Luxembourg banks double profits as deposit-mortgage rate gap widens: CSL

The European Central Bank’s aggressive interest rate strategy has created record-high gaps between deposit and mortgage rates in Luxembourg, boosting bank profits by 116% over two years, notes a publication from the Luxembourg Chamber of Employees (CSL).

Luxembourg’s financial sector has experienced a significant surge in interest income, with bank profits doubling due to delayed adjustments in deposit rates, the Luxembourg Chamber of Employees (CSL) in an economic publication released on Tuesday 20 August.

The ECB’s decision to sharply increase interest rates since the post-covid recovery and the onset of Russia’s war in Ukraine was intended to curb record-high inflation. However, its impact has extended beyond price stability, affecting interest margins, deposit rates and mortgage costs, said the CSL.

One of the ECB’s primary mechanisms for controlling economic activity and inflation is through its three key interest rates. The effectiveness of this approach depends on how quickly financial institutions transmit these rate changes to their customers. Historically, the interest rate on household term deposits has almost always matched the ECB’s main refinancing rate, which is the rate banks pay when they borrow money from the ECB for one week. This alignment persisted for nearly two decades until a divergence emerged in November 2022, noted the CSL.

Following the , the main refinancing rate stood at 4.25%, while term deposit rates lagged at 3.3% in the same month.

Term deposit rates vs ECB refinancing rate

The gap between the fixed-term deposit rates of Luxembourg and the ECB’s refinancing rates in September 2023 reached its highest point in at least 20 years. Between January 2003 and October 2022, the average difference between these interest rates was 0.29pp. However, between November 2022 and June 2024, this gap widened significantly, averaging 1.03pp, a shift described by the CSL as “exceptional.”

Current account rates vs ECB deposit facility rate

Before the 2007-2008 financial crisis, the interest rate on current accounts, which allow for withdrawals and deposits on demand, was closely aligned with the ECB’s deposit facility rate, which banks use for overnight deposits with the Eurosystem. Banks passed on almost entirely the interest they received from the ECB to their customers. However, the low-interest environment of the 2010s saw current account rates drop to the level of term deposits, remaining within the corridor of key ECB rates. Banks were unable to pass on negative interest rates to customers, as doing so would likely have led to withdrawals of savings, noted the CSL.

However, the recent rise in key interest rates has not been mirrored to the same extent in current account rates. In June 2024, the ECB’s deposit facility rate was 3.75%, while current accounts earned only 1.64%. The gap between these rates has also reached a two-decade high, with the average difference between January 2003 and October 2022 standing at 0.41pp, according to the CSL. This disparity grew to 2.15pp between November 2022 and June 2024.

Variable-rate mortgage rates vs ECB marginal lending facility rate

The impact on variable-rate mortgages differed from that on deposits. From 2003 to 2012, mortgage rates tracked the ECB’s marginal lending facility rate closely. This is the rate at which banks get overnight credit from the Eurosystem. However, since 2012, banks have not fully passed on interest rate cuts to the cost of mortgage loans for households, said the CSL. While the average gap between mortgage rates and the marginal lending facility rate was 0.31pp from January 2003 to December 2011, this increased to 1.17pp between January 2012 and June 2022.

During the period of negative interest rates, this difference was nearly four times higher than in the preceding years. Unlike the delay in adjusting deposit rates, banks swiftly passed on recent key rate increases to mortgage borrowers.

Banks’ interest margins

Data from the Luxembourg Central Bank (BCL) revealed that the interest margin for all credit institutions in Luxembourg surged over the past two years, noted the CSL. In 2023, the difference between interest income and interest expenses reached €10.7bn, a 116% increase compared to the average of €5bn between 2003 and 2021.

Dividends in the banking sector

Luxembourg banks were not alone in benefiting from these developments. According to a report by asset manager Janus Henderson, global dividend payments by companies in 2023 rose by 5.6% year-on-year to a record $1.66trn, the CSL pointed out. The banking sector contributed significantly to this growth, with dividends increasing by over 13% year-on-year to reach $220bn in 2023. Compared to 2021, this represented a 28.6% rise, underscoring the financial windfall for shareholders.

While the ECB’s monetary policy played a crucial role in controlling inflation, it also had adverse effects on indebted households, said the CSL, who argued that the shift in interest rates and the corresponding increase in dividends distributed by banks indicate a redistribution of wealth from debtors to shareholders.