Draghi’s leaving message for euro area banks: learn to live with negative rates

The pressure remains on the region’s banks to grow volumes, cut costs and diversify their business models, while investing in digitalisation, as Europe faces a prolonged period of ultra-low rates.

“Many banks will find it difficult to implement such a strategy amid falling profits from intermediation and steadily rising regulatory capital requirements,” says Marco Troiano, analyst at Scope. “Outgoing ECB President Mario Draghi’s latest measures only underline the scale of the challenge,” Troiano says.

The ECB at its 12 September meeting announced several measures aimed at further easing monetary policy, including a further 10bps cut to the deposit facility rate, open-ended forward guidance and a resumption of asset purchases.

To at least partially offset the negative side effects of a prolonged period of negative policy rates on bank profitability, the ECB also introduced a new tiered remuneration system for excess reserves and offered the banks better conditions for the upcoming TLTROs.

“However, the new reserve remuneration system will cover only a minor part of excess liquidity in the system which limits any benefit to banks’ profitability,” says Troiano.

First, the ECB will continue to charge a negative rate on the deposit facility balances and only exempt excess balances held in current accounts. Secondly, the exemption will be set as a uniform multiplier of minimum reserve requirements. The multiplier was initially set only at six but could be adjusted over time as the ECB keeps expanding its balance sheet and thereby increases reserves held by the banking system.

“We calculate that a 6x multiplier would exempt about EUR 800bn from negative rates, less than half of the EUR 1.7tn excess liquidity at the end of August,” says Troiano.

Taking into account the higher -0.5% penalty rate on the deposit facility, the annualised cost of excess liquidity would still be EUR 4.6bn per year compared to EUR 8.5bn without tiering. While not immaterial, the EUR 4bn shield is less than we had expected and the impact on banking sector ROEs will be minimal.

The impact is further reduced by a uniform multiplier that makes no adjustment for the uneven distribution of excess reserves across the system.

“The initial multiplier would be sufficient to exempt most of the excess liquidity in Spain and Italy – but the low multiplier will not cover the much higher excess reserves in countries such as Finland, Germany, France and Luxembourg,” says Troiano.

The ECB’s one-size-fits-all design limits the relief for the system as a whole due to the fragmented nature of euro area money markets. While the multiplier has been set as to not interfere with money markets in countries with the lowest levels of excess liquidity such as Italy and Spain, it is insufficient where it matters most: for banks in countries with high excess reserves.

Partly counterbalancing the underwhelming design of tiered remuneration, the ECB announced improved terms on the TLTRO loans, extending their duration from two to three years and lowering the basic rate from 0.1% to 0%. Such design will provide an incentive for banks below the multiplier to draw TLTRO loans and redeposit the funds at the ECB with a free option to profit from a lower bonus rate should they meet their lending benchmark. Again, such design will mostly benefit banks in peripheral euro area countries, where excess liquidity is lower.

Draghi was quite clear that protecting bank profitability is not a major concern. The ECB believes that negative side effects on the transmission mechanism are more than off-set by its anticipated benefit in form of higher nominal growth expectations

“In other words, banks cannot expect higher interest rates or other material forms of support from the central bank to come to their rescue anytime soon and should instead seek alternative levers to boost their earnings potential,” says Troiano.