The European Central Bank is looking at ways to stop banks earning billions of euros in extra profits from the ultra-cheap lending scheme it launched during the pandemic when it starts raising interest rates later this month.
The 2.2 tonnes of subsidized loans granted by the ECB to banks helped to avert a credit crunch when the Covid-19 crisis hit. But with the central bank now planning to raise interest rates, it is set to provide a bonanza of extra revenue worth up to € 24 billion for eurozone lenders, according to analysts.
The ECB̵[ads1]7;s Governing Council will discuss how to curb the extra margin that hundreds of banks will be able to earn on their subsidized loans by simply putting them back on deposit with the central bank, according to three people familiar with the plans.
The people said it would be politically unacceptable for the ECB to give banks a taxable profit while increasing borrowing costs for households and businesses, and most commercial lenders pay bonuses to employees and distribute dividends to investors.
The ECB has said it intends to raise the deposit rate to minus 0.25 percent at its meeting on July 21, while signaling a larger increase in September is likely to take interest rates above zero for the first time in a decade, followed by further increases if inflation remains high.
An alternative could be for the ECB to change the terms of the loans to reduce the possibility for banks to provide an automatic return on money, just as it made them more attractive after the pandemic started in 2020.
The ECB defended its cheap loans to banks, saying: “Without them, the pandemic would have hit the real economy much harder.” It declined to comment on how it could stop lenders with unexpected gains.
Morgan Stanley estimates that banks could earn between € 4bn and € 24bn in extra profits by putting the ECB’s cheap loans on deposit with the central bank from last month until the end of the scheme in December 2024, partly depending on how fast interest rates rise in the coming months.
One person who was briefed on the case said that the ECB estimated that the total gain available to banks was almost half of Morgan Stanley’s maximum estimate. More than 740 banks applied for the loans at their peak in June 2020, when € 1.3tn was distributed, but the total number of participants in the scheme is not publicly available.
The ECB began offering the loans – known as targeted long-term refinancing operations (TLTRO) – in September 2019. Initially, they were available at the ECB’s deposit rate of minus 0.5 per cent. But after the pandemic hit, the ECB cut interest rates to minus 1 percent, and in fact paid banks even more to lend money, provided they did not shrink their loan books.
The ECB returned the TLTRO rate to the deposit rate last month. But it is crucial that the interest rate on the loans is calculated as an average over their three-year life. Banks can repay the money early every three months. Last month, 74 billion euros in early repayments were made, far less than expected, reflecting the increased attractiveness of the scheme when interest rates rise.
“Some banks double-checked their profit estimates with the ECB, then dropped the idea of repaying them early,” an official said.
Fabio Iannò, a senior credit manager at Moody’s, said: “We expect European banks to hold on to their TLTROs for as long as they can because it’s just free money.” He predicted that the bulk of ECB liquidity would not finance loans, but would be deposited in the central bank.
Morgan Stanley calculated that if the ECB raised the deposit rate to 0.75 per cent by the end of this year, a bank that took out a TLTRO loan in June 2020 could earn a profit margin of 0.6 per cent on the money until it is due. repaid in June 2023.
“This trade has been quite profitable for us,” said the CFO of a European bank. “It was difficult for banks to shout out loud about it – you do not want to say that you as a bank profited from the pandemic.”
While the ECB does not break the data from banks, French lenders were the largest users of cheap liquidity with an exposure of close to € 500 billion in April, followed by their peers in Italy and Germany.
At Germany’s largest lender Deutsche Bank, € 44.7bn of TLTRO loans accounted for around 9 per cent of the total € 481bn loan book.
Last year, Deutsche’s interest income strengthened by EUR 494 million from subsidized ECB liquidity, or 15 per cent of profit before tax. Deutsche, which counts TLTROs as a “government subsidy” on its accounts, declined to say how much was deposited with the ECB.
A person familiar with the bank’s decision-making processes said that “a carry trade versus cash was not the purpose of Deutsche Bank’s TLTRO participation”.