By Tommy Stubbington And Margot Patrick 

Bank stocks led an intensifying rout in financial markets, amid concerns that global central banks struggling to boost growth will worsen an already tough environment for lenders.

The Dow Jones Industrial Average closed down 254 points on Thursday, and U.S. oil prices fell near $26 a barrel, in a broad flight from risk that sent haven assets climbing. Gold gained 4.5% to its highest level in a year. Bond prices rose, sending the yield on the 10-year U.S. Treasury note, which tends to decline when investors get nervous, to its lowest level since May 2013.

The pressure reflected concerns that investors have wrestled with for months, including falling commodity prices, a slowdown in China and heavy debt loads in emerging markets. What is new is that investors are now worrying that banks are being caught in the middle as central banks in Europe and Japan turn to negative interest rates to spur growth.

Those policies, which charge lenders for reserves they keep on deposit with central banks, are crimping lenders' profits and amplifying fears of a wide economic slowdown. At the heart of the concerns is an alarming conundrum: While hobbled banks may not be able to tolerate rates this low, limping economies may not be able to tolerate them any higher.

The "doom loop" that sent eurozone banks and countries into a spiral of mutual deterioration four years ago could now be encircling central banks and lenders.

"The markets see this club of central bankers barreling down this path, which is really experimental for a number of reasons and doesn't seem well thought out in terms of the impact it could have," said Scott Mather, chief investment officer U.S. core strategies at Pacific Investment Management Co., or Pimco.

Bank shares plunged on both sides of the Atlantic, with Bank of America Corp. down 6.8% and Credit Suisse Group AG falling 8.4%. The KBW Nasdaq Bank Index of large U.S. lenders fell 4.2%.

For battered banks in Europe and beyond, negative rates come at the worst possible time. Regulations implemented after the financial crisis are making banks simpler and more resilient, but revenue streams have been cut off, and stock, bond and commodity trading is less profitable. Large fines at many banks for past misdeeds have held back capital building.

Now, subzero rates are threatening their most traditional source of income: the difference between what a bank earns from lending and the amount it pays for deposits. Instituting a negative deposit rate drags down other interest rates in the wider economy, making borrowing cheaper.

Investors said the recent rate moves into negative territory by central banks in Europe and Japan are an important ingredient in the cocktail of fears hammering bank stocks around the world. At the heart of concerns that European banks could stop paying interest, or coupons, on their riskiest debt, or will need to raise new equity, is a sectorwide decline in profitability that shows no signs of easing.

Economists at J.P. Morgan Chase & Co. warned this week that banks might respond to negative rates by hoarding cash and cutting lending, although that hasn't been the case yet in countries with negative rates, including Switzerland, Denmark and those in the eurozone.

The European Central Bank cut rates further into negative territory in December, while the Bank of Japan introduced a negative rate last month. Some smaller nations have gone further, with Sweden's central bank lowering its main interest rate to minus-0.5% on Thursday.

Meanwhile, on Thursday, Federal Reserve Chairwoman Janet Yellen said the U.S. central bank is studying the feasibility of pushing short-term interest rates into negative territory should it need to give the economy a stronger boost.

In a way, the move below zero was a gamble. The theory went like this: Banks would take a hit, but negative rates would get the economy moving. A stronger economy would, in turn, help the banks recover.

It appears that wager isn't working.

The consequences are deeply worrying. Weak banks may now drag the economy down further. And with the economy weak and deflation--a damaging spiral of falling wages and prices--looming, central banks that have gone negative will be loath to turn around and raise rates.

Moreover, central banks have few other levers to escape that doom loop. The ECB has instituted a bond-buying program, but President Mario Draghi last month indicated he was ready to launch additional monetary stimulus in March. Japan's decision to implement negative rates follows three years of aggressive monetary easing, aimed at ending two decades of low inflation and stagnant growth.

The pushes into negative territory also amount to a sort of competitive currency war that no one seems willing to call off.

Major economies around the world are desperate to spur inflation; one way to do that is to cut interest rates, which typically would make their currencies less attractive. Lower currencies raise the prices of imported goods and boost the fortunes of exporters.

Switzerland, Sweden and Denmark have all used negative rates to help ward off inflows of foreign funds that push up their currencies. Economists said an aim of the Bank of Japan's move to negative rates last month was to weaken the yen. It hasn't worked: The yen shot up Thursday and is stronger than it was before the rate cut.

The move below zero compounds the miseries for lenders in those countries. Banks traditionally make a profit by lending at higher interest rates than the rates they pay on deposits, a difference called the net interest margin. Low rates have already squeezed that margin, and banks' funding costs from other sources, such as bond markets, have surged this year.

German banks earn roughly 75% of their income from the margin between rates on savings accounts and the loans they make, according to statistics from the Bundesbank, the country's central bank. Plunging rates dragged German banks' interest revenue down to EUR204 billion ($230 billion) in 2014 from EUR419 billion in 2007, according to the Bundesbank.

Negative rates cost Danish banks more than 1 billion kroner ($151 million) last year, according to a lobbying group for Denmark's banking sector.

The impact is showing up in lackluster bank earnings. Shares in Italy's UBI Banca SpA tumbled 12% Thursday after it reported net interest income below expectations. Bank analysts said further surprises to investors' expectations on bank margins are possible. U.K. banks HSBC Holdings PLC and Standard Chartered PLC are poised to benefit from higher U.S. rates, but further rises by the Federal Reserve are looking less likely.

For now, one factor working in banks' favor is that negative rates touch only a small piece of their balance sheets. Even for the cash they do have at central banks, a host of rules exempts portions of those reserves from the negative-rate penalty. So far, just 2.2% of banks' assets in the eurozone are subject to negative rates imposed by the ECB, according to Alex Dryden, a global market strategist at J.P. Morgan Asset Management. In Japan, the figure is just 0.9%.

"Negative interest rates on a benchmark basis are not the final frontier. Only when negative rates begin to impact consumers and the real economy will we be entering a topsy-turvy world," Mr. Dryden said.

More deeply negative rates would force banks to make a choice: Either suffer an even greater hit to their margins or risk scaring off customers by passing on negative rates to them. Either outcome would mean more pain for the banking sector.

Philippe Bodereau, global head of financial research at Pimco, said he doesn't expect that to happen in the eurozone, because the ECB will be wary of sparking a crisis in the banking sector that spreads to the real economy.

"We would be very surprised if the ECB went into a deeply negative interest rate as this would raise concerns over financial stability," he said.

Christopher Whittall and Madeleine Nissen contributed to this article.

Write to Tommy Stubbington at tommy.stubbington@wsj.com and Margot Patrick at margot.patrick@wsj.com

 

(END) Dow Jones Newswires

February 11, 2016 19:44 ET (00:44 GMT)

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