Europe Investment Report 2014 — One Policy Rate, Nineteen Borrowing Costs

By 2014 the euro area had a problem that is easy to state and was hard to fix: the central bank's policy rate was not reaching borrowers evenly.

The observable form: a small or medium-sized business seeking a loan paid materially different rates depending on which member state it was in — differences of several percentage points between comparable borrowers, under a single monetary policy.

Why this matters more than it sounds: a monetary union's entire purpose is a single monetary condition. If the policy rate produces different borrowing costs by location, the union is not delivering the thing it exists to deliver — and cutting the policy rate further does not help the places where transmission is broken.

The causes were the ones this archive has documented:

• Bank balance sheets were still impaired, per the slow recognition described in the Europe Investment Report 2008. A bank conserving capital lends less and prices higher.
• Banks were tied to their sovereigns through the four channels in the Europe Investment Report 2011, so a weak sovereign meant expensive bank funding meant expensive lending.
• Cross-border banking had fragmented, so a bank in a core member state with surplus deposits did not lend into a periphery member state where returns were higher.
• And credit demand was weak because the economies were weak, which makes the direction of causation genuinely hard to establish.

The year's principal action addressed the first cause directly. A comprehensive asset quality review and stress test was conducted across the major institutions — under a single methodology, by the new single supervisor, before it assumed responsibility.

Why this worked where six years of national assessments had not: the assessor was not the same authority that would have to fund the consequences, which removes the incentive not to look too hard. This is the same principle as the statistical verification problem in the Europe Investment Report 2009.

The second theme is deflation. Inflation had fallen close to zero and was heading lower, helped by the oil collapse in the Global Investment Outlook 2014. For an economy carrying the debt described throughout this track, falling prices are specifically dangerous, and the response tested where the lower bound on interest rates actually sits.

Measuring a broken union

The fragmentation is directly measurable, and the measurement is worth setting out because it converts an abstract concern into a number.

The relevant statistic is the interest rate on new loans to non-financial corporations, disaggregated by member state and by loan size — small loans being the proxy for small and medium-sized businesses.

What it showed:

• Large dispersion between member states for comparable loan sizes.
• The dispersion tracked sovereign spreads, confirming the bank-sovereign channel.
• It was widest for small loans, because large corporates could access bond markets and bypass their domestic banks entirely.
• And it persisted despite policy rate cuts, which is the definition of impaired transmission.

The last point deserves emphasis because it determined the policy response:

When the policy rate falls and lending rates in some member states do not follow, the problem is not the level of the rate. Cutting further transmits to the places where transmission works and does nothing for the places where it does not — which widens the gap rather than closing it.

The distributional consequence within the union was severe: small businesses in stressed member states faced expensive credit precisely where the economy was weakest and where firms had fewest alternatives. Large firms in the same countries could issue bonds and were largely unaffected, so the fragmentation fell entirely on the smallest borrowers.

This is the market-based versus bank-based transmission distinction from the Europe Investment Report 2015, arriving as a within-union inequality: the union had a market-based channel for large firms and a broken bank-based channel for everyone else.

The policy responses that followed — targeted lending operations conditioned on banks actually extending credit, and eventually asset purchases — were attempts to reach the borrowers the rate was not reaching.

Why one assessor changed the answer

The asset quality review's design explains why it produced recognition that years of national exercises had not.

The problems with national assessments, as run between 2009 and 2013:

• Different methodologies, so results were not comparable across countries.
• Different definitions of what counted as a non-performing exposure, which is the central measurement.
• The assessing authority was national, and its government would bear the fiscal consequence of a large capital shortfall. The incentive to apply a lenient standard was structural.
• And results were repeatedly followed by institutions requiring support shortly afterwards, which destroyed the exercises' credibility.

What the 2014 exercise did differently:

• One methodology applied uniformly across all significant institutions.
• A common definition of non-performing exposures, which had not previously existed and which by itself moved reported figures materially.
• Conducted by an authority that would supervise the institutions but was not the fiscal backstop, removing the incentive problem.
• And conducted before that authority assumed supervisory responsibility — so any problems found were inherited rather than owned, which is a genuinely clever piece of sequencing.

The last point is the underrated design feature:

An incoming supervisor has every incentive to find problems, because the problems belong to their predecessor. A supervisor examining its own past decisions has the opposite incentive. The exercise was timed to exploit that, and it is why it produced a credible number.

The result was identified capital shortfalls and, more importantly, a comparable dataset on asset quality across the union for the first time. The comparability was arguably worth more than the shortfall figure.

The residual criticism is legitimate and worth stating: stress tests are only as demanding as their assumed scenario, and the scenarios used were regarded by some as insufficiently severe — particularly on deflation, which is the risk the same year identified as most pressing.

Where the floor actually is

The deflation response tested a proposition that had been treated as settled: that nominal interest rates cannot go below zero.

The theoretical argument for a zero floor: if a deposit paid a negative rate, holders would withdraw cash instead, which pays zero. So no one would accept a negative rate, and the floor is zero.

Why the floor is actually below zero: holding cash is not free.

• Storage costs — secure vaults for large quantities are expensive.
• Insurance costs, which scale with the amount held.
• Transport and handling costs.
• And transaction inconvenience. Cash cannot be wired; large payments in physical currency are impractical.

So the effective floor is negative by roughly the cost of holding cash, which is small but not zero, and varies by holder — an individual with modest savings faces different costs from an institution holding billions.

What happened in practice:

• Negative policy rates were introduced and did not immediately trigger large-scale cash withdrawal.
• Banks largely did not pass negative rates to retail depositors, absorbing the cost in their margins instead — which is why the transmission was weaker than the rate change implied.
• Institutional and corporate depositors did face negative rates, since their alternatives were more expensive.
• And the floor's location was discovered empirically, by moving rates down and observing behaviour, rather than derived in advance.

The zero lower bound turned out to be neither zero nor a bound. It is a region where the instrument becomes progressively less effective, and where it stops working is a question about cash handling costs rather than about monetary theory.

The consequence for bank profitability was direct and lasting: a bank that cannot charge depositors but earns less on its assets faces compressed margins, which the Europe Investment Report 2016 develops as a sector-defining problem.

Why falling prices were the binding concern

The deflation risk deserves setting out because it explains the urgency of the response.

Three mechanisms make falling prices specifically dangerous for this economy:

Real debt burdens rise mechanically. Debt is a fixed nominal claim. If prices and incomes fall, the debt does not — so its real weight grows every year without anyone borrowing more. For an economy carrying the sovereign, bank and corporate debt this track has documented, that is directly counterproductive.

Real interest rates rise when nominal rates cannot fall. The real rate is roughly the nominal rate minus expected inflation. With nominal rates at their effective floor, falling expected inflation raises the real rate — so monetary conditions tighten automatically when they should loosen. The instrument moves the wrong way on its own.

And expectations become self-sustaining. Wage negotiations, contracts and pricing decisions built on an assumption of flat or falling prices produce flat or falling prices. Escaping requires changing a belief, which the Global Investment Outlook 2013 shows is far harder in the real economy than in financial markets.

The diagnostic difficulty was real: much of the observed disinflation came from the oil price collapse, which is a temporary supply effect that should be looked through. Distinguishing that from a durable expectations shift was not possible in real time.

The choice made — to treat the risk as genuine and act — is defensible and was contested. The Global Investment Outlook 2014 sets out the symmetric error: treating a supply shock as an expectations shift means over-easing; treating an expectations shift as a supply shock means arriving too late to a self-reinforcing process.

The sequencing insight that this year established is the more durable contribution:

Stimulus applied through a broken channel does not arrive. Repairing bank balance sheets was not an alternative to monetary easing — it was the precondition for the easing to reach anyone.

Why bond markets did not fill the gap

If banks could not lend, the obvious question is why capital markets did not simply take over — and the answer explains why the fragmentation was so persistent.

Large corporates did substitute successfully. Firms with scale, ratings and existing investor relationships issued bonds instead of borrowing from banks, and issuance rose substantially. For them the bank problem was an inconvenience.

Smaller firms could not, for reasons that are structural rather than cyclical:

Fixed costs of issuance. A bond issue carries legal, rating, listing and distribution costs that are largely independent of size. Below a threshold — broadly, a mid-sized issue — those costs make issuance uneconomic, and most European firms are far below it.

No credit rating. Most institutional bond investors require one, and obtaining a rating is expensive and time-consuming for a firm that has never had one.

Investors cannot analyse thousands of small firms. A bank has a local relationship, ongoing account data and a loan officer. A bond investor has a prospectus. The information a bank uses to lend to a small firm does not translate into a public document.

And the loan sizes are wrong. A firm needing a modest facility cannot access a market whose minimum efficient transaction is many times that.

This is the structural asymmetry the Europe Investment Report 2015 develops, appearing here as an inequality within a single monetary union:

The union had a working market-based channel for large firms and a broken bank-based channel for everyone else. Since small and medium-sized firms account for most European employment, the channel that broke was the one that mattered for jobs.

The attempts to bridge it and why each was partial:

• Securitisation of small business loans, packaging many small exposures into instruments investors could buy. The mechanism is sound and the market carried the reputational damage of 2008, which limited both regulatory enthusiasm and investor appetite.
• Public guarantee schemes and development bank lending, which worked but at limited scale.
• Private credit funds, per the Private Credit Report 2013 — which grew substantially but served the mid-market rather than genuinely small firms, since the origination economics do not work at small ticket sizes.
• And targeted central bank operations conditioned on banks extending credit, which addressed the price of bank funding but not the banks' willingness to lend.

The durable conclusion is that there is no quick substitute for bank lending to small firms. The relationship and the local information are the product, and repairing the banks was the only route to repairing the channel — which is why the asset quality review mattered more than any rate decision that year.

What an allocator could act on

Measure union fragmentation directly. Lending rates to non-financial corporations by member state and loan size are published free and monthly, and their dispersion is the observable state of monetary transmission.

Note that fragmentation falls on the smallest borrowers. Large firms bypass domestic banks through bond markets; small firms cannot, so the entire gap lands on the businesses with fewest alternatives.

Check who conducts an asset quality assessment and what they bear. An assessor who would fund the consequences applies a different standard from one who would not, and the incoming-supervisor timing was what made 2014 credible.

Read the effective rate floor as an empirical question about cash costs. It is below zero, it varies by holder, and it is a region of declining effectiveness rather than a hard bound.

Expect margin compression where negative rates cannot be passed to depositors. Banks absorbing the cost is both why transmission weakened and why sector profitability became a structural problem.

Assess whether a channel works before assessing whether policy is loose enough. Easing through a broken transmission mechanism widens dispersion instead of closing it.

What 2014 established

• Identical borrowers faced different rates by member state, which is a monetary union failing at its core function.
• A single assessor with no fiscal exposure forced recognition that six years of national exercises had not.
• The effective rate floor is below zero and was located empirically, not derived.
• Deflation raises real debt burdens and real rates simultaneously, which is why it was the binding concern.
• Transmission repair precedes stimulus, since easing through a broken channel does not reach borrowers.