ECB preparing to inflict more pain on banks

Tokyo

THE European Central Bank (ECB) is about to turn the screws again on financial institutions by diving even deeper into negative interest rates.

Lenders including Deutsche Bank AG and UBS Group AG are bracing for another blow to their profitability after five years of sub-zero monetary policy. While the ECB's strategy is to boost growth and inflation by lowering borrowing costs for companies and households, squeezing banks too much could hamper their ability to supply the credit that fuels the economy.

"The interest-rate policy is an enormous burden," Christian Sewing, chief executive officer of Deutsche Bank, said at a conference in Frankfurt last week. "In the long run, negative rates ruin the financial system."

Such pleas are unlikely to stop the ECB. It began a two-day meeting on Wednesday to prepare stimulus to respond to risks including US protectionism and Brexit. The most Mr Sewing and rivals can hope for is accompanying measures to soften the blow.

The ECB's deposit rate used to be the interest banks received for keeping their excess cash at the central bank overnight. Now at minus 0.4 per cent, it has become a charge, one that Deutsche Bank says could cost it hundreds of millions of euros this year.

Many lenders already pass the charge onto corporate and institutional clients, but doing so with ordinary people - whose savings are a key source of bank financing - could prompt them to withdraw their cash.

"Retail is really a difficult area because then the trust comes in," said Kees van Dijkhuizen, CEO of ABN Amro Bank NV.

So banks suck up the cost, at least until their profitability is eroded so much that they're forced to retrench, hurting the economy. That's the point known to economists as the reversal rate.

"Banks would have to reflect that on deposits, and that of course would create a big backlash," former ECB vice-president Vitor Constancio told Bloomberg Television last week. "My personal view is we're already close to the limit."

Scope Ratings reckons euro-area banks have incurred 23 billion euros (S$35.05 billion) of charges at the ECB since negative rates started in 2014, and are currently paying almost seven billion euros a year. Return on equity is about 40 basis points lower than it would otherwise have been.

The ECB says the cost to lenders is small - executive board member Benoit Coeure called it "peanuts" - and outweighed by the profit on increased lending in a stronger economy.

That argument may be reaching its limit. President Mario Draghi said after July's policy meeting that "we are not at the reversal rate" but "certainly there is a danger". He's considering whether to grant banks relief such as exempting some reserves from the charge - a system known as tiering - as the Swiss National Bank already does.

"Improvements like a tiering system are necessary to soften the detrimental consequences," said Mr Sewing. "But they don't change the fundamental problem."

Academics have also questioned the policy. A recent study published by the University of Bath found negative rates decreased lending. Federal Reserve Bank of San Francisco research concluded the introduction of the policy in Japan actually lowered inflation expectations.

According to Gilles Moec, chief economist at Axa SA, what the eurozone really needs is fiscal stimulus - and while governments have so far been reluctant to go down that route, negative rates could help. BLOOMBERG