11 January 2015

The real danger lying in wait for the commercial banks is the low level of interest rates which, combined with risk limitation requirements, curbs their potential profitability. Moreover, the banks are facing major operational challenges, as they have to bear the operating costs of two retail channels (physical and digital) at a time of recession.

The intermediation margin, i.e. the difference between interest received and interest paid, may well become too narrow to ensure a satisfactory return for the shareholders. This is a real problem, as an economy needs profitable banks in order to absorb the risks they take. An insufficiently profitable bank no longer takes risks and so no longer fulfils its social purpose.

This is why the interest rate on bank deposits, which already provide only weak returns given the present context of extreme economic liquidity, could drop to zero or could even become slightly negative, as is already the case for certain banks in Northern Europe. Cause for concern? No, as the interest rate is the price of liquidity (which is excessive) and deposits are guaranteed by the public authorities up to a ceiling of 100,000 euros. Granted, it would lead to the situation that banknotes would retain their face value while that of bank deposits declined. And some might ponder a move into banknote hoarding, but any such trend would remain marginal – as well as looking after deposits, banks provide many other services, and electronic cash has long since supplanted fiduciary money (the use of which is in any case more and more tightly regulated).

A context of low interest rates signals that an economy is really suffering

It may look like good news for States, which can finance themselves more cheaply, but unfortunately it may herald difficulties in paying off public debts. Those debts are rising as a proportion of GDP, reaching levels even higher than those of the post-war period, despite the low interest rates, as the economy is not growing sufficiently fast. As these public debts have been repatriated (in other words, they have shifted into the assets of the banks in the countries that issue them), the countries of Southern Europe are still bearing the risk of sovereign default. That prospect is a real threat to the profitability of the banks.

This reality is made all the worse by a weakening of the demand for credit, which in turn is one of the consequences of the drop in economic demand. To recycle savings, the banks buy large quantities of State bonds, i.e. they lend to the State. But unlike ordinary credits, State bonds require scarcely any proportionate capital holdings by the banks. So States have been granting the banks special conditions in order to promote their own funding. This is a circular situation, as the banks have diluted their own imbalances with those of the States.

The role of the European Central Bank has also changed

The ECB is supervising the banks through tighter prudential controls and financial health checks (stress tests, Asset Quality Review etc.). Indirectly, the ECB also controls public debt, as State debts are for the most part funded through commercial banks (and insurance companies), which channel the savings of households and businesses, via their asset sheets, into the financing of the States that control them. The ECB, assisted by its national outposts, has therefore become the real banking regulator, and it is more concerned with the sustainability of the euro than with shareholder value from the banks.

The situation of recession and deflation is also leading the ECB to play a different role. In normal times, the ECB has a passive role in the monetary circuit, restricting itself to simply calibrating the short-term interest rate in order to guide the inflation rate. Thus, cash flow is created by the commercial banks via the credit multiplier (deposits leading to loans etc.). The ECB also acts as lender of last resort, refinancing commercial banks on an exceptional basis. Deflation modifies this set-up, as the ECB is no longer simply a lender of last resort. Rather, it runs the whole monetary circuit instead of the commercial banks, whose own credit circulation has become more sluggish. This also explains why the ECB’s monetary policy ceases to operate: the money created coagulates within the banking loop, due to the lack of demand for credit – a lack that is itself caused by the recession.

Towards latent nationalisation?

Preposterous though it may seem, a long period of stagnation and low interest rates could move the commercial banks towards latent nationalisation of the kind observed at the start of the Japanese recession. Such nationalisation would not lead to the expropriation of shareholders, but rather to their marginalisation in a context where the banks are placed under the increasingly oppressive tutelage of the public authorities and the ECB. And while a nationalised bank can operate perfectly well in line with private norms and constraints (Belfius is the best example of this), this cannot be allowed to spread to the whole of the banking sector, as control over the granting of private credit would then gradually pass to public bodies.

So the banks are facing major challenges – lower earnings combined with high costs. The ECB is obliged to play a role that goes beyond the normal competences of a central bank. State control is being strengthened within an uncertain, deflationary monetary context. The banks’ business model is shifting towards more IT and fewer jobs. Questions should therefore be asked about the need to keep banks under crisis-style regulatory constraints even though the economic landscape is completely different from that of the 2008 crisis. These issues call for serious reflection, not just sweeping judgements or political soundbites. After all, the banks help to create the cash flow that keeps the economy ticking.

Bruno Colmant

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