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How negative interest rates helped turn Germany's biggest bank into a disaster

CNN logo CNN 7/29/2019 Matt Egan

Deutsche Bank, once a superstar in Europe, is now a disaster.

Germany's biggest lender is rapidly slashing jobs, it's losing a ton of money and the stock is trading near all-time lows.

Many of Deutsche Bank's problems are self-inflicted. It's been badly mismanaged. Deutsche Bank never fully cleaned up its crisis-era balance sheet. Restructuring efforts fell short. And its countless legal black eyes haven't helped matters.

But Deutsche Bank's struggles have also been amplified by something the 149-year-old lender never imagined, mostly because it had never happened before in modern history: negative interest rates.

In 2014, the European Central Bank wanted to boost the sluggish economy but interest rates were already at zero. The unconventional decision to take them into negative territory was aimed at encouraging growth and avoiding deflation, but it meant banks were charged a fee for parking their reserves with the central bank.

The ECB's extreme policies may have injected some life into Europe's sleepy economy, in turn giving Deutsche Bank and other lenders a boost. However, negative rates are also crushing the profitability of all banks, Deutsche Bank included. And this unorthodox policy — one that the ECB is on the verge of doubling down on — is making it awfully difficult to revive the champion of Germany's banking system.

"Negative interest rates have been another nail in the coffin," said Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics.

Although all banks in the eurozone have been subject to the ECB's extreme policies, Deutsche Bank's business model, and precarious balance sheet, made it particularly susceptible to this pressure.

Negative rates didn't cause Deutsche Bank's troubles, Vistesen said, but they "absolutely" magnified them.

Very destructive

It's no secret that negative rates are an outright tax on banks.

Under normal times, lenders earn interest when they keep excess reserves at the central bank. But under negative rates, it's the opposite: The central bank charges banks interest for sitting on that cash. The goal is to encourage lending — but in practice it has squeezed lending profitability, also known as net interest income.

"The business model of running a bank with negative rates is very destructive," said Jeffrey Sherman, co-portfolio manager of the DoubleLine Core Fixed Income Fund.

Lately, Deutsche Bank's share price has dropped almost in tandem with bond yields, which have recently tumbled even deeper into negative territory.

There has been a strong correlation of 0.85 between Deutsche Bank stock and German 10-year yields over the past year, according to Sherman.

Goldman Sachs analysts said in a recent report that sharp declines in interest rates beginning in 2014 corresponded with a "substantial" decline in net interest income at eurozone banks, relative to where estimates were in 2014.

Mass job cuts, sinking stock price

Deutsche Bank has made just one annual profit since 2014. The bank announced plans earlier this month to eliminate 18,000 jobs as part of a new effort to stem the red ink.

Deutsche Bank's NYSE-listed stock topped out at $124 in May 2007, in the dawn of the global financial crisis. Although some big banks have failed to return to their all-time highs, many have at least come close. Deutsche Bank, on the other hand, is trading at $8, or more than 90% below its pre-crisis highs.

Most of those losses occurred well before ECB chief Mario Draghi launched negative rates in June 2014 in a push to accelerate Europe's economy and prevent deflation. But the numbers aren't pretty after that either.

Deutsche Bank's stock has plunged 77% since the ECB announced negative rates.

"You're basically kicking a wounded animal while it's down. Negative interest rates have simply annihilated European banks," said Danielle DiMartino Booth, CEO and chief strategist for Quill Intelligence and a vocal critic of modern central bank policy.

Counterproductive policy?

The Euro Stoxx Banks Index, a basket of eurozone lenders, is down by more than 40% since the ECB ventured into negative interest rates.

While the eurozone enjoyed a growth spurt in 2017, the economy has slowed significantly of late, in part because of global trade tensions and demographic challenges. Draghi, the outgoing ECB chief, warned last week that the eurozone's economic outlook is getting "worse and worse."

"Monetary policy in Europe has been spectacularly unsuccessful," said David Kelly, chief global strategist at JPMorgan Funds. "These negative rates are counterproductive. They are slowing the European economy down."

Kelly noted that Europe's economy depends more on bank lending than America's because the European capital markets aren't as deep.

"The banking industry cannot flourish on negative rates," he said. "And that is acting as a drag on the entire European economy."

Would things be even worse without negative rates?

To be sure, there have been benefits from the ECB's policies. Negative rates, along with massive asset purchases, have helped lift the stock market and made it easier for companies to borrow. That has likely helped bolster confidence among households and businesses to go out and spend.

Vistesen also said that negative rates have boosted credit growth among European households. He pointed to cheap mortgage rates in Spain and Italy and improved home prices.

And proponents of the ECB's extreme stance on rates argue that the European economy would be in even worse shape without negative rates. Higher unemployment and loan losses would surely be a negative for the eurozone banks, Deutsche Bank included.

But that's impossible to prove. No one knows for sure how the economy would have acted in a different environment.

Some argue that allowing the economy to fall into a recession could be healthy, even if it's painful. That's what happens in business cycles. Downturns shake out the weaker companies, leaving more room for the healthier ones. Negative rates do the opposite, keeping so-called "zombie" firms alive.

"What's wrong with a recession?" asked Sherman. "Capitalism says that things that are ill-advised should go to zero."

Deutsche Bank is especially vulnerable to further rate cuts

Banks are now bracing for the ECB to go even deeper into negative territory.

Draghi said last week an "ample degree of monetary accommodation is still necessary" to boost inflation and "softening" global growth.

The German Banking Association put out a statement warning that the ECB's plan to "intensify its ultra loose" stance is a "repeated and heavy burden on banks, financial stability, savers and companies."

Deutsche Bank is especially at risk.

A rate cut of just 0.2 percentage points would wipe out 42% of Deutsche Bank's estimated 2019 earnings, according to Goldman Sachs. That's by far the most of any eurozone bank in the firm's coverage universe.

Goldman Sachs said the banks most at risk from negative rates are ones that have a substantial balance of retail current accounts and a low level of recurring profitability. Deutsche Bank checks both boxes.

ECB seeks to soften the blow

Deutsche Bank Chief Financial Officer James von Moltke told analysts last week that the bank is "highly cognizant of the headwinds" from further rate cuts.

Legal restrictions limit the ability of banks to pass on negative interest rates to retail clients, although they have passed on some of the cost through fees.

"We have been imposing deposit fees and account fees now for some time," von Moltke said. "That's just a process that needs to continue for us and the industry."

In terms of corporate clients, Deutsche Bank said it is working hard to "make sure that we have passed on negative rates wherever we can."

Although banks rarely charge negative interest rates to clients, Deutsche Bank signaled that may have to change.

The good news is that the ECB has signaled a willingness to try to "mitigate" the fallout from negative interest rates. The central bank's staff are drawing up a tiered system for reserves that would exempt some deposits from the most punitive rates. The Bank of Japan has a system where most deposits up to a certain level avoid the lowest rates. The Swiss National Bank, another central bank with negative rates, also has a tiered system to ease the pain on banks.

Goldman Sachs said a tiered system would be a "critical" part of any further rate cuts by the ECB.

"Without it, an extremely challenging operating environment becomes worse," it said.

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