that current efforts to make the European financial system safer could have a series of counterproductive consequences:
- They could hamper efforts to unlock alternative forms of credit for non-financial corporations.
- Restrictions on bank activities at home could lead to more risk taking abroad (as evidenced in an ECB study), thereby making big, global financial institutions more vulnerable to sudden shocks.
- The current emphasis on a safer banking system could end up preventing a true consolidation of the banking sector and keep its size relative to euro area GDP simply too big to be saved. Without significant cross-border consolidation, funding the European recovery could prove to be a very difficult task. The continued oversupply of banks relative to the size of the economy would cause intense competition among financial institutions, compress their profit margins, and make it harder to attract fresh capital. In the absence of stronger capital markets capable of offsetting a prolonged phase of adjustment in the banking sector, and with banks continuing to be the main providers of funding for non-financial corporations, traditional credit institutions would remain very vulnerable to financial shocks and less inclined to fund consumers and non-financial companies.
Regulators are still struggling to find the right balance between the need to make the financial system safe and the efforts to encourage banks and other credit institutions to support the real economy. Stronger capital markets would no doubt unlock additional forms of funding for companies, especially small and medium-sized enterprises that are the vital engines for growth and employment across the Atlantic.
The U.S. economy is already in a strong position to take full advantage of its capital markets. If European regulators, SMEs, and financial corporations move in the same direction, the continent’s recovery could gain traction. Unless this happens, Europe, and the euro area in particular, could face years of what the ECB describes a very “weak, uneven, and fragile” recovery.
 See Michiel Bijlsma and Gijsbert T. J. Zwart, “The Changing Landscape of Financial Markets in Europe, the United States and Japan,” Bruegel Institute, 18 March 2013, http://www.bruegel.org/publications/publication-detail/publication/774-the-changing-landscape-of-financial-markets-in-europe-the-united-states-and-japan/.
 See “Investment and Investment Finance in Europe,” EIB, 14 November 2013, http://www.eib.org/infocentre/publications/all/investment-and-investment-finance-in-europe.htm.
 See European Central Bank, Research Bulletin, No. 16 (Summer 2012), http://www.ecb.europa.eu/pub/pdf/other/researchbulletin16en.pdf.