Banking Crisis

GUEST ARTICLE: Enough Is Enough - Have Central Banks Run Out Of Ideas?

Marino Valensise Barings Head of Multi Asset & Income 17 October 2016

GUEST ARTICLE: Enough Is Enough - Have Central Banks Run Out Of Ideas?

The levers and buttons that central banks have pulled and pressed to make economies speed up or slow down appear to be unreliable at best and possibly harmful at worst. What does the future hold for these state institutions' ability to set the macroeconomic weather?

As readers cannot help noticing, the efforts of central banks and their various attempts to revive flagging economies though “quantitative easing” and other ploys – in plain English, printing money – have achieved limited success in terms of the stated goals. Asset prices have been affected and some wealth managers point out that QE may have aggravated inequalities of wealth in ways that have political consequences. So what to think about how central banks are trying to steer economies? An understanding of these very broad issues can and does inform investment decision-making and asset allocation by wealth managers. With those thoughts in mind, the editors of this new service are pleased to share these insights from Marino Valensise, head of multi asset and income, Barings

As is always the case, the editors here do not necessarily share the views of guest writers but welcome contribution to debate, and invite readers to respond. You can email

Central bank policies have gradually lost their effectiveness, with negative side effects now dwarfing potential benefits. I believe it is only now that policymakers are taking stock of the situation and recognising its flaws. 

The first flaw has been how cheaper money has actually become detrimental to the economy. Collapsing short-term rates has had a series of unintended consequences. Among these consequences is a paradox: lower rates and flatter yield curves have had a negative impact on the profitability of lending, providing banks with a disincentive to extend credit. 

Secondly, the transmission mechanism of quantitative easing programmes must also be called into question. Central banks’ purchases of government bonds were supposed to release liquidity to banks, to be redeployed into commercial lending. However, this has been weaker than intended, and the banking system has not always recycled this extra liquidity as aggressively as expected or desired.

The third flaw relates to how QE programmes are implemented. The expansion of central banks’ balance sheets has been aggressive and, if protracted further, could absorb the majority of assets available for purchase. The IMF forecasts that the Bank of Japan (BoJ) will be reaching "capacity" between 2017 and 2018. Likewise, the European Central Bank (ECB) will at some stage be forced to expand its eligible universe to avoid running out of assets to buy. 

A new focus? 
Soon we will be experiencing a regime shift away from monetary policies whose effectiveness has been exhausted towards something else. What comes next? 

Over the past few quarters central banks have shifted their focus towards different types of initiatives. How to provide banks with an incentive to engage in lending? The answer is a combination of easy access to funding and cheap money. The Supplementary Loan programme by the BoJ and the TLTRO II programme by the ECB are two key tools. These ensure cheaper-than-normal access to funds for banks that are willing to extend credit to corporates and households. Such an approach, if appropriately structured, could provide a tighter transmission mechanism and true support to the economy.

A big issue 
Economic growth requires a healthy dose of credit growth. However, an extremely loose monetary policy actually inadvertently provided banks with a disincentive to extend credit. In Japan, the level of interest rates has collapsed. But perhaps the flattening of the yield curve is what has taken the biggest toll on banks’ profitability. So, how can Japan move from a monetary policy that is profit-destructive for banks to one that is profit-enhancing? 

To the rescue 
The first measure taken by the BoJ to make the life of banks easier came a few months ago. Japanese banks were given larger and easier access to the existing US dollar funding facility at the BoJ. While not a revolutionary reform, this supported the “plumbing” for the overseas lending and the investment activities of Japanese banks. It was a clear sign that future policy would support the stressed banking sector. 

Towards the end of September, two further support measures were announced as part of the BoJ’s comprehensive review. 

The first measure was the implicit commitment of support for the share price of banks. The JPY6 trillion equity ETF programme will now emphasise the TOPIX, which will benefit from the majority of the flows. The weight of bank shares in the TOPIX is higher than in the Nikkei, hence these should receive more technical support in the future. 

Secondly, the BoJ is introducing a new aggressive and quite intrusive tool defined as “curve control”. Traditional monetary policy involves the central bank managing the short end of the interest rate curve. The BoJ has now declared its intention to actively manage the yield on 10-year JGBs, targeting a yield of around zero per cent. The willingness of the BoJ to steepen the yield curve and restore profitability in lending, by creating a higher net interest margin, is admirable. However, the policy does contradict other BoJ initiatives and, as a result, market participants are somewhat perplexed. This additional manipulation of asset markets can therefore only be a temporary measure rather than a solution to the bigger problem. That said, despite its controversy, the policy is a clear sign that the BoJ will not tolerate a flatter yield curve, and that it sees the profitability of commercial lending as an important aspect to defend.

An investment opportunity? 
During 2016, share prices of Japanese banks have fallen substantially as investors have questioned the viability of the traditional business model in a flat yield curve environment. An interesting and attractive feature of Japanese banks is the cash flow that is returned to investors annually through dividends and share buybacks. Major sector players deliver flows between 3.5 per cent and 4.5 per cent per annum. 

In terms of regulatory capital, these businesses are solid and many are better capitalised than their international competitors. In terms of overall business, Japanese banks are more international and diversified than they were some years ago - a reaction to Japan’s poor sector dynamics. International lending has more than doubled over the past five years, and it now represents a large market share. Non-lending and fee-based revenues are also rising, with substantial market share gains in the global syndication market.

In an environment where the BoJ succeeds in steepening the yield curve, the exposure of banks to JGBs could be seen as a threat. Fortunately, it is no longer a problem as holdings of JGBs have more than halved over the past few years. Exposure is now only to those safer, short-term maturities. 

A separate threat could be the equity cross-holdings, as these have the potential to trigger pro-cyclical behaviour in bank stocks. When the equity market weakens, bank shares perform very poorly because of their exposure to domestic peers and corporates. This generates losses, erodes capital and slows down overall lending activity. Although the problem does still exist, in the last few years major banks have already reduced their cross-holdings by 20 per cent, and will continue to do so. 

The last threat is stagnation. If the BoJ is unable to create a more constructive environment for banks, bank shares will fail to deliver interesting returns. However, given their very cheap valuations, I do not believe these stocks to have much downside. 

In summary, a “textbook” value trade which should reward investors. Value hunters might, however, have to wait a little bit longer for the market in banking shares to turn.

A final word 
Ultimately, central banks have the ability to lower the price of money at both the short and long end of the curve, expand their balance sheets, identify more reliable transmission mechanisms for policies to affect the real economy and even create commercial incentives for lenders. All of this smacks of old-style central planning: a world in which central banks might become the main player in certain asset markets and fix their prices. None of the above will enable central banks to structurally tackle the issue of lacklustre aggregate demand. 

Still, should the situation not improve or should a further economic slowdown occur, I believe "Helicopter Money" coupled with a targeted fiscal plan will be the most effective solution to the issues we are currently facing.

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