Once again, this year brought to investors’ attention the big difference between the U.S. and the European financial systems. A clear understanding of how the two functions is critical for every trader or investor trying to make sense of what the central banks do to respond to economic challenges.
The truth is that U.S. and European companies use different sources of financing. As such, the two central banks, the Fed in the United States and the European Central Bank (ECB) in the Eurozone, use different tools to alleviate the need for funds during a crisis.
U.S. Corporations Depend on Financial Markets
The image above tells everything about the difference between the two systems. While for the European companies, access to bank loans is critical for funding their needs, the U.S. corporations use mostly other features available from financial markets – IG (Investment Grade) bonds, HY (High Yield (bonds), etc.
In other words, to make credit available to private America, the Fed’s focus is on lowering the yields (a.k.a interest rates) on the yield curve, so corporations have access to cheap money. On the one hand, the Fed lowers the rate, but it cannot do so below zero (at least it has ruled out such a possibility). On the other hand, it uses Quantitative Easing (QE) to distort the yield curve by buying government debt.
European Corporations Depend on Bank Loans
In sharp contrast, banks are key to European corporations. 80% of all loans originate from the banking industry. Therefore, if the ECB wants to ease the monetary policy during a crisis, it does so a bit differently than the Fed. On the one hand, the ECB lowers the interest rate to zero – for one rate, the deposit facility, it lowered it even below the zero boundaries. On the one hand, it has some other tools to use – one is the QE, with a similar effect. However, QE works in the Euro area only to some extent. To fully support the European financial system, the ECB engages in LTROs (Long Term Refinancing Operations) or TLROS (Targeted Long Term Refinancing Operations).
Perhaps many traders wondered why TLTROs are part of the ECB’s toolkit every time there is a crisis? The answer is that this is the most effective way to address liquidity and financing needs on the European corporate level.