ECB Imposes Negative Interest Rate – And Why They Will Not Create Jobs

As you surely must have heard, last week the European Central Bank (ECB) lowered its benchmark interest rate from 25 basis points (bp) to 15 bp. and imposed negative rates for banks that hold cash with the ECB (mostly German banks). This measure is intended to kick-start lending in the periphery countries, where credit to SME and corporates is decreasing. With better credit availability, the ECB seems to think, growth will follow. It is often argued that credit is what is needed for young entrepreneurs and small businesses to get their ideas started. This is how these measures are sold to the gullible public. Needless to say,  none of this will have the desired effect, on the contrary it only unnecessarily delays necessary reforms by providing ever cheaper finance for the incompetent political class in europe.

Two years ago I had the opportunity to visit an italian subsidiary of a european bank. The subsidiary was in deep trouble, its previous management had expanded to quickly without proper risk management in place. As a result, it had mounting non-performing loans and losses. The decision was taken to work out the portfolio as quickly as possible and without making any new loans. The company had previously only employed sales-staff, whereas what was now needed were workout-specialists. As the headquarter found out, however, firing the old staff would have cost three annual salaries for every employee, thereby basically significantly lowering the “recovery value” of these operations. For instance, even in Austria, over-regulated, overtaxed and facing a serious pension problem itself, it would “only” have cost the equivalent of three monthly salaries, i.e. less than one tenth the cost in Italy. The bank reasoned, the only viable option was to retrain former sales staff into workout specialists. I wished them good luck…

It is easy to see why no one in his right mind would open a business under these conditions in Italy (or Spain or France for the matter where labour markets are similarly rigid). The rigid labour laws in italy kick-in once you employ more than seven employees. This is the main reason why company structures remain small and uncompetitive. The italian entrepreneurs try to overcome these obstacles by employing family members, as they are more unlikely to go to court over these matters. Contrary to what many think,  it is not their sense of family or whatever, no, it is often the only way to stay in business. Now, I do not know whether the law is still in place or not, but is easy to see how the lower ECB interest rate and the planned asset backed repo program will not induce entrepreneurs to expand under such conditions. The labour law has been the binding constraint forever, NOT credit availability.

But what about start-ups, don’t they need credit to start the business? Let them worry about the “seven employee problem” later, once they are established… This argument is often made by politicians in public discussions, and then always some (ex-post) successful entrepreneurs are quoted who mortgaged their parents’ house in order to start their businesses. While I generally admire such people, the unfortunate fact is that most of the time this gamble goes wrong. The reason? Young businesses need EQUITY NOT DEBT! Financing a start-up with debt is really bad corporate finance advice. After all, most businesses do not produce cash flow from the start, you must have the staying power to whither the first hard years. This is why silicon valley is heaven for equity investors but not for bank lending (unless they need an IB for the IPO).

The next thing the ECB doesn’t seem to understand is that european banks are themselves constrained by their risk weighted assets (RWA) and increasing regulatory requirements. As SME lending is mostly unsecured, they simply do not have enough equity to expand their loan book by lending to companies, for which they have to hold more costly equity, than if they buy their government’s bonds. No bank manager will go to prison because five years down the road his government maybe defaulted on its government bonds and a bank run ensues. But probably this is the ultimate goal of the ECB, to make sure cheap funding for incapable governments is still available for the (near future)…


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