Wait, what!? Wasn’t it the self-proclaimed goal of the ECB to save banks and thus sever the doom-loop connection between sovereigns and lenders? Yes. But it’s gone wrong. Here is why and what to do.
Since the onset of the crisis eight (!) years ago, the ECB created ever-grander schemes of propping up banks access to liquidity. While the first measures clearly were lender-of-last-resort activities (flawless ones, I might add), as the crisis dragged on, ECB’s suppression of interest rates endangers the very business model of even healthy banks.
Remember that (boring) banks engage in a thing called term transformation, i.e. taking in short-term deposits and lending long-term, making money on the interest spread. This means that by their very construction, banks are illiquid and require a decent spread between the lending and borrowing rates. A closing spread hurts not only profits (this maybe alright, as long as they remain positive), but in turn also the stock value. Falling capitalisation makes it harder for banks to raise equity, something we rightfully demand from banks after the crisis.
Unfortunately, the ECB’s ultra-accomodating monetary policy has depressed interest rates, for both borrowing and lending, so far that the spread is too low for banks to operate, let alone make profits or pay dividends to shareholders. On the other side of the balance, banks are no longer paying decent deposit interest, moreover try to raise money via fees, reluctant to pass negative interest rates on to depositors. In other words, banks are stuck between a rock and a hard place. Several rocks, actually.
First, the direct threat to the business model. Ultra-low interest rates will sooner or later kill banks simply by making the usual business of making a cut from transforming deposits into loans. And yes it will even kill the too-big-to-fails, with all the dire consequences. A direct example would be Germany’s Commerzbank, reporting diminishing capital today. Deutsche Bank’s problems are manifold, but ultra-low interest rates eating into revenues are not helping either. The same holds true for other European banks, especially for the Italian ones. Diminishing capital means banks are not as resilient against the next banking crisis, exactly the opposite of what things like the new Basel rules try to accomplish.
Second, not offering decent returns or enraging customers with fees, may lead to decreasing deposits, hurting banks’ ability to lend and thus making money. I have already heard from people, they consider stashing cash somewhere at home, precisely what the ECB doesn’t want.
Third, there is probably a run for yield, no matter how risky, while we actually aimed for banks to be safer and more boring. Instead we encourage banks to lend to people who cannot afford owning a home or a car or to problematic investments. As a side-effect, this also distorts scarcity signals, but hey.
The basic idea behind ECB’s policy is the textbook-notion that low interest rates encourage investments in credit-starved companies who actually produce stuff that is demanded. Only that this doesn’t work in Europe right now. Scarcity of credit supply is not the problem, credit demand is dire. People and companies are worried about their jobs and profits, respectively. Little wonder that demand and investment are low. Europe’s economies need several things, productive infrastructure investments, labour market reforms, political stability, to just name a few. A new round of bank bail-outs, especially a self-inflicted one, is definitely not on this list. The ECB should kill two birds with one stone and hint at tightening, this will take pressure of banks’ stocks and maybe also increase the spread a little bit, and more importantly force slack governments (Germany included!) to do more for their economies, by busting monopolies and repairing bridges and increasing productivity. This will increase demand, decrease unemployment and ramp up economic activity, which is by the way the only way to bring inflation – what some people see as a kind of holy grail, instead of what it actually is: a side-effect. Hopefully, after years of ultra-loose monetary policy with no effect, the ECB will finally reverse course and, quite ironically, save banks by raising interest rates.