High debt, rise of non-banks risk tying ECB's hands, Schnabel says

ECB's Monetary Policy at Risk from High Debt and Non-Bank Finance Growth

Challenges Facing the ECB's Monetary Policy

Rising Public Debt and Non-Bank Finance Expansion

FRANKFURT, Nov 5 (Reuters) - Rising public debt and the rapid expansion of non-bank finance could curb the European Central Bank's ability to set the appropriate monetary policy, ECB board member Isabel Schnabel said on Thursday.

The ECB is now raising interest rates to combat excessive inflation, fostering worries that higher debt costs could make some budgets unsustainable, particularly for vulnerable France, curbing the ECB's ability to set the appropriate monetary policy out of fear it sets off financial instability.

Impact of Increased Debt Held by Non-Banks

The issue is that public debt has ballooned since the start of the century and much of the new debt is held by non-banks, including hedge funds, which may be highly leveraged, Schnabel said.

Transmission of Interest Rate Changes and Market Volatility

The result of this transformation is the ECB's interest rate changes are now transmitted more rapidly, potentially raising market volatility, which could then force leveraged investors to dump bonds as collateral values fall and margin requirements rise.

"To restore transmission, central banks may then be forced to stabilise markets to prevent a liquidity crisis from turning into a full-blown credit crisis," Schnabel said in a speech in Frankfurt. "Such interventions can interfere with the central bank’s mandate and threaten monetary dominance."

Policy Responses and Recommendations

Regulation of Banks and Non-Banks

Europe should respond by resisting any temptation to deregulate banks and in fact should introduce stronger regulation of non-banks, such as hedge funds, investment funds or insurers, Schnabel said.

"Stronger regulation of non-banks would also bolster the case for considering their access to central bank facilities, which could further support systemic stability," said Schnabel, who is leaving the ECB for a senior role at the IMF in January.

Fiscal Reforms and Economic Growth

The more difficult issue may be putting public finances in order since the effective rate governments pay on their debt is now higher than economic growth, she argued.

This only bolsters the case for Europe to embrace the much-discussed institutional reforms that could over time reverse the drop in potential growth, Schnabel said.

(Reporting by Balazs KoranyiEditing by Tomasz Janowski)