[ad_1]
Mario Draghi addresses the European Parliament in Strasbourg earlier this month
This year’s rout of European bank stocks has raised concern about how far below zero the European Central Bank can cut interest rates without inflicting too much damage on lenders’ profits.
The pledge by Mario Draghi, ECB president, in late January to “review and possibly reconsider” his central bank’s policy stance ratcheted up expectations of further loosening. In recent weeks, more action has become a near certainty as a host of factors have conspired to darken the economic mood in Europe.
IN EU Economy
The diminishing prospect of a rate rise in the US any time soon has strengthened the euro against the dollar. A stronger currency makes the ECB’s task of hitting its inflation target of just below 2 per cent more difficult because it lowers the cost of goods imported into the region. Market expectations of the ECB hitting its target five years from now have weakened, while inflation looks set to dip back into negative territory in the coming months.
A sharp, unexpected fall in German industrial output in December and weak trade figures have highlighted the risk that the eurozone’s recovery may not be as strong as surveys have suggested. Analysts expect GDP figures out on Friday to show growth failed to pick up in the final quarter of last year. Unchanged growth of 0.3 per cent is the average forecast.
“Europe’s not in a recession, but expectations about how strong the recovery is need to come back to reality. Growth isn’t as strong as Europeans think it is,” said Richard Barwell, economist at BNP Paribas Investment Partners. “They still have plenty of ammunition left to fire, but there is an argument to say that the ECB can’t do much more by cutting rates.”
The deposit rate charged on banks’ reserves parked in the coffers of the ECB has, along with quantitative easing, become one of the most important pillars of eurozone monetary policy.
Europe’s not in a recession, but expectations about how strong the recovery is need to come back to reality. Growth isn’t as strong as Europeans think it is- Richard Barwell
In December last year, the deposit rate was lowered to minus 0.3 per cent and another cut of at least 10 basis points is tipped for March.
Negative deposit rates are supposed to complement QE by forcing banks to seek out riskier lending opportunities and assets to compensate for losses on their interest rate margin. This so-called “portfolio rebalancing effect” helps spur growth by providing funds to credit-starved parts of the region and lowering the cost of borrowing for riskier sovereigns and companies. Negative rates are also viewed as one of the most effective ways to weaken the euro.
Nevertheless, views among policymakers on how low rates should fall are mixed.
Minutes of the ECB’s December vote show some of the policy makers who opposed further asset purchases under QE would have supported a deeper 20 basis-point cut in the deposit rate, to minus 0.4 per cent.
But policymakers have also expressed concern about the impact of negative rates on banks’ profitability. Lenders have been reluctant to pass on the costs of negative rates to customers and have taken almost all of the hit.
Research by the Bank for International Settlements, the Basel-based central bankers’ bank, suggests the impact on profitability becomes more drastic over time as short-term benefits, such as lower rates of loan defaults, diminish.
This topic of negative rates and banks’ profitability certainly seems to be at the forefront of investors’ minds. Some policymakers clearly think there is room to cut rates. But there may be some nervousness about going more negative- Nick Matthews
The recent dip in eurozone banks’ shares partly reflects fears over the impact of further rate cuts. Deutsche Bank, one of the lenders worst affected by the fall in bank stocks, has argued that rather than prompting banks to take on more risk, negative rates have had the opposite effect by pushing investors into bonds at the expense of equities.
“In light of recent developments, this topic of negative rates and banks’ profitability certainly seems to be at the forefront of investors’ minds,” said Nick Matthews, economist at Nomura. “Some policymakers clearly think there is room to cut rates. But there may be some nervousness about going more negative.”
Serious discussions among the governing council about what the ECB will do on March 10 are unlikely to begin until later this month. One option is for the ECB to follow the Bank of Japan and introduce a tiered deposit rate system to protect banks from losing money on most of their reserves. That would, however, reduce pressure on banks to invest in riskier assets.
“It’s not an easy situation, that’s for sure,” said Dirk Schumacher, economist at Goldman Sachs. “You could introduce a tiered rate system, but then you are potentially undermining the portfolio rebalancing effect. It’s hard to say what the final conclusion will be.”
[ad_2]
