A tiered system of remunerating reserves to mitigate the impact of lower rates on bank profits will have a limited effect, according to Scope Ratings. Euro Area (EA) banks have already incurred €23.2bn in charges since the negative-rate began policy in 2014, €7.5bn in 2018 alone.
Scope calculates the annualised current running cost of excess liquidity is €6.8bn. Any further cut to the deposit rate would cost EA banks €1.7bn.
“In other words, EA bank ROE is c.40bp lower than it would be in the absence of negative rates, all other things equal,” said Marco Troiano, deputy head of the financial institutions group at Scope Ratings and co-author of a new report on the topic.
A further rate cut would see this impact rise. Further deployment of unconventional measures, such as targeted longer-term financing operations (TLTRO) or resumption of the ECB’s Asset Purchase Programmes, would increase the amount of excess liquidity and the corresponding cost to the banks.
“While the ECB could introduce a tiering system as soon as its September 12 meeting, it will avoid paying a positive rate on excess liquidity, as this would allow banks to arbitrage the deposit facility against the upcoming TLTRO,” Troiano said. “It will also aim to avoid remunerating the entirety of banks’ excess liquidity so as to minimise the risk that the overnight money-market rate de-anchors from the deposit facility rate. This would negate the effect of any further interest-rate cuts.”
The ECB could lean towards an exemption-based approach set on a bank-by-bank basis and adjusted periodically to cover a set percentage of excess liquidity in the system. This dynamic adjustment could be calibrated at the individual country level, as diverging trends in liquidity accumulation would otherwise lead to excessive allowances in some countries and insufficient allowances in others.
“Such a system would ensure that some excess liquidity remains outside of the exemption at all times, while also neutralising most of the direct negative impact on bank profits from holding excess liquidity,” said Chiara Romano, senior analyst in Scope’s financial institutions team and co-author of the Scope report. A risk with such a design is that a country-based adjustment may not be seen as politically palatable.
“Depending on implementation and the underlying interest-rate scenario, the potential uplift to sector ROE ranges from 22bp to 46bp. This impact would, however, be unequally distributed, with banks with higher stacks of excess liquidity benefiting the most. For example, the ROE uplift for German banks could be up to 71bp, an amount not to be sneered at for a banking sector with low single digit profitability,” Romano continued.
The introduction of a tiering system would be welcome, but insufficient to restore the profitability of euro area banks to acceptable levels, the report says.
“Aside from liquidity parked at the central bank, profits are held back by a structural flattening of the yield curve, which challenges maturity transformation in general during a period of rising prudential capital requirements,” Troiano said. “But while shareholders may understandably worry about their returns, low ROEs solely due to higher capital requirements and excess liquidity should not overly concern credit investors.”
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