Italy shook markets with extra profits of banks

The Italian government’s decision to levy an extra 40% tax on Italian bank profits this year. Photo: Italy Prime Minister Giorgia Meloni

The Italian government’s decision to levy an extra 40% tax on Italian bank profits this year shook the markets yesterday, but will be seen by many as a one-off. For while the timing of the announcement was a shock, the government had hinted at such a move earlier in the year. It has also been far more vocal than other euro zone governments about the “excess” profits of banks that stem largely from “excessive” rate hikes by the ECB.

As far as we are concerned, we should not see Italy’s move in isolation for there seems to be a more general uneasiness about bank profits and the role central bank rate hikes have had to play in “aiding” the banks.

When energy prices surged after Russia’s invasion of Ukraine, many governments acted quickly to siphon the profits of energy companies and here we could be seeing a similar profit-snatch directed towards the banks. In some ways this makes economic sense. Banks have increased the level of reserves they hold at central banks substantially since quantitative easing started.

In the UK, for instance bank reserves have doubled since the pandemic and, if you go back to the 2008 financial crisis, reserves have risen a huge 40-fold. With central banks paying interest on these huge reserves the transfer from the central banks to commercial banks has grown exponentially. In the UK, for instance, the payment from the Bank of England to the banks is around GBP45bn which is about 1.7% of GDP. In the US it is around USD176bn or some 0.7% of GDP.

These transfers are so huge that some, such as economist Paul De Grauwe have argued that central banks should refuse to pay interest on banks minimum reserves, even if they continue to pay up on banks’ excess reserves. Interestingly enough, this is exactly what the ECB decided to do at the last meeting. This brings us on to the first significant conclusion which is that cutting the rate to zero on minimum reserves can improve the efficiency of monetary policy – as the ECB alluded to in its statement.

The argument here is that if banks face a hit to profits from the removal of interest on their minimum reserves (which stand at some EUR165bn in the case of the ECB), they will seek to claw this back by increasing the rates they charge on bank loans, meaning that the ECB’s policy rate has a bigger bang for the buck when it comes to tightening financial conditions.

Perhaps this was one reason why the general tone of the ECB’s meeting last time was a bit more dovish than anticipated – because it knew that stopping interest payments on minimum reserves would tighten the financial conditions associated with the pre-existing policy setting.

Many other central banks that have been asked about this have pushed back against it – not least the Bank of England. But perhaps what the Italian government has shown is that, if the central bank is unable, or unwilling, to claw back the “excess” profits made from these reserves, the government can do it through levying a temporary profit tax.

The Italian government has said it would be only applied to 2023 profits, but it could arguably be justified in carrying it on if policy rates stay high next year and beyond. There is also an issue here that attacking the banks can prove popular with the public, especially when banks set higher mortgage rates and are accused of being slow to lift deposit rates.

As mentioned earlier, this “cost” to the central bank is particularly large in the UK. A populist-seeking pre-election Conservative Party might just consider whether similar action to Italy’s could be considered. In the end, the Standard Bank doubts it will choose to do so, but there could be threats – and more than enough market anxiety to negatively impact risk assets.