Random profits in the billions for Europe’s big banks

There is no such thing as a “free lunch”, i.e. a risk-free profit, on the financial markets. At least that was the prevailing opinion among market participants. However, the European Central Bank (ECB) uses two mechanisms to ensure that large commercial banks can earn tens of billions of euros at the expense of the central bank with virtually no risk. That was originally planned somewhat differently, which is why the high profits of the banks are now also an issue for many members of the Governing Council of the ECB.

ECB targets chance profit

DZ Bank alone, Germany’s second-largest private bank, is earning a mid-double-digit million amount from the system this year without risk, and next year it could be much more. Calculated across the entire euro zone, bank profits from ECB transactions are likely to be just under EUR 29 billion in 2023 and EUR 3.4 billion in 2024 Karsten Junius of all people, the chief economist at the Basler Bank J. Safra Sarasin. The banks can borrow money from the ECB very cheaply in the long term and then invest it back with the ECB at higher interest rates in the very short term.

In the coming week, the ECB could now make corrections to limit banks’ windfall profits. However, all changes to the previous system are associated with certain advantages and disadvantages, which is why the options are hotly debated. Ultimately, the central bank is also concerned with reducing its enormous balance sheet total, which has grown to almost 9 trillion euros in recent years, which corresponds to 65 percent of the gross domestic product (GDP) of the euro zone. In 2010, the balance accounted for only 20 percent of GDP and in 2019 around 37 percent.

How do the billions in profits come about? In September 2019, the ECB began launching a new series of targeted long-term refinancing operations for commercial banks, known in technical jargon as Targeted Longer-Term Refinancing Operations III, TLTRO III for short, are denoted. The instrument was introduced by the ECB in its original form in the wake of the financial crisis in order to remedy the problems with lending in the banking sector at the time.

Subsidies for the banking sector

Market participants see the TLTRO III, launched in 2019, as a subsidy for the banking sector, with which the central bank wanted to compensate commercial banks for the negative interest rates prevailing until the summer. In total, the ECB issued ten tranches of the TLTRO III loan, each with a term of three years, with the last tranche at the end of 2021.

With the refinancing operations, the central bank intended, according to its own statements, to encourage the banks to lend to companies and private individuals, even in difficult economic times, in order to support the economy. This was particularly true for the period after the outbreak of the corona pandemic in Europe in spring 2020. The conditions were intentionally attractive from the start, but in the meantime the loans have developed into an extremely lucrative business for the banks due to rising interest rates.

With the blessing of the central bankers, the commercial banks were able to borrow money for three years and invest the funds that were not passed on to companies and private individuals again overnight with the ECB at a higher interest rate – a wonderful deal.

In detail, this worked as follows: The banks were allowed to borrow money from the ECB with a term of three years and with interest rates of up to -1 percent for at least part of the term. So they got money from the ECB for participating in the program. All the banks had to do was promise not to reduce their lending during the crisis. They were then allowed to invest the money they received overnight at the ECB at the central bank’s deposit rate, provided they had not passed it on to their end customers. The deposit rate was -0.5 percent as of July 26 this year, so banks earned up to 50 basis points on the TLTRO loans, which totaled $2.1 trillion.

Central bank is reviewing its options

At the end of July, the ECB then started the rate hike cycle. The interest rate is currently 0.75 percent, and by the end of the year the deposit rate is likely to be 2 percent or higher – and the trend will continue to rise. Then banks could earn 2 percentage points or more on the TLTRO loans. From the point of view of an asset manager who does not want to be quoted, it is definitely a “free lunch” or at least a kind of chance win. Safra Sarasin’s Junius adds that when the ECB launched the TLTRO tranches in 2019, it did not consider that it could raise interest rates so sharply over the three-year term.

The banks’ profits from this mechanism also correspond to the ECB’s losses from it. This has drawn criticism in recent weeks, not least from politicians who are demanding an end to business. Especially in view of the collapsing economy and the high inflation caused by energy and food prices, these chance profits are inappropriate for the banks, according to the critics.

Many observers were surprised that the ECB did not at least turn off the money supply to the banks a little at their meeting in September, which is why bank stocks were among the big stock market winners immediately after the council meeting. However, ECB President Christine Lagarde indicated that the terms of the TLTRO III loans would be reviewed in due course. That time could come this week when the ECB Governing Council meets for its regular monetary policy meeting on Thursday. Observers also expect interest rates to rise by 0.75 percentage points to 1.5 percent.

From the point of view of market observers, the ECB has several options: First, it could change the conditions of TLTRO III for the tranches with a remaining term up to the end of 2024 and demand a higher interest rate from the banks. That would reduce banks’ profits or make them repay the funds early. At the same time, this would reduce the high level of liquidity on the market, which would also be desirable from a monetary policy point of view due to the high inflation rates.

However, subsequent changes could lead to legal problems. In addition, retrospective changes would be deemed unfair by the banks and would reduce the ECB’s credibility for possible similar deals in the future.

Stop bond reinvestments

Second, the central bank could significantly increase the minimum reserves that the banks have to deposit with it without interest. This would be at the expense of the interest-bearing excess reserves that the banks are allowed to deposit with the ECB. Third, the ECB could introduce a tiered interest rate on excess reserves. Both variants could either apply to all banks or depend on the outstanding amount of TLTRO III loans of the respective bank. Safra Sarasin’s Junius argues for the former because otherwise banks could easily circumvent the lower interest rates by lending the liquidity to other banks.

However, variants two and three would not lead to the reduction in liquidity in the market that is desired by monetary policy. Junius therefore suggests that the ECB could reduce liquidity by issuing debt securities to encourage banks to swap their excess liquidity for longer-dated ECB paper. This is exactly what the Swiss National Bank (SNB) is already doing. According to Junius, liquidity-absorbing repo transactions by the central bank would also have the same effect.

With the total assets of the ECB amounting to almost 9 trillion euros, the TLTRO III account for around 2.1 trillion euros, the various securities purchase programs have increased the balance sheet by 4.9 trillion euros. Many observers now think it appropriate for the ECB to reduce its balance sheet. This can be done not only by changing the TLTRO III, but also by reducing the share of securities. The ECB would simply no longer have to reinvest the funds from maturing bonds. Market participants assume that this process could start in the first half of 2023.

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