Macro Exposure

One of the main problems for Europe is the broken transmission mechanism. It’s been a problem for quite some time.

When the ECB cut its rate, it won’t pass through to the areas of Europe that need it: the periphery. There is thus a world in which it is easy to get cheap credit (the core) and a world in which it is expensive (the periphery) — no matter how low the refi rate is.

With that in mind, here’s a Goldman Sachs graph from an excellent note by Huw Piil:

Here’s Goldman’s explanation of the graph (their emphasis):

Exhibit 1 illustrates the latest data, demonstrating the persistence of the gap between lending rates in the ‘core’ countries (Germany and France) that remain well integrated into Euro financial markets and the ‘peripheral’ countries (Spain and Italy). Indeed, in the January data, this specific measure points to a widening of the gap, despite the success of the ECB’s OMT programme in stabilising government debt markets and narrowing sovereign spreads.

Taking a somewhat longer perspective, it is apparent that the ECB’s easing actions over the past 18 months (the rate cuts in November 2011 and July 2012; the implementation of 3-year LTROs in December 2011 and February 2012; and the announcement of the OMT in September 2012) have passed through to lower bank lending rates in Germany and France, whereas, at best, these measures have only served contain the rise in bank lending rates in Spain and Italy.

The problem summarised by Piil:

Given the weak macroeconomic situation in the periphery, there is a concern that monetary stimulus is not being transmitted to the countries where it is most needed — this is the essence of the impairment to monetary policy transmission that so consumes ECB policymakers. And there is an important sectoral dimension to this impairment, in addition to the cross-country element that has been emphasised thus far: larger companies with access to capital markets are able to issue debt at narrow spreads to sovereigns (and therefore now at reasonable rates even in the periphery), but SMEs are dependent on banks and thus face the elevated rates shown in Exhibit 1. These two dimensions interact and amplify each other: the Spanish and Italian corporate sectors are both dominated by the SME sector.

There are thus two reasons: 1) peripheral countries are more risky and banks (and companies) are increasingly trying to match assets and liabilities on a state-line instead of on a euro zone basis, and 2) the sectoral composition of companies who need credit, where the peripheral have more SMEs without access to capital markets.

So how to ease? As Piil suggests, the ECB could use its collateral framework to support financial innovation. By now, most will probably react like this guy when they hear ‘financial innovation’, but the idea is quite good.

By relaxing the collateral the ECB accepts to include asset-backed securities where the underlying is loans from SMEs in the peripheral, the securitization could start to work.

If the loans could be packed into ABS that could be pledged at the ECB as collateral, it might increase the amount of lending in the peripheral at rates closer to the core. Obviously haircuts would have to be low enough to make it worthwhile, but not so low as to make Weidmann go crazy.

To make ABS backed by peripheral SME loans eligible as collateral might be a way for the ECB to alleviate the problems of structural differences across the monetary zone.

For reference, here’s the ECB’s website on collateral eligibility; and their website on their newly established ABS loan-level initiative.