Living with negative interest rates: how much longer can banks stand it?
European banks have been contending with negative interests since 2014. Against all odds, they have succeeded in stabilising their revenues. However, their room for manoeuvre is increasingly limited at a time when the operating environment is showing signs of deteriorating.
More than €1,800 billion of excess liquidity is deposited with the ECB, earning negative interest at -0.40%. This costs banks around €7 billion a year and, above all, has a knock-on effect on money market rates as a whole. This surplus cash is a result of expansionary monetary policy: by increasing its assets through securities purchases and TLTROs (Targeted Longer-Term Refinancing Operations), the ECB injects liquidity into the banking system, which ends up returning to the central bank’s liabilities in the form of deposits.
Since the introduction of negative interest rates in 2014, combined with growth in excess liquidity, European banks’ revenues have remained surprisingly stable.
Consolidated revenues for the main banking groups rose by an average of 1% between 2013 and 2018. Net interest income as a proportion of total revenues fell from 52% to 50% over the period, and from 55% to 48% for French banks. Breaking revenues down into broad business areas, we see that in domestic retail banking in Europe, it has declined by 6.2% over the past five years. Asset gathering businesses (insurance, asset management and wealth management) have offset this impact (up 11.5%), followed by specialised financial services (up 9.2%). Revenues in corporate and investment banking have declined 3.8% overall, though this figure masks a high level of volatility over the period.
In retail banking, banks have adopted various strategies to limit the decline in their revenues.
On the lending side, a trade-off has been made between margins and volumes. Countries where competition to capture demand is high have opted to go after volume over margins. Of the main eurozone countries, France has seen the fastest lending growth over the past few years (with household lending up 5.4% a year and business lending up 6.2% a year, based on January 2019 data); however, it is also the country where margins on new lending have declined the furthest. Germany has also followed this path, though more belatedly. Conversely, in southern Europe, sluggish lending and the high cost of risk have, relatively speaking, limited the potential for margins to decline.
On the deposit side, distortion of the funding mix has also helped cushion the impact of negative interest rates.
- At first, the reallocation of a portion of time deposits into sight deposits helped lower the cost of attracting deposits, while the other portion was reallocated into off balance sheet savings, generating commissions for branches. Note that this reallocation was less pronounced in France due to the appeal of regulated savings. At 38%, French sight deposits as a proportion of total deposits are well below the European average.
- In the vast majority of cases, negative interest rates have not been applied to sight deposits, except for business deposits in Germany, the Netherlands and Latvia. In any case, negative interest rates have not been applied to personal customers, apart from in a few anecdotal cases generally limited to private Banking.
- Negative interest rates have encouraged banks to diversify their funding sources to include more market funding and ECB facilities. TLTRO-II was designed to neutralise the effect of negative rates, bearing interest at the deposit facility rate as long as lending targets are met.
How much longer can banks live with negative interest rates? The coming period could be even more unfavourable.
Excess liquidity is here to stay: while the ECB halted net asset purchases in December, it will continue to roll over its stock of securities for at least two years. Furthermore, the central bank has ruled out any interest rate hikes until end 2019 at the earliest. This timescale could be extended if there are increasing signs of weakness in growth and inflation. In September, TLTRO-II will be replaced by TLTRO-III, the conditions of which are not yet known. No one knows whether banks will be given the option of borrowing at the deposit facility rate if lending targets are met, as is the case with TLTRO-II.
Since the end of last year, the operating environment has shown signs of deteriorating. Low interest rates had helped squeeze loan loss provisions to an all-time low, but the latter rose significantly in the final quarter of 2018. Although it is too early to tell whether this was the beginning of an upswing, it would indicate that the cost of risk has bottomed out.
Business lending in peripheral countries has also fallen (with outstanding loans down 0.5% and 2.4% year on year in Italy and Spain respectively, based on January 2019 data) and growth in household lending in the eurozone has dropped off across the board (up 3.2% relative to January 2018). While France and Germany are not affected at this stage, surveys suggest that lending conditions are set to harden and demand is expected to slow in the first quarter of 2019.