European banks fear no escape from negative rates

Mario Draghi's final act as ECB president was to cut interest rates to minus 0.5 per cent. Photo / AP

European lenders are bracing for deeper cost cuts and consolidation after the European Central Bank extended a punishing five-year stretch of negative interest rates.

The region's banks were left disappointed by Mario Draghi's last major act as ECB president, in which he last week cut its key deposit rate to minus 0.5 per cent, while also unveiling a new tiering system designed to shield a portion of the deposits lenders keep at the ECB from negative rates.

However, the relief provided by tiering will barely offset the lost earnings from lower base rates, according to analysts and executives interviewed by the Financial Times, piling pressure on a sector already struggling to generate acceptable returns.

The ECB is expected to cut its deposit rate again by next year, which could lower even further the Euribor rate on which many loans are priced.

"Deposit tiers . . . [are] a drop in the ocean," said Morgan Stanley analyst Magdalena Stoklosa. "Profitability uplifts could be minimal for most banks . . . as sensitivity to Euribor is multiple times greater versus savings on cash reserves parked at the ECB."

Negative interest rates were first introduced in the region in June 2014 to boost a flagging economy by nudging banks into lending more money, rather than leaving excess liquidity languishing at the central bank.

But its knock-on effect has been to further dent the already-strained earnings of Europe's banks, which are holding a combined €1.9 trillion ($2.9t) of reserves to satisfy post-crisis regulations.

The benchmark index for the sector is languishing near a 20-year low and the average return on equity of European banks stands at just around 6 per cent, far below their estimated 11 per cent cost of equity and barely half the level of their US rivals.

"Deposit tiering doesn't help us even nearly enough," said a top executive at a major German lender. "The ECB's decisions make it impossible to generate a return of 10 per cent or more. In this environment we'll do well to get to 7 [per cent]."

It is a view echoed by Kian Abouhossein, an analyst at JPMorgan Chase, who expects lenders to unleash a lending price war to win share in a market in which deposits are growing faster than loans.

The Swiss central bank may also cut its rates deeper into negative territory from minus 0.75 per cent. Photo / AP

"The ECB is in effect reducing the structural profitability of European banks in the long run, while tiering is only helping in the short term," said Abouhossein.

"Banks can only deal with this is to become more competitive on the cost side, or by engaging in M&A."

In 2018, European banks paid €7.2 billion in interest for their deposits at the ECB, according to the Association of German Banks. The lobby group estimates that tiering will lower the annual bill to €5b as the ECB won't charge negative rates on about €800b of liquidity parked with it.

Analysts at Morgan Stanley and Citigroup estimate European banks' net profits will rise an average 2 per cent, but cautioned this would be offset by a negative 1.5 per cent hit from the 10 bps rate cut in the ECB's key rate.

Deposit-heavy Deutsche Bank and Commerzbank should benefit the most with around 12 per cent and 3 per cent uplift respectively, but those numbers are flattered by the current low levels of profits.

"We believe the impact is net neutral for the sector," Citi's Andrew Coombs said.

"Ultimately banks are still hurt from the effective zero-bound on deposits . . . [and] passing on negative rates to retail clients is still politically unpalatable."

The deposit-tiering system, modelled on that of the Swiss central bank, gives lenders an exemption for their excess deposits up to six times the value of their minimum reserve requirements at the ECB. This compares with 20 times at the Swiss National Bank and even higher in Japan.

Draghi, who steps down at the end of October, said the new system was not intended as a subsidy for banks. He sharply pushed back against criticism from the likes of Deutsche chief executive Christian Sewing, who warned that cutting interest rates further into negative territory would "ruin the financial system".

Draghi said executives should focus on cutting costs and digitising their business models rather than "being angry about negative rates".

Banking lobbyists reply that the ECB's policy is harming an industry that is already frail.

Hans-Walter Peters, president of the Association of German Banks, points out that at €2.3b, the annual bill for German banks from negative interest rates in 2018 was equivalent to close to 10 per cent of the sector's annual pre-tax profit.

"It's just not reasonable to weaken European banks like this," he said.

Negative interest rates have sparked fierce criticism, particularly in Germany, where they are accused of punishing savers. Last week, the German tabloid newspaper Bild Zeitung accused Draghi of being "Count Draghila" who "sucks our bank accounts empty".

Finance minister Olaf Scholz is considering pre-emptively banning banks from passing on the cost of "penalty rates" to high street savers.

As central banks cut rates around the world it is stirring up a debate about the impact on the banking system. The US Federal Reserve is on Wednesday expected to cut its interest rates by a quarter point for the second time in two months, while on Thursday the Swiss central bank may also cut its rates deeper into negative territory from minus 0.75 per cent.

German banks are hit the hardest in Europe by negative interest rates. Photo / Getty Images

In Europe, many banks are already passing at least some of the cost of negative rates on to companies and other financial institutions. In Switzerland UBS and Credit Suisse recently started charging their wealthiest clients to deposit francs and euros.

However, no bank thus far has dared impose charges on regular retail customers, a politically contentious move that many fear could push consumers to move their money to a cheaper rival or withdraw it as cash.

Amid general disquiet that tiering fails to offer sufficient protection, Italian and other southern-European banks could prove relative winners from the policy. One tactic could be for them to sell short-term, negative-yielding sovereign bonds and put the money on deposit at the ECB for free instead.

Another could be to utilise the ECB's third iteration of its ultra-cheap "targeted longer-term refinancing operation" (TLTRO III). Under this new facility banks can borrow money for three years at minus 0.5 per cent, then deposit it for free at the central bank, pocketing the difference.

"The ECB in effect creates the opportunity for a carry trade," said Abouhossein, adding that banks in the eurozone's periphery will be able to park €55b in the ECB's negative-rate-exempt facility. About €43b of that sits at Italian banks with the remainder in Portugal and Greece, according to Abouhossein.

German banks are hit the hardest in Europe by negative interest rates as they hold about a third of the total excess ECB deposits. Deutsche has been the most vocal, considering its woes and its systemic importance to the eurozone.

Deutsche normally holds around €75b and €100b at the central bank, which means the minus 0.4 per cent rate cost it around €400 million in 2018. Under the new regime, the outlays will roughly halve, according to JPMorgan, boosting the expected 2020 profit before tax by 10 per cent.

However, executives had counted on interest rates rising out of negative territory by 2022, the last year of their three-year turnround plan. Instead, the ECB has signalled negative rates will remain for at least the medium term.

As a result, less than two months after announcing radical cuts to its investment bank and new financial targets, Deutsche has already softened the goals. Chief financial officer James von Moltke has said it will earn as much as €1b less than the €25b initially sought by 2022. Privately, executives admit making a return on tangible equity of 8 per cent may no longer achievable in that timeframe.

Every single European bank is looking at their business plan afresh in light of the new environment," said one senior banker at a Swiss lender. "Some very tough decisions are going to have to be made in the next few months."

Written by: Stephen Morris, Olaf Storbeck and Martin Arnold

© Financial Times