Last Thursday, European Central Bank Governor Mario Draghi announced a 25 base point cut in the Central Bank’s main refinancing rate taking this down to 0.50 per cent. This rate cut could have already been partly priced in, but what followed during the same announcement was probably not.
That would mean charging depositors a fee to safe keep clients’ deposits
As soon as Draghi made this announcement, the euro started strengthening against the US dollar as the market hoped for and welcomed this measure. In the introductory statement, the Governor presented the background to this rate cut during which the word ‘weak’ needed to be used several times.
Weak labour market conditions, weak short-term indicators, weak growth estimates and declining inflationary pressures presented the ECB with the perfect timing for this rate cut. The Central Bank is very worried about the outlook for the eurozone economy and the lack of lending.
None of this really came as a surprise and the audience and market would not be blamed to believe that the communication was over. However, the real news was still yet to come. Draghi went on to say that the ECB has an “open mind on negative deposit rates”. Whatever strength the euro had gained versus the US dollar following the announcement of the rate cut was very quickly reversed.
The deposit rate sets a hard floor to money-market rates. There is never any need for banks to accept less than the ECB will pay on deposits, since the latter is a risk-free counterparty. This rate has been at zero since last July, but there are still over €100 billion in excess bank reserves parked in the facility, mainly from banks in Germany, France and the Netherlands. In summary, Draghi is signalling that the ECB will not be constrained to a zero deposit rate and that negative rates will be considered, even though this goes against the orthodox monetary thinking which has been practised for decades.
This will make eurozone banks go back to their drawing boards and rethink their risk-reward strategies. The ECB is forcing banks to lend to each other or to their clients, increasing the supply of credit otherwise their net interest income will suffer as a result of negative deposit rates. The question, however, remains one of trust and risk assessment.
Are banks being forced to provide credit to the retail and institutional market which would expose the bank to a level of credit risk which is outside its comfort zone? The answer to this very much depends on whether the underlying risk is an actual or just a perceived risk. Whichever it is, Draghi is pushing banks to take on this risk and increase the supply of credit. However, these banks do have an option and that is to pass on the baton to their end customer. That would mean charging depositors a fee to safe keep clients’ deposits.
These German, French and Dutch banks which hold over €100 billion with the ECB must either lend this money, or return it to depositors and shareholders or place it with the ECB and get charged. If the last option is chosen the bank may want to consider charging the ultimate depositor to keep the funds with the ECB. As controversial as this may sound, there may be someinstitutional clients which may prefer paying for this service (safe keeping) rather than allow the bank expose their funds to a capital risk over which they have no control.
This is not what the ECB wants to achieve and indeed it may not even reach this point. Signalling will, hopefully, be enough. However, a problem is best tackled by addressing the core and if banks believe that lending to third parties is too risky, then they shouldn’t lend at all. Banks do however have a role to play – bank shareholders may need to adjust their expectations and understand that they are invested in a utility stock and not a growth stock given the overall economic health profile of the European economy.
Providing a return to shareholders may drive the bank to charge for safe keeping of deposits if no attractive lending opportunities are identified. This may be the start of the real cleansing process the European banks seem to need which would hopefully result in the reinstatement of trust between banks. This however may take longer, much longer, than the ECB has in mind.
The problem is that this stable scenario may not last long enough. A time will come when a new generation of investors, depositors and banks will start pushing the risk parameters once again. Greed and short-sightedness will always remain a problem.
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Curmi & Partners Ltd is a member of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. The value of investments may fall as well as rise and past performance is no guarantee of future performance.
Karl Micallef is an executive director at Curmi and Partners Ltd.