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Negative rates: Margin pressure could incite more risk-taking among banks

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Negative rates: Margin pressure could incite more risk-taking among banks

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Greensill Capital's collapse has raised questions around increased risk-taking at banks, which some analysts believe is a consequence of negative interest rates.
Source: Oli Scarff/AFP via Getty Images

The collapse of U.S. family office Archegos Capital and trade finance firm Greensill Capital (UK) Ltd. earlier this year sent shock waves through the banking sector, markets and politics, raising questions about operating models and risk appetite.

The scandals, which affected some of the largest global banks, have triggered a slew of regulatory investigations and political hearings across Europe and the U.S. In the latest move, the U.S. Department of Justice launched a probe against the banks that traded with Archegos and lost over $10 billion amid its collapse, Bloomberg News reported June 24.

Looking at the reasons why European banks may have taken on more risk, analysts see the negative rate environment as playing a role. Lenders have struggled with low profitability since the global financial crisis, and the introduction of negative rates by the ECB in 2014 has added more pressure to the sector's performance.

Negative interest rates have eradicated the key competitive advantage of banks, namely the benefit of cheap, stable funding in the form of retail deposits, Johann Scholtz, equity research analyst at Morningstar, said in a written comment. To improve returns, he said, banks only have two options: cut costs or increase the spreads they generate on their assets.

Higher spreads can only really come about by taking on more risk or by having less competition, but competition is actually increasing, especially from shadow banks and other nontraditional, nonregulated players, Scholtz said.

With the ever-increasing regulatory burden and a constant push for deeper cost cuts to boost profits in the absence of revenue growth, European banks are caught in a difficult situation, according to Scholtz. "I am not always convinced that regulators fully grasp that a profitable banking sector is a stable banking sector and that banks that are able to generate a decent return from providing vanilla services to their clients are less likely to take on excessive risk than banks that are unable to cover their cost of funding," he told S&P Global Market Intelligence.

Read more on the impact of negative interest rates here: European banks must reinvent themselves in quest for profit

Although banks are not likely to deliberately look to expand their risk appetite, "the hunt for profits will always be present," said Elizabeth Rudman, head of the European financial institutions team at DBRS Morningstar. "You could see recent problems at Archegos and Greensill Capital as examples of banks increasing their risk appetite without full due diligence."

Greensill is a classic example of "banks chasing higher returns because of the negative rate environment," according to Tom Kinmonth, fixed income strategist at ABN Amro. But this also speaks to increased risk-taking in the wider financial services ecosystem. "The whole industry, from insurance companies to big pension funds to asset managers, are all looking for yield ... so, in the end, people are pushed to take more risk," he said.

Dozens of German towns faced €255 million in total losses from the collapse of Greensill Bank AG because municipal authorities chose to deposit their money with the lender, as, unlike many of its peers, it offered positive interest rates.

The ECB itself named risk-taking as one of the main concerns relating to the impact of negative rates. Banks may start to lend to "riskier borrowers" while "a search for yield among institutional investors ... could lead to a disproportionate demand for high-yielding risky assets," the bank said in a 2017 paper.