Boring But Important: ECB Relaxes Collateral Rules

This news hit wires pretty quietly Thursday, but the ECB took action to help solve a major issue that is impeding the recovery in Europe.

One of the problems I and others have been discussing for some time in Europe is the inability for very cheap money (low interest rates) to get into the hands of so- called “SMEs,” or small to medium enterprises.  The idea was supposed to work like this:  The ECB lends money to banks at virtually 0%, and banks provide current loans (mortgages, inventory loans, etc.) as collateral for the funds.  The banks are paying virtually 0% for the money, and they can then turn and lend it to the SMEs (or the real economy) at a higher rate, and everyone wins:  The SMEs get fresh capital to invest and expand, the banks make a spread on the loans, and the ECB helps revive the EU economy.

Here’s what’s been happening instead: Cheap funds from the ECB have been staying on bank balance sheets. It’s not because of the “evil bankers”; it’s because a lot of the ECB’s new rules require greater capital ratios, and the ECB won’t accept certain types of loans as collateral for cash, which smaller commercial banks can then lend out to “SMEs,” which will hopefully stimulate the economy.  So, like most things fiscally speaking in Europe, it was a “one foot in, one foot out” approach, and that’s why it hasn’t worked.

Well, yesterday the ECB took two steps to help change that.  First, they relaxed some of the ratings requirements on certain loans that could be pledged as collateral for cash loans to these central banks.  Second, the ECB realized “haircuts” on asset-backed securities pledged as collateral for loans from the ECB to these commercial banks.

Previously, because asset-backed securities are deemed riskier, if I were a commercial bank and had a 100-million-euro loan from a car dealer secured by the inventory, I could pledge that to the ECB to get fresh capital to lend. But I wouldn’t get 100 million; I’d only get 75 million or 80 million, because the ECB imposed a “haircut” in the loan to insulate it from losses.  (I’m making up the numbers, but it illustrates the point.) Well, that “haircut” made it not worth it to me economically, so I didn’t do it.  Now, with haircuts on asset-backed securities reduced, this is a viable option, and it is one of the better ways to help get all this cheap money in the hands of SMEs (or the “real” economy) and break the capital logjam at the banks.

So, yesterday’s news was positive for two reasons:  First, it’ll help the EU economy.  Second, it implies the ECB is still working on ways to stimulate economic growth in the EU, and it will boost expectations that more plans may be announced at the ECB meeting in August.

Bottom line, though, this is a positive for, first, European banks and, second, the European economy.  And, it’s more of a tailwind on my “long” UK idea (ETF symbol EWU, the iShares MSCI United Kingdom Index).  While it doesn’t really affect the UK, it’s peripherally positive.