31-Mar-23 Europe

Lending squeeze, rather than credit crunch

For a change, Europe’s banking sector appears in reasonably good shape. That’s good news, not least as supranational decision-making remains fragmented.

Long before Covid-19, economists studying financial-market panics began to take inspiration from biological modelling of infectious diseases[1]. Arguably, this has given regulators a better understanding of how networks of financial contagion work, how and why the structure of complex financial systems matters and what steps regulators can take to mitigate and manage crises.

Hence the widespread hopes of resilience, when troubles started with the collapse of Silicon Valley Bank a few weeks ago. Reality was always likely to prove messier. Researchers familiar with modelling of both infectious diseases and financial contagion tend to compare the current state of the latter with where epidemiology was in the 1970s and 1980s: a lot of theoretical insights, but plenty of question marks on how best to implement those in practice[2]. A stronger reason for confidence for European banks might be that many of them have just been through quite a tough decade. Under the supervision of the European Central Bank (ECB) since 2014, banks have been forced to fund lending with more capital. Perhaps as importantly, a perennial sense that trouble could pop up anytime probably helped rein in excesses[3].

Eurozone lending, already getting squeezed

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Sources: Haver Analytics Inc. European Central Bank (ECB), DW Investment GmbH as of 3/29/23

So far, European banks appear to have weathered the ECB’s monetary tightening quite well. Mortgage rates have more than doubled and this led to a decline in demand for new loans. As our Chart of the Week shows, the stock of outstanding loans is still growing, but the latest ECB data that came out this week show that new loans for house purchases have declined substantially. Overall tighter monetary policy should feed through in weaker credit dynamics, with the stock of outstanding loans likely to decline in coming months.

More details should soon be forthcoming, notably in the Bank Lending Survey due at the end of April. “Given the tightening of monetary policy and the tension in the banking sector we do expect a further tightening of credit standards,” points out Ulrike Kastens, Senior Economist Europe at DWS. As Eurozone economies are largely bank-based, such tightening will also be necessary to get inflation back on track towards the ECB’s target of below 2%.

To be sure, there are risks. Significant deficiencies remain in Europe’s current regulatory and bank-resolution frameworks, with progress towards the long-promised banking union incomplete. For example, insolvency procedures vary significantly across member states and plenty of powerful veto players could slow down decision-making, especially for smaller-bank rescues[4].

As with any new regulation, well intentioned rule-making will – inevitably – have had unforeseen behavioral effects, perhaps in seemingly far-removed corners of Europe’s or the world’s financial system beyond regulatory supervision[5]. For now, though, it seems that Europe, at least, is likely to avoid a full-blown credit crunch, where many banks simultaneously stop lending altogether.

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