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ECB could copy Japan's special rates for reforming banks

ECB_Adobe_575x375_10November2020
By Jasper Cox
10 Nov 2020

The Bank of Japan has said that it will pay extra on reserves deposited by banks that become more cost efficient or that merge. A similar policy could well be introduced in Europe too, although perhaps with different aims.

The BoJ's policy board is introducing what it calls a special deposit facility to "enhance the resilience of the regional financial system", it said on Tuesday.

The context is that, in the words of the central bank, "financial institutions' profitability through domestic deposit taking and lending activities has continued to decline in the long term.

"While this is partly due to a continued environment of extremely low interest rates, it is important to recognise that structural factors such as the shrinking and ageing of the population, the decline in growth expectations, and the excess savings in the corporate sector are significantly at play."

It warns that this hits regional firms particularly hard, and that if profitability keeps falling, financial intermediation could stop functioning smoothly.

So, how does the special facility help? Well, it will reward regional banks that push on with strengthening their business model, by paying 10bp more interest on their current account balances.

To be eligible for the better rate, financial institutions must either improve their ratio of overhead costs to gross operating profits by a certain amount, or just lower those costs by a certain proportion.

Alternatively, they are also eligible if they decide to embark on M&A or business integration. The BoJ will judge if this activity contributes "to strengthening business foundations".


Support M&A? Or green?

Europeans are likely to be watching closely. Could the European Central Bank use targeted rates to stimulate cost-cutting and M&A?

Supervisors are more supportive of M&A than they once were. The effect of the coronavirus crisis on loan books and low interest rates make profitability challenging for many lenders, meaning consolidation could well be the only escape route.

And while it may seem bizarre in a capitalist economy to have to encourage banks to become more resilient, for wider society it is imperative that they have a decent enough business model to withstand shocks. Banks' owners may not be sufficiently focused on this versus, say, short-term profitability as to give the go ahead to mergers that would improve resilience.

However, the ECB copying the BoJ in this particular regard seems unlikely. Many would see it as overstepping its mandate, and would not want it to reward what in many cases would amount to cutting jobs.

Where the Japanese central bank's tool may have more of a future in Europe is in the realm of sustainable finance, although here too it would face internal and external resistance.

The BoJ already points the way. Alongside the other conditions, the regional banks must be "committed to contributing to sustainable development of regional economies" to take advantage of the beneficial rate, although from the English language explanation on its website it is not clear what exactly this means.

The ECB has already been incentivising certain bank behaviour through its Targeted Longer-Term Refinancing Operations (TLTRO). The amount banks can borrow from these operations is linked to the loans they make to non-financial firms and households.

In the latest version, TLTRO III, the interest rate for the financing is linked to the banks' lending patterns, with funding offered at a more attractive rate if the bank executes more lending to non-financial firms and households, excluding mortgages.

Positive Money Europe, a not-for-profit research and campaigning organisation, and the Sustainable Finance Lab, an academic network, have proposed a green TLTRO programme. The interest rate on this would depend on how many loans a bank issues that are compliant with the EU Taxonomy, which is set to provide a framework for classifying activities as sustainable.

Members of the ECB have engaged with this particular idea, and appear open to it.

The BoJ's tool offers a different route to encouraging banks to contribute to a sustainable economy: the star performers could be rewarded and the laggards punished via the rate they receive on deposits.

Unlike with the green TLTRO proposal, this method would involve judging a bank's business model as a whole, rather than just the green lending they do.

Whatever such a tool is used to incentivise, it will be difficult to work out how to measure performance and also how much of a carrot to offer. It may turn out not to have the desired effects. We can also question whether central bankers would be doing too much of the heavy lifting versus elected politicians.

However, the innovative BoJ has placed a shiny new tool in the central banks' toolkit, which aside from anything else allows it to cushion the effect of the negative policy rate on banks. Those in Frankfurt will surely be keeping an eye on this.

By Jasper Cox
10 Nov 2020