Banks in Europe are unexpectedly rallying after Draghi’s comments

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European Bank stocks fell on Wednesday more than 3.5 percent, after ECB President Mario Draghi hinted that the Central Bank is considering the “side effects” of negative interest rates on the banking sector.

Draghi reiterated at the annual meeting of ECB observers in Frankfurt that the growth risks in Europe remain and that significant adjustments are still needed to bring inflation back to the bank’s objective.

Draghi’s prepared statement also included a line on the banks ‘ depressed net interest spreads, adding:”if necessary, we need to think about possible measures that can maintain the favorable implication of negative interest rates for the economy while mitigating the side effects if necessary”.”

Net interest margin is the difference between the interest income of banks and the amount of interest paid to their creditors

European bank shares fell by almost 20 percent last year due to lower profitability, competition and a favorable interest rate environment.

Banks usually earn money when yield curves are steep by lending at higher interest rates and paying deposits at lower interest rates. However, the ECB’s benchmark interest rate is currently minus 40 basis points and forces banks to place deposits and current account reserves at the central bank.

The ECB has set a negative interest rate to encourage banks to lend to the real economy, boost growth and inflation.

Draghi’s comments today led many to believe that the ECB is considering options to mitigate some of the negative side effects of low interest rates on the banking system.

If the ECB were to introduce the new system, it would probably benefit French and German banks, which account for about 65% of deposits and 55% of current accounts. Deutsche Bank recorded an increase of almost 3% at the meeting, while the French major banks Societe Generale and BNP Paribas also recorded a similar increase.

One measure could be that other central banks with negative interest rates, such as the Swiss National Bank and the Bank of Japan, which pool deposits, apply a method. This effectively reduces the amount of excess liquidity that generates a negative return on the deposit rate by placing some of the bank’s excess reserves at the main Reserve rate (MRO) instead.

According to Goldman Sachs analyst Sven Jari Sthen, around 94 percent of the ECB’s deposits earn a negative interest rate.

“If 50 percent of the excess liquidity would be subject to zero instead of -0.40 percent, the profit for the banking system would be just under four billion euros a year,” he said in a statement earlier this month.

Jari Sthen added that bank profit before tax in the euro area in 2017 was around 120 billion euros.

While tiering could relieve banks in the short term, a bank analyst CNBC said on the condition of anonymity that what is really needed is a rate hike.

“This would have much larger and longer-term benefits, as tiering cannot solve the systemic problem of low profitability.”

However, UniCredit chief economist Erik Nielsen told CNBC by e-Mail that the increase “could be a real way to alleviate negative effects” as the rise in interest rates was “practically impossible”.”