Why central banks will double down on lending schemes 

Policymakers experiment to refresh parts of parts of economy quantitative easing cannot reach

Huw van Steenis

The headquarters of the European Central Bank which is gearing up to inject more monetary stimulus into the eurozone’s flagging economy © Reuters


Of all the innovations in central banking this year, few are as intriguing as Bank of Japan’s special bonus interest rate to regional banks that cut costs, merge or lend for sustainable development.

The underlying issue is one that worries all central banks. Will banks will be strong enough to fund the recovery, particularly for small and midsized businesses, when government guaranteed loans expire? 

How policymakers answer this question has major implications for bank dividends, financial regulation and the shape of quantitative easing programmes. This makes the next salvo of measures from the European Central Bank all the more interesting.

Last month, the Japanese central bank took the unprecedented step of paying Japan’s smaller regional banks an extra 0.1 per cent of interest “to enhance the resilience of the regional financial system”. It warned that if profitability were to keep falling, financial intermediation could stop functioning smoothly.

Guaranteed lending has represented almost all small business loans this year across the eurozone, UK and US. Little wonder central banks are being creative to try to improve monetary policy transmission to refresh parts of the economy that other QE programmes cannot reach. 

New Zealand just introduced a funding-for-lending scheme to help banks lend to small business. And this week the Federal Reserve extended the scheme helping banks fund loans under the payment-protection programme.

So far in the pandemic crisis, banks have been the dog that did not bark. In the main, they have been resilient, not amplified risks across the system, and worked with policymakers to disburse emergency lending or offer forbearance.

But zero and negative interest rates have hit their profitability hard by squeezing profit margins. The longer these are in place, the greater the side-effects. A recent study by the San Francisco Fed persuasively demonstrated this.

Japanese regional banks were already the least profitable globally, on return on assets. 

Now, an increasing number of small to midsized banks around the world are starting to struggle to cover their fixed costs, especially if you exclude the gains on sovereign bond holdings.

There is a new dimension. The pandemic has accelerated banks’ need for technology investment by three to five years, according to Mohit Joshi, president of Infosys. This requires far greater investment and bigger firms can cover their costs better and invest more in innovation. 

Simply put, the winner-takes-most dynamic we see in most digital markets is coming to banking — and fast.

This means an uphill battle for subscale regional banks. Hence the prompt by the Japanese central bank to merge or take out costs. In Europe, Andrea Enria, chair of the ECB’s supervisory arm, has also been leading the calls for mergers.

An alternative is for banks to piggy back on another's scale through far greater use of utilities or outsourcing their entire back end to a cloud provider, as I argued in the Future of Finance report for the Bank of England. This can take years, so schemes would be needed as bridges.

The market implications of central bank policy shifts are fourfold. Any changes that shield banks more effectively from the corrosive impact of negative rates are net positive for bank securities and, in turn, financial stability. 

Eurozone bank earnings could benefit more than 5 per cent on UBS estimates, should the ECB extend their scheme or improve its terms. But the spread of winners and losers is likely to widen over time as the winner-takes-most dynamic plays out. 

Second, the more the special lending schemes, such as the ECB’s targeted long-term refinancing operations (or TLTROs), are extended, the greater will be the pressure to make them support the transition to a lower carbon economy.

Third, expanded special lending schemes will have spillovers into sovereign bond markets. Given that the ECB’s TLTROs are disproportionately taken by southern European banks, this will keep bids on peripheral eurozone bonds strong.

Fourth, the more workarounds there are for banks, the longer policy rates could stay at zero or negative rates. The pressure on pension funds and insurers to optimise their asset allocation in the face of ultra low rates will be intense.

Milton Friedman used to say nothing was as permanent as a temporary government programme. Funding-for-lending schemes look likely to follow his maxim.


The writer is chair of the sustainable finance committee at UBS

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