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54 Deleveraging, What Deleveraging
demand. The first LTRO, with a one-year term, was implemented in early 2009; a
second wave was implemented in late 2011 to early 2012, with a three-year term.
As a result, the balance sheet of the Eurosystem expanded meaningfully. Indeed,
the expansion in that period is comparable with that of the Federal Reserve
system resulting from quantitative easing. But, given the temporary nature of
the LTROs and the option for banks to repay funds borrowed under the scheme,
the ECB balance sheet started to shrink in 2012 in line with an easing of liquidity
tensions and some banks repaying their loans. This removed excess liquidity in
the system and put upward pressure on money market rates, effectively creating
a monetary contraction.
Although aggressive ECB action was essential to save the financial system from
collapse, there are two critical problems. First, there is evidence that the first wave
of LTROs, implemented in the midst of the liquidity crisis following the Lehman
collapse, was successful in relation to both financial stability and monetary
policy. 22 As the crisis deepened, however, it became clear that solvency problems
of sovereigns and banks were at the core of the financial crisis. Given the lack of
government action and the constraints on other forms of ECB intervention, the
LTROs were likely instrumental in preventing a collapse of the banking system,
but they were neither adequate to deal with the solvency problems of banks, nor
sufficient to avoid a fully fledged credit crunch.
Indeed, it can be argued that, in the absence of action to recapitalise the
banks, one of the consequences of the LTROs was to keep insolvent banks alive,
particularly in the euro periphery, and to delay the deleveraging of the banking
sector. As shown above, financial debt remained almost constant in 2011-12.
The LTROs did not prevent a credit crunch in the economy, as the funds
they provided were used to buy government bonds rather than to lend to the
economy, as shown by the increase of the ratio of sovereign bonds to assets in the
Eurozone banks’ balance sheets (Figure 4.13). This change in asset composition,
particularly strong in Spain and Italy, has been a significant feature of the
Eurozone banks’ adjustment and has involved, in particular, domestic sovereign
bonds (see, amongst others, Battistini et al., 2014). As a consequence, as argued
by Reichlin (2014), lending in the second recession was weaker than in the first
if we control for the fact that the decline in real economic activity had been less
pronounced (see Figure 4.14).
In sum, weak lending and a change in asset composition in favour of sovereign
bonds are the result of a combination of factors: undercapitalisation in the
banking sector; restrictive fiscal policy; geographical segmentation of financial
markets leading to a high correlation between bank risk and sovereign risk; the
ineffectiveness of monetary policy in this context; and persistent stagnation
of the real economy. Progress has been made towards the establishment of the
banking union which, together with the new European Systemic Risk Board,
promises to lead to more timely action on banks in the future (although with
much uncertainty related to the limited resources to be available for use in crisis
resolution).
22 In a quantitative study, Giannone et al. (2012) have shown that the macroeconomic effect of these
policies was small but significant.