Does banks' profitability really suffer under low interest rates

Question

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.

Answer 1

A simple correlation/beta analysis of the Banks-relative-to-market versus interest rates or bond yields 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 the equity market and to 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 Zero Lower Bound (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 is the duration element of a bank's profitability. Banks also find it easier to pay savers below-riskless (to reflect their operating costs) when interest 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 (BDD), is 2.5%. Assuming 1% of debts go sour, that's a net 1.5%.

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. Gross NIM is 1.25% - 0% = 1.25%. Profits are down 50%, before BDDs, to which the bank's profits have also become increasingly geared!). Net of the same 1% BDD provisions, 0.25% net vs 1.5% above is a ~80% decline. Or 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 ;-(

Answer 2

Simplified: Banks usually live of the margin between what interest people pay fro credit vs. what interest people get for leaving their money with the bank. The higher the difference between the two, the more money is left for the bank. Before the last crisis banks increased this margin by high risk investments, which promised higher interest rates.

Several factors now trim the margin on the European market:

1. Negative interest for parking money with the ECB
2. Customers are used to free banking services and it will take time for this to change
3. Increased requirements for liquidity of banks: Banks are required to have a higher percentage of their money as a zero risk reserve, which they cannot easily invest for profit - so there is no alternative than to pay negative interest on this money
4. Lower interes rates for loans mean lower margin for profits. If the market effectively allowed for 4,8% before the bank could probably push 5,5% on customers, leaving 0,7% gain. Now with rates as low as 1,8% the bank is hard pressed to gain 0,3% out of this.
5. Increased costs to fulfill requirements. New anti money laundering and security rules in Europe require huge investments in IT and new personell from banks. On the other hand the options for high risk/high gain investments are severely limited with the new rules, so banks cannot easily gamble to rise the bottom line.
6. Slow market change and running contracts. Many personal products are tailored in a way so the cost/interes for the customer stays constant and the bank cannot easily change this and might even have trouble ending this contract without precedent. These contracts were designed for a high interest rate market and are now drowning the banks.

Answer 3

The main source of income for banks like many other fundamentally financial enterprises is to work more efficiently than the average guy on the street making use of their services.

In a low interest environment (which also is a low inflation environment) the average guy on the street can just put his money under the mattress. He has no need to take his money to the bank for what amounts to zero interest. In turn, that leaves the banks with no money to invest with better average returns (whether in safe or risky investments) than they pay to the guys with fewer financial skills.

When interest rates are higher, banks receive more money to work with because it would lose more value (on average) under the mattress than there is a risk of the bank going broke.

Answer 4

Yes of course. They pay billions in interest to the central bank (ECB) and that consumes most of the profit they make on lending it out. European banks in particular are struggling to turn profitable.