“The ECB’s missing chart”

The key (missing) chart

Summary

The ECB published its November 2019 Financial Stability Review (FSR) this week with a suitably cautious outlook for financial stability, economic growth, and banking sector profitability in the euro area (EA).

The analysis is as insightful and thorough as usual and supports many of my current views. However, it “falls short” in one key respect – the FSR presents its analysis through the traditional household (HH) versus corporate (NFC) framework, rather than through the increasingly more relevant COCO versus FIRE-based credit framework.

The risk here is that it underplays the hidden risks in QE, namely that the majority of credit in the EA is directed into “unproductive” FIRE-based credit rather than more “productive” COCO-based credit. As such, current policies to support/stimulate credit demand have potentially negative (if unintended) implications for leverage, growth, stability and income inequality.

Key messages from the FSR (Nov 2019)

The FSR states that the “the euro area financial stability outlook remains challenging“. It highlights four key issues:

1. Signs of asset mispricing suggest potential for future correction
2. Lingering private and public sector debt sustainability concerns
3. Growing challenges from cyclical headwinds to bank sector profitability (“75% of EA significant banks have ROE < 8%”)
4. Increased risk-taking by nonbanks may pose risks to capital market financing

In mitigation, the FSR notes that: (1) euro area banks are adequately capitalised with a 14.2% CET1 ratio; and (2) all Euro Area countries have activated macroprudential measures. Nonetheless, it concludes that “more active use of macroprudential policies could be appropriate to contain vulnerabilities“.

The FSR argues that the economic outlook has deteriorated and that growth is expected to remain subdued for longer, with risks tilted to the downside. It also concludes that “while the banking sector is resilient to near-term risks, challenges from a more subdued profitability outlook remain“. Four headwinds facing banks are cited: eroding interest margins; slightly higher costs of risk; high cost inefficiencies, and plateauing capital positioning.

I have covered many of these factors in recent posts including:

• “Macro building blocks revisited”
• “Debt dynamics in the developed world”
• “The changing face of global debt”
• “Looking beyond the yield curve”
• “Power to the borrowers”

The ECB’s framework

The FSR presents its analysis of the HH and NFC sector separately. The HH sector is discussed in Section 1.3 (Euro area household resilience supported by low interest rates) and the NFC sector in Section 1.4 (Emerging pockets of corporate sector vulnerability).

In summary, the FSR describes HH lending as “robust, with continued divergence across countries and types of loans”, HH indebtedness stable (with considerable heterogeneity across EA countries) and risks to HH debt sustainability contained. My comments:

1. HH credit is growing at the fastest rate in the current cycle (3.4% nominal and 2.6% real YoY growth) but rather than robust, I would describe this growth as relatively subdued especially in relation to historic cycles
2. As noted in previous posts, and illustrated in the graph above, HH growth is concentrated in Germany, France and the Benelux
3. In “Debt dynamics in the developed world” I agreed with the conclusion that excess credit growth risks in developed economies were relatively contained (and limited largely to non-EA countries such as Norway, Switzerland, Canada and Sweden, see graph below).

In the NFC sector, the FSR highlights the deceleration in corporate profits, along with increases in external financing and slightly elevated corporate indebtedness, but suggests that risks are offset by favourable financing conditions and large liquidity buffers.

I would suggest that this underestimates risks in this sector:

1. The NFC debt ratio (% GDP) is currently 105% in the EA, above the 94% average for all BIS reporting countries and the BIS maximum threshold level of 90%
2. At the country level, only Italy, Germany and Greece have NFC debt ratios below the BIS threshold
3. My analysis also highlights relative high “growth” and “affordability” risks in the French NFC sector.

An alternative framework

In September, I presented an alternative framework for analysing global debt dynamics. I argued that, in its broadest sense, lending can be split into two distinct types: lending to support productive enterprise; and lending to finance the sale and purchase of existing assets. The former includes lending to NFCs and HH consumer credit, referred collectively here as “COCO”-based lending (COrporate and COnsumer). The latter includes loans to non-bank financial institutions (NBFIs) and HH mortgage or real estate debt, referred to collectively as “FIRE”-lending (FInancials and Real Estate). 

In short, COCO-based lending typically supports production and income formation, while FIRE-based lending typically supports capital gains through higher asset prices. Lending in any economy will involve a balance between these different forms, but to repeat the key point from September: a shift from COCO-based lending to FIRE-based lending reflects different borrower motivations and different levels of risks to financial stability.

Over the past twenty years, FIRE-based lending has increased from 48% of total loans to 55% as at the end of September 2019. The current level represents the highest share of FIRE-based lending. Only three of the large EA economies have COCO-based lending above or equal to FIRE-based lending: Greece; Austria, and Italy.

Why does this matter?

The hidden risk in QE is that the ECB is “Fuelling the FIRE” with potentially negative implications for leverage, growth, financial stability and income inequality in the Euro Area.  

1. Leverage: while COCO-based lending increases absolute debt levels, it also increases incomes (albeit with a lag), hence overall debt levels need not rise as a consequence. In contrast, FIRE-based lending increases debt and may increase asset prices but does not increase the purchasing power of the economy as a whole. Hence, it is likely to result in high levels of leverage
2. Growth: similarly, COCO-based lending supports economic growth both by increasing the value-add from final goods and services (“output”) and an increase in profits and wages (“income”). In contrast, FIRE-based lending typically only affects GDP growth indirectly
3. Stability: the returns from FIRE-based lending (investment returns, commercial and HH property prices etc) are typically more volatile that returns from COCO-based lending and may affect the solvency of lenders and borrowers. The FSR notes that house prices rose faster than GDP in 1H19 and highlights signs of overvaluation, which now exceeds 7% on average, “but with a high degree of cross-country heterogeneity” (see graphs below)
4. Inequality: the returns from FIRE-based lending are typically concentrated in higher-income segments of the populations, with any subsequent wealth-effects increasing income inequality.

Conclusion

The FSR’s outlook for financial stability, economic growth and bank sector profitability is in-line with the views expressed in my recent posts (albeit with some differences in emphasis). However, the hidden risks associated with the ECB’s unorthodox monetary policy are potentially understated, in my view.

The alternative framework presented here, that draws the distinction between productive COCO-based lending and unproductive/less-productive FIRE-based lending, provides a clearer perspective of these risks.

The on-going shift in the balance of lending in the Euro Area has negative implications for leverage, economic growth, financial stability and income inequality.

Please note that the summary comments above are abstracts from more detailed analysis that is available separately.