One Phrase, 10 Years On

At the height of the European sovereign debt crisis in July 2012, then ECB President Mario Draghi famously pronounced the ECB would do "whatever it takes" to preserve the euro. In the decade since, the European Central Bank's (ECB) accommodative monetary policy has supported the eurozone economy, reshaped its banking industry, and increased debt issuance and market stability. But while the significant stimulus has reduced credit risk, policies are now arguably exacerbating duration risk and leading to weak investment returns for investors as conditions tighten and rates rise.

The Outright Monetary Transactions (OMT) announced after "whatever it takes" were not enough to eliminate the risks of redenomination in the face of looming deflation risk and as the main policy rate hit zero. As a result, the ECB in mid-2014 began using its balance sheet in combination with interest rates policy--a process it has maintained since--to profoundly change European monetary policy by (see chart 1, and Appendix for definitions):

• Introducing a negative interest-rate policy (NIRP), with the deposit rate becoming the main policy rate instead of the weekly repo rate, alongside additional other new policy rates (two-tier system for the remuneration of reserves, discount from the deposit rate for TLTRO);
• Strengthening the credit easing program with a series of targeted long-term refinancing operations (TLTROs) to incentivize banks to grant loans, especially to small and midsize enterprises (SMEs);
• Implementing quantitative easing (QE) with the launch of the large-scale Asset Purchase Program (APP) for private and public assets.

The ECB completed these three elements in 2016 by extending the forward guidance on interest rates to the size and the duration of QE to better drive markets' expectations on QE purchases and minimize volatility. But in 2019, as disinflationary forces persisted, the ECB resumed net asset purchases after a pause of barely one year--which pushed the deposit rate deeper into negative territory and saw the introduction of a tiered system for the remuneration of reserves to alleviate the pain on banks' profitability. The additional shock of the COVID-19 pandemic resulted in the significant Pandemic Emergency Purchase Program (PEPP) QE program and a third round of TLTROs at even better conditions for banks.

Chart 1

These changes to the ECB's framework tripled the size of the ECB's balance sheet--to almost 68% of GDP, or €9 trillion, in January 2022 from 30% of GDP, or €3 trillion, at the time of Draghi's speech in July 2012 (see chart 2). QE net purchases now account for 80% of this balance sheet expansion, and measures of credit easing (TLTRO) account for 20%. Along with this, banks' excess liquidity soared to €4.6 trillion (see chart 3).

Chart 2

Chart 3

The ECB's Actions Have Been Largely Positive For The Eurozone Economy And Markets

According to the ECB's estimates, the measures it has taken since Draghi's speech in 2012 have lifted GDP by a cumulative 5 percentage points and consumer prices by more than 2 percentage points, with QE accounting for the majority of the effects (see related research).

Chart 4

Equity market volatility has also been more subdued, on average (see chart 5). In the 10 years ended 2012, the average daily close on the volatility index VSTOXX40 was 25, with an associated standard deviation of 10.25. This is in contrast with an average and standard deviation of 20.4 and 7.2, respectively, in the 10 years since.

Chart 5

Considering how stabilization of the euro was a prime motivator for Draghi's now famous phrase, the currency has largely been more stable in the decade since (see chart 6), in part because of ample market confidence in the central bank's firm commitment and clear communication about its policies.

Chart 6

Unconventional Policies, Ultra-Low Rates, And Direct Lending Have Fundamentally Changed Banking

Although the ECB had expanded its bank refinancing operations since 2009, the introduction of TLTROs in 2014 was a more meaningfully market milestone. By extending the maturity of its refinancing operations and broadening the scope of eligible collaterals, the ECB provided eurozone banks with a large, low-cost, and stigma-free borrowing facility that the sector drew on enthusiastically. Eurozone banks also benefited from the institutionalization of an open-ended swap line between the ECB and the U.S. Federal Reserve that thereby guaranteed access to U.S. dollars.

The ECB's ultra-accommodative monetary policy stance also bought time for eurozone banks, especially in peripheral countries, to restructure their balance sheets and strengthen their funding. Over time, eurozone banks have increased the share of customer deposits in their funding base and reduced their reliance on wholesale funding, which had proven more volatile through previous crises (see chart 7).

Chart 7

A liquidity crunch was simultaneously avoided because eurozone banks were incentivized by the terms of the TLTROs and able to ensure a steady provision of credit to the real economy. During 2016-2021, annual compounded average lending growth was approximately 3%, though growth varied across banks and geographies (see chart 8).

Chart 8

This is especially true for SMEs, which account for two-thirds of jobs in Europe. They mainly rely on bank financings and saw their financing gap close during the period (see chart 9 and "Financing Faster Growth For Europe's SMEs"). Accommodative funding conditions also supported the debt-servicing capacity of eurozone corporates and households, and therefore banks' asset quality. While loan delinquencies spiked at the onset of the 2011-2012 economic crisis, the trend started to reverse in 2013. Economic growth and banks' proactive measures in subsequent years to reduce their nonperforming loans--largely under regulatory pressure--led to a broad improvement in asset quality metrics, with the nonperforming loans ratio dropping to 2% in 2021 from 7% in 2013.

Chart 9

The ECB's unconventional monetary policies, however, also had unintended consequences for the eurozone financial sector as ultra-low policy rates, associated with an effective forward-guidance policy, led to a lower and flatter yield curve. This impaired banks' capacity to generate profits via maturity transformation and led to a gradual decline in net interest margins, to 1.25% in 2021 from 1.55% in 2014. In 2014, the introduction of negative policy rates, which eurozone banks were only partially able to pass on through deposit rates, created a significant drag on banks' profits. This particularly hurt retail banks because of their high reliance on sight deposits, which aren't sensitive to declining interest rates. The ECB's mechanisms weren't enough to offset the impact of lower net interest margins on banks' overall profitability.

Ultimately, this led many eurozone banks, especially in countries more severely hit by the crisis, to draw significantly, and for a long period of time, on public-sector funding (see chart 10), while still struggling to generate sufficient earnings to cover their cost of capital. As of December 2020, total public-sector funding--which includes repo-based refinancing operations with central banks such as TLTROs, public credit guarantees, and other schemes--represented 7% of total European bank funding, or €1.3 trillion.

Chart 10

In reaction to the low interest rate, eurozone banks exited marginally profitable businesses and tried to diversify their revenue sources. But not all banks had sufficient diversification, pricing power, or capacity to meaningfully reduce their dependence on net interest income (NII). At the eurozone level, NII still represented 54.2% of total income in 2021, down from 56.1% in 2015. Several banks embarked on cost reductions, but the lack of revenue growth limited the impact on overall efficiency, as the cost-to-income ratio increased from 60.5% to 64.3% over 2015-2021.

Prolonged periods of loose financing conditions can distort price fixing and lead to banks (and other financial sector players) increasing their risk-taking in search for higher yield. As a result, policymakers materially tightened the regulatory framework for banks over time, for instance with the application of Basel III capital and liquidity rules. In addition, and specific to the eurozone, the setup of the Banking Union led to more convergence in the application of regulatory standards across jurisdictions. The efforts of the single eurozone supervisory and resolution authorities were instrumental in having banks strengthen their balance sheets and enhance their risk management capacity.

Credit Markets Take On More Risk As Rates Fall And Stability Increases

One of the most immediate and consistent responses to the ECB's expanding monetary toolkit has been a decline and convergence in interest rates across Europe. Beginning with benchmark government rates, yields in Europe have fallen dramatically after 2012 and spreads have tightened (see chart 11). Interest rates have quickly risen this year as markets anticipate tighter monetary policy, but it remains to be seen how much of a pullback the ECB can achieve.

Chart 11

Corporate issuers have enjoyed falling borrowing costs alongside falling benchmark yields over the last 10 years (see chart 12). Primary market yields have shown some volatility month to month, but generally have declined across investment-grade and speculative-grade bonds.

Chart 12

Lower borrowing costs have enabled European corporates (both among financial services and nonfinancials) to issue more and more debt (see chart 13). From 2002-2011, the average annual total corporate bond issuance was €580 billion. In the subsequent 10 years, that annual average rose to €833 billion. In 2012 alone, €728.5 billion was issued--almost €150 billion more than the prior year. Total annual corporate bond issuance reached roughly €1 trillion in 2021.

Chart 13

Despite many direct means of receiving funds with incredibly favorable conditions directly from the ECB--such as negative-yielding loans via the TLTRO program--bank borrowing via primary bond markets has remained steady over the last decade. Nonfinancial bond issuance between 2011-2012 increased by roughly €100 billion, and growth has continued at a consistent annual pace.

The riskiest debt levels have been the biggest boosts to corporate bond issuance (see chart 14). Total speculative-grade bond issuance nearly doubled year over year from €48.4 billion in 2012--an all-time annual high--to €91.1 billion in 2013. This is in stark contrast to prior to "whatever it takes," when the proportion of 'CCC'/'C' rated bonds would, at times, reach 10% or more of the annual total, and in other years, there was no bond issuance at that level. After 2012, 'CCC'/'C' issuance became much more consistent, around 4.7%, on average, and never exceeded 6%.

Chart 14

The eurozone has seen a noticeable increase in initial speculative-grade issuer ratings over the last decade, particularly at the 'B' level (see chart 15)--despite downgrades typically exceeding upgrades over time. Some of this increased high-yield issuance likely came from investment-grade issuers that eventually were downgraded to speculative grade.

Chart 15

The ECB's expanded monetary policies have arguably increased both overall debt issuance and market stability, by improving access to more favorable lending conditions and the bond market to aid in the larger goal of disintermediation.

From 2012-2019, the European speculative-grade default rate was both low and stable, at a 2.08% average on a trailing-12-month basis (see chart 16). The eurozone also saw a low default rate through the recession of late-2011 through early-2013 during the sovereign debt crisis.

Chart 16

Despite defaults picking up during the recession in 2020 that spawned one of the one deepest GDP contractions in history, the peak default rate of just under 6% was significantly below the peak double-digit default rates of prior recessions. This is partly attributable to the further expansion of monetary support from the ECB throughout the pandemic, most of which is still active.

Expanded ECB Support Is Likely To Continue For Years

With the ECB only beginning to embark on policy normalization this year, it could take another decade to reduce current policies by any substantial amount. This largely applies to balance sheet normalization and the pulling back of lending innovations, while interest rate increases will happen faster, but may be more limited than other central banks.

The size of the ECB's balance sheet has followed an inverse relationship to policy rates: The lower (or even negative) the interest rates, the larger the amount of excess reserves held by banks at the ECB (see chart 17 and "A Future For QE: Monetary Policy In Two Dimensions"). If this continues, and the ECB succeeds in bringing the policy rate back to its neutral level of around 1.5%, from the current 0% for the repo rate and -0.5% for the deposit rate, the ECB balance sheet could shrink by €3.5 trillion and bank excess reserves could shrink to less than €1 trillion from more than €4 trillion.

Chart 17

But such a sharp reduction in the ECB's balance sheet is unlikely to happen anytime soon (see "Implications Of The ECB's Policy Normalization For Interest Rates, The Balance Sheet, And Yields"). This is because the ECB does not yet consider the active sale of bonds as a tool to wind down the QE pocket of its balance sheet--which explains 80% of its expansion over the past 10 years. Reinvestments in bonds maturing through the end of 2024 and the seven-year duration of the QE portfolio make passive quantitative tightening a decade-long operation. The ECB also said that it will launch an anti-fragmentation instrument. Its design remains unclear for now, but it might lead to further balance sheet expansion if this instrument is, unlike the OMTs, not sterilized. A sharp reduction of the ECB balance sheet is unlikely to happen soon also because banks have low incentives to repay the third round of TLTROs prematurely. In addition, it is not out of the question that the ECB might decide on a new round of TLTROs, if bank funding deteriorates unevenly in the region due to rising rates.

The ECB balance sheet has not only ballooned more than the Fed's balance sheet, but it has also become more complex, after years of fighting low inflation by means of negative interest rates, and quantitative and credit easing measures. At the end of the fourth quarter of 2021, the ECB's balance sheet was almost twice as large as the Fed's relative to the size of their respective economies (68% of GDP in Europe, compared with 36% in the U.S.) (see chart 18).

Chart 18

Higher Bank Profits, But More Price Discrimination

Changes to the ECB's supportive policies could affect the banking system via profits, inflation, and risk differentiation.

In the short to medium term, we expect rising interest rates to be a net benefit for most European banks under our base case, but NII benefit could vary significantly, and some banks could be more affected than others by weakening asset quality.

An ECB decision to lift interest rates, and more importantly to move them out of the negative territory, would generally provide a boost for bank profits in 2022 and 2023. Based on banks' disclosures, we estimate that, at the eurozone system level, a parallel increase in interest rates by 200 basis points would lift NII by around 14% (see "When Rates Rise: Not All European Banks Are Equal"). This would represent an additional approximately €37 billion of annual NII for significant eurozone banks--meaning, all else being equal, an increase of 26% in pretax profits.

Higher inflation clouds the benefits that banks will see from rising NII. As we're seeing in economies like the U.S. and U.K. that are ahead in the rate-hiking cycle, eurozone banks will face heightened pressure on wages and other operational expenses, as well as rising credit costs (see "U.S. Banks: Net Interest Income Gains Offer Buffer Amid Emerging Risks" and "U.K. Banks Are Poised For Higher Revenues And Elevated Costs In 2022").

Over the medium to long term, the gradual normalization of the ECB's monetary policies will bring the funding question back to the fore for eurozone banks. Because eurozone banks have greatly enhanced their funding and liquidity over the past years, and their recourse to TLTROs today is more driven by a cost/benefit analysis than by a lack of market access, we expect banks will be able to manage the gradual transition with repayment/deleveraging and refinancing (assuming that no further TLTRO-equivalent scheme is put in place).

However, a normal functioning of interbank/wholesale markets might create more price discrimination, with market funds available on better terms for banks that are perceived to be stronger. This could come at a time when financing needs from the real economy are likely to pick up. In this context, banks' ability to defend their funding franchises and maintain low-cost funding would become key for their businesses as they compete for new opportunities. And in the longer run, the still largely unresolved sovereign/bank dynamic increases the chances of a more fragmented funding picture for eurozone banks.

Capital Markets Will Likely Become Riskier If Policies Normalize

The actions of the ECB and other central banks have had a quantifiable impact on pricing and primary issuance, but the effects on market confidence, reliance, and volatility are more difficult to measure.  While some reversal of these far-reaching supports is expected, we don't expect a full reversal, and would not be surprised if the tightening of policies proves to be limited, or even temporary. No longer looking to governments or rate policy alone to restore order during crises, market participants have increasingly required more support from central banks. While the COVID-19 response is the most recent and effective example of central banks' ability to return stability to markets, the role the ECB and other central banks played also raises questions about how markets can become more independent without increasing volatility. Even the clearest of signs and signals from central banks might disappoint markets that have grown accustomed to the presence of the buyer of first and last resort.

Markets have already pushed yields up on various asset classes in anticipation of upcoming ECB moves. This caused the ECB to hold an ad-hoc meeting on June 15 to assuage markets that it will work to stabilize widening credit spreads and to be cognizant of supporting credit to weaker member states amid likely upcoming market turmoil. This move supports our belief that widespread monetary tightening will be difficult at best. That said, rate increases are easier to implement, which would have an impact on the trends we've discussed.

Significant monetary stimulus over the last decade has reduced credit risk, but is now arguably exacerbating duration risk and leading to painful investment returns as conditions tighten and rates rise.  This has particularly affected market participants that increased their holdings during recent years of record low coupons.

Low rates and sustained monetary stimulus in recent years has made it difficult for fixed-income investors to generate target returns, forcing many investors to go longer and lower in search of appropriate yield. Global bonds with yields or 2% or less have constituted nearly two-thirds of the global stock for five of the last six years, and peaked north of 90% in 2020 (see chart 18). The return of growth and, more importantly, inflation is now increasingly creating duration risk and pricing pain for fixed income investors, with the role of central banks and the quantum and nature of the monetary stimulus unleashed arguably increasing this pain. Bonds with low coupons and longer maturities are most exposed.

Credit risk premiums, which fallen materially in recent years as investor hunted for yield, have risen sharply in recent months. While the central bank isn't solely accountable, its increasingly accommodative policies over the last 10 years have been a contributing factor. The unwinding of these supportive policies could hurt fixed income and credit investor appetite in the near term.

Chart 19

Accommodative monetary policies adopted by the ECB and other central banks over the last 10 years have contributed not just to market growth but also to the increasing risk profile of rated issuers.  If these policies are reversed, it is likely credit markets, and in particular rated issuers, would also revert to pre-support characteristics, perhaps painfully, including:

• Rising borrowing costs;
• Reduced bond issuance, particularly among speculative-grade issuers;
• A slowing of the growth of new speculative-grade issuers coming to market;
• The potential for increased downgrades; and
• A return to a more volatile, and higher, average default rate, especially if long-term yields remain high after the current high levels of inflation subside.

As we're already seeing, tighter monetary policies can result in rising interest rates even before the ECB takes action. With yields rising across the board, returns on safer assets may crimp demand for riskier assets. Speculative-grade bond and leveraged loan issuance is already down markedly this year.

Since the creation of the Corporate Sector Purchase Program in 2016, the ECB has purchased certain corporate bonds directly, largely from investment-grade companies. This has coincided with increased upgrades and rating stability for investment-grade issuers relative to 1999-2015. Being a large, reliable buyer of corporate bonds has helped push borrowing costs down and stabilize funding, which has supported credit quality. Alongside rising rates, if the ECB discontinues buying these bonds, it is possible that investment-grade corporate entities could see an increase in downgrades and lower rating stability (see chart 20).

Chart 20

The number of European speculative-grade issuers has nearly doubled over the last 10 years, and in the pursuit of yield, markets have supported a growing share of issuers rated 'B-' and lower (see chart 21). At the end of March, 29% of European (excluding the U.K.) speculative-grade issuers had a rating of 'B-' or lower. When combined with the potential for higher interest rates and fewer policy supports, this population with relatively weak credit quality could become more susceptible to default.

Chart 21

Related Research

• Altavilla et Al., "The Financial and Macroeconomic Effects of the OMT Announcements," International Journal of Central Banking, 2016, Vol. 12, No 3, pp. 29-57
• Rostagno et Al., "A tale of two decades: the ECB's monetary policy at 20," ECB Working Paper 2346
• Hutchinson and Mee, "The impact of the ECB's monetary policy measures taken in response to the COVID-19 crisis," in Economic Bulletin, Issue 5/2020

Appendix

Note that we exclude the U.K. and its tax havens from our analysis.

Terms referenced in the article:

• OMT--Outright Monetary Transactions
• TLTROs--Targeted long-term refinancing operations
• QE--Quantitative easing
• APP--Asset Purchase Program
• PEPP--Pandemic Emergency Purchase Program
• MRO--Main refinancing operations (rate)
• MLF--Marginal lending facility
• DFR--Deposit facility rate
• ABSPP--Asset-Backed Securities Purchase Program
• CBPP3--Third Covered Bond Purchase Program
• APP--Asset Purchase Program
• PSPP--Public Sector Purchase Program
• CSPP--Corporate Sector Purchase Program
• PEPP--Pandemic Emergency Purchase Program
• PELTROs--Pandemic Emergency Longer-Term Refinancing Operations