Financing the Recovery: the State of Europe’s Financial Sector

Financing the Recovery: the State of Europe’s Financial Sector
  • Opening Intro -

    The relationship between finance and growth is complex and not necessarily stable over time.

    Although there is no doubt that financial markets are crucial for the functioning of the economy, their exact contribution to growth is somewhat uncertain and varies over the cycle.

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In principle, credit cycles are strongly correlated with economic cycles. On the one hand, access to external finance enables companies to pursue investment projects. Through the well-known financial accelerator process, credit expansion translates into economic growth.

Brief History

On the other hand, as an economy picks up, households and companies become more confident and increase their demand for credit. A growing economy can also raise collateral values and borrowers’ income prospects, which improves perceptions of creditworthiness and makes it easier for them to get loans.

While history offers examples of credit-less recoveries, in which output grew without an increase in credit, these may not provide helpful insights for the euro area because most examples come from countries with less-developed financial markets, where competitiveness gains came from exchange rate depreciation. Research shows that credit-less recoveries tend to be weaker and driven more by consumption than investment. Economic recoveries accompanied by credit growth, by contrast, tend to be stronger and more broadly based.

This is a brief analysis of whether Europe’s financial sector is currently fit to provide a supportive role for European growth.

The financial crisis severely hit the financial markets and economy of Europe (financial markets have stabilized remarkably well however). Over the last two years, however, the situation has started to revert. And conditions on financial markets in the EU and globally have markedly improved. The rebound has been substantial, widespread and broad.

Summary

After suffering severe disruption during the banking and sovereign debt crisis, European financial markets have stabilized and started to function properly again over the last few years. Although risk sentiment has broadly recovered and disparities in financing conditions across the euro area have diminished, credit to support economic growth is not being created. The fact that banks still need to adjust their balance sheets continues to hamper their ability to lend. At the same time, demand for credit remains low because the economic outlook is still fragile and private debt levels are already high. The weaknesses in bank lending means that more should be done to foster alternative sources of finance.

Other challenges that remain ahead include persistently high levels of public and private debt, fragile economic prospects, external risks from emerging markets, and the uncertainties surrounding the results of the European Central Bank and European Banking Authority’s comprehensive health check of the banking system.

 
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Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk
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Bestseller No. 2
Labor, Credit, and Goods Markets: The Macroeconomics of Search and Unemployment (MIT Press)
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Credit Markets for the Poor
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Last update on 2017-03-29 / Affiliate links / Images from Amazon Product Advertising API

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