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).
Germany New Lending Rates Spreads

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.

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5 responses to “The surprising effects of negative rates on German banks”

  1. Chris Mahoney says :

    Classic banking used to consist of attracting low-cost retail deposits and renting them at higher yields in the wholesale markets. In the Golden Age, BofA used to have billions in low-cost retail deposits that it could lend into the interbank market at a profit. But today, the all-in cost of retail deposits (branches, service) is higher than the interbank rate. Branch networks and retail deposit relationships are now a drag on profitability. Classical retail banking is now obsolete. Banks must close branches and move toward cheaper wholesale funding, which means liquidity risk. And they must replace low-risk interbank assets with risker ones. A recipe for the next disaster. We need more inflation immediately.

    • Julien Noizet says :

      Chris,

      I believe online and mobile banking can solve some of retail banking’s problem.
      The trends are positive, though banks need to invest in IT. Many branches should disappear.

      I’m not sure why you believe banks need more inflation though. It looks to me like a way of further compressing margins in real terms as the inflation-adjusted interest income from the back book and legacy securities portfolio falls.

      • chris mahoney says :

        Julien,
        Generally speaking, the higher the nominal interest rate, the more room there is for a bank to under-compensate retail depositors. If the nominal rate is 6%, banks can get away with retail funding at 3% for certain products. (This is why the Brazilians used to be so profitable.) When rates are 1%, there is no room for undercompensation. As to ALM risk, I’m sure that some banks would suffer from higher rates, but others would benefit. Banks don’t have to be long bonds.

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