One day a colleague of mine saw a headline which was saying that the three month Euribor dropped below zero and asked somehow puzzled “how does this work? Banks are now getting paid to borrow?”
It doesn’t take a lot to acknowledge that this is a fair question even though we got used to negative government yields nowadays. I wrote about what can justify negative government yields some time ago: (i) expectations for further declines in yields (ii) expectations for currency gains (iii) excess cash or (iv) flight to safe assets. However, these arguments cannot be used for justifying negative interbank lending rates (such as Euribor). What is happening then?
The only viable explanation I can think of is the excess liquidity. Through its various monetary easing measures ECB has flooded the banking system with liquidity, hoping that this will boost lending and hence, revive growth. However, for an extended period, a large part of this was used to buy government bonds or simply parked at the ECB in deposits. As a side note, the fact that this liquidity was not feeding into the real economy meant that inflation remained at bay and, if anything, risks were skewed to the downside.
As policy makers saw this, they went an extra mile by (i) introducing negative deposit rates (-0.2 per cent) (ii) announcing cheap long term loans targeted towards credit growth and (iii) launching a sovereign bond buying programme. I think the former have much to do with the trend towards negative Euribor rates. More specifically, the credit institutions now can choose to put their extra liquidity into ECB deposits and pay 0.2 per cent or lend the funds to other banks and pay a much lower rate (-0.119 per cent for one week, -0.05 per cent for one month or -0.012 per cent for three months). However for such options to become viable the excess liquidity should be really at high levels; custody costs should be high enough to prompt banks to offload some of the cash available.
Thus in my opinion, if the situation persist for long it could be a sign that banks are rather pessimistic about the economic outlook and, as such, they refuse to significantly increase lending.
On another note, many European banks set their lending rates as a spread over Euribor (most often the three or the six months rate). As such, borrowers have seen their lending rates falling by 0.3-0.4 percentage points over the last year.
The media reported that there were even reported instances in which banks ended up owing interest to their clients; in these cases however the reference rate was the Swiss equivalent of Euribor. “I’m going to frame my bank statement, which shows that Bankinter is paying me interest on my mortgage, said a customer who lives in Madrid. That’s financial history. The client in 2006 took out a roughly €500,000 home mortgage loan based on Swiss franc Libor, plus 0.5 percentage points. Since then, Swiss franc Libor has fallen far enough into negative territory to make his mortgage rate negative.” (Source: WSJ)
What are the implications for banks? This is a complicated exercise and perhaps better to be conducted at a bank and a country level. While lower lending rates mean lower income, it should also result in lower defaults and overdue payments. What is more, the funding costs (deposit rates, bond yields or ECB funding) have also decreased over the last few months for most of the banks.
Disclaimer:
This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.