The surprising effects of negative rates on German banks

Several banks have already made public their intentions to withdraw their excess reserves from the ECB, following the central bank’s decision to charge banks for keeping excess reserves deposited with it (i.e. negative deposit rates). It is unclear what’s going to happen to this cash. If it is redeposited at another Eurozone bank, then it still ends up on an ECB account. Euros could potentially be placed somewhere outside the Eurozone to reduce the aggregate amount of excess reserves in the system, but there is no guarantee they would not come back either (through non-Euro companies paying Euro suppliers for instance). Banks could also withdraw paper money, but this involves storage costs.

Very low ECB main rates already represented a pressure on banks’ net interest margins. The ECB negative deposit rates were seen as a way to bolster the interbank money markets. Unfortunately, many banks are now also retracting from interbank markets altogether because of the very poor yields obtained on those placements… thanks to the low ECB main rate. Seen this way, very low ECB refinancing rates and negative ECB deposit rates look contradictory.

But there’s something new.

In Germany, some banks (mostly the largest ones), are now passing on negative rates to… their clients. Handelsblatt reported last week that institutional clients such as mutual funds and insurers have now been asked to pay interests on short-term deposits… To be honest, I wasn’t really expecting such a move, given the instability it can create in banks’ funding structure. However, the effects remain for now limited as retail clients, as well as other types of corporate clients, are unaffected.

Let’s get back to our basic bank’s profit equation:

Economic Profit = II – IE – OC – Q

where II represents interest expense, IE interest income, OC operating costs (which include impairment charges on bad debt), and Q liquidity cost.

As we recently saw, low ECB interest rates impact II downward, negative ECB deposit rates impact IE upward, meaning ceteris paribus that the only thing banks can do to remain profitable in the short-run is to cut fixed costs (OC). Ex-post, banks can also influence IE by repricing their loan book upward.

This is indeed what has been happening in Germany: banks have been cutting staff, deleveraging, and outsourcing expenses to low-cost countries. The spread between new lending rates and the ECB main rate has also remained consistently high since the rate cuts, and has even started to increase again following the most recent rate cuts (see below, blue arrows represent rate cuts, red arrows represent spread increases).

By passing negative deposit rates onto customers, banks found a way of quickly increasing II to partially offset the increase in IE. The effects are faster than further increasing the interests charged on lending, as it directly impacts the outstanding stock of deposits (unlike repricing, whose pace depends on the volume and maturity profile of the bank’s loan book).

However, this provides customers with an incentive to withdraw their deposits, introducing instability in the banks’ funding structure, increasing Q. Given the limited range of customer concerned so far, those banks probably thought it was a worthwhile temporary bet. Indeed, increasing their lending volume to reduce their excess reserves, or investing those reserves somewhere, would also have increased Q anyway. Furthermore, those institutional clients are likely to have significant brokerage/trading/custody relationships with those banks, making it difficult for them to close their accounts and move funds away without disrupting their business.

I have no information regarding the implementation of such policies by other banks of the Eurozone so far. If those policies become widespread, the ECB’s decisions will not only have been pointless, but they will also have succeeded in making the funding structure of the whole Eurozone banking system more unstable and in reducing the purchasing power of non-bank corporations that have to maintain deposits in the Eurozone.