The agony at Deutsche Bank is overshadowing the pain elsewhere in the European banking system—but pain there is.
Last week Commerzbank, Germany’s second largest bank and biggest Mittelstand lender, announced 9,600 job cuts and sold its Frankfurt headquarters to Samsung of Korea. Yesterday ING said it would lay off some 20% of its Dutch and Belgian headcount and trim its branch network, while in recent days banks elsewhere in the eurozone have laid out plans to axe an additional 5,000 staff in a bid to cut costs in the face of squeezed profitability.
To a certain extent this is what the European Central Bank wants to see. In its role as banking regulator the ECB has long argued for sector consolidation and a switch away from traditional deposit-taking and lending-driven business models. Yet the current round of cost-cutting and contraction lays bare the contradiction at the heart of ECB policy.
Negative interest rates and quantitative easing were intended to lower borrowing costs and to encourage banks to step up their lending to the real economy, so supporting economic recovery.
But the resulting yield curve-flattening has compressed interest margins and hurt profitability so severely that banks are being forced to cut costs by shrinking their operations: hardly conditions conducive to an expansion in lending.
The ECB is right that the eurozone is over-banked. Germany has over 1,500 banks and Italy over 600. But its insistence that banks should diversify their revenues away from interest income and more towards fee and commissionbased businesses is in part an admission that growth and inflation prospects in the eurozone are so poor that banks cannot count on a steeper yield curve to bolster earnings any time soon.
Inflation in the region rose to the highest in more than two years in August, but that was due to the fading effect of last year’s oil price fall rather than any pick-up in core inflation. With negative rates and QE in place for the foreseeable future, Europe’s banking sector is set to remain under pressure.
If the ECB is indeed hoping its policies will lead to a productive round of banking sector consolidation, it faces a few problems:
1) The ECB itself is responsible for keeping zombie banks alive with liquidity operations that guarantee indefinite access to free funding. Italy’s Banca Monte dei Paschi de Siena is a case in point. Over the last five years it has raised EUR 15bn in new capital, yet its market capitalization has fallen to just 546mn. Chief executives have come and gone but the bank continues to stumble along, failing stress tests, and failing to clean up its balance sheet.
2) Restructuring European banks is difficult. New rules governing the recovery and resolution of failing banks dictate that private sector bond-holders (and potentially depositors) must be bailed in before public money can be injected. As Italy has found, this condition makes swallowing the medicine of bank reform politically unpalatable, especially with elections or referendums on the horizon. With plentiful liquidity on offer, allowing the zombies to live on is the expedient option.
3) While large scale bank restructuring, remodeling, and consolidation would be in the eurozone’s long term economic interests, the process would threaten to undermine the region’s near term prospects of economic recovery. The recent cuts demonstrate that as ECB policies squeeze the profitability of traditional lending businesses and erode the ability of banks to support capital ratios in line with regulatory demands, the banks will begin to shrink their operations, cutting lending to riskier borrowers. Naturally these tend to be job-creating small and medium sized businesses that drive growth.
4) Calls for banks to shift away from traditional lending and towards a more capital markets-based business cut little ice. European capital markets remain fragmented and underdeveloped. Regulatory and legal obstacles persist, as do differences in taxation, insolvency, company law and market rules. Europe’s proposed Capital Markets Union is intended to overcome these difficulties. But a waning appetite among European politicians for further financial integration as Euroskeptic parties gain popular traction—not to mention complications thrown up by the Brexit vote—is making the planned 2019 implementation less and less likely.
In short, the ECB’s stance is deeply contradictory. Its policy of negative interest rates together with quantitative easing is intended to encourage bank lending to the real economy.
But the effect threatens to be the exact opposite, as declining profitability pushes banks to cut costs by shrinking their operations. Moreover, the ECB’s exhortation on banks to switch to a capital markets-based business model is unlikely to work given the unfavorable state of the regulatory environment. With little sign at the moment either of a softening in opposition to public bail-outs or of a reversal in ECB policy, expect the pain in the European banking sector only to intensify.