The European Central Bank (ECB) announced a raft of policy measures on Thursday, March 10, intended to give a further boost to euro area economic performance. Most of these measures were unconventional and yet still precedented. The ECB lowered its main policy rates, accelerated the pace of its asset purchases, and widened the pool of assets eligible to be included in its purchasing program. It also renewed its program for targeted loans to banks that extend credit to the non-financial sector. The only new element was the rate of interest that the banks would pay to access credit that they could lend for investment. The question is whether that new wrinkle will make much of a difference. As is often the case, the answer depends less on the mechanics of monetary policy than on the magic of market ‘confidence’.
Initially, the ECB announced that the new lending ‘can be as low as the interest rate on the deposit facility.’ Later, it clarified that that the interest rate charged will be equal to the rate on the main refinancing facility (meaning zero) but that it would decline linearly for any bank that exceeded its new lending target for the period ending in 2018. If a bank managed to go beyond target by 2.5 percent, then it would be charged the prevailing the deposit rate, which is a negative 0.40 percent on the money it borrowed. In other words, the ECB will be paying those banks that expand their lending.
This new wrinkle in the ECB’s policy toolkit speaks volumes about the impact that unconventional policy measure has been having on the profitability of European banking. Two factors are worth mentioning. One is the negative deposit rate; the other is the flattening of the yield curve.
The negative deposit rate has drawn more attention than the flattening of the yield curve. When the ECB first reduced its deposit rate below the ‘zero lower bound’, the expectation was that this would trigger a flight to foreign currency or cash holdings – anything to escape the charge imposed on ‘risk-free’ overnight deposits. As it turned out, the flight to foreign currency was significant. Soon after the ECB announced its negative deposit rates, the euro began to fall against the dollar. It was $1.30 when the policy started and $1.10 when the ECB made its next big policy move to start large-scale asset purchases almost eight months later.
The threat to profitability from exchange rates is not immediate. On the contrary, banks that accept currency exposure stand to gain while the euro depreciates against the assets that they purchased. The challenge comes when they all try to unwind that exposure and the euro moves in the opposite direction. Meanwhile, the flight to cash holdings did not materialize. There was some talk about an expanding market for cash-equivalents but the overall effect of the policy was not enough to overcome the cost of storage and insurance.
Of the two concerns about the negative deposit rate, the flattening of the yield curve is more important. When the negative deposit rate was introduced in June 2014 the short end of the yield curve was just above zero and the long end (with a 30 years maturity) was about 3.5 percent. By the time the ECB started its large scale asset purchases in March 2015, the short end of the curve was still close to zero but the long end of the curve was down to about 1.6 percent. This flattening had a significant impact on bank profitability because banks make their money through the intermediation of short-term deposits into long-term lending.
The introduction of large-scale asset purchases widened the spread between short and long rates by pushing the short rates below zero by one quarter of one percent (or roughly 25 basis points) and nudging the long rates higher through the promise of faster growth. But the banks could only benefit from the rise at the long end because they could not fund their lending with rates below zero. Hence the net effects of the policy for bank profitability were more limited.
The new policy addresses this asymmetry by allowing the banks to fund their lending at negative rates on the short end of the yield curve. In theory, this will give the banks a wider spread to play with. In practice, though, the new policy reveals additional underlying problems.
The spread between short and long interest rates is important for bank profitability but it is less of a constraint than volume, capital requirements, cross-border balance sheet restrictions, and the hierarchy among creditors. This is point at which we have to shift the focus from the mechanics of monetary policymaking to the magic of market confidence. The ECB’s first round of targeted long-term refinancing operations disappointed not because the interest rate paid by the banks was too high but because there were too few actors in the non-financial sector who were willing to borrow. New loans picked up on the periphery of Europe and credit conditions loosened in Italy in particular but the aggregate impact on new lending across the euro area as a whole was not evident. The new policy of paying banks to lend money may stimulate new borrowing, but only by compressing yields at the long end of the maturity spectrum. In that case, the net effect of lower funding costs will be mitigated.
This is where the capital requirements and cross-border balance sheet restrictions become important. Although credit conditions have eased for firms in the new, more liquid, environment, banks are still likely to be concerned about the capital costs associated with taking on new risks. They will also have to be conscious of the requirement to match assets and liabilities within national regulatory jurisdictions, even if only after the four-year ‘long-term’ refinancing operations are ended. By implication, the policy can loosen credit conditions on the periphery of the euro area but only insofar as new activity is likely to prove self-funding over the medium term.
In the meantime, the hierarchy among creditors is a concern. Money borrowed from the ECB is inexpensive and yet such borrowing is well-collateralized and the ECB is senior to other creditors. That means any losses on lending financed under the new policy will have to be borne by others on the credit ladder, starting with equity holders but moving up through senior bank debt. This is unlikely to constrain the banks from expanding business with existing clients but it will make them more reluctant to use the funds to price in new business with clients with whom they are less familiar.
The bottom line is that the new wrinkle in the ECB’s policy toolkit is likely to prove less impressive than the notion of paying banks to lend might suggest. The ECB can influence intermediation margins but only within limits. The reduction in funding costs addresses only one of many constraints. It can offset some of the impact of unconventional monetary policy on bank profitability but only at the margins. The open question is whether that will be enough to strengthen business confidence so that the ‘animal spirits’ of market participants will take up the slack.Follow @Erik_Jones_SAIS