The Financial Fragmentation of the Euro Area Is the Main Challenge for the ECB and the Sustainability of the Monetary Union

Abstract

This research note explains that the deep division in the governing council of the ECB results from the underlying financial fragmentation of the euro area. Disagreements between members of the governing council have been growing since the start of unconventional monetary policy implementation. The most striking feature of the financial fragmentation in the euro area is the diverging patterns of the spontaneous financial flows of funds between the countries of the periphery and those of the center, since the financial crisis. The countries of the center of the euro area are characterized by net global financial inflows.On the other hand the peripheral countries of the euro area are characterized by net global financial outflows. The consequence is that the banking systems of the periphery and those of the center of the euro area widely differ in their funding needs and excess liquidities. It is shown that banks located in countries of the center of the euro area already have abundant liquidities, without having to borrow much additional liquidities from their national central bank. They pay the most part of the negative interest rate penalty. On the contrary banks located in the periphery of the euro area have a very low level of liquidities deposited with their national central banks, but massively borrow from them. They use the largest share of LTROs and TLTROs. It is thus shown that event after the establishment of the tiering system, the negative interest rate is penalizing the banks of the countries of the center of the euro area, while TLTROs favours mainly the banks of the periphery. The banks of the peripheral countries of the euro are remain excessively loaded with bad quality loans, even if they are decreasing. The banking sector of the euro area remains fragmented. It is also striking to observe that, since the start of the recovery in the euro area, bank loans have strongly grown in France and Germany, but remain depressed or are even decreasing in Spain and Italy, despite several years of extreme monetary policy accommodation. The pernicious loop linking the risks related to the solvency of banks to the risks related to the sovereign debt of their country is still very active. Most countries of the euro area banks remain very exposed to the public debt of their country. In percentage of their equity, this exposure however varies widely. Another feature of the fragmentation of the euro area is the extreme geographical heterogeneity of the inflation rate, based on the HICP. Therefore an ultra accommodating monetary policy with negative or very low interest rate seems completely inappropriate for the citizens of countries where inflation is close to the target, or even higher. Even the efficiency of monetary policy is threatened by this heterogeneity. The problem is that policy interest rates are the same for the whole euro area. The common policy implies higher real interest rates in the periphery than in the center of the euro area, which is exactly the contrary of what should be achieved. It is a big problem for the transmission of the monetary policy of the ECB. There are also big divergences between euro area countries, related to real activity and income.