Monetary policy: The hidden hand behind the Euro zone’s response to the economic crisis
The COVID-19 pandemic has triggered a worldwide public health crisis, resulting in severe global socioeconomic disruption.
Understandably, the response of authorities worldwide initially focused on containing and combatting the virus. The resulting preventive measures inadvertently severely impacted global economic activity, with most of the world’s population currently under varying degrees of lockdown.
Faced with a global economic crisis of an unprecedented nature, policy makers worldwide have introduced various sets of fiscal stimuli measures. These measures are aimed at mitigating the short-term economic impact of the crisis, while ensuring that the foundations are in place for a recovery once the public health crisis starts to subside. The fiscal stimuli measures implemented have primarily focused on helping businesses survive the crisis by injecting liquidity into the real economy, while also preventing mass unemployment by directly subsiding wages.
The role of monetary policy in mitigating the economic crisis and facilitating a recovery
Fiscal stimuli measures have a direct and visible impact on the real economy and have thus been given a high level of attention worldwide. While not featuring as heavily in the narrative, monetary policy is just as critical in containing the economic impact of the crisis and in supporting an economic recovery.
In fact, the European Central Bank (ECB) has implemented several banking supervision and monetary policy measures aimed at mitigating the impact of the COVID-19 pandemic on the euro area economy and supporting all European citizens. These measures are primarily focused on the banking sector, which acts as a channel for policy makers to provide higher liquidity to the real economy via monetary policy and changes to banking regulation.
As outlined by Andrea Enria, Chair of the ECB Supervisory Board, “Unlike in the 2008 financial crisis, banks are not the source of the problem this time. But we need to ensure that they can be part of the solution.”
The ECB’s measures to support the euro area economy
The ECB has provided an overview of the different banking supervision and monetary policies it has implemented as a reaction to the pandemic. These measures are summarised below:
Encouraging banks to release unutilised capital buffers
Banks play a critical role in supporting the economy by acting as financial intermediaries, channelling funds efficiently between savers and borrowers. As a result of their unique role in the economy, banks are regulated heavily, ensuring they are well placed to withstand shocks, thus reducing the risks of spill-over effects as seen in the 2008 financial crisis. As part of this regulation, banks are required to retain adequate levels of capital as a defence against shocks in a moment of crisis, often referred to as capital buffers.
One of the key components of the ECB’s response to the crisis has been to encourage banks to utilise these capital buffers. The ECB anticipates that this measure can release €120 billion in capital. These capital buffers can be utilised by banks to offset the anticipated losses resulting from the crisis. Alternatively, they can be utilised to provide fresh financing of up to €1.8 trillion, providing households and businesses with the continued access to finance they critically require throughout the crisis.
Adjusting the treatment of non-performing loans
Banks are required to assess the performance (or non-performance) of their loan portfolio. A non-performing loan (NPL) is a loan in which the borrower is in default and has not made any scheduled payments of principal or interest for some time, or is deemed unlikely to meet their future obligations. Banks are required to set aside funds to cover non-performing loans. In such a widespread economic crisis, a significant proportion of bank customers are expected to encounter temporary difficulties in meeting their loan repayments, resulting in these loans being classified as non-performing.
To mitigate this impact, the ECB has provided banks with increased flexibility when classifying loans that are backed by public guarantees. Furthermore, banks are required to set aside a lower amount of funds to cover losses on government-backed loans. Similar to the impact of the first measure, this measure should free up capital on the banks’ balance sheets, resulting in households and businesses having increased access to finance.
Reducing the burden of supervision
As outlined previously, banks are subject to extensive regulation and supervision, ensuring the financial system remains stable. This involves extensive reporting requirements.
Cognisant of the operational challenges of banks throughout the crisis, the ECB has eased banks’ reporting requirements relating to supervision, allowing banks to focus on providing finance. In practice, this involves adjustments to supervisory timetables, processes and deadlines according to each bank’s situation. For example, the ECB will consider rescheduling upcoming inspections in the supervised banks and extending deadlines for them to correct shortcomings identified in recent inspections.
Discouraging the outflow of capital from banks
The crisis has had a profound impact on citizens and enterprises within the euro area. Governments throughout Europe have emphasised the importance of solidarity and burden sharing amongst stakeholders.
In line with this thinking, the ECB is encouraging banks and their shareholders to bear part of the impact of the crisis, by discouraging dividend pay-outs and share repurchases. This will allow banks to utilise the funds freed up by the measures above where they are most needed, i.e. absorbing losses and providing finance to households and businesses.
Extending its expansionary monetary policy stance
The ECB is also extending its expansionary monetary policy stance through asset purchases and long-terms loans to banks. This should ensure higher liquidity for banks and corporates, mitigating the economic impact of the crisis and assisting with the recovery.
For example, the ECB has announced the €750 billion Pandemic Emergency Purchase Programme (PEPP). Under this programme, asset purchases will be conducted until the end of 2020 and will include all the asset categories eligible under the existing asset purchase programme (APP). Eligible assets include bonds purchased directly from banks (allowing for higher liquidity in the financial system), as well as corporate bonds (providing direct credit). The purchase of these types of assets by the ECB will boost spending and investment, with the aim of stimulating economic growth.
The ECB is also offering long-term loans at very favourable conditions to banks, with the condition that they continue to provide access to finance where most required. Another measure includes the ECB applying more flexible rules on the assets banks must provide as insurance, or “collateral”, for these loans, to ensure banks have enough collateral. Again, these measures are targeted at ensuring that banks continue to provide financing where required.
The role of monetary policy in mitigating the impact of the economic crisis and assisting with the recovery
A complex and unprecedented economic crisis requires an intricate and effective policy response. The introduction of a wide range of fiscal stimuli measures by governments worldwide has ensured that businesses remain liquid in the short term, while also reducing mass insolvencies and unemployment.
Leveraging on the lessons learned in the 2008 financial crisis, the European Central Bank (ECB) is also utilising monetary policy to ensure that the current economic crisis is not exacerbated by a liquidity crisis in the financial system, resulting in further spill over effects on the real economy.
Looking ahead to the future, finding the right mix of monetary and fiscal policy will also be critical in assisting with the economic recovery.
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