The five years since the global financial crisis have seen a drastic shortening in the average maturity of bank credit. This contraction in long term finance is often regarded as the main factor behind the fall in corporate investment and infrastructure spending. In the eleven new EU countries of central Europe, for instance, fixed capital formation has fallen from 26 per cent of GDP before the crisis to under 21 per cent in 2012.
This component of investment is closely associated with trend growth over the medium term, underlining that the present contraction will have lasting effects within the region. Yet, as in many areas in economics, causation could run either way. Sorting out the relevant factors is a key policy issue, occupying no less than the G20, and is a priority as the EU considers various new policy instruments to address the shortfall.
Data on the maturity composition of bank lending for most of the new EU countries in central and south-eastern Europe indeed show that term funding has disproportionately suffered amidst the present credit stagnation.
In Hungary last year’s contraction of about 10.5 per cent in lending to non-financial companies was primarily in the segment of long term loans which contracted by almost 16 per cent over a year earlier (Figure 1a). Even in countries where credit growth remained marginally positive, as in Romania, growth in maturities above one year has been negligible (Figure 1b).Leveraging of longer maturities
Regulators within EBRD countries of operation will typically attribute the decline in long term credit to the deleveraging by European banks which dominate local financial markets. European cross-border banks can fund their subsidiaries in the more developed capital markets of their home countries, and contributed to a lengthening of maturities in host countries over the period of large funding inflows prior to 2008.
Since then this process appears to have gone into reverse. Figure 2 charts the proportion of cross-border claims to the 11 new EU members in central Europe (including Croatia) at maturities in excess of 2 years. Following a rapid increase up to 2009 this ratio has since declined markedly, as banks appear to have let their longer-term exposures run off – in direct lending, though also in funding to their subsidiaries. A similar picture emerges from the syndicated lending by European banks within the EBRD countries of operation. Between 2008 and 2012 the share of loans in excess of 5 year maturities declined from 32 to 24 per cent.
Tighter financial regulation: shorter maturities?
European banks, in turn, have blamed maturity shortening on the raft of new financial regulations that have been imposed in the process of regulatory reform in the EU.
Regulators, but also the Financial Stability Board (FSB) which has designed the key directions in financial regulation across the G20, respond that the main ambition of regulation is to make the system safer and more resilient. This by itself should support the provision of long term credit. Maturity mismatches played a key role in the financial crisis and gave rise to two new liquidity requirements under the Basel III framework.
However, neither of these two liquidity ratios target exposures of more than one year. Asian banks, for instance, are subject to the same regulatory tightening but appear to have raised the share of their long term funding.
Banks nevertheless contend that uncertainty over the tightening of liquidity regulations plays a key part in contraction, in particular in project finance. The introduction of the so-called ‘Net Stable Funding Ratio’ in 2018 will limit exposures over one year in relation to banks’ longer term funding.
Moreover, European insurers have been one of the key sources of banks’ long term funding but will soon be subject to the EU’s Solvency II regulation, which stipulates more onerous capital requirements for long term assets on insurers’ balance sheets.
The concerns over the impact of fresh regulation on long term finance are nevertheless taken seriously. The Basel Committee that governs financial regulation in key markets recently loosened one liquidity ratio, taking the characteristics of emerging markets into account. Following the work programme under the Russian G20 presidency the FSB (in Basel) will also monitor the impact of financial regulation on various aggregates more closely.
Uncertain prospects: declining appetite for long term ventures
In essence, the decline in long term investment projects is of course a reflection of a more uncertain macroeconomic outlook, and the associated risk premiums in financial markets. Private demand for investment projects with long pay-off periods has sharply declined.
Banks, for their part, price long term exposures on the basis of internal risk models. Models of volatility, correlations and expected prices at maturity are used to measure riskiness of individual asset classes, and hence the cost of capital. As macroeconomic and financial market risks rose, this has penalized long term exposures disproportionately. This is reflected in surveys of lending conditions, for instance in Poland, which underline that credit standards have tightened disproportionately for long term credit.
Policy responses: can the state provide a substitute?
The collapse in long term investment spending in central Europe is the result of lingering uncertainty over the growth outlook and financial stability in Europe, cuts to capital spending in national budgets, and structural shifts in banks’ business models.
European cross-border banks have become more risk averse and subject to liquidity regulations under EU rules whose effects are as yet hard to make out. This has given rise to a range of responses within countries.
Some countries are seeking to re-build their pension funds as a source of local long term institutional investment. All three Baltic countries are close to restoring contributions into mandatory pension funds to levels originally foreseen prior to the crisis. An early success came when Latvenergo, Latvia’s dominant state enterprise, floated long-dated bonds to pension funds from all three countries.
Slovakia and Poland have announced plans for sizable investment funds that are state sponsored though outside the budget framework (and funded by state assets in the case of Poland). Spending on large scale and long term investment projects in infrastructure and energy efficiency are key objectives of these funds. State development banks, with their privileged access to financial markets on the back of a sovereign guarantee are making a comeback across the region.
At the same time multilateral banks are increasingly called upon to fill the gap in long term funding, in particular in the infrastructure sector. In the case of the EBRD, the average loan tenor in annual business volumes has in fact slightly increased since 2007, to 9.3 years in early 2013.