Asset management

29 July 2013

Economist Insights Rain-makers

There has been somewhat of a drought in Eurozone bank lending in the last two years. Higher borrowing costs for banks, pessimism about the economic outlook and regulation on bank capital reserves have all constrained bank lending. However, after a long dry spell, there are finally some hopeful signs as fewer banks reported tightening their credit standards for loans in the second quarter. But looking at the breakdown across the different countries shows that credit availability is very mixed. It will still take a lot to normalise the banking environment for Eurozone firms. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

The publics attitude to banks is a bit like their attitude to rain. Both are necessary, but we still like to complain about them. When there is too much rain, you get a flood, just as occurred in eastern parts of Europe in June. When there is too much banking, you get a flood of liquidity, just as occurred in the run-up to the financial crisis. In the Eurozone the banking problem is not one of flooding, but rather one of drought. In the US larger firms can rely on the credit market for financing, and the banks that provide the rest are in healthier shape than their European counterparts. In Europe banks are responsible for almost all external financing for firms. Without bank liquidity, the next crop of firms and investments will not take root. In the last two years, lending standards in the Eurozone have been resiliently tight (see Economist Insights, 20 May 2013). Numerous factors have constrained bank lending in the Eurozone. The biggest factor has been higher borrowing costs for banks because of concerns over their balance sheets and the balance sheets of the sovereigns that stand behind them. Pessimism about the economic outlook discourages banks from lending as well; why lend money to a company that you think might fail due to lack of demand? As if this wasnt enough to hold things back, extra capital rules for banks require them to increase their capital ratios either by finding more capital or by shrinking their balance sheets. When new capital was hard to come by, most banks instead shrank their balance sheets by reducing the number of loans that they made (see Economist Insights, 2 April 2013).

After a long dry spell, there are finally some hopeful signs for Eurozone bank lending. The European Central Banks Q2 Bank Lending Survey showed that credit conditions in the Eurozone are stabilising as fewer banks are tightening their credit standards for loans to firms, and virtually all the banks expect to keep standards unchanged in Q3 (see chart 1). This may not sound that great, but banks have on average been tightening credit standards every quarter since the middle of 2007. Just as importantly, the banks are expecting demand from firms for loans to increase.
Chart 1: Forecast of rain Net percentage of banks reporting looser credit standards for firms or stronger demand for credit from firms, % 30 20 10 0 -10 -20 -30 -40 -50 -60 -70 -80

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Loosening (tightening) of credit standards to rms Expected credit standards Reporting stronger credit demand from rms Expected demand

Source: European Central Bank

Just as the rain, when it comes, can fall in the wrong place, credit standards demanded by banks across the Eurozone are far more mixed. A number of national central banks produce their own bank lending surveys, providing a breakdown of how bank conditions differ within the Eurozone. Looking at the degree of loosening or tightening of bank standards in any one quarter can miss the full story. If banks changed standards drastically in response to the crisis but have not loosened since, then the absolute level of credit availability will still be very tight. As a rough approximation of the level of tightening you can look at the running total of the responses since before the crisis. The result will depend much upon the chosen starting point, and ignores the size of the loosening or tightening (which is not recorded in detail). Nonetheless, the results are revealing (see chart 2). Banks in Germany, where the economic performance has been stronger and bank liquidity ample, have seen little need to change their credit standards. Spanish banks have also left their standards unchanged in recent years, but that may be because they could not really tighten standards any further after 2008. Italy continues to see ever tighter credit conditions, but curiously enough Irish banks have only tightened about as much as France. This is likely due to the restructuring involved in creating the Irish bad banks: removing the bad debt from the Irish banks did leave the banks more room to manoeuvre, albeit at the taxpayers expense. Perhaps the most surprising change is amongst banks in the Netherlands, which drastically tightened credit conditions before starting to loosen, and more recently have begun to tighten again drastically. The Netherlands is not usually associated with the Eurozone sovereign crisis in investors minds, but the country had a pre-crisis housing boom to
Chart 2: Scattered showers

rival Californias. The on-going problems with mortgages are weighing on both bank balance sheets and the economy, forcing Dutch banks to shrink their balance sheets, including loans to corporates. Comparing these countries with the UK and the US shows the degree to which credit conditions have turned around faster in the latter two countries. Banks tightened very rapidly in the US, but have been steadily loosening since then, and the UK banks are pretty much back where they started. On reported demand, Germany shows the most strength in loan demand, but interestingly enough Italy was also strong until recently. However, dig deeper into the surveys and it turns out that in both countries most of the demand for loans is for debt restructuring (refinancing at lower costs). Demand for loans for the purposes of investment continues to shrink right across the Eurozone. The same story of demand driven by debt restructuring applies to other parts of the Eurozone, but overall demand is down further in those countries. There may be first tentative signs of a turnaround in bank lending in the Eurozone, but the drought has been long and it will take a lot to normalise the banking environment for firms. Some of the detail is a lot less favourable: there is less and less lending for new investment and more and more refinancing of old debt. This could represent ever-greening of loans that should really be non-performing, which would actually be detrimental to long-term growth. And as in so many other things, the improvement within Europe depends on where you are. Just as the real world flooding occurred mostly in Germany, it looks likely that most of the liquidity is likely to come in Germany the country that needs it least.

Cumulative loosening (tightening) of bank credit standards to firms and reported demand for loans by firms, since Q1 2007, %

Credit standards

Eurozone
400

Germany
400 400 0 0

Spain
400 0

Italy
400 0

France
400 0

Ireland
400 0

Netherlands
400 0

UK
400 0

US

0 -400
-800

-400

-400

-400

-400

-400

-400

-400

-400

-800

-800

-800

-800

-800

-800

-800

-800

400

400

400

400

400

400

400

400

400

Demand

0 -400
-800

-400

-400

-400

-400

-400

-400

-400

-400

-800

-800

-800

-800

-800

-800

-800

-800

Source: European Central Bank, Federal Reserve, Bank of England, various Eurozone national central banks Note: The cumulative sum is taken by adding the quarterly reported changes in credit standards or demand, but this will be an approximation because banks do not report the exact magnitude of change each quarter.

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