12 Sep 2014

Jan Pieter Krahnen: "ECB faces a dilemma with planned ABS program"

ECB will not succeed in stimulating bank lending by introducing a sustainable ABS program / A too lax program however involves high risks

Jan Pieter Krahnen, Professor of Finance at Goethe University Frankfurt and director of the research centers SAFE and Center for Financial Studies, doubts that the European Central Bank (ECB) will be able to considerably stimulate bank lending by European banks with the announced purchase of asset-backed securities (ABS). “In particular with regard to small and medium-sized enterprises, it is questionable whether ABS purchases by the ECB will improve the access to bank loans.” Last week, the ECB announced to buy a large volume of asset-backed securities from banks which pool credit risks. The ECB’s objective is to relieve financial institutions from parts of their risks and, as a result, free resources for bank lending. The exact specifications of the program are currently underway.

“The high expectations in this program show how dramatic the situation on the credit markets is perceived, especially in Southern European countries,” Krahnen says. Nevertheless, one should not forget what the financial crisis has taught about ABS: “When selling securitized loans, it is crucial that the lending bank still participates in possible losses of these loans.” If this is not the case, the lending bank has no incentive to precisely assess the borrower’s risks, to monitor the borrower during the repayment term, and to insist on collecting the money. “A significant experience from the crisis was that the specifications of ABS instruments that were used in large parts of the financial sector worldwide gave the wrong incentives,” Jan Pieter Krahnen says. “This mistake should not be repeated”.

In order to design the program in a sustainable way, it is important that part of the risks remain at the lending bank. Assets in ABS packages are separated in three tranches according to their default risks: senior tranche, mezzanine tranche and equity tranche. For a sustainable ABS financing the equity and perhaps also parts of the mezzanine tranche should remain at the lending bank. However, if the ECB follows this security measure, it will not succeed in considerably relieving banks of risks by buying ABS from them. And thus, it will not manage to free bank equity, which was bound to back these risks, for new credits.

As a result, the ECB faces a dilemma: “Either it takes over incalculable high risks by buying ABS with perverse incentive effects and is maybe left with high losses in the end; or it designs a sustainable ABS structure but does not manage to create substantial stimuli to the credit markets,” Krahnen said.