The link between Meloni’s windfall tax and the ECB’s bloated balance sheet

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Over the next few weeks, the European Central Bank will probably write a letter to Rome. In that letter — formally, a legal opinion — it will almost certainly criticise the Italian government’s plans to tax a substantial chunk of the net interest income of its banks. 

Upon receiving the missive, Giorgia Meloni, Italy’s prime minister, should not feel unfairly singled out. The ECB has taken aim at Madrid too over its banking windfall taxes, warning that it could weaken lenders’ capital positions.

Yet the central bank’s own actions may, ultimately, have set in motion the chain of events that led to governments’ decisions to levy their lenders.

Two of the eurozone’s largest economies have now unveiled windfall taxes, as well as Lithuania. We’d bet that others may follow suit.

In an environment where lawmakers — and voters — are struggling to make ends meet, taxing banks’ profits inflated by central banks’ interest payments is an option too politically attractive, and too fiscally lucrative, for the likes of Meloni to ignore.

Especially when lenders across the region are, to varying degrees, failing to pass on higher central bank interest rates to savers.

There simply is less cause for them to do so, however, in an environment where the side-effects of the ECB’s decision to purchase trillions of euros’ worth of debt — as well as offer cheap long-term loans — are still being felt.

Let’s row back a little.

Throughout history, looser monetary policy has not only meant lower rates, but more plentiful supplies of cheap central bank cash.

However, the scale of central banks’ aggressive easing during the last cycle has created a scenario where important elements of looser monetary policy cannot be easily unwound.

Let’s look at the Eurosystem’s balance sheet.

Eurozone central banks still hold about €5tn-worth of mostly government bonds. Several of their targeted longer-term refinancing operations (TLTROs), which offered abundant supplies of dirt-cheap liquidity, are yet to expire.

And so the balance sheet, deep into the current tightening cycle, still stands at north of €7tn, compared with less than €2tn when rate-setters last raised borrowing costs in 2011.

Why does this matter?

In the past, when central banks wanted to raise borrowing costs, they did so by hoovering up excess reserves through their open market operations.

That process guided market rates upwards as the need for lenders to roll over their central bank funding — “reserves scarcity” in the jargon — allowed officials to easily control the price of reserves by controlling the quantity on offer.

Yet, despite rates hurtling back to historical norms, 15 years of aggressive monetary easing has meant that deep into the current cycle, banks still have all the liquidity they need.

Lenders do not, on the whole, need to take part in central banks’ open market operations to access cash, and have far less need to compete with their rivals for deposits, as years of QE and TLTROs have left them flush.

Central banks, therefore, appear to have far less control on the interest rates that lenders offer on deposits than in past cycles.

A striking recent note from the banking team at Berenberg shows the same issue is facing the Bank of England in the UK (our emphasis in bold)

We estimate that there is around £160bn of surplus UK private-sector deposits (relative to trend). This has fallen from a peak of c£250bn but remains historically abnormal.

This abundance of deposits helps to support UK private sector resilience as borrowing costs and living costs rise. For banks, this also reduces the relative need to increase deposit rates to attract funding (at least at an aggregate level).

Consistent with this, UK banks’ loan-to-deposit ratio has fallen 45ppt since its 2006 peak and by 10ppt versus 2019. Liquidity is also abundant.

As a result, UK banks have less need to attract deposits relative to past periods during which interest rates were around the current level.

Interestingly, Berenberg’s research shows that the lack of pass-through is concentrated on current accounts, with those with the financial security to be able to stuff their savings into time deposits feeling most of the benefits of higher rates.

Which leads us back to the current trend towards windfall taxes.

Rather than rationalise lenders’ behaviour as a natural reaction to the idiosyncrasies associated with central banks’ mass asset purchases and generous supplies of credit, politicians such as Meloni have cried foul. 

Lawmakers have accused the banks of being motivated by greed. But, in normal circumstances, more competition for deposits would mean lenders might not be able to take advantage of central banks’ interest outlays to the same extent.

This newsletter is not an attempt to claim that the chaos that has surrounded Italy’s windfall levy is in any way the ECB’s fault.

The Italian prime minister’s coalition government has gone about introducing its measure in a haphazard fashion, with numerous about-turns and communications gaffes along the way.

Yet, set aside the unnecessary confusion that has surrounded the measure’s introduction, and — at its root — this, and the other windfall taxes befalling Europe’s banks, may say more about the aftermath of central banks’ giant easing experiments than who’s in charge in Rome.

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