Draghi Covets Bank Clean-Up as ECB Weighs Fix

Ricard Mollon, founder of a designer furniture firm near Barcelona, says he can see the way to success but can’t get a bank loan to fund it.

“It’s a vicious circle: To obtain money, you have to show results first,” the 32-year-old said in an interview. With Spain’s banks lacking capital and burdened with bad debts, Mollon said he expects no help from them to fund marketing and expansion at his firm, Quattria S.L. “They won’t pay attention to us as a small company.”

For two months, European Central Bank policy makers have discussed ways to help entrepreneurs like Mollon access funds they need, even as the region endures its longest-ever recession. While ideas range from a limited tweak of collateral rules to packaging small-business loans for investors, ECB officials, including President Mario Draghi, are now hinting little can work unless banks unload their toxic legacy debt.

“Probably more efficient than any measure to support lending is to start the cleaning of banks’ balance sheets,” said Laurence Boone, chief European economist at Bank of America Merrill Lynch in London. Still, “allowing long-term investors to take a stake in SME funding I think in spirit is positive. It makes sense if we want the economy to start accelerating again.”

Encouraging Banks

The ECB’s shift in focus to bank lending coincides with a further depletion of its conventional policy armory after it cut its interest rate last month to a record-low 0.5 percent. Officials will keep it there at their decision tomorrow, the median of 59 forecasts in a Bloomberg News survey shows.

A slump in investment and exports in the first three months of this year drove the deepening of the euro-area’s recession, data published by the the European Union’s statistics office in Luxembourg showed today. Gross fixed capital formation subtracted 0.3 percent from gross domestic product, which fell 0.2 percent overall, the office said.

Draghi kindled speculation of an asset-backed securities program in April, and in May he announced consultations with the European Investment Bank on a measure to promote a “functioning market” for them. Twelve months of falling bank lending had pushed policy makers to consider either incentivizing banks to lend, or making it detrimental for them not to do so.

Rajoy’s View

“We would consider very useful if the comments made by the ECB’s president Mr. Draghi on the necesity of solving SME funding difficulties were to lead to concrete proposals,” Spanish Prime Minister Mariano Rajoy told reporters today in Brussels after meeting European Commission President Jose Barroso.

A measure to encourage bank lending might require the ECB to couple a reduction in the discount it imposes on asset-backed securities presented to it as collateral, with a new vehicle to help generate such securities backed by loans to small businesses. Such a plan would likely involve a partial guarantee by at least one European Union body.

“This solution would solve the medium-term problem that we’re too reliant on banks,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London. “But it requires that the banks be fixed first for it to work. The ECB can hold out a carrot to governments to complete financial union, but it can do little about cyclical fragmentation.”

Balance Sheet

More attractive for banks would be if the ECB stimulated the market for loans by buying the assets itself, using its potentially unlimited balance sheet. Officials including Draghi, Joerg Asmussen and Peter Praet have publicly hinted at this.

For now, the weak point of any plan to stimulate lending is that with economies so sluggish, further loans may simply worsen banks’ balance sheets.

“Is it sensible to be incentivizing banks in countries where the economy is in recession to increase exposure to domestic companies?” said Nick Kounis, head of macro research at ABN Amro in Amsterdam. “Banks are already worried about lending and not getting it back.”

Spanish banks received 41 billion euros ($53.6 billion) in European aid in 2012 to replace capital lost through bad loans linked to real estate, and the International Monetary Fund this week called for “strong supervision” of them. Italy’s banking association says a record 131 billion euros of loans in the country aren’t being repaid.

Bank Health

With the health of banks in the periphery far from assured, ECB policy makers are now signaling that any move to kick-start bank lending might be tied to prompt action by European governments to plug holes in bank balance sheets. The ECB will conduct an “asset quality review” as a condition for the central bank taking over euro-area supervision duties is concluded early next year.

“We need to create full transparency about the risks on banks’ balance sheets,” Draghi said in Shanghai this week. “Such transparency is a pre-condition for the banking sector to return to lasting health. And a healthy banking sector is a pre-condition to revitalizing bank lending.”

Once that review is finished, Draghi added, national budgets, and if needed, the European Stability Mechanism bailout fund, will have to “provide an adequate backstop.”

Executive Board member Yves Mersch said on May 17 that the ECB could finish inspecting assets on banks’ balance sheets by the end of the first quarter of 2014, with a stress test afterward in cooperation with the European Banking Authority. Results of both investigations could be ready by the middle of the year as the ECB begins supervision duties.

‘Messier’ Risk

“It’s feasible that the ECB says to governments at the summit of leaders in June that it needs to commit to recapitalization before the ECB will unveil a plan,” said Carsten Brzeski, senior economist at ING Belgium SA/NV in Brussels and a former European Commission official. “It could also be messier and less distinct than that.”

In the meantime, Spanish entrepreneurs such as Ruben Vidal are left wondering how businesses can grow without a functioning banking system to assist them.

“Banks used to fund any project, now there is no money even for those that are valuable,” Vidal, a 33-year-old technical director at Atika Karam, a Granada-based consultancy firm for companies seeking to export to Morocco, said in an interview. “These banks are like a shoe shop without shoes.”

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