The limits of central bank lending

EU lending Oct09.jpgOver the past year, much of the Western financial system has been on life support. Now the European Central Bank (ECB), like its peers, is grappling with the question of ‘What happens next?’
ECB Board member Lorenzo Smaghi set out the key issues yesterday:
“Our role (as a central bank) is limited to the provision of liquidity to solvent banks.
“This role does not include the recapitalisation and restructuring of the banking system.
• “We expect banks to take a more active role in the process of recapitalisation.
• “The banking system cannot be supported indefinitely by the extraordinary measures taken by central banks. An exit strategy will inevitably need to be implemented in due course.

He highlights the issue with the above chart, which shows the collapse of all forms of financial activity in the eurozone over the past 2 years. And he argues that nothing will change unless “individual incentives, those of bank managers and shareholders, are aligned with the collective incentives to support the economy.”
Currently, of course, most banks are instead pursuing their own agendas to maximise short-term bonuses and profits. The blog therefore shares Smaghi’s concern that unless politicians and regulators act quickly, the eurozone may well repeat “the experience of Japan over the past decade, where delays in restructuring and recapitalising the banking system undermined the recovery after the crisis”.

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