European Central Bank Launches QE Lite : Will it Work? On September 4 th, the European Central Bank (ECB) President Mario Draghi announced a further reduction in the interest rates for ECB lending facilities, along with the creation of an asset-backed securities purchase program (ABSPP) and a covered bond purchase program (CBPP). These asset purchase programs are widely viewed as the ECB s first foray in quantitative easing, or QE. The ECB introduced these QE tools as traditional monetary policy measures have been unable to foster acceptable growth trends and reductions in unemployment. In this commentary, we discuss our views on the structure of the ECB s QE program and the potential impact on the European financial system. ECB QE: QE Lite Government debt securities have been the primary asset purchased by central banks in other QE programs. The ECB s structure as a supranational entity creates a significant execution hurdle for such a QE program, as monetary financing of governments is banned under European Union law. As a result, the ECB s QE program specifically targets asset-backed securities (ABS) and euro-denominated covered bonds (debt securities backed by cash flows from mortgages and loans, but which remain on issuers balance sheets). The ECB further stated that its new QE program targets ABS to reflect the role of the ABS market in facilitating new credit flows to the economy, extending efforts beyond the liquidity measures previously provided. Although the size of the ECB purchase programs has not been disclosed, President Draghi noted that the ECB would be comfortable taking its balance sheet back to its 2012 peak level of approximately 3 trillion, compared to approximately 2.1 trillion now. The ABSPP and CBPP are expected to drive about half of the anticipated balance sheet growth, implying a program size around 500 billion. The balance will come from the previously announced targeted longer-term refinancing operations (TLTRO), which begin this month. QE Program Comparison 20,000 18,000 16,000 14,000 QE, total program (in USD), lhs 2013 GDP (in USD), lhs % GDP over program life, rhs 25% 20% 12,000 15% 10,000 8,000 10% 6,000 4,000 5% 2,000 - Federal Reserve (QE1, QE2, QE3) Bank of England (2009, 2011) Bank of Japan (2013) ECB Projected 0% Source: Central banks, World Bank, TCH estimates; ECB program purchases estimated over one year 1 P a g e
Bank system assets as % of GDP What are the ECB s Policy Goals with QE? Prior to this announcement, the ECB had utilized its policy tools to maximize liquidity availability in the European markets with low (now negative) interest rates and liquidity mechanisms such as long-term refinancing operations (LTRO). However, sufficient improvement has yet to be seen in the real economy. We believe the primary goal of the newly announced QE Lite program is to support demand and credit creation via securitization, thereby addressing credit and capital constraints rather than simply addressing liquidity. We expect higher demand for European ABS and covered bonds from the ECB s buying program could help increase securitization volumes and create deeper, more liquid markets for these securities. Furthermore, better availability of credit via securitization markets could disintermediate European banks. This could be seen as a positive development because many banks are capital-constrained, and therefore unable to significantly increase on-balance sheet lending. Banks Primary Mechanism for Credit Intermediation in Europe A deeper understanding of the ECB s QE approach can be gained when considering the program within the context of the European financial system. European banks remain the primary providers of credit in the Euro area, in contrast to the U.S. where capital markets financing has more extensively disintermediated banks. For example, the chart below shows that European banks total assets are 290% of Euro area GDP, whereas US bank assets are roughly 100% of GDP. Banks' activities as percentage of GDP 400 350 300 250 200 150 100 50 0 Source: Fitch, June 2014 On the flip side, the relative size of securitization markets are smaller in Europe compared to the U.S. Total European securitizations outstanding in Europe were approximately $1.9 trillion as of 1Q14, according to SIFMA, and European covered bonds represent another $2.7 trillion. In the U.S., total securitizations outstanding, including agency MBS, are approximately $10 trillion. So whereas the capital markets have more broadly taken over the credit intermediation functions in the U.S., credit intermediation in Europe is much more dependent on banks. 2 P a g e
30 25 20 15 10 5 0 Monetary and financial indicators (in Euro tn) 211% 103% 102% 32% Euro Area US Japan China Credit* Outstanding debt securities Stock market capitalisation GDP Debt securities/credit 250% 200% 150% 100% 50% 0% *Includes loans and non-financial institution securities held by financial institutions Source: Table 1.1, ECB Statistics Pocket Book, April 2014 Crucially, European banks remain the primary providers of credit for small and medium sized enterprises (SMEs). SMEs are the economic engine in the Euro area, accounting for 85% of job creation between 2002 and 2010, and representing 99% of enterprises in the EU according to a recent report by the Association for Financial Markets in Europe (AFME). 1 The same report noted that SMEs were facing a marginal deterioration in the availability of bank loans over the six months to March 2014, and highlighted that deeper European securitization markets could play a role in helping to fill the SME funding gap. As such, the ECB s decision to initiate an ABS purchase program is likely driven by the fact that banks are unable or unwilling to meaningfully ramp-up lending, particularly to SMEs. European Banks: Regulatory Issues and Balance Sheet Repair at the Forefront European banks are facing major regulatory changes that are forcing many of them to focus on balance sheet repair and capital conservation rather than loan growth. 1. Basel III - First off is the implementation of Basel III capital rules, both risk-weighted and simple leverage ratios. Given lackluster earnings growth and the high cost of common equity, the most palatable option for many European banks has been to shrink the size of their balance sheets in order to improve capital ratios. Accordingly, we have seen European banks continue to pull back from lending as their balance sheets decline. We note that the ECB is introducing a modified LTRO program later this month that will explicitly tie ECB funding to lending, and may have better success than earlier LTRO programs. 2. Liquidity Coverage Rule - Another new rule that may also be hampering the extension of credit is the liquidity coverage ratio, or LCR, which requires banks to maintain sufficient quantities of liquid assets to meet potential stress scenarios. The result of this new ratio is that European banks have been focused on building their liquidity buffers, mainly by holding higher levels of liquid debt securities on their balance sheets. 1 High-quality securitisation for Europe: The market at a crossroads. Association for Financial Markets in Europe, June 2014. 3 P a g e
3. Asset Quality Review - A final hurdle for European banks is the ECB s own systemwide asset quality review (AQR) and comprehensive assessment (stress test). Results of the AQR and stress test are expected in late October 2014. One of the goals of the ECB review is to harmonize recognition of problem assets, and it is widely believed that the results may force some banks to set aside provisions for higher levels of problem assets than previously disclosed. European banks have been actively raising capital in advance of the results. As a result, these regulatory and capital constraints have reduced European banks capacity to grow loans. Prior ECB programs, such as the LTRO, have shown that access to liquidity is not sufficient to jumpstart lending when the banks are capital constrained. This conclusion is confirmed by a recent academic study 2 that examined the impact of QE programs in the UK. The report noted that the design of the UK s QE program was specifically targeted at asset prices rather than bank lending, and concluded that policymakers were correct in going around the banks since the UK banks were capital constrained at the time. What are the odds of success? The probability of success of the ECB s QE program is highly dependent on the specific details of the program which are to be announced on October 2 nd. The ECB has indicated they will purchase a broad portfolio of simple and transparent asset-backed securities and euro-denominated covered bonds, but beyond this, program details are scant. We believe that the most bang-for-the-buck these programs could offer would come from support or expansion of the ABS market. The ECB indicated it will buy the senior-most tranches of the capital structure of an ABS transaction and will only buy the riskier (called mezzanine or credit) tranches if the bonds receive an acceptable guarantee. In our view, the ultimate success of the ABS purchase program lies with its ability and commitment to purchase these riskier securitization tranches, or to incentivize others to do so. Although senior bonds will likely see their spreads benefit slightly, ECB buying of higher credit risk tranches would lend more support to bank lending activity and credit creation because a major headwind to the expansion of the securitization market in Europe has been the inability to place the lower tranches of new deals. Removal of these securities from bank balance sheets and incentivizing investors to increase exposure to them by providing market support will go the farthest in achieving the ECB s ultimate goal of increasing credit availability to both SMEs and consumers. Beyond measuring the success of credit creation, a final consideration is whether demand will follow. With individuals and corporate balance sheets still under pressure, getting houses in order can very easily trump growth initiatives. This could be described as the Japan syndrome, in which years of loose monetary policy did not lead to sustained loan growth. We recognize that similar to QE policies in the US, Japan and UK, the September announcement may represent only a first step to a much larger program. In the event this QE Lite program is not sufficient to spur credit creation, we expect the ECB to pursue additional policy tools or a broader QE program. Indeed, a second-order benefit of the QE Lite announcement was to reconfirm to financial market participants that the ECB remains committed to doing whatever is necessary to improve economic 2 Joyce, Michael A.S. and Spaltro, Marco. Quantitative easing and bank lending: a panel data approach. Bank of England Working Paper No. 504, August 2014. 4 P a g e
conditions in the Euro area, especially as heightened geopolitical risk has added even more pressures to recent European economic conditions of late. Market Reaction and Implications The initial market reaction to the QE Lite program was positive, as some had thought the ECB would wait until its next meeting to act. Furthermore, the breadth of assets the ECB will purchase was greater than expected given the inclusion of residential mortgage-backed securities and covered bonds. The positive market reaction has driven European ABS approximately 10-15 basis points tighter across the board in recent days. Further, US Treasuries sold off as investors moved out of risk-free assets, while the US dollar strengthened versus the Euro. We anticipate treasuries and currencies could further reprice when the ECB releases details on October 2 nd. Longer term, QE Lite has the potential to meaningfully alter credit supply dynamics in the Eurozone if effectively executed. This would carry positive implications for banks as capital is freed up and risk assets move off of balance sheets. Further, corporate entities that are able to access more attractive lending terms, term out debt and improve financial profiles will benefit, much like we have seen in the US over the past five years. As fixed income investors, we are also mindful of structural implications the QE Lite program may have on the markets. We anticipate the program to be a catalyst for growth in European covered bond and ABS market, potentially closing the gap versus the size of the US market. US-dollar denominated debt is also likely to benefit on more favorable cost of European funding as investors consider the most attractive investment options within a global context. 5 P a g e
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