The difficult fight against inflation

The inflation rate is at the highest level in years. Fear for recessions is all over the place. In January 2023 the European Union annual inflation rate was 10%, and 9.9% in February. It’s down to 8.6% in March, which is still extremely high. The fact of the matter is that people are still spending, a lot, while the ECB has been quite aggressive in raising the interest rates. Why is the impact from all these rate hikes still limited? 

Low interest rates

Let’s start with basic economics: the reason the ECB is increasing interest rates is to fight inflation. People are simply spending too much. This might be driven by new technologies that just make it easier to spend money (contactless payments, debit/credit card adoption, etc.), an abundance of capital in the market, but it’s also driven by the fact that keeping money on your bank account doesn’t generate a return. Increasing the interest rates by the ECB should make saving money more attractive, and spending money less attractive, but ONLY if the banks across the EU translate that higher ECB rate to an attractive rate they provide to their customers. Otherwise, it’s rather meaningless. Unfortunately, this is not happening to the extent that it should. 

Now, before I get into the issue of why banks are reluctant to increase the interest rates for retail customers, let me first explain in simple terms how a bank works. 

How does a bank work?

The balance sheet of a bank is actually the reverse of a normal firm. All the savings that a bank holds are liabilities, and their lending book are assets. A bank basically makes money on the spread between their assets and liabilities. Meaning: they make a certain return on their assets (mortgages, lending, etc.) and pay a lower rate on the liabilities side (e.g. savings). The difference, is gross profit. This is obviously overly simplified, but you get the point. 

In Western Europe, the average savings rate is currently around 0.5%, while the ECB overnight interest rate (Ester) is 2.9%. Meaning, if a bank would park their cash at the ECB overnight, they would get an annual return of 2.9%. They can also decide to buy bonds or invest in other assets. Even the lowest risk government bonds generate a yield of 2-3% per annum. Next to this, many banks have a lending book that generates a return of 4-6% annually (sometimes even more). All this, while they are still only paying customers a rate of 0.5% on their savings. Because of this, larger banks are therefore now making millions of euros per day. 

No need to make savings more attractive

The underlying reason for not increasing the interest rate is that banks are currently not looking for more liabilities. Banks in Western Europe are very cash rich. Why look for more liabilities when you already have a very attractive savings book? Increasing the interest rate means that you will attract more savings, but it comes at a price: significantly less revenues. So, it’s very attractive for banks to keep this interest rate artificially low. 

The above obviously impacts the objective from the ECB. I’m speculating here, but it’s not unthinkable that if banks would have increased their interest rates to the level of the ECB, we would have had a larger drop in the inflation rate than what we currently see.

Opportunity

This obviously also creates an opportunity for challenger firms. We hope that challengers in the financial industry will take the lead in increasing the interest rates to provide customers with a fair return on their cash. Within financial services, we all have a role to play in helping people build wealth for the future and establish a solid financial position. And, especially in an environment with high inflation rates, all financial services companies should have a duty towards their customers to help them in this regard.