Draghi Faces Mission Conflict as ECB Reviews Banks

Mario Draghi’s two biggest policy tasks for this year threaten to run into conflict.

The European Central Bank president convenes the first rate-setting meeting of 2014 in Frankfurt today with a to-do list that includes supporting the recovery in the 18-nation currency bloc and carrying out a balance-sheet review of its largest lenders. The risk is that banks pull back even further on loans, derailing the already-fragile economic revival, to avoid being ordered to raise more capital.

“The ECB’s bank assessment will have a dragging effect on credit lending, deteriorating an already bad situation,” said Ebrahim Rahbari, an economist at Citigroup Inc. in London. “They could counter this by providing incentives on the monetary-policy side, for example conditional long-term loans, but such a move isn’t straightforward.”

The dilemma highlights the challenge of requiring the ECB to take on multiple responsibilities after politicians entrusted it with overseeing a banking system that nearly toppled the currency bloc two years ago. Draghi now has to balance his pledge to ease monetary policy if needed with an assurance that liquidity won’t be used to plug banks’ capital gaps.

Severing Links

The Governing Council will hold fire today and leave the benchmark rate unchanged at a record low of 0.25 percent, according to all 51 economists surveyed by Bloomberg News. The central bank will announce its interest-rate decision at 1:45 p.m. in Frankfurt and Draghi will hold a press conference 45 minutes later.

The Bank of England will probably keep its benchmark rate at a record-low 0.5 percent at 12 p.m. in London, while its bond-purchase plan will stay at 375 billion pounds ($618 billion), according to separate Bloomberg surveys.

European leaders agreed in 2012 to set up a banking union with the goal of severing the financial links between lenders and sovereigns that fueled the region’s debt crisis. The ECB, which says the union will bolster confidence and underpin economic growth, is hiring 1,000 people to start its supervision role in November. Finance ministers agreed last month on the blueprint of a resolution mechanism for winding down failing lenders, the next stage in the union.

Impaired Credit

Before becoming the supervisor, the ECB will conduct a three-stage review, known as the Comprehensive Assessment, to identify any capital shortfalls on the balance sheets of the region’s biggest lenders. The exercise may require institutions to raise as much as $200 billion and damp lending further, according to an Ernst & Young LLP report this month.

Bank credit to companies and households in the euro area shrank for a 19th month in November even after the ECB cut rates twice in 2013 and Draghi pledged to keep them at current levels or lower for an extended period. Vice President Vitor Constancio said last month that lending may not pick up until 2015.

“The ECB’s first priority should be to fast-track cleaning up the banking sector so that supply constraints, such as bad loans on bank’s balance sheets, no longer impair the flow of credit,” said Andrew Bosomworth, managing director at Pacific Investment Management Co. in Munich, who forecasts no change in rates today. “Currently, we think deflation risks do not warrant further easing, but the situation is critical.”

That echoes Draghi’s comments in an interview with German magazine Der Spiegel released on Dec. 28, in which he said “at the moment there’s no immediate need to act.”

Conditional Loans

Still, euro-area inflation has been below the ECB’s 2 percent ceiling for 11 months and officials have said they’ll ease policy if necessary. Draghi reiterated last month that a negative deposit rate or providing banks with conditional long-term loans are options that have been discussed.

The ECB flooded banks with more than 1 trillion euros ($1.4 trillion) of three-year loans at the height of the debt crisis in 2011 and 2012. While that helped ease a credit crunch, banks used the liquidity mostly to buy government bonds rather than lend the money to households and companies.

If the central bank provides more liquidity, “we will want to make sure that this is being used for the economy,” Draghi said on Dec. 5. “We will want to make sure that this operation is not going to be used for subsidizing capital formation by the banking system.”

Improving Confidence

The concept of contingent long-term loans was floated in October by Klaas Knot, the Dutch representative on the ECB’s Governing Council. Not all policy makers are convinced it would work. Executive Board member Yves Mersch said on Dec. 9 that conditional loans risk interfering in the functioning of markets and Governing Council member Ardo Hansson said in an interview on Dec. 13 that he’s “skeptical” of such a measure.

Those doubts, paired with an improving economy, may prompt the ECB to hold off from more action even if lending continues to contract.

The euro area emerged from its longest-ever recession in the second quarter of last year and the ECB estimates gross domestic product will expand 1.1 percent this year, accelerating to 1.5 percent in 2015. Policy makers can also point to improving economic confidence in the currency bloc. Sentiment rose to the strongest last month since July 2011, according to data from the European Commission in Brussels today.

“Further improvement in the economy will at some point reflect positively on the region’s banks and therefore increase their willingness to lend,” said Kristian Toedtmann, senior economist at Dekabank in Frankfurt. “That’s why the ECB will keep tolerating weak lending numbers for some time and refrain from further expansionary policy steps.”

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