The ECB’s measures, including negative interest rates are proving to be effective in increasing inflation and reducing the overall risk in the economy. However, banks should adapt continually to the changing environment by adjusting their business models as well as reducing their operating costs and non-performing loans, to stay resilient in the long term.
January 10, 2017 | Atul Desai
- European Central Bank has been maintaining negative interest rates to ensure sufficient stimulus is provided to the economy
- While the negative interest rates have affected profitability, Swedish banking industry is an exception and prime example on how to reduce cost and increase returns
- For banks to stay strong, they must make the necessary adjustments in their business models
With years of low interest rates, Mark Knopfler of Dire Straits, might even adapt the lyrics of his popular song “Money for Nothing” as – “Money for nothin' and loans for free, Now that ain't workin', that's the way you do it”. Surely, when European lenders look across the Atlantic to the US and see the Federal Reserve pushing ahead with their interest rate normalisation policy, they must wonder with envy whether they too would see a similar change in European Central Bank’s (ECB) interest rate policy.
Post global financial crisis, the ECB adopted an ultra-accommodative policy stance with multiple objectives to stimulate the European economy. This helped alleviate Euro-area political and systemic risks and support the profits of banks, whose balance sheets were inundated with non-performing assets from the Euro-area and beyond. Since 2014, the ECB has moved into the realm of negative rates, and has performed various asset purchase programmes, including its own version of “Operation Twist”, so as to ensure that the slope of the yield curve remain productive.
Banks no doubt benefited, with the lowering of the cost of funds; and this has helped stabilise extreme level of systemic financial stress. However, as time goes by, a slow economic response to the stimuli and the low yields on assets have contributed to the slowdown of organic capital formation of banks, thereby weakening them. The disincentive to lend, as the risk adjusted returns of loans are often below the cost of capital, has resulted in low profits for lenders across the continent. As such, many European lenders source their deposits from retail investors. However, there are economic limits to the tolerance of the lower bound in deposit interest rates, to which the ECB policy is seen to be intransigent. Banks with surplus liquidity place deposits with the central bank at low-negative yields, which is further compounded by the Basel III directive on liquidity coverage ratio (LCR). LCR has further manifested itself in banks turning away deposits that are volatile in nature, i.e. institutional deposits, so as to reduce their burden of additional capital charges associated with holding proportionate high quality liquid assets (HQLA). LCR requirements were aimed at ensuring banks hold sufficient short-term liquidity in case of a banking crisis.
In this context, while negative interest rates have squeezed margins, the experience of Swedish banks has been remarkable. In fact, the Swedish Central Bank, Riksbanks’ Annual Monetary Policy Report 2016, highlighted that negative interest rates have been beneficial, when the transmission is efficient, as in the case of Sweden. This has helped to lower the overall cost of finance to businesses, with minimal impact on the banks’ own lending margins leading to higher returns on equity (ROE). However, the report did clarify that the sample of European banks used in the comparison have larger loan losses and higher operating costs that negatively impact their ROE. Nevertheless, the approach and steps taken by Swedish banks to maintain high levels of ROE is a good reference for other banks in modeling their strategic direction in response to ECB’s low rates policy.
A natural response to a prolonged low interest rate regime has been to push banks into higher risk asset class, in search of higher yields, as is seen in the flow of money into emerging Asia. Consequently, banks may also need to set aside higher capital for potentially higher risk weighted assets (RWA) and expected losses (EL) for these assets, owing to revised capital adequacy models for Basel III rules, which comes into effect in 2019.
The first flush of light that we see from across the Atlantic, does however have a silver lining for European banks. The expected hike in FED’s rates this year and the hope-induced growth taking root, will also alleviate the interest rate pressures in Europe, and help meeting European growth and ECB inflation targets. Furthermore, with the low y-o-y base effect of energy prices taking effect this year, the vectors on prices and inflation will point upwards and will support top-line growth.
So, the light may finally shine and a change in ECB’s low interest rate policy may come faster than expected. Therefore, banks must recognise the paradigm shift in the business models in order to succeed in the new landscape. Having seen some of these transformations closely, I believe all banks must increasingly become transaction-led rather than balance sheet-led, so that revenues are capital light and efficient. Liabilities and assets must be churned with a higher velocity to earn greater fees, strip unworthy assets, optimise balance sheet risk, and maximise client relationships. Businesses need to be simplified drastically to reduce cost/income ratios. Strategic partnerships based on excellence, with non-competing financial institutions and fintechs should to be embraced in order to transform banking models, deepen market access and add greater scale.
Note: Atul Desai is the head of financial institutions - Asia, transaction services, RBS. The opinions expressed in this article are strictly his own.
Categories: Liquidity Risk
, Markets & Exchanges
, Risk and Regulation
, Transaction Banking
, interest rate
, Basel III