Could deposit tiering lead to more bank M&A?

For monetary policy to succeed, you need a health and integrated banking system. Europe has neither. That is why it is important not to consider the ECB’s potential plan to introduce tiering on deposits in the context of a new cheap long term financing program for banks (TLTRO-III) and potentially lower short term interest rates.

By reducing the negative deposit rates payable by core European banks, which acts almost like a tax; and changing the TLTRO programme, which is effectively a subsidy for many weak banks (TLTRO), the ECB could be trying to encourage the transfer of the excess reserves from core Europe to the periphery via the banking system. The mechanism would be re-igniting the interbank lending market or, more likely, encouraging banking industry consolidation, especially across borders, at a more rapid pace than we have seen to date.

The ECB currently charges a flat negative interest rate on bank deposits. Since the German and French banks have the largest excess of reserves to keep on deposit, a flat negative rate hurts them the most. The benefit to peripheral and smaller banks would be less as they have less excess reserves sitting at the ECB.The negative deposit rate on core banks excess reserves has a direct negative impact on profitability. For example, German banks have around EUR 600bn of excess reserves on deposit with the ECB and at -40bps effectively “costs” the banks some €2.4bn in ‘lost’ profits.

To put this into context, the German banking system earned around EUR 12bn of profits in 2017. A tiered deposit rate would provide some relief if the rate on excess deposits was moved from -40bps to 0bps, automatically increasing the earning power of the core European banks and leave them in an improved financial position to consider participating in cross-border consolidation. German and French banks that could give them enough firepower to spur cross border consolidation.

At the same time, you have a vast swathe of smaller and peripheral European banks who remain reliant on the ECB’s cheap long term funding programme (TLTRO). By changing the terms of that programme (TLTRO-III) the ECB is trying to take some of the support away. The aim would be to expose enough of them to allow some M&A without taking away so much support as to create a credit crunch.

This consolidation would help towards the ECB’s long held goal of increasing financial integration and transferring excess returns from the core to the periphery. If the policies play out as we’ve described here then much of the initial M&A would be within countries but it could easily set up larger, cross-border mergers which the ECB is keen to see.

Credit markets are largely unmoved by what the ECB has said on the tiered deposit rate and I suspect that is because most people are focussed on the macro signals being sent and not these second and third order impacts. Mario Draghi has dropped some big hints about the future and the time to think about what that means at a more granular level is now.