Dr. Draghi and the transmission mechanism…

This is not a science fiction adventure, as the title may lead us to believe, even if Draghi in Italian does mean the plural of dragon. Our Draghi is not at all a dragon, rather a well-connected and well-read ex banker and former university professor, with political ambitions, both within the EU and for a presidency armchair back at home in Italy.

If one was to assess his position in the light of his policies, one would rapidly jump to the conclusion that he is not a civil servant, or at least one that does not fulfil his constitutional duties.

In fact he certainly has failed at the one most common sense and important mission he was entrusted as president of the ECB, and as former president of the bank of Italy; pushing liquidity in the real economy, first in Italy, then in Europe. Not only has he failed, he has also given us the certainty that if by chance he will succeed in future it will be at a high price.

He has not failed by negligence, or by incompetence nor has he failed by deploying a wrong plan, he just never had this “peculiar” goal amongst his top ranking ones. He is an expression of, and a functional part of an establishment. He sees the world through the filters of his experiences, and his priorities are hard coded in him, he is a banker, nominated by bankers and pursues their agenda, no matter how socially useless and self-defeating the agenda is, that is who they are, and who he is.

Mr. Draghi knows banks well, having sat in the firm-wide management committee of Goldman and having covered significant roles in some of the world’s largest and more complex public banks.

Given his background, had he been a real civil servant, he should have produced a much better “mechanism to transmit” liquidity to businesses and families in the euro zone, and he should have done so five years ago. His decision not to do so, both now and then, substantiates the validity of my critical statements in the previous paragraphs.

The recently trumpeted operation to “enhance the functioning of the monetary policy transmission mechanism” is only a new gift to his employers, the real ones, not us.

By reading the press release of the ECB, it sounds like the ECB is now saying to banks just what they want to hear; we will give you for free, up to three times your outstanding book of loans to non-financial private sector entities for two years. Interest to the ECB will have to be paid in arrears only after repayment, no sooner than 24 months after the loans are taken out.

Up to this point we learned about the carrot part of the mechanism, now comes the stick; to ensure that the money is effectively “transmitted” the ECB, will verify (i feel sick), that the net lending to borrowers will have increased over the 24 month period, and if it hasn’t It will ask the institutions to pay the money back, in September 2016 plus interest.

Did you see the stick anywhere? Or is it just me missing it?

Of course I am sure that it is not as simple as that. But somehow, I do not see this trade as being such a bad one for banks, notoriously keen on short term profiteering.

I could easily write a list of 100 wrong things that banks could (will) do with free money, driven by the incentive models currently in place within them.

Yes, some of the money will feed down the economy, but why does Draghi think that banks that are incapable of lending for lack of credit expertise, will lend other than through the sale of standardised products, centrally engineered by some 25 year old kid, and characterised by flawed credit risk metrics outside of an excel sheet?

Mr. Draghi is no fool; he knows that this is exactly what banks will do if they actually get down to lending.

So here comes the second part of the master plan, revitalize the ABS market; banks can start selling to CLO and CDO managers lovely fresh portfolios of poorly written loans, (or distressed loans that they hold) so that in turn rating agencies can start rating these new securities, and institutional investors can buy them; déjà vu someone? Subprime the revenge…?

But face it, be realistic, who cares if this is not sound behaviour? After all we know that this wrongdoing is encouraged by nice fat fees for everyone to pocket, and therefore it will be scalable, and it could even jump start the economy, and someone may get the credit for it, and in two or three years we may find Draghi hailed as a saviour and sitting on a bigger chair than the one he is currently occupying.

Who will then blame him for starting the recovery only after 7 years from when he should have done, and for doing it in such a short sighted way? By the time it all blows up again, he will not be responsible for it, after all we do live in the world of amnesia, and connecting distant causes to contemporary events is not a rewarding game for the watchdog media. (Watchdog, hum?)

But why not give this free money (not free for citizens) directly to small and medium industries, by organizing an ECB funded purchase program of purposely issued SMI senior secured or asset backed bonds with 5 year maturities, which start paying interest in two years…? Why not Draghi? Why not? I could set that up in six months given the balance sheet!!

Why do we have to have inefficient, corrupt and expensive intermediaries between public money and the place where the money is most needed? Who has interest in keeping them intermediaries there Mr. Draghi?

Of course Mr. Draghi has interest; he has to bail banks out, after all this is what all the establishment has been doing in Europe for the last 6 years, or else the big chair disappears from his horizon.

In hindsight, the US has survived quite well the demise of Lehman Bros, Bear Stearns, and hundreds of commercial banks, which have been neatly allowed to fail. How many did we let go in Europe?

Defendants will argue this mechanism is a step in the right direction, maybe, but the medicine is far too approximated, delivered far too late and has known and terrible side effects.

The problem truly lies in the culture that has been engineered within most credit institutions; most contemporary financial institutions have been reduced to large selling machines, it can be observed easily through the analysis of the curriculum and of the incentive structure of their employees, particularly senior ones.

How on earth can someone gifted with the varied and sophisticated skills required to be a salesman, be entrusted with running organizations that have the mission of accepting deposits and channelling those deposits into lending activities?

Furthermore, if the compensation models are based on fees earned on transacted volume, it becomes clear to anyone that an organization made up of smart selfish boys and girls, will concern itself with quantity rather than with quality, particularly if they need to meet quarterly objectives.

Volume can be achieved where economies of scale can be created. Credit underwriting is by nature a granular business, work intensive and needy of much diligence and serious time consuming structuring.

It is simple to explain why recurring systemic problems like the savings and loan crisis of the 1980s and the recent crisis of the subprime housing markets, to name just a few, always spring out of poorly underwritten credit books.

Hence while Draghi presents programmes and rules to improve the amount of lending, he expects structurally inadequate organizations to implement his plan – smart stuff!

Banks are just business, and like all business, they should be run within the boundaries of social utility, and the job of regulators should be the one of keeping them within those boundaries, not to bail them out of them.

Just as we would (should) shut down a chemical business that pollutes, we should simply unwind a bank that does its job poorly, and if we don’t we will pick up the price for fixing its wrong doing as well as pushing the consequences on the weakest parts of society.

If credit institutions are unwilling or incapable to transmit liquidity from central banks to industry and consumers, they no longer serve their purpose to society.

Effective measures should be adopted relying on more trustworthy and correctly incentivised intermediaries, as well as by interacting directly with borrowers, even using new technologies to increase the social impact of expensive new money being printed by the ECB.


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