ECB board member Isabel Schnabel
ECB board member Isabel Schnabel © Ralph Orlowski/Reuters

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The increase in eurozone loan defaults expected as a consequence of the coronavirus pandemic is set to offset one of the key benefits of negative interest rates for the bloc’s banking system, according to a senior European Central Bank official.

The global recession caused by the pandemic is likely to lead to a surge in banks’ non-performing loans, ECB executive board member Isabel Schnabel said on Wednesday. For years the ECB’s use of sub-zero interest rates has helped to mitigate the level of NPLs on banks’ balance sheets, she said.

“It cannot be taken for granted that negative effects [of sub-zero interest rates] on bank profitability from depressed profit margins can be compensated by lower loan-loss provisions also in the future,” said Ms Schnabel in a speech

“Absent a forceful policy response, the current pandemic is likely to put substantial pressure on banks’ profitability due to rising loan-loss provisions and defaults, at a time when euro area banks’ profitability is already depressed, mostly due to structural reasons.”

Officials said Ms Schnabel, a former economics professor who was appointed to the ECB board by Germany in January, was not signalling any change in the bank’s stance on negative rates. She has previously rebuffed critics of sub-zero rates in her home country, who argue that the policy penalises prudent savers while bailing out profligate borrowers.

On Wednesday Ms Schnabel argued that governments needed to address the structural reasons for low European bank profitability — such as lack of consolidation in the sector — by making progress on eurozone banking union and capital markets union as well as boosting the economic recovery with fiscal policy. 

“While the ECB can mitigate potential negative effects, solutions to the underlying structural causes go beyond the remit of monetary policy,” she said.

“In spite of the overall positive assessment of the ECB’s experience with negative interest rates, a persistent period of negative rates may pose additional challenges,” she added.

Negative interest rates turn the principles of finance on their head by making commercial lenders pay to keep money at the central bank instead of earning interest on it. 

Line chart of Central bank policy rates (%) showing The negative rates club

The aim is to encourage banks to lend more, while cutting financing costs for companies and consumers. But since the policy was introduced several years ago in the eurozone, Japan, Switzerland and Denmark, debate has raged in central banking circles on whether it works or if it is undone by damaging side-effects for the financial system. 

The Bank of England has been considering cutting its main policy rate below zero since Andrew Bailey replaced Mark Carney as its governor in March. But the US Federal Reserve has dismissed the idea and Sweden abandoned the policy earlier this year.

Ms Schnabel acknowledged that negative rates had squeezed the traditional lending margins that banks generate, but she said there had been just as many positive effects that offset the effect.

Repeating the ECB’s longstanding position that the positive effects of sub-zero rates “have exceeded their side effects”, she said they “have been effective in stimulating the economy and raising inflation” in combination with other policy measures.

Bank bosses complain that their sector has paid over €25bn in negative rates to the central bank since it cut its deposit rate below zero six years ago, eating into their already weak profits.

The ECB cut its deposit rate to a record low of minus 0.5 per cent last September. That prompted some lenders to warn they would start passing on more of the costs by charging their larger depositors, even though the central bank gave the sector an exemption from negative rates for a chunk of its deposits.

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Much of the debate about negative rates hinges on the idea of a “reversal rate” below which it becomes more attractive to hold physical cash than to deposit money in a bank and at which point lending is subdued and starts to fall.

But the ECB still insists it could cut its rates further into negative territory if needed.

Ms Schnabel said: “There is considerable uncertainty as to the precise level of the ‘reversal rate’ and current estimates suggest that the ECB has not reached the effective lower bound.”

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