Rate cuts are unlikely to boost banks’ net income

The European Central Bank’s (ECB) decision to cut its benchmark interest rate by 50 basis points to 2.75 percent last week opened the way for some large Greek banks to slash their deposit and lending rates by half a percentage point or less. Although this appears at first to help their profitability, it is doubtful whether the new round of rate cuts will prove beneficial in the medium term. EFG Eurobank Ergasias was the first to announce last Thursday it would trim its savings deposit rates by 50 basis points, effective on December 9, with its new savings deposit rates ranging between 0.5 and 2 percent. The bank also announced a 25-basis-point cut in its base rate, bringing it down to 6.5 percent. Alpha Bank followed up on Friday with an up to 50-basis-point rate cut in deposits to be in effect as of today, and said lending rates linked to the interbank reference rate Euribor will also be reduced. Other major Greek banks, such as National, Commercial and Piraeus, are also expected to proceed with some kind of adjustment in their deposit and lending rate structure. Undoubtedly, all major Greek banks are not the same; they share, though, some common characteristics which are difficult to dismiss. First, they fund a great deal of their assets via low-rate deposits. Second, they consider themselves retail banks and want to expand fast in that sector, featuring the lowest loan-to-GDP ratios in the eurozone. Third, competition is on the rise. Fourth, their cost structure is relatively inflexible and high compared to the European Union average. Fifth, they operate in a high-growth, high-inflation environment which is expected to continue over the next two years. Indeed, nine-month balance sheet figures show that the five major Greek banks rely heavily on cheap deposits to fund their interest-bearing assets, with the average deposit to interest-bearing assets ratio standing around 85 percent, compared to an estimated 62 percent or less in the European Union. Moreover, the average Greek bank deposit rates are lower than in the eurozone, which means the major Greek banks have an advantage in the sense of having access to cheaper interbank market funding. At the same time though, this creates problems in a declining interest rate environment because they have greater difficulty in passing on the rate cuts to their depositors. The fact that Greek inflation exceeds the nominal interest rates earned on deposits complicates things further for local banks. Greek national inflation was running at 3.7 percent year-on-year in October and EU-harmonized inflation at 3.9 percent the same month. The average nominal deposit rate was estimated around 1.5 to 2 percent, even before applying the withholding tax. In other words, even before adjusting for taxes, the typical Greek depositor earned a negative real return of 2.2-1.7 percent based on the national inflation figure. Even with average national CPI inflation expected to decline to 2.8-3.2 percent next year, the negative returns would still be around. Their already low deposit rates – some were set between 0 and 0.5 percent for small sums even prior to the ECB’s latest rate cut – coupled with their heavy reliance on cheap deposits to fund a good deal of their interest-earning assets means some banks may have difficulties in passing their new deposit-rate cuts on to clients because they run the risk of facing deposit withdrawals. This means they have to fund their assets via more expensive interbank funding, therefore hurting their net interest income. Of course, some banks fund a greater proportion of their interest-bearing assets via repos (repurchase agreements) and the interbank market. Of growing importance, repos are considered part of deposits even though they are repriced faster. These banks, namely Piraeus, Commercial and EFG Eurobank Ergasias, should be expected to benefit the most from the ECB’s rate cut since they are able to fund their assets more cheaply than before. In addition, these banks have excess capital, a non-interest bearing liability, which translates into lower net interest income in an environment of declining money market rates. Even if some is placed in fixed-rate government bonds, which presumably gain in such an interest rate environment, some banks have swapped their fixed-rate bonds into floating-rate bonds for hedging purposes, therefore depriving themselves of any benefit. Despite the effects of interest-rate cuts on the liability side of their balance sheet, the major Greek banks have to confront another dilemma, that is, how and by how much to reduce their lending rates. This may be easier in the case of business or other types of loans linked to a market money rate, such as the three- or six-month Euribor. It may be more tricky, though, when it comes to other loans, such as fixed rate or even floating rate. The fact that the Greek economy is growing fast and is projected to do the same in the next couple of years helps increase the demand for loans in a country widely regarded as under-leveraged. However, the banks’ relatively high cost-to-income ratios make them more vulnerable to a price war if loan growth stagnates.