Can banks survive negative rates?

Sat, Sep 14, 2019 – 5:50 AM

THE declining economic outlook and increasing political pressure are pushing central banks into more aggressive unconventional monetary policies.

Simultaneously, fears are growing that such steps, especially negative interest rates, actually threaten the stability of the financial system. They risk setting off dangerous feedback loops in credit markets and the real economy, where the second- and third-order effects are difficult to anticipate or control.

As the experience of banks in Japan and Europe has illustrated, the process follows a predictable pattern. Low growth, low inflation, output gaps, unemployment and underemployment – combined with financial instability, especially volatile asset prices – first prompt central banks to lower rates below the zero bound. The objective is to stimulate borrowing to finance consumption and investment, thus setting off a self-sustaining growth cycle.

Heightened risks

Typically, however, negative rates aren't fully reflected in actual borrowing and lending rates. Regulations require banks to maintain customer deposit bases. The fear of losing customers dissuades those banks from cutting deposit rates too far. In Europe, to date, only large corporations have faced negative rates, which means they are charged to maintain deposits.

As interest rate margins contract and profits are squeezed, banks raise fees or turn to other revenue measures to boost earnings. This keeps actual borrowing costs relatively high, undercutting the whole point of a negative rate policy.

As the economy continues to sputter, desperate policymakers slash rates more and more deeply. Government bond yields grow increasingly negative and the yield curve flattens. Banks, which hold large amounts of government debt, see their profits decline even further.

Weak earnings, in turn, impact banks' share prices and raise doubts about future dividends, buybacks or capital returns. Weaker institutions run into funding difficulties. Virtually all face higher borrowing costs. This perversely reduces the amount of credit available, which again dampens consumption and investment.

Given that bank payouts make up a significant source of investor income, fears of shrinking dividends add to the gloom. Instead of stimulating the economy, negative rates increase uncertainty about the future. Households, worried about saving for retirement and other goals, spend less.

Slowing growth increases the number of non-performing loans. This further erodes bank profits and reduces lending. It also increases borrowing costs for banks, which results in higher credit margins for borrowers.

Negative rates distort incentives. Facing declining profits, banks grow reluctant to foreclose on distressed borrowers. They extend lifelines to zombie companies, which can service their debt when interest rates are so low even if they have no prospects of repaying the principal. This is an inefficient use of capital which reduces potential growth and sets the stage for long-term economic underperformance.

Struggling banks also naturally have less demand for government bonds, which restricts the ability of countries to finance their activities. In extreme cases, where banks need help to stay afloat, already heavily indebted governments must borrow to recapitalise them or guarantee deposits. Increased debt levels and rising debt-service commitments lock the state into a low or negative interest rate environment.

The ill-effects of these trends will initially vary depending on how profitable a country's banks are, as well as their interest margins and the quality of their loan portfolios. European and Japanese banks facing low profit margins and a growing pile of non-performing loans are especially vulnerable. And, ultimately, the problems will spread. US banks have begun to lower earnings guidance, Read More – Source

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