Negative interest rate policies (NIRP) implemented by ECB and Bank of Japan are often blamed for eroding banking sector profitability. Anxiety about banks' profits has resulted in the massive selloff of bank stocks during the three-quarters thus far of 2016. STOXX Banks index has lost 28.7% during the past 52 weeks and 23.8% year to date. However, the eventual effect of the negative interest rate environment is ambiguous since a number of other factors can affect the profitability of banks. Moreover, negative interest rates may even have offsetting positive effect on banks' profits.
Negative interest rates gained prominence in 2014 when ECB was the first major central bank to introduce NIRP. In 2016, Bank of Japan followed ECB by taking a similar step. By these measures, both regulators are trying to defeat deflationary trends in the economies. However, a number of other central banks, namely Denmark, Sweden and Switzerland, have already lowered interest rates below zero before, though for a slightly different purpose - in order to fight capital inflows and currencies appreciation due to the Eurozone crisis.
Currently, negative interest rates are generally attributed to rates banks are subject to pay for storing excess reserves in national central banks. In order to avoid paying this kind of levy, banks would seek to lend out excess reserves at an even lower rate than currently prevails on the interbank market. Eventually, all rates across the economy tend to fall through the traditional monetary policy transition mechanism. Falling rates stimulate demand and ease credit conditions, stimulating new borrowings.
In the short term, negative interest rates, along with other easing measures, were efficient in defeating deflationary trends, stimulating credit growth and eliminating zero lower bound of this policy tool. Below are the charts for Eurozone headline inflation and growth rates of credit to households.
However, in the long term, NIRP efficiency is often questioned due to zero lower bound on retail deposit rates. Since retail depositors do not bear costs for storing cash (contrary to banks, which, according to ECB, would prefer to pay interest on reserves to storing cash), conventional wisdom predicts banks would not be able to transmit negative rates on retail deposits broadly. Further, the potential lending rate reduction would result in a decreasing net interest margin and net interest income of banks. In addition, negative interest rates are direct costs for banks, since under this regime, they pay out instead of earning interest on excess reserves. Generally, these statements are right, however, the potential negative effect of NIRP on banking sector profitability is not obvious for several reasons.
Direct costs of NIRP are low. According to ECB data, currently there are about €550 billion of excess reserves on ECB's current account. Assuming this figure rises to €1 trillion due to the continuing QE program, and given a -0.4% deposit facility rate, direct costs of NIRP would be about €4 billion annually for all euro area banks, or about 8% of total euro area banks 2015 profits. Obviously, the effect would not be distributed among banks equally, since banks with large excess reserves would bear higher direct NIRP costs.
Indirect costs resulting from zero lower bound on retail deposits and declining net interest margins do not entail linear profit decline. First, despite the fact that the negative deposit facility rate has already resulted in lower deposits and lending rates across euro area countries, retail deposit rates are still well above zero in many major euro area economies. For example, according to ECB data, in Italy deposits with maturity up to one year pay rates are above 1%, in Finland and Netherlands - about 0.4%, in France - about 0.2%,and in Germany 0.1%. That provides room for a slight deposit facility rate reduction if needed; however, there is a consensus that new major ECB rate cuts are not expected. Thus, the negative deposit facility rate has played out as traditional rate cut so far. Net interest rate margins in certain euro area economies have remained rather stable a year and a half after the introduction of this unconventional tool.
The same is true for lending margins on loans to non-financial corporations and households (difference between weighted average new loans rates and new deposits rates), for which more extensive data period is available. Moreover, even if deposit rates approach zero lower bound, banks may choose to stop cutting lending rates in response to monetary easing in order to keep lending margins from deep decline and preserving profitability at some appropriate level. Thus, the problem of profitability may transform into the problem of the monetary policy transmission. In addition, banks may introduce service fees on current account deposits (which is where rates are the closest to zero) to offset declining interest margins.
Second, growing lending volumes and decreasing loan loss provisions may offset reduction in interest margins. As monetary conditions ease, demand for borrowings rises and both households and businesses can afford more debt. In addition, the current debt burden decreases, so banks may decrease loan loss provisions and impairments. That will have a positive effect on banks' profit. According to ECB financial stability review, during 2015 the principal contributor to the growth of European banks' net income ((NASDAQ:EUFN)) was volume growth component (see the chart below). In 2015, net provisions and impairment were at the minimum level since 2008.
Third, asset prices appreciation also may have an offsetting effect on decreasing interest income. According to ECB data, about 13.3% of euro area monetary financial institutions assets are debt securities issued by European residents. Ultra-low interest rates push prices on these securities higher, allowing banks to record additional income.
Fourth, eventual effects of decreasing interest margins would vary among banks according to compositions of their assets, funding base and reliance on interest income. The more assets held which consist of floating rate instruments, the faster an institution will face interest income decline. On the contrary, institutions with a relatively high share of fixed rate instruments may even increase their interest income in the short term, given that loans typically have longer maturity than deposits.
Decreasing interest rates result in declining funding costs for banks. The more a bank relies on market funding (the debt issuance and wholesale short-term funding), the more pronounced the effect of decreasing funding costs would be and the more space a lending rate has to decrease without causing sharp reduction of interest margin. Below is the chart according to ECB data demonstrating shares of market funding of banks in several European countries.
Sweden banks are leaders in relying on market funding. It comprises 50% of the total funding base. If banks face a significant pressure from squeezing net interest margins they can adjust their funding base to make it more market-oriented. In addition, if interest income comprises a bulk of a bank total income, an institution will face a sharper profit decline due to decreasing interest margins. Below is ECB chart showing euro area banks' income structure.
Obviously, decreasing interest rates across the whole maturities spectrum will cause decreasing euro area banks' interest margins. However, the potential effects of negative interest rates is not obvious, since there is a number of offsetting effects. Due to differences in banks' balance sheets composition different banks will be affected differently by NIRP. The ultimate effects will depend on a specific bank's ability to generate income from sources other than maturity transformation, to reduce costs and to be more efficient. In addition, there is a number of other structural factors dragging on euro area banks profitability. Among them low economic growth, high non-performing loans ratio (above two times higher than in US) and tougher regulatory environment with lower leverage ratios and higher capital requirements.
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