Outstanding Germany’s resilience aside, probably the most puzzling feature of the current eurozone cycle juncture is the lending dynamics that at face value so far has been unscathed by the financial crisis erupted eight months ago. This holds particularly true when one looks at official figures on loans to non-financial corporations (NFC) as computed by the ECB, whilst household lending (both for house purchases and consumer credit) had already started to slow down in the wake of the monetary tightening started in December 2005. Latest available figures referring to February 2008 show an annual growth of 10.9% in aggregate loans to the private sector with a smashing 14.8% yearly change in lending to NFC. Technicalities – like the re-intermediation of the unsuccessful pipeline of last year– may help to explain at least partially these figures, but still this is not the lending picture one would expect to encounter during a credit squeeze (see also the section on ECB Bulletin).
As a matter of fact, the last two ECB lending surveys paint a gloomier picture, and the new issue due for publication in mid-April, will be probably the most important piece of information to look at in coming weeks. In Q4 2007, tightening in credit standards reached levels seen in the 2002-2003 credit slowdown (when Germany was experiencing a textbook credit crunch), and net demand for loans by enterprises entered a declining trend (2% from the prior 5%). We think that, although a credit crunch in the euro area remains an unlikely scenario, the credit cycle has probably turned, or is about to invert shortly, and this eventually will take its toll on domestic demand throughout this year and next, contributing decisively to keep growth below-trend throughout almost all the forecast horizon, with the risk of witnessing below-par GDP readings until the end of 2009 should the ECB postpone the start of the monetary accommodation.
There are some qualitative indications that underpin our view. An ECB’s study shows that the annual growth rates (in real terms) of loans to households and non-financial corporations have followed a broadly similar cyclical pattern over the past 25 years. In general, growth in household loans has tended to turn earlier in the credit cycle than growth in corporate loans, with the maximum correlation between the two at a lag of around four quarters, and the peaks and troughs being typically higher and deeper in the case of corporate loans. If history is of any guide, a deceleration in actual corporate lending has to be expected– if it is not already here.
From a more structural standpoint, a typical monetary (tightening) transmission process will be at work. As usual, this will take place via higher financing costs, lower credit availability, with the relevant risk (hence not embedded in our baseline scenario) that the bank lending channel may play a more important role than in past cycles
because of the unwelcome consequences of the de-leveraging process triggered by the burst of the structured credit bubble.
Since last August, the 3-month Euribor rate has averaged 4.60%. This constitutes a de facto
monetary tightening which the ECB did not compensate for. This has in turn resulted in higher rates across the lending spectrum. As expected, because of the higher correlation with money market rates, the impact has been more sizeable on shorter-maturity lending rates. As banks remain by far the largest funding source for companies – at the end of 2007 outstanding loans to NFCs stood at EUR 4.3trn vs. “only” EUR 700bn of outstanding corporate bonds – and provided that borrowing costs in capital markets have significantly increased for a large part of the corporate sector, higher lending rates constitute more than a mere factor of worry
, especially if the rising trend were to persist. In its January Bulletin, the ECB was clearly flagging this risk by admitting that “Higher market rates at term maturities in the unsecured interbank market will, to a certain extent, influence the cost of bank funding, thus potentially also affecting the cost of bank borrowing for firms and households. A rise in borrowing costs is likely to have a dampening impact on loans…
KEY CORRELATIONS BETWEEN MONEY MARKET AND LENDING INTEREST RATES
Source: ECB, UniCredit Global Research
Especially because of the structural break of the adoption of the single currency, the ECB has devoted relevant research efforts to understand and quantify the working of the monetary policy transmission. Some of the main findings may be relevant to our analysis, although one shouldn’t forget that the ongoing tightening in monetary (and lending) conditions is not related to a typical monetary policy action. Angeloni and Ehrmann
 show that after the introduction of the euro the response of lending rates to the higher money market rates has become progressively stronger and more homogenous, although not speedier and this may help to explain why interest rates on loans have not fully responded yet to the higher costs that banks are now experiencing in almost all their funding sources. More recently, two other ECB scholars have quantified the pass-through. According to their estimates in the euro Big 4, the 71% of the increase in money market rates is passed onto short-term loans, and 63% onto long-term loans to enterprises. Mortgages overshoot to higher borrowing costs. The speed of adjustment is relatively contained, in line with previous findings. These results clearly play in favor of higher lending costs going forward. Our estimates displayed in the table above tend to be aligned with the main literature findings.
The real bad novelty of this credit cycle may be represented by the bank lending channel. Because of the massive diffusion of securitisation, this channel has progressively lost importance. A recent ECB working paper
shows that securitisation reduces the relevance of the bank lending channel first of all because it increases banks’ liquidity while reducing banks’ funding needs in the event of a monetary tightening. Second, securitization allows banks to swiftly transfer part of their credit risk to the market, thereby reducing their regulatory
requirements on capital. The net effect has been, ceteris paribus
, an increase in supplied lending because of this capital relief, and a larger insulation of banks from a monetary shock. But this insulation works as long as the underlying asset market keeps functioning
. In that case, the impact would be quite manageable.
The crisis of the “originate to distribute” model may define the key difference between this and past credit cycles. Indeed, it is the world of securitization that is now experiencing the most serious problems of pricing, thus creating a big disconnect between lenders and holders of balance sheet losses, and the consequent crisis of confidence has seriously posed under threat the very existence of a huge market. This asset market crunch in turn may entail a faster and more painful credit cycle downturn this time
. Together with likely further write-downs (our Chief Economist, Marco Annunziata has been long calling for a greater transparency on the real exposure of euro area banks’ balance sheets), and the need to bring back stretched capital ratios to sounder levels, this means that eventually banks may be forced to reduce their leverage. In its December 2007 Financial Stability Review, the ECB carries out some econometric estimates to show that the banks leverage depends positively on size and collateral, and negatively on market-to-book-ratio, profits and dividends. In the end, deleveraging means either raising equity capital or reducing the assets side, namely slower credit growth. However, even in a more conservative – and optimistic – scenario, a reduction in the availability of credit associated with the large development of securitisation over recent years is safely in the cards
. Just to reinforce this message, the ECB working paper quoted above show that if an increase of 100bp in the short-term interest rate is associated with a reduction in the nominal growth rate of GDP of 0.5pp, then the insulation effect of securitization activity on lending vanishes and banks experience the same drop in their lending irrespective of their activism in the securitization market.
Let us be crystal clear: we are not penciling in a significant credit rationing, rather we are trying to depict which are the factors that at this juncture may impact on the credit outlook, given the contradicting signals provided by the available evidence. The one good news is that the financing gap of non-financial corporations (defined as the difference between capital formation and savings, hence providing a measure of external funds) has increased during the recent period of strong investment growth, but firms’ leverage doesn’t seem to have been excessive, as it has not reached levels comparable to the ones seen in 2002. This suggests that eurozone corporates should be able to cope relatively well with the current financial crisis and the projected credit slowdown. But, in our view, risks of a more severe credit slowdown are rising by the day as money market dislocations persist, the structured credit market has ceased to function and banks’ balance sheets stay under pressure
. So far, the ECB has shown a great deal of constructive imagination to try and solve the liquidity crisis. But eight months after the outburst of the bubble, the employed tools have not proven able to provide a lasting solution. More fantasy is needed and probably the Fed is indicating a new way out. We acknowledge that the ECB’s task is made no easier by current unprecedented inflation rates. However, we think that the real economy is settling below potential and the distance with the trend rate will depend on how fast and effectively the crisis will be solved and on whether the credit slowdown will remain relatively contained or will become a major drag on growth. In the latest issue of the Financial Stability Review, the ECB maintained “In a negative scenario, however, a protracted disruption in the money and credit markets could lead to a more persistent hoarding of liquidity by banks and further tightening of availability of credit…A protracted period of uncertainty is likely to contribute to a more substantial tightening of credit in the financial system, thus increasing the probability of real economic implications of the financial market turmoil”
As we argue in the ECB Watcher section, rate cuts are only a matter of time and although our June call now looks stretched, monetary easing remains in sight. Lower rates will not be the tool to solve the crisis. They will be necessary to help GDP resuming trend by the end of next year.
 See “The cyclical pattern of loans to households and non-financial corporations in the euro area”. ECB Bulletin, June 2007.
 See Angeloni I. And Ehrmann M. (2003), Monetary Transmission in the Euro Area: Early Evidence, Economic Policy vol.18 (37), pp. 469-501.
 See Sorensen Kok C., Werner T. (2006), Bank Interest Rate Pass-Through in the Euro Area: a Cross Country Comparison, ECB Working Paper 580.
 See Altunbas Y., Gambacorta L. and Marqués D. (2007), Securitisation and the Bank Lending Channel, ECB Working Paper 838.