Why banks are not invited to the European Market Day

Investors have spent the last six weeks preparing for Mario Draghi's last stand. Since the President of the European Central Bank hinted in a speech in mid-June that he intended to end his mandate with a renewed stimulus package, the markets are partisan, the actions and eurozone bonds recording big gains. One area, however, was remarkably absent from the festivities: the banks in the area.

Behind the market euphoria sparked by the prospect of Mr Draghi's departure gift, there are fears that easing the ECB regime will slowly strangle lenders in the euro area. While government bond yields have hit record lows and the Euro Stoxx index has appreciated 15% this year, the equity financial sub-index has declined slightly.

Sub-zero rates have been widely blamed for having exacerbated the recent problems of Deutsche Bank, which has begun 18,000 job cuts as part of a recovery plan. ING chairman Ralph Hamers protested against the ECB this week, saying it was not the time to move forward, which would hurt consumer confidence.

In turn, this has given rise to wider concern that by cumbersome banking, the ECB may mitigate the overall benefits of the rate cuts for the economy.

"If you want monetary policy to work, you need a healthy banking sector," said Salman Ahmed, chief investment strategist at Lombard Odier Investment Management. "If you put too much pressure on banks, more rate cuts become counterproductive."

These concerns are likely to increase. Mr Draghi is expected to substantially reduce central bank deposit rates in September and possibly revive his bond purchase program.

Negative interest rates function as a tax on banks. Eurozone banks currently hold more than € 1.7 billion of excess liquidity at the central bank. As the deposit rate of the ECB is currently less than 0.4%, the total cost is about 7 billion euros per year. At the same time, it is difficult for lenders to put this burden on their customers in the real world. Nobody wants to charge their deposits to individual customers, as UBS plans to do with very wealthy Swiss customers. The result is a painful compression of the margins.

The ECB plans to sell the pill at even lower rates by exempting some of these excess reserves from the punitive charge – a so-called negative interest rate prioritization.

Such projects would certainly relieve the big banks in the euro zone countries, which account for the largest share of the ECB's excess reserves: Germany, France, the Netherlands, Belgium, Austria and Luxembourg represent more than 80%. Apolline Menut, euro zone economist at AXA Investment Managers.

The concentration of reserves in the banking systems of only a few countries also helps to focus the benefits of segmentation. Italian and Spanish regional banks, some of which are more dependent on retail deposits than large multinationals, would benefit from little respite.

For the banking system as a whole, the precise design of the prioritization system is a thorny issue. "There is a good balance to be found: exempting too many deposits from the negative deposit charge could create a tightening of financial conditions similar to a rate hike," said Ms. Menut. "And exempting only a small portion of deposits from filing fees basically limits the purpose of prioritization."

The ECB itself pointed out that the damage to banks' profits by negative rates has been offset by other, more positive, effects of its stimulus efforts. The vice-president of the central bank, Luis de Guindos, said last month that the overall effect of its monetary policy on the profitability of the banking sector had been "globally neutral".

"Nevertheless, the overall effects of negative rates on the banking sector need to be closely monitored, especially because their effects will depend on how long the rates stay in negative territory," de Guindos added.

This last point may be of greater concern to investors in European banking stocks. Talking about prioritization seems to be the ultimate confirmation that rates well below zero are here to stay.

"What worries investors is the possibility that rates will fall even longer and fall back periodically in the future, which looks like a structural compression of net interest margins," said Richard Barwell, head of BNP Paribas Asset Management macro search.

Mr. Draghi could look for other ways to ease the pain. The ECB has so far not purchased bank debt as part of its quantitative easing program, due in part to a conflict of interest arising from its role as the regulator of the financial sector.

A new round of quantitative easing could be forced to dispense with such scruples, according to economist Jefferies Marchel Alexandrovich. In addition to reducing banks' borrowing costs, such an initiative would allow the ECB to increase its bond purchases at a time when public debt is insufficient. "He is killing two birds with one stone," he said.

For the moment, the gloom is moving away from the banking sector in the euro zone. During a recent trip to the United States, Mr. Alexandrovich found that fund managers were reluctant to touch the sector.

"If interest rates go down, it will be difficult to build an optimistic record for banks," he added. "For investors who have the choice to go elsewhere, it's a difficult sell."