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ECB Stimulus Signal is Good for Growth, Bad for Bank Profits

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ECB Stimulus Signal is Good for Growth, Bad for Bank Profits

Highlights

After the ECB yesterday signaled further monetary stimulus, we still expect that it will cut the deposit rate by 10 basis points in September and resume net asset purchases of €15 billion per month in October.

Yet, given that risks to economic growth are external, we expect this new easing package will support, but not lift, growth and inflation beyond what we currently forecast.

The prospect of even lower for even longer interest rates also means another turn of the screw for European banks, with the risk that low bank profitability turns from a cyclical phenomenon into a more structural problem.

Bank creditworthiness remains well supported by the substantial balance-sheet strengthening of the past several years, but sustainable business models matter too.

Jul. 26 2019 — Amid weak growth and muted inflationary pressures, the European Central Bank (ECB) yesterday opened the door to further monetary policy accommodation in September. Introducing an easing bias in its forward guidance, it signaled "interest rates to remain at their present or lower levels at least through the first half of 2020". The central bank also confirmed that all options are on the table. As well as looking into ways to strengthen its forward guidance on rates, it is examining mitigating measures such as "a tiered system for reserve remuneration", and considering potential new net asset purchases. It also took a step into unchartered territory by adjusting its inflation aim.

Based on the outcome of this meeting, we continue to expect a 10-basis point (bp) rate cut in September and think the ECB is likely to announce the resumption of net asset purchases by €15 billion per month from October. The central bank will also have to adjust its forward guidance, since we do not expect it to be able to raise rates at least until the second quarter of 2021.

Lower For Longer Will Have Only Marginal Effects On Growth And Inflation

With this package of measures, monetary policy will provide some support to growth and inflation in the eurozone. However, it will not eliminate the downside risks to growth, which all are external and will likely persist--U.S. tariffs on European car imports, Brexit, a U.S.-China tech and trade war, geopolitical developments in the Strait of Hormuz, and China's economic transition.

Lower interest rates are supposed to help reflate the domestic economy by incentivizing domestic credit growth, especially in the housing sector. However, in many countries, the construction sector is running at full capacity. Lower rates can also translate into rising price pressures (see chart 1) rather than more activity. As the ECB faces an effective lower bound because of the possibility for households to convert their bank deposits into zero-interest-bearing cash, the negative interest rate policy can only be incremental. Moreover, when uncertainty is as high as at present, lowering rates further might have limited returns. Without visibility on demand for their products, firms may still delay their investments even if borrowing costs go down. The latest ECB Bank Lending Survey seemed to confirm this (see chart 2). What's more, less productive companies are kept alive for longer when borrowing costs are low, which makes the allocation of capital less efficient. Finally, the ECB is cutting rates in an environment of widespread monetary policy easing worldwide. Therefore, the effect on the exchange rate will be limited, and will thus provide limited additional buffers to exporters.

By resuming net asset purchases, the ECB will compress the term premium lower and for longer. The €2.6 trillion of asset purchases is already compressing yields by constraining the supply of those assets available on the market. Additional purchases will reinforce that effect, especially in a context of low sovereign bond issuance in the eurozone (see: "Sovereign Debt 2019: Eurozone Commercial Borrowing To Increase 1.6% in 2019," published Feb. 22, 2019). This will ensure that market financing remains cheap in the eurozone, creating more fiscal space for governments, and it will continue to push investors to reallocate their portfolio towards riskier assets.

Practically speaking, it would be easiest for the ECB to restart buying sovereign bonds because other markets, such as the covered bond or even corporate bond markets, are much less liquid. Should it choose to do so, the ECB will have to work around two constraints: low sovereign bond issuance, and its 33% issuer limit. This does not mean in our view, that balance-sheet expansion has a limit. On the legal aspect of buying sovereign bonds, the ECB can get around the self-imposed issuer limit by reneging its veto right in case of restructuring and extending the limit to something like 50%. The ECB could embark on purchases on the derivatives bond market, for instance buying future contracts on government bonds. It could buy exchange-traded funds (ETF), as a proxy for equities. The ECB could also look at private equity shares of small and midsize enterprises, although we think this is less likely. The only taboo for the ECB, in our view, would be to buy bank debt, since this would with its role as banks' supervisor. However, all new classes of assets it purchased would add to the ECB's burden by increasing its (new) role as an asset manager and a risk officer.

A Change In Inflation Target Poses Risks

The ECB's introduction of a symmetric inflation aim in its July policy statement was a clear attempt to lift inflation expectations. Although experts have widely debated that changing inflation targets to boost inflation, no clear consensus has emerged on whether this would work. Inflation expectations raised by households, professional forecasters, or market participants for the short term are largely adapting to the current pace of price development. Therefore, there is a risk that the ECB could jeopardize its credibility should inflation expectations not react to a change in the price stability target.

For this reason, we think the ECB should carry out a deep and broad strategy review before validating any change. That said, should the introduction of a symmetric inflation target help lift inflation expectations by 20bp--the current gap between "close to but below 2%" and a "close to 2%"--the yield curve should shift down somewhat, as financial markets would expect more easing from the central bank. However, a change in the slope of the yield curve would depend on the long-term credibility of the new target.

Another Turn Of The Screw For European Banks

Yesterday's monetary policy communication is potentially further bad news for European banks. Although the ECB will examine mitigating measures for banks, such as tiered remuneration of central bank reserves, it is yet unclear whether any material measures will result from these discussions.

Yesterday's communication indicates that ultralow policy rates across the Continent may be more long-lasting than we assumed previously. As a result, low profitability may become a more persistent structural problem for some European banks. Indeed, declining yields on the capital and money markets in anticipation of central bank loosening, may be hurting bank earnings already as they eat into interest margins on loans and securities investments over deposits. The possible introduction of reserve remuneration alongside further rate cuts might have some mitigating effect on those banks that hold significant excess liquidity and would suffer more than most from lower rates.

The prospect of an even more negative interest rate environment contrasts with the gradual normalization of monetary policy we envisaged at the start of the year. We remain mindful of the potential downside risk of these developments for our base case assumptions for European banks' earnings and business strategies.

European bank creditworthiness generally remains well supported by the substantial strengthening in capital, liquidity, and funding in the past several years and a degree of economic recovery in the countries that suffered most in the crisis. However, banks are businesses--not balance sheets. Management teams will need to start proving to investors that their banks have sustainable business models that are able to adapt to a lower-for-longer interest rate environment.

Incremental Squeeze On Bank Earnings

With the prospect of gradually rising rates at the turn of the year, we assumed a minimal positive impact on bank profitability through 2019 and into 2020. Instead, the rate decisions and market reaction in anticipation of yesterday's ECB meeting herald an additional squeeze on European banks' profitability. Lower-for-longer rates represent a renewed headwind to banks' revenues, that is, by further trimming the margin banks earn between interest rates on deposits and loans as they struggle to pass on lower rates to the bulk of their depositors. Even worse, banks generally will not be able to grow their way out of this problem because the decision comes as GDP growth slows for European economies and the impact of the new ECB's package should not lift growth and inflation. The slowdown will likely further weaken loan demand, particularly by corporate borrowers, and therefore banks' revenue.

Key factors softening these pressures are financing conditions and macroeconomic growth. However, credit quality in most European countries may be as good as it gets for the sector already. The potential introduction of a tiered system for reserve remuneration might also be a mitigating factor. However, even if authorities are be able to come up with a scheme, we think that further rate cuts and a potential expansion of the ECB's asset purchase program are likely to still have a net negative effect on banks' profitability. We are also not convinced that the tiering of banks' reserve remuneration would help boost lending much in the eurozone. As such, the banks that would benefit from tiering--those with the largest excess reserves are based in countries where the credit recovery has already happened (France and Germany; see chart 3).

Not All Banks Are Equally Exposed

Since we did not project a boost for European banks' profitability previously from initial rate hikes expected in the past, a change in our base case assumptions will not lead to a landslide revision of our earnings forecasts. That said, lower-for-longer interest rates pose different degrees of headaches across the sector, from mild to migraine. Institutions in overbanked markets that are heavily reliant on interest income from mainstream lending and deposit taking are the most exposed to an erosion of revenues, in our view. They may have to rely on their ability to redouble efforts to improve costs because the time for tactical measures is running out, and strategic measures may be needed instead.

Although we believe that weakly performing banks can make the necessary adjustments, this takes time. Until some of them address the question of the long-term viability of their business models by adapting it to a lower for longer interest rate environment, investor confidence will remain weak. Moreover, implementation of the revised Basel III framework could mean that some European banks need to hold more capital in the future. This could further suppress return on equity, unless banks take mitigating actions.

By contrast, while few banks will be able to shrug off these pressures entirely, some start from a position of strong profitability having already made operating models more efficient and benefiting from superior pricing power in more concentrated markets.

We also acknowledge that some banks are not focused on maximizing net profit and payout to shareholders, such as mutual or government-owned institutions. Although low profitability could still hurt their risk profiles and lead to higher funding spreads, their shareholders might continue to more patiently accept lower returns.

Risk Of Renewed Economic Imbalances, Underinvestment In Digital Transformation

Regardless of the starting point of individual banks, a delayed normalization of interest rates would prolong pricing distortions in the market, could lead to higher risk taking as banks search for yield, and the risk of a build-up in economic imbalances could resurface. Moreover, lower revenues might curtail some banks' capacity to invest in technology and transformation of their business models, where appropriate. Lower investment capacity might constrain their ability to defend and potentially expand their franchises (see "The Future Of Banking: Will Retail Banks Trip Over Tech Disruption?" published May 14, 2019).

Low(er) For Longer Not Limited To Eurozone Operations

Obviously, the ECB's monetary policy decisions have the most direct impact on banks domiciled in the eurozone. However, the interconnectedness of European economies means that central banks in European countries outside the eurozone may also delay interest rate normalization given that they are facing similar GDP and inflation trends. Moreover, the decisions are in the context of downside risks to economic growth globally and worldwide easing in monetary policies. Therefore, rates might be lower for longer across major economies. These developments might weaken the profitability of European banks domiciled outside the eurozone. They might also reduce the profitability of European banks' operations globally through the potential for lower U.S. dollar rates, even if emerging markets might generally benefit from the U.S. not raising its rates.