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Banks in Europe are unexpectedly rallying after Draghi's comments. Here's why

Key Points
  • European banking stocks were among the biggest gainers in trade on Wednesday.
  • ECB President Mario Draghi has hinted that help could be on the way for bank profits.
Mario Draghi, president of the European Central Bank (ECB), looks on during the 'ECB and its Watchers' conference in Frankfurt, Germany, on Wednesday, March 27, 2019.
Bloomberg | Bloomberg | Getty Images

European banking stocks bounced more than 3.5 percent Wednesday after European Central Bank President Mario Draghi hinted that the central bank is looking at the "side effects" of negative rates on the banking sector.

At the annual ECB Watchers conference in Frankfurt, Draghi reiterated that growth risks in Europe remain and that substantial accommodation was still needed in order to get inflation back to the bank's target.

Draghi's prepared statement also included a line about banks' squeezed net interest margins adding "if necessary we need to reflect on possible measures that can preserve the favorable implication of negative rates for the economy while mitigating the side effects, if any", adding that "low bank profitability is not an inevitable consequence of negative rates."

Net interest margin is the difference between the interest income generated by banks and the amount of interest paid out to their lenders

European banking stocks are down almost 20 percent in value over the past year, a function of lower profitability, competition and a benign interest rate environment.

Banks will typically make money when interest rate curves are steep by lending out at higher rates and paying deposits with lower rates. But the ECB deposit rate is currently set at negative 40 basis points, forcing cash rich banks to pay for placing deposits and current account reserves with the central bank.

The ECB has set a negative rate to encourage banks to lend out to the real economy, drive growth and stimulate inflation.

Draghi's comments today led many to believe that the ECB are considering options to help mitigate some of the negative side effects low interest rates have had on the banking system.

If the ECB did go ahead and introduce the new system, it would likely benefit French and German banks, which account for about 65%of deposits and 55% of Current Accounts. Deutsche Bank traded up almost 3% higher in the session while the large French Banks Societe Generale and BNP Paribas were also up a similar amount.

One measure could be by pursuing a method used by other central banks with negative rates such as the Swiss National Bank and Bank of Japan, which tiers deposits. This effectively reduces the amount of excess liquidity earning a negative return at the deposit rate by allowing part of bank's excess reserves to sit at the zero percent MRO (Main Refinancing Operations rate) instead.

According to Goldman Sachs analyst, Sven Jari Sthen, about 94 percent of deposits that are held at the ECB earn a negative rate.

"If 50 percent of excess liquidity were to be subject to a zero rate instead of -0.40 percent, the gain for the banking system would be just below four billion euros a year," he said in a note earlier this month.

Jari Sthen added that Euro area bank profits before tax were around 120 billion euros in 2017.

While tiering might provide short term relief for the banks, one banking analyst told CNBC on condition of anonymity that what's really needed is a rate hike.

"That would have much bigger and longer lasting benefits as tiering doesn't fix the systemic issue of low profitability".

But Chief Economist of Unicredit Erik Nielsen told CNBC by email that tiering "could be a neat way of mitigating negative effects" because the narrative of raising rates would be "virtually impossible to pull off."