How damaging are the latest interest rate cuts for European banks?
Last month the European Central Bank (ECB) cut its deposit rate further into negative territory, taking it to -0.5%, and restarted its asset purchase programme (known as quantitative easing or QE, this involves buying assets such as government bonds).
With economic growth lacklustre and inflation muted, many in the market expect further rate cuts to come.
Low or negative interest rates are supposed to help stimulate the economy by making borrowing cheaper (and saving less attractive). Buying bonds is supposed to encourage investors into higher risk/higher return assets.
But there are many reasons why low interest rates are bad for banks and share prices have suffered accordingly. The chart below shows the performance of the sector compared to the MSCI Europe index over the last 15 years.
This has left bank valuations some 20% cheaper relative to the market compared to their historic levels (left), and 25% cheaper in absolute terms (right), as the charts below show.
Why are low interest rates bad for banks?
- They reflect a weak economy
Firstly, it’s important to remember that low interest rates are designed to stimulate an already-subdued economy. If the economy is weak, then demand for loans from consumers and businesses is likely to be low. This means banks will struggle to grow their business and may need to reduce the interest rate on the loans they offer.
In some countries banks may even need to reduce the interest rate on loans they have already made. Rules vary, but if market interest rates come down and customers ask for a corresponding decrease in the rate paid on their mortgage or loan, then banks in some countries need to pass on that decrease. This makes it very difficult for them to defend their profit margins. Banks in France are particularly vulnerable to this.
Meanwhile, in other countries, loans are typically priced at a fixed spread over Euribor which cannot be altered over the term of the contract (Euribor is the Euro Interbank Offered Rate, i.e. the rate at which banks lend to each other). Lower rates mean lower profit margins for the banks. In this case it is banks in Spain and Italy that are particularly impacted.
- Banks hold lots of bonds
Secondly, banks typically hold large volumes of bonds on their balance sheets; in part to earn interest and in part to manage their liquidity risks. With bond yields so low (QE increases demand for bonds, thereby pushing up prices and lowering yields), banks are earning very little income this way.
- For more on low bond yields, see The death of yields in six charts
- They’re forced to invest deposits
Thirdly, despite the low interest rate environment, deposit growth is actually pretty strong because uncertainty encourages customers to hold cash. Charging retail customers in particular for deposits is taboo (and even illegal in some countries such as Spain). Banks therefore often have little choice but to invest this growing pile of deposits at the ECB or in short-term securities, for negative interest.
The ECB has taken some measures to address the final point. It is introducing a tiered system where not all of a bank’s deposits at the central bank will be subject to the negative interest rate. It is also introducing a new round of cheap funding (TLTRO 3, or targeted long-term refinancing operations). The idea is that banks can access funding below market cost, but it is conditional on them growing their loan book, which is hard to do in a weak economy and will likely put pressure on lending margins.
What is the impact across the sector?
Justin Bisseker, European banks analyst, says:
“The big picture is that low interest rates are bad for banks’ revenues. The ECB has taken some steps to mitigate the effects but these will have a limited impact.
“That said, the significance of low interest rates varies hugely, country to country and bank to bank. The pan-European banking sector includes numerous different geographies: not just the eurozone but also the UK, Nordics and Switzerland. The ECB’s latest move clearly affects eurozone banks the most.
“Eurozone-listed banks make up about 50% of the pan-European sector by market capitalisation. But only around 30% of the sector market cap is actually exposed to eurozone earnings. There’s a large chunk that has significant exposure to other markets. Examples include Austria’s Erste Bank and Italy’s UniCredit, which both have businesses in eastern Europe, while the large Spanish banks have major operations in Latin America. There are many others.
“And then in other geographies, the UK for example, interest rates are positive. Norway’s central bank raised interest rates again in September and Norwegian banks will be able to pass on the increase to borrowers; they are able to reprice mortgages every six weeks.
“For banks suffering under the pressure of low interest rates, cutting costs is an option to try and protect profitability. But it’s easier said than done. Restructuring a business is costly and many banks simply don’t have sufficient capital to fund it. What’s more, the cost of reducing employee numbers can be prohibitive in countries with strong unions – this mainly applies to eurozone countries whereas job cuts can be made more easily in the Nordics and the UK.
“All of this makes for a very diverse sector and therefore a huge variation in terms of the impact of low rates and banks’ ability to respond to them. It’s possible that the interest rate pressure may abate – market expectations for rates can change very quickly and positive news, such as a US-China trade deal, could see rates rise. But if the current situation persists, it seems clear that the banks that have lost out in recent years will continue to lose, while the winners will keep winning.”
How can investors respond?
The diversity of the sector offers the chance for stockpickers to invest in what they see as the stronger banks and avoid the weaker ones. As the charts above showed, the sector as a whole has become lowly valued by the market compared to the broader index. While the pressure from low interest rates may persist, market valuations at these levels may offer opportunities for contrarian investors who see the market’s view as overly pessimistic.
Despite the ECB’s decision to cut interest rates in September, the pan-European banking sector actually performed very well over the month. The sector returned 9.5% compared to 3.8% for the MSCI Europe index (source: FactSet as at 30 September).
This illustrates that share prices rarely move because of one single driver. Interest rates are enormously important for banks’ business models but valuations and stock-specific issues also need to be taken into account when investing.