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ECB’s rate rise delay is likely to hurt banks’ profitability

We now forecast the next interest rate rise will be in March 2020.

8 März 2019

Azad Zangana

Azad Zangana

Volkswirt

  • The European Central Bank announced rates will likely be on hold until next year and new loans will be offered to support the weakest banks
  • We see the delay as a policy error that will hurt the profits of the sector overall
  • We now forecast rates to rise in March 2020, and again in December 2020.

European Central Bank (ECB) president Mario Draghi unexpectedly announced that interest rates are likely to remain on hold until at least 2020. This is later than previous forward guidance had suggested, and beyond the end of the Italian’s term in office.

Previous forward guidance had suggested that interest rates would remain on hold until the end of this summer, but a deterioration in the near-term outlook has persuaded the ECB Governing Council to extend the period of record low interest rates.

The ECB downgraded its growth and inflation forecasts for this year and next, as it sees some of the temporary factors that dampened growth at the end of 2018 lasting into the start of this year. Moreover, concerns over global trade and Brexit persist, leaving the ECB to conclude that risks to their forecast are skewed to the downside.

In addition to the change in forward guidance, the ECB decided to offer a third round of cheap funding to banks in the form of targeted long-term refinancing operations (TLTROs). These loans were introduced at the height of the sovereign debt crisis when banks struggled to hold on to deposits and raise wholesale finance. More recently, the banks that have continued to use the facility are those that are less stable than the majority, with many in Italy and the periphery.

The third round of the scheme differs in two ways. First, the expiring three-year loans will be replaced by two-year loans, and second, the interest rate of the new loans will not be fixed as previously, but instead indexed to policy interest rates. This will ensure higher costs associated with a rise in the policy rate would also impact the banks that decide to take up these loans.

While the new round of cheap loans will help the weakest banks, the delay in rate rises will hurt the profitability of the banking sector overall. Negative interest rates have been a disaster for many banks, especially in Italy, Spain and Portugal. The ECB acknowledges that some banks are negatively impacted, and that in turn lending may be lower. Nevertheless, it continues to support the use of negative interest rates, despite it being a clear policy error.

Overall, the ECB has clearly decided to take a more dovish approach with the change in its forward guidance. Our latest forecast update did anticipate a delay in the next rate rise and the new TLTROs, but we had only expected a delay in the rate rise until the end of 2019, rather than into 2020.

As a result, we now forecast the next rate rise in March 2020, followed by just one more hike in December 2020. This would take the deposit rate to zero, and the refinancing rate to 0.50% (previous forecast was for 0.25% and 0.75% respectively).  

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