investment insights
Q&A on the recent ECB announcements
The ECB on 12 September 2019 unveiled a new package of easing measures as a response to the ongoing slowdown of the euro area economy. We discuss the macroeconomic impact and assess the potential repercussions on the profitability of the banking sector in Europe.
What did the ECB announce in its September meeting?
As expected, the European Central Bank (ECB) delivered a broad-ranging package of easing measures at its latest meeting (12 September 2019). These included a 10-bps deposit rate cut, which now stands at -0.50%; a new system of tiered reserves (explained in detail below) aimed at protecting bank profitability from the adverse effects of negative interest rates; the resumption of asset purchases at a monthly pace of EUR 20 bn with an open-ended time horizon; as well as more generous targeted longer-term refinancing (TLTRO) terms, with the applicable funding rate now as low as the deposit rate (as opposed to 10 bps above the deposit rate previously) and with maturity as long as three years (instead of two).
The ECB also strengthened its forward guidance – committing not to hike interest rates until it sees robust convergence of inflation to a level “sufficiently close” to 2%, and to ending asset purchases only shortly before it begins to raise interest rates.
What is the likely macroeconomic impact of the new package?
We think the macroeconomic impact is likely to be limited. As we have discussed in the past (see here), monetary policy typically operates through a reduction in the cost of capital, i.e. by easing borrowing conditions, which in turn stimulates demand. With the lending channel currently not showing any signs of impairment (see chart), it is not clear whether the economy will see significant benefits from the latest ECB easing. In fact, as a large part of the ongoing weakness is externally driven, the risk is that the ECB’s ammunition may prove largely ineffectual. Moreover, in several countries such as France, loan demand is actually so strong that national central banks have introduced macro-prudential measures such as countercyclical capital buffer increases. This requires banks to hold more capital against loans and is intended in part to cool down loan growth, but more importantly, to ensure that banks can release this extra capital in a downturn and continue lending.
The creation of fiscal space through the reduction of governments’ funding costs has the potential to generate more substantial benefits. In fact, ECB President Draghi made a clear push for more active fiscal policy in his press conference, suggesting that this is part of the ECB’s thinking. It remains unclear whether the governments that have a significant amount of fiscal capacity – in particular, Germany – will choose to act in order to stimulate demand through an increase in public spending, as political opposition to this idea remains considerable. Recent signs of a shift towards fiscal stimulus by the Dutch government may be the first step in this direction.
The ECB has announced the exemption of a portion of “excess reserves” from negative rates. What exactly are excess reserves?”
Banks are required to hold a minimum amount of reserves at the central bank. These are called minimum required reserves (MRR), and they are usually a percentage of banks’ liabilities, typically their deposits. In the euro area, the minimum reserve requirement is 1%. However, banks will typically hold a higher amount of reserves with the central bank than the minimum required. These are called excess reserves or excess liquidity.
In Europe, banks do not pay interest on minimum required reserves. However, up until now, banks had to pay negative rates on excess reserves. With rates at -40 bps, this implied a cost of EUR 7.1 bn for the banking sector.
However, in other countries where policy rates are in negative territory – such as Japan or Switzerland, central banks have introduced a deposit tiering system, whereby only a portion of the excess reserves are charged negative rates, with the remainder being charged 0%. This helps the profitability of the banking sector.
How does deposit tiering work?
As mentioned above, deposit tiering seeks to exempt part of the excess reserves from being charged negative rates. There are different ways of doing this. The ECB has followed a path similar to what we have seen in Switzerland. It calculates exempt reserves by applying a multiplier of 6 to a bank’s minimum reserve requirement. If we take the banking system as a whole as an example, we would multiply the amount of required reserves, i.e. EUR 131 bn, by 6. This would give us EUR 786 bn of exempt reserves, i.e. on which no interest is charged. However, on the remaining reserves, i.e. EUR 984 bn, the new rate of -50 bps would be charged. This represents a cost of EUR 4.94 bn, implying EUR 2.16 bn in cost savings for the banking sector.
How does it affect the banking sector?
The main objective of a tiering system is to allow for deposit rates to remain negative for long, or even to be cut further, without damaging the banking system, by alleviating some of the pain from lower rates. Given that the ECB cut rates by a further 10 bps to -50 bps and indicated that it expects rates to remain at their present levels or lower until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2%, tiering allows it to pursue its monetary policy while mitigating the impact on banks. Indeed, the impact of tiering and the rate cut on earnings for the banking sector as a whole looks to be neutral, i.e. one offsets the other, though of course individual banks may be more or less affected.
Were there any surprises?
Yes, there were some surprises: core banks benefited less and periphery banks more than expected. Indeed, given that banks in Germany, France and the Benelux hold significantly more excess reserves than banks in Ireland, Spain and Italy, we had thought that they would benefit disproportionately from excess reserves. However, given that the ECB is basing its calculation on minimum required reserves and is using a very low multiple of 6 (the Swiss National Bank, which has implemented a similar system, uses a multiplier of 20x), this limits the amount of exempt reserves for core European banks. At the same time, this proves to be more generous than expected for periphery banks, notably in Italy where calculated exempt reserves appear, in some cases, to be higher than actual excess reserves. This means that some periphery banks could either borrow in the interbank market in order to place additional funds with the ECB to close this gap, or perhaps use some TLTRO funds. This would create a small benefit to profits as these banks could borrow at a negative rate and place the proceeds at 0%.
This has caused the short end of the yield curve to reprice upwards, which is probably not the effect desired by the ECB. However, we do note that the ECB has the power to adjust the multiplier at any time and it could easily eliminate the issue by increasing the multiplier.
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