It is always said that European banks suffer, amongst other things, from the low interest rate environment governing the Eurozone. And that in a rising interest rate environment, banks' profitability will rise. I want to believe but I find no logical conclusion.
Say the ECB raises its refinancing rate (i.e. the rate of unsecured borrowing from the ECB), then of course a European bank can charge more from clients for borrowing. But first, a source of funding, namely that of the ECB, gets more expensive for a bank. But at the same time the interest rate on its deposit funding is also rising. Is it simply a case that the bank raises its lending rate far more than the rise in deposit funding interest? Furthermore, as stated in the St. Louis Fed Report, a bank's maturity profile to lend for longer maturities and borrow short-term means that a rising interest rate environment will lead to higher short-term costs. Many of these factors should lead to downward pressures on the Net Interest Margin. I do not see how this leads to improved profitability.
Furthermore, the other rate the ECB has at its disposal is the deposit rate. If this is raised then any money the bank parks at the ECB will generate greater returns, but surely the amount parked at the ECB is inconsequential in comparison the scope of the bank's activities. Anyone who can illustrate why my thinking is wrong is greatly appreciated.
1 Answer
A simple correlation/beta analysis of the Banks-relative-to-market will tell you that the effect is real enough, whether in Europe, the US, or Japan... Likewise, a simple multiple regression of bank equity to market and swap rates will also suggest that the rates beta is almost as significant, sometimes more so, than the market beta.
The general presumption in the market is that this effect is due to the inability of banks to charge a spread over riskless when riskless is at/near the ZLB, compared to when the riskless baseline is positive. This expresses itself on the banks' income statements as NIM compression.
To unpack this economically, recall that there are two elements to a typical bank's profitability. They take overnight deposits, funded close to riskless; and lend risky for longer periods. At the ZLB, monetary accommodation then has to crush the yield curve, which the duration element of a bank's profitability. Banks also find it easier to reward savings with lower-than-riskless to reflect their operating costs when rates are high.
In short: Bank A has loans:deposits of 1x. Riskless overnight is 3%. The bank pays 2.5% for deposits. 5y swaps/bonds are at 3.5%, ie a "normal" yield curve. They lend at 4.5%. Gross NIM, ie assuming zero bad/doubtful debts, is 2.5%
Bank B has loans:deposits of 1x. Overnight rates are at -0.25%. The bank pays 0% for deposits, because it cannot realistically pass on neg-rates to retail customers, for very obvious reasons. 5y swaps/bonds are at 0.25%, which is the same yield curve as before. The bank lends at 1.25%, which is the same credit spread as before. NIM is 1.25% - 0% = 1.25%. Profits are down 50%, before BDDs (to which the bank's profits have also become increasingly geared!). Then start to crush the yield curve, and the problem only worsens.
This is the essence of the problem. PA long and wrong on the banks being "cheap" a la Warren ;-(
