EU Banking Stresses Give ECB Added Incentive to Tighten Monetary Policy Sooner Rather than Later

Deutsche Bank's ongoing woes are symptomatic of a struggling Eurozone banking sector. Image © Deutsche Bank.

- Data isn't the only consideration in town for ECB

- Weakening European banks may be a factor swaying the ECB to normalise more quickly

- Low interest rate environment has hit banks hard as evidenced in recent news

The European Central Bank's September meeting forms the focus for the Euro this week, with markets likely to take some bets off the table heading into the event.

Eurozone data has been mixed over recent weeks, and this has led some to expect a steady, if somewhat cautious message from the Bank.

Such an outcome would be consistent with a weaker Euro, if historical precedent is anything to go by.

However, most analysts are expecting the ECB to offer minimal new guidance and stick with its commitment to 1) end quantitative easing in 2018 and 2) raise interest rates towards the end of 2019.

And, we believe markets might be overlooking an important consideration that will likely keep the ECB on this path, regardless of the data.

Europe's banks are struggling on the hangover of non-performing loans from the crisis, fines for malpractice and increased regulation limiting their more lucrative trading activities.

Also weighing are years of low interest rates.

"European banks are constantly shrinking in size. Blame it on the financial crisis, the low interest rate environment or the massive fines that these banks have had to incur, but the sector is gradually becoming smaller," says Sam Merideth, a correspondent for CNBC. "In the last year, lenders like RBS, Credit Suisse and BNP have announced their plans to close operations that they see as less profitable. Banks across Europe have also seen mergers and consolidation, especially in Spain and Italy in order to save banks from going bankrupt, which could lead to a bigger systemic risk across the region."

The ECB's -0.4% negative deposit rate imposes a de facto 'fine' on Eurozone banks parking their money with the ECB which directly impacts their bottom-line and removes a low-risk space for capital enhancement.

It has been an obstacle to European bank profitability.

The recent week has seen supposed untouchables such as Deutsche Bank and Commerzbank fall out of major indices.

Deutsche fell out of Europe's blue-chip Euro Stoxx 50 index on September 4 after its shares dropped 37% in a year and Commerzbank fell out of the Dax, Germany's leading top 30 share bourse the day after, due to similar declines.

"Shares of both listed lenders suffered badly since the start of the year, losing more than a third of their value. That has reflected the fading hope for a quick rise in interest rates, increasing doubts over the banks’ ability to cut costs and successfully restructure themselves," says Olaf Storbeck, a correspondent for the Financial Times.

In Japan the Bank of Japan stepped in with yield curve targeting to support its banking system due to the effect of years of low interest rates limiting their profitability from core lending practices.

In the US part of the reason why the Fed started raising interest rates was to help banks increase profitability.

Although the situation is not as bad in Europe, the ECB has so far done little to shore up bank profitability except suggest it will raise interest rates after the summer of next year.  

Perhaps this is all the more reason to expect it to try to stick to its normalisation road-map - even if the economy doesn't comply - European banks are 'banking on it.

For currency traders it suggests upside rather than downside risks to the Euro as the ECB is more likely to opt to plough a tighter rather than looser policy furrow.

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