ANZ's BlueNotes editor Andrew Cornell looks at the negativity of negative interest rates

By Andrew Cornell* 

One of the key things banks do is borrow money for short periods of time and lend it out for long periods – maybe take deposits for three months and make home loans for 20 years. It is what is called ‘maturity transformation’ and when all goes well, it’s a profitable business.

That’s because short-term interest rates are normally much lower than long-term ones and banks profit on the spread. Hence the old bankers’ joke about the 3-6-3 rule: borrow money at 3 per cent, lend it at 6. Be on the golf course by 3pm. 

Of course, plenty can go wrong. Loans can go bad. There can be a run on deposits, draining cash reserves. And today there is another issue: because inflation is so low and central banks are printing so much money, there is very little spread between short and long term rates. 

It’s the negative 1-1-0 rule: borrow at less than nothing, lend for almost nothing. And no golf. 

This Wonderland of negative interest rates is hitting bank profitability. Meanwhile, even though central banks are the ones driving rates negative in a bid to lift economic growth, those same banks are wary of unintended consequences, collateral damage and policy binds. 

(Increasingly too, central bankers such as the US Federal Reserve’s Janet Yellen or the Reserve Bank of Australia’s Glenn Stevens are debating whether such low rates are even working as a basic stimulus.) 

Restore health

During the savings and loans crisis in the US in the 80s in the United States, which saw massive insolvencies in the banking sector, regulators were able to use the interest rate spread to help restore health. They lent otherwise sound banks money at low rates, those banks were then able to place the money in other highly secure assets and rebuild their balance sheets on the spread profits. 

Negative rates then are becoming a systemic challenge. As the global banking lobby, the Institute of International Finance (IIF) outlined in a recent paper, they hit bank and other financial institution earnings and valuations in a number of ways. 

According to the IIF: 

• Bank net interest margins are compressed pressuring income, leading to lower market valuations, which raises the cost of equity. 
• Insurers face rising re-investment risk. For insurers with duration mismatches, low rates could impact their ability to generate the income needed to meet long-term liabilities. 
• Pension funds face growing funding deficits as interest rates fall to very low levels. Ultimately, negative rates could render the whole concept of saving for retirement unworkable, potentially requiring some form of public policy assistance to retirees.  

European Central Bank executive Benoît Cœuré addressed the dilemma in a recent speech

“It has been suggested that at some point the level of rates can become low to the extent that the detrimental effects on the banking sector outweigh the benefits of lower rates,” he said. 

That point is known as the “reversal rate” and at that point bank profitability will fall, reducing capital generation via retained earnings, which is “an important source of capital accumulation, and thereby eventually restricting lending”. 

That is, at that point, low rates which are intended to boost investment would have the opposite effect. 

There have been volumes written on whether money printing and zero or negative interest rates will actually work and Keynes’ famous description of “push on a string” comes to mind. 

Last week, two public companies, Henkel and Sanofi, issued bonds at negative yields. In theory, they should now spend the money raised investing but there’s no indication they will. Meanwhile those who bought the bonds – guaranteeing they would cost themselves money – presumably assumed there’s no growth on the horizon and other options would cost even more. 

Even in Australia, where the latest economic growth figures were promising and the official interest rate remains well (ish) above zero, the market is analysing the impact on bank profits. 

Damage 

Credit Suisse’s Jarrod Martin produced a research note last week outlining the damage zero interest rates in Australia would do to bank profits. CS’s conclusion is zero rates would cut major bank earnings by 9 per cent. 

“We see this easing cycle (in the official overnight cash rate) as being different from the past four – it has been sustained for a far greater period and looks to continue further; we believe that negative earnings impacts for banks become more pronounced with each incremental step towards the zero bound.”

So are negative interest rates doing more harm than good? Harm in the sense the aim – easier financing to generate investment – is being more than offset by the cost to banks rising to such an extent it crimps their ability to make that finance available. 

The ECB’s Cœuré offers no answer: “While theoretically appealing, a precise estimate of the point where accommodative monetary policy becomes contractionary and/or an issue for financial stability is extremely challenging.” 

As he says: “Low (and negative rates) have both a one-off short-term impact and more persistent effects on a bank’s profitability and capital. And bank capital matters for credit provision and for financial stability, as low bank capital means high leverage.” 

Critical hit

Critically, Cœuré emphasises how interconnected modern financial systems, both nationally and globally, across markets and regulatory structures, are. It’s not a matter of whether something is good or bad for banks or the economy but rather how each measure of policy interacts with others. 

“The exact magnitude of the effect of negative interest rates on aggregate bank profitability is uncertain, since it has to be put in the context of what would happen in the absence of monetary policy action,” he says. 

Moreover, there are a range of second order impacts which could potentially create instability in the financial systems. Take the case of companies issuing negative rate bonds. 

What that means is investors are prepared to accept lower and lower returns but risk has by no means declined by the same amount. 

In chasing better returns, financiers too go further out on the risk curve. If rates do rise or economies continue to stumble, that could contribute to a bad credit cycle.

“Financial stability risks could also materialise outside of banks, through excessively inflated financial asset prices and if zero or negative rates encourage asset price volatility,” Cœuré says. 

There is a body of research which suggests ‘bad’ risk taking, when the price (interest rate charged) does not reflect the risk is more prevalent when rates are low. 

Australia’s new central bank governor, Philip Lowe, alluded to these challenges in his first speech as governor. 

“Maturity transformation has become more expensive,” he said. “So too has providing market making services in some financial instruments, generating concerns about a lack of liquidity in bond markets.” 

“More broadly, the cost of many forms of financial intermediation across banks’ balance sheets has become more expensive. The promised benefit of this additional expense is that the system is now more stable. But we need to keep an eye on this trade-off, because a well-functioning system needs to be able to take risk at a reasonable price.” 

While the populist argument is often ‘banks are too profitable’, the reality is banks are an essential component of economic recovery and even central bankers struggle with the right balance between shareholders, customers and taxpayers.

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*Andrew Cornell is managing editor of ANZ’s BlueNotes. This article first appeared on the BlueNotes website here, and is used with permission.