Monetary Policy and Capital Market Integration in the Euro Area: What Is the Role of Covered Bonds?

Abstract

Covered bonds have played a central role in funding strategies of European banks over the past two centuries. As the fragile recovery in the euro area exposes fault lines in a heavily intermediated financial system, the complementary role of covered bonds relative to securitization has become central to supporting monetary policy and the greater integration of capital markets, especially in the context of the European Central Bank’s (ECB’s) current private asset purchase program. However, covered bonds also have an important role to play in cultivating alternative, market-based, long-term sources of finance. Credit supply to the corporate sector is heavily influenced by the lending behavior of banks, which has constrained the recovery of credit supply, particularly to small- and medium-sized enterprises (SMEs), which constitute the greatest share of European output and employment. Widening the scope of covered bond markets in tandem with restarting securitization could help mitigate structural constraints on credit supply by lowering the economic cost of capital and encouraging the use of standardized and more-efficient origination and loan pricing processes, leading to lower transaction costs. More official-sector involvement is required to ensure progress toward 1) providing greater regulatory differentiation among securities of different quality across the spectrum of structured finance, 2) completing necessary structural reforms, such as the harmonization of insolvency frameworks and the standardization of loan reporting requirements within the euro area, and 3) facilitating the cross-country harmonization of asset structures for covered bonds.