EU banks on lookout for ECB sweeteners

Frankfurt

BANKS are waiting to hear how Mario Draghi plans to sweeten the bitter pill of more interest-rate cuts.

The European Central Bank (ECB) president has said that if rates are reduced further below zero, as looks likely because of economic weakness, measures may be needed to prevent the policy from squeezing lenders' profitability so much that they pull back on loans. Financial institutions have long complained that they cannot pass on the cost - a charge on their overnight reserves - to their depositors.

The latest evidence of that impact could come on Wednesday, when embattled German lender Deutsche Bank publishes its financial results. An ECB survey on Tuesday showed that euro- area banks unexpectedly tightened credit standards for companies in the second quarter.

Of five central banks with negative rates, the ECB is the only one not to include offsetting measures. A fair system for the 19-nation eurozone is no simple matter though. Two-thirds of excess deposits are at German, French and Dutch banks, with only 10 per cent at Italian and Spanish lenders. Here are some of the questions the Governing Council, which meets this week, must address: How to do it?

The most common proposal is known as tiering, in which some overnight deposits are excluded or charged a different rate. The Swiss National Bank allows an exemption equal to 20 times the minimum reserve - the cash that all banks are required to keep at the central bank. Anything above that is charged at 0.75 per cent.

Denmark operates a two-tiered system in which some overnight money can be parked for free, but any excess is kept instead in one-week deposits penalised at 0.65 per cent.

When the Bank of Japan (BOJ) went negative in 2016, it rolled out a three-tier system. Minimum reserves are exempt, as is liquidity acquired by banks that sold assets to the BOJ under its quantitative easing (QE) programme. Most funds beyond that are charged 0.1 per cent.

How much should be exempted? Eurozone banks currently park more than 1.7 trillion euros (S$2.6 trillion) in excess liquidity at the ECB each night. At a deposit rate of minus 0.4 per cent, that costs them more than seven billion euros a year. Executive Board member Benoit Coeure said that amount is "peanuts" and the real focus of attention should be dealing with technological competition and bad loans.

Analysts at Rabobank did not think that banks can bear much more though. They said that the ECB is likely to cut its deposit rate as low as minus 0.8 per cent over the coming year and, to fully offset that, about 800 billion euros of excess liquidity should be exempted.

Louis Harreau at Credit Agricole said that the "hot potato" effect - in which banks lend their cash to someone else to avoid the cost of holding it, so driving down interest rates for the whole economy - stops working beyond a certain point. He said that the ECB should first exempt 250 billion euros, and then increase the exceptions until a maximum of one trillion euros is subject to the negative rate.

Could it backfire? Big exemptions mostly benefit banks with large deposits. In the euro area, those institutions are largely in the northern nations, inviting criticism that the stronger economies are being unfairly supported.

Banks with sizable exemptions might also feel less pressure to lend the cash out - the "hot potato" principle in reverse. That could hurt the market and push rates higher, especially in peripheral economies, according to economists at Barclays.

Moreover, the ECB's targeted longer-term refinancing operations (TLTRO) programme of long-term loans to banks at cheap rates complicates things. Under certain circumstances that could throw up an arbitrage opportunity, according to Rabobank.

Barclays and Rabobank both said that the ECB should subtract the TLTRO loans from each individual bank's deposit-rate exemption. That would effectively create a group of net depositor banks - mostly in northern Europe - and net borrowers, mostly in the south.

Both groups would benefit. The net depositors would gain from exemptions under tiering, while net borrowers would be compensated by the generous terms on their TLTROs.

What else can the ECB do? Mr Draghi has always talked about "mitigation" of negative rates - and that does not have to mean tiering. One option might be for the ECB to start buying bank bonds, which would lower lenders' funding costs as a way to offset the impact of another deposit rate cut, according to Axa chief economist Gilles Moec, a former Bank of France official.

That would be controversial - the ECB previously dismissed the idea of including bank debt in its QE programme because its role as the euro area's bank supervisor could create a conflict of interest. Still, Mr Moec said that all of the options on offer present a dilemma.

"We actually do not think that at this juncture it would rank very high in their preferences," he said. "We simply consider that this approach would not be the most problematic on a menu which, unfortunately, is in any case quite unappealing." BLOOMBERG