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Markets have entered territory once thought unimaginable: a negative interest rate environment, with European interbank markets, government yield curves, and even some benchmark policy rates all below zero.
In March, the ECB doubled down on its negative interest rate policy (Nirp) by cutting the deposit rate by another 10bp to minus 40bp, triggering the 12-month Euribor rate to fall further into negative territory, while Sweden’s Riksbank lowered the benchmark repo rate to negative in February 2015.
The experience of Japan demonstrates the risk that cuts in already historically low rates will fail to inspire corporates, saddled by weak demand and bad debts, to borrow to expand capacity. Instead, the negative-rate gamble might further savage European banking profitability, without delivering any boost to the real economy, at a time when banks need retained earnings to meet rising capital requirements.
Monetary officials admit they are experimenting to determine the rate level needed to generate deflation-busting credit growth, and say they are monitoring risks to European bank earnings.
There’s little sympathy for lenders, given the simplistic assumption in the market that banks perennially covet higher policy rates, irrespective of the natural interest rate in a given economy, to generate better margins on their asset exposures, from loans to investments.
But this assumption misses the mark. The pass-through from lower policy rates, market rates and bank earnings all rests on lenders’ flexibility to reprice loans, deposits and other liabilities, their ability to generate fees and commissions and the relative importance of net interest income to profitability. Not to mention what happens with funding costs.
For example, during a period of bull steepening, when benchmark market rates at the short-end fall faster than the long-end, the interest rate on banks’ outstanding fixed-rate exposures remains the same while funding costs fall, a tidy boost to their net interest margins (NIM). (The latter is simply the difference between banks’ interest income and interest expense expressed as a percentage of average earning assets.)
European bankers, therefore, in principle, have plenty of reasons to be sanguine about a low-rate environment, as most were in the immediate post-crisis years, while cognizant of its potential to boost real-economic activity. This time, however, is different, even with the Bund curve bear steepening last month, which, in theory, should be earnings accretive to NIMs.
Savings and retail banks are unable to impose negative rates on deposits, challenging their ability to reprice liabilities to protect margins. New loans are being renewed at low, and barely economic, rates while banks face a large negative carry on government bonds, with the latter challenge made worse by new liquidity and leverage rules. Up to 90% of floating rate banking markets, from Spain, Italy, Finland, to the periphery, are swimming in negative rates, imperilling risk, liquidity and maturity transformation for lenders.
Sector-wide NIMs in Europe – which are lower than in the US, a key reason for bank underperformance – have contracted in recent years to barely economic levels. Negative rates can deliver some benefits for lenders geared towards lower-quality credits that benefit from ever-falling funding costs, collateral values that would benefit from reflation, and clients’ with debt-servicing challenges, more generally. But the average rates of return on bank assets have fallen significantly while eurozone banks are incapable of transferring the cost of negative rates to most of their depositors.
Monetary officials must, therefore, tread carefully. Nordic lenders, for example, have imposed extra premia to new lending business to offset margin pressure at the back-end of loan book. A further fall in earnings of eurozone banks, with ROEs still at Lehman-crisis levels, could trigger financial disruption.