Negative Interest Rates - Affaritaliani · 6 NEGATIVE INTEREST RATES August 17, 2016 S&P GLOBAL Table 1: Central banks with negative interest rates Introduced Present ECB June 2014,

Negative Interest Rates August 17, 2016

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NEGATIVE INTEREST RATES

August 17, 2016 | S&P GLOBAL

Table of contents

Executive SummaryJohn Kingston

Charles Mountsp. 3

Negative interest rates: the list grows, the effectiveness questioned but part of the landscape for now

Robert Palombi p. 5

Europe’s scorecard: negative interest rates have helped the Eurozone “point upward”

Jean-Michel Six p. 8

Weighing the pluses and minuses on negative interest rates: the scales aren’t balanced

David Blitzer, PhD p. 11

The logic and limits of negative interest rate policy Dr. Paul Sheard, PhD p. 14

Plenty of incentives to loan out money aren’t offsetting the European banking sector’s many hurdles

Alexandre Birry p. 17

Japan’s negative interest rate policies show few signs of boosting the economy

Ryoji Yoshizawa p. 19

Pay me to give you back less than what you gave me: the new era for money market investors

Andrew Paranthoiene

Emelyne Uchiyama p. 22

European life insurers adjust to the reality of “lower for longer” interest rates

Lotfi Elbarhdadi p. 24

Asset managers widen their scope of investments—and their risk appetite— to compensate for ultralow and negative interest rates

Cristiano Zazzara p. 26

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Following the Global Financial Crisis, policymakers and central banks around the world have been pursuing a myriad of “unconventional” monetary policies in an attempt to revitalize economic

growth and/or combat disinflationary pressures. The adoption of negative interest rates is the latest monetary tool to be added to the policy toolbox—and looks to be the most unconventional one of all.

Executive summaryBy Charles Mounts and John Kingston

THE SCALE OF NEGATIVE POLICY RATES has reached un-precedented levels. The European Central Bank and the central banks of Denmark, Japan, Sweden and Switzerland have all adopted this drastic policy strategy. In fact, countries with negative policy rates cumulatively represent nearly 25% of global GDP according to the World Bank and are home to nearly 500 million people. While in this paper we refer to negative interest rates as the policy rates imposed by cen-tral banks in relation to various deposit and transactions within the banking sector, we also note that more than half of world’s sovereign bonds in a key S&P Global Index—the S&P Global Developed Sovereign Bond Index—carry negative interest rates.

No matter what the policy goal of negative rates may be across countries (e.g. counter weak inflation, curtail currency appreciation, spark economic growth), the impact and impli-cations of negative policy rates remain uncertain.

S&P Global has gathered the views of a cross-section of our analysts and economists from across the company to dis-cuss the impact of negative interest rates on various sectors, markets and national economies.

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Project directors

Charles Mounts, Global Head

of Research and Design,

S&P Dow Jones Indices;

John Kingston, Director

of Global Market Insights.

Among our findings:

• Data in Europe is showing enough signs of to suggest that negative interest rates are having the desired stimulative effect, either through incentivizing bank lending or the reduction in the value of the Euro, with its own positive impact on economic activity.

• There is little evidence to find a similar impact for Japanese economic performance. On top of that, the yen has not behaved as intended, and its strength has almost certainly limited the impact of negative interest rates for the country.

• A policy of negative interest rates that remains in place too long could damage bank profitability, weakening one of the key credit transmission mechanisms that could help boost financial activity.

• Political conditions complicate the use of fiscal policy to stimulate economies, leading to the rise of monetary tools such as negative interest rates. This is occurring even though fiscal policy may be a more effective tool and doesn’t carry with it the unintended consequence of incentivizing asset managers, insurance companies, pension funds and other market participants to in-crease their investment risk profiles.

• The impact of negative policy rates has been thrown into more uncertainty with the UK vote to leave the EU, the subsequent fall in the value of the pound and the quantitative easing the Bank of England announced in early August. While the ECB’s goal in its negative interest rate policy is focused primarily on the dollar, having another currency slide relative to the dollar may complicate the ECB’s goals.

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Negative interest rates: the list grows, the effectiveness questioned but part of the landscape for nowBy Robert Palombi

With negative interest rates now settled into the Eurozone, Japan and several other European countries with no foreseeable end in sight, S&P Global has gathered

some of our leading analysts, economists and other experts to review this rare but now somewhat entrenched phenomenon. And it’s clear as we have compared notes that there seems to be one overriding reason why negative interest rates have been adopted: central banks had little choice.

With most of the Western economic world stuck in extremely low growth rates, where the 2% expansion in the US is envied by others, one must come to the conclusion that central banks are pursuing negative interest rates to head off deflationary pressures in their economies. And they are doing so because they are seeing little in the way of fiscal stimulus to support higher growth levels.

There are now four European central banks with negative interest rates: the European Central Bank, the Danish Central Bank, the Swedish Central Bank and the Swiss National Bank. The Bank of Japan also has set negative interest

rates. The ECB also provided additional funding to banks through what’s called a targeted long-term refinancing operations (TLTRO), a program whose second phase kicked in midyear. Under that program, some banks will be able to borrow from the central bank at negative interest rates, in essence, getting paid to take money that they presumably will turn into (potentially) growth-producing financing to the private sector.

The choices in national policies to fight deflation and stimulate growth are few, given that interest rates were already low to begin with and fis-cal stimulus either has not worked or is having limited impact. The only other options for central

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Table 1: Central banks with negative interest rates

Introduced Present

ECBJune 2014, deposit rate cut to -0.1

-0.4, since March 2016

Japan 2016 at -0.1% Still in effect

SwedenFeb 2015, repo rate cut to -0.1%

Repo rate at -0.5%, since February 2016

Switzerland January 2014 at -0.25 -0.75%, since January 2015

DenmarkJuly 2012, main policy rate at -0.2%

-0.75%, since early 2015

bankers are to expand asset purchases—quan-titative easing—or pursue a policy of negative rates. The European Central Bank has engaged in QE since early 2015, and launched a new round earlier this year, at the same time that it doubled down on negative interest rates. At the March launch of its latest QE program, the ECB also set its so-called “headline” borrowing cost to zero, and forced banks to pay 0.4% if they wanted to leave cash on deposit at the bank.

As S&P Global’s analysts discussed in a recent internal roundtable, a palpable sense of con-cern was heard that any increase in economic growth from negative interest rates is elusive in the data. That has occurred even though the amount of global debt instruments yielding less than zero is not insignificant. According to the Institute of International Finance’s July/August report, “as much as $19 trillion of sovereign and corporate bonds (are) now trading at negative yields.” The IIF said that was about a quarter of the world debt market. A month earlier, IIF put the percentage at about 20%.

On S&P Global’s Credit Conditions Committee, which establishes the company view of credit conditions that serve as a starting point in our ratings, we have attempted to measure the impact of negative interest rates. One of the impacts we look for is vulnerability in the

macroeconomic and macro financial environ-ment that could distort demand or supply for credit, and in turn would lead to asset bubbles. Those bubbles would be unsustainable and cause a disruption in the flow of credit to the economy. The result? The restrained growth lev-els we have now would be undermined further.

There are other potential downsides to negative interest rates that our analysts have identified.

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Negative rates could erode the profitability of banks by narrowing their net interest margins, which is the gap between commercial banks’ lending and deposit rates. Non-bank institu-tional lenders also face pressures. Pension funds or insurance companies, for instance are a particular concern, because negative rates and low yielding fixed income securities reduce the investment returns these institutions rely on to meet their long-term liabilities. These inves-tors may expand their risk appetites to achieve the returns needed to meet financial obligations to pension plan members and policy holders. This search for higher investment returns could also enable riskier borrowing and raise the debt burden of nonfinancial companies that tap public bond markets to fund their financing requirements.

The concern then is what might be called a “feedback loop”: negative interest rates lead to excessive risk-taking, which could create more credit pressures and possibly defaults that have a deleterious impact on the economy, and cre-ates the need for more stimulus. This feedback

loop would be avoided, however, if the negative rate policy is successful in lifting GDP growth, supporting the debt servicing capacity of busi-nesses and households, and easing disinflation-ary pressures in the economy.

The history of finance does have periods of negative interest rates. But the current adoption of this round of “less than zero” is generally be-ing viewed as either unprecedented or certainly the first in an era of globalized markets. How will it play out? We hope this collection of analyses from S&P Global will help answer that question.

Chart 1: Selected Five-Year Government Bond Yields

Robert Palombi Managing Director,

Chief Economist,

S&P Global, Canada.

Chair, S&P Global Credit

Conditions Committee.

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Negative interest rates in Europe—introduced in stages by both the ECB and individual countries since 2008—have been, in our view, generally positive to the economy, with data

on economic performance to support that conclusion. Clearly, the impact on credit creation through lower bank lending rates has been encouraging.Granted, it is difficult to separate out the im-pact of negative interest rates from the entire package of stimulative measures undertaken throughout the continent. The ECB is buying covered bonds, government bonds, and most re-cently, is wading into the market for purchasing private debt securities.

As we noted in a report several months ago, one of the goals of the ECB from its first introduction of negative interest rates in June 2014—with further reductions after that—was to reduce the value of the euro relative to other curren-cies. It is a traditional method for seeking to boost exports and raise imported inflation. And in fact the Euro has fallen from $1.35 per euro in mid-2014 to approximately $1.10 two years later. A broader parallel goal was to ease credit conditions throughout the EMU, with the hope of stimulating lending.

The most recent numbers coming out the Eurozone are clearly pointing upward. Even against a backdrop of market volatility in the first quarter—the most recent quarter where data is available—Eurozone GDP grew at a rate of 0.6% during that period. That exceeded growth rates in both the U.K (0.4%). and the U.S (0.2%). *

Figures on lending were even more robust (See Chart 2). Annual household credit growth grew 1.7% in May from 1.6% the previous month, indicating a progressive recovery in lending. Meanwhile, new loans to nonfinancial corpo-rations grew by 3.6% in April. At country level, among the Eurozone’s big four, credit growth to corporates continued to be strongest in France (+15% year on year) and Spain (+15.0%).

Europe’s scorecard: negative interest rates have helped the Eurozone “point upward”By Jean-Michel Six

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rates, in theory “core” banks would presumably have less incentive to trade with other core banks, instead preferring to trade with banks on the periphery, where they can attract a higher fee. But that isn’t how things have played out.

Data is showing a rise in Target2 imbalances. (See Chart 3). With negative interest rates the-oretically posing a disincentive to banks to lend to the ECB, it would presumably spur a rise in lending from the central banks of richer nations, like Germany or The Netherlands, to nations on the periphery of the EU. But that isn’t happening; the rise in Target2 imbalances bear that out.

As we wrote in a recent overview of the Eurozone economy: “Domestically, private consumption is likely to have been robust, and there are signs that investment has remained strong, supporting the sustainability of the recovery and suggesting that external headwinds have not derailed the investment revival. The invest-ment recovery is likely to gather pace as global demand improves and credit conditions remain extraordinarily supportive.”

The policy of negative interest rates does not mean simply charging banks for holding reserves at the central bank. Another key component of cheap money supplied by the ECB are the two rounds of Targeted Long-Term Refinancing Operation, TLTRO and TLTRO II. While the program is complex, at the heart of it is the ECB loaning money to banks and providing them under certain conditions a negative inter-est rate for the service. TLTRO II was more gener-ous than the original, and is expected to be used by many banks to refinance loans taken out in the first TLTRO. Seven rounds of the original TLTRO saw lenders take up €425 billion, and the expectations for the second iteration are that most of the lending will be to refinance initial borrowing at more favorable terms.

But that fact—that it will be refinancing rather than new debt—gives TLTRO a mixed grade as a stimulus. TLTROs have provided significant funding, but the data is not showing that bor-rowing to be rising. As we wrote in a report: “The magnitude of the positive impact has not been as large as it could have been because the major economies afflicted by low growth have suffered from banking systems being on the mend, as well as high debt levels.” †

One market reaction that isn’t following the script: interbank lending. With negative interest

Chart 2: ECB private sector loan growth rates (adj. sales/securitization)

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What S&P Global has called a “convincing expla-nation” for this may be the fact that the national central banks that carry out quantitative easing for the ECB may be buying their nation’s debt, but it isn’t necessarily held by people from that country. So the Spanish central bank purchase of Spanish debt held by a German entity could mean that the proceeds of the sale simply end up in what is a rising German savings rate.

At some point, negative interest rates will be-come positive interest rates. My colleagues at S&P Ratings recently looked at what would hap-pen to government finances under the scenario of more normal interest rates and by extension, borrowing costs.

The conclusion? “The fiscal implication of a re-turn to “normal” government borrowing costs are significant: “The headline deficits for the major-ity of the 25 sovereigns covered in our sample would have been between 1 and 2 percentage points of GDP higher in 2015 under ‘normal’ rates than they have been under the beneficial ultralow effective interest rates, Moritz Kraemer of S&P Ratings wrote in the early June report, “Ultralow Interest Rates Mask Sovereigns’ Underlying Fiscal Imbalances (6/7/2016.)”‡ Even Germany would see a shift into deficit, though some countries would actually benefit from higher rates, including Brazil and Russia. But the overwhelming impact in a selection of 25 countries by S&P Ratings was decidedly nega-tive, with Belgium’s budget deficit widening by 2.3 percentage points.

The report concedes that government finances are more complex than a function of interest rates. Budget balances could be improved on the back of a strengthening economy; “there remains a notable output gap to be closed,” the report said. National budgets may be looking better, but that is “mostly due to the palliative effects of monetary expansion.”

Chart 3: Change in general government balance 2015, assuming “Normal” interest rates

Jean-Michel Six

Managing Director,

Chief Economist,

S&P Global, Europe.

* https://media.spglobal.com/documents/Jean_Michel_Eurodata_stats.pdf

† http://media.mhfi.com/documents/TLTRO_report_requested_by_compliance.pdf

‡ https://media.spglobal.com/documents/Ultralow_rates.pdf

https://media.spglobal.com/documents/Jean_Michel_Eurodata_stats.pdf

http://media.mhfi.com/documents/TLTRO_report_requested_by_compliance.pdf

https://media.spglobal.com/documents/Ultralow_rates.pdf

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The move to negative interest rates by central banks in Europe and Japan—and the concept of negative rates in general—makes sense given concerns about fiscal policy options.

Weighing the pluses and minuses on negative interest rates: the scales aren’t balancedBy David Blitzer, PhD

* https://youtu.be/Akul-yzmwpc

https://youtu.be/Akul-yzmwpc

https://youtu.be/Akul-yzmwpc

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excessive debt levels and doubts about the ef-fectiveness of government spending.

One of the strongest arguments in favor of neg-ative policy rates is to push down the value of the currency, making exports more competitive. There is evidence that moves to introduce neg-ative interest rates in Japan, the EU and several non-eurozone countries did accomplish that,

But there are few arguments in favor of the move beyond that. The list of potential economic damage from these policies is substantial.

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Chart 4: Despite negative interest rates, the Yen rises

It’s important to note that negative interest rates in the broader economy can arise without government policies. Nominal interest rates are the rates quoted on loans or bonds. Real interest rates are defined as nominal rates less the rate of inflation. Negative real rates occur in any economy with positive inflation rates and are neither rare nor unusual. The current debate is about negative nominal interest rates, and in particular, the policy rate, which determines the interest rate the central bank pays/charges on deposits of commercial banks at the central bank.

Why would a central bank use this tool when faced with sluggish to nonexistent economic growth? Central banks have gotten to this point because they are finding it difficult to answer the question: what else is there to do?

From an academic point of view, the only other potential tool would be fiscal policy, but that is not the proper province of central banks. It’s po-litically prohibited and further, there appears to be limited appetite for governments to engage in significant fiscal policy stimulus.

Yet, fiscal policy works. China largely escaped the Great Recession through increased in-frastructure spending; in the US government spending in 2009 was part of the recovery as well. The barriers to fiscal policy are fears of

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make –loans where the return does not justify the risk of default – or it imposes a tax on bank earnings. The tax is likely to be passed through to bank customers and shareholders. Recalling the lending problems of the financial crisis, is the right approach a tax that encourages risky and unwise lending policies?

Since the central bank’s policy rate sets the pattern of short term interest rates for the en-tire economy, a negative policy rate will spread negative interest rates across the economy. Damage beyond eroding bank profits may re-sult. Insurance companies and other nonbank financial institutions facing long term liabilities at fixed nominal rates will suffer. Pension funds and other long term investors which rely on bonds for part of their portfolio will find prudent asset allocation impossible.

If negative interest rates spread beyond major financial institutions to the overall economy, the economy will shift increasingly towards a cash-only economy. This means increased transaction costs and rising risks of theft. Some industries might benefit: home protection services and safe manufacturers. You would be moving back toward a pure cash society. If nothing else, it’s a cost in productivity. It gets more difficult and expensive to complete trans-actions. You really turn the clock back.

but only temporarily. The yen, in particular, has stubbornly been on an upward trend even after the early-year adoption of negative interest rates (See Chart 4). And negative interest rates have been just one tool with Swiss central bank has attempted to tamp down with value of the Swiss dollar to little avail (though it might have been far higher had it not been for negative in-terest rates).

Negative policy rates are an attempt to coerce banks to lend more. Commercial banks funds deposited at the central bank are a combina-tion of required and excess reserves. In normal markets, banks minimize the amount of excess reserves because it is more profitable to loan funds than hold them in low-paying accounts at the central bank. When interest rates are close to zero, loan demand is soft, the economy is weak and the risks of lending money is per-ceived as high, banks prefer the safety of de-posits at the central bank to the risk of lending funds at extremely low interest margins.

Under these conditions, lowering interest rates won’t encourage bank lending or promote eco-nomic activity. Pushing interest rates below zero and charging commercial banks for their deposits at the central bank is an attempt to coerce them to lend. Either this forces banks to make loans that they would not otherwise

David Blitzer, PhD Managing Director,

Index Management,

S&P Dow Jones Indices.

Chairman, Index Committee.

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Negative interest rate policy, as an aspect of monetary easing by central banks, is an odd thing. How can an interest rate be negative? Doesn’t that mean the lender gets back less

than it lends, seemingly violating the economic truism that there is a (positive) time value of money?

The logic and limits of negative interest rate policyBy Dr. Paul Sheard, PhD

* https://youtu.be/2xf4bDPZGG0

https://youtu.be/2xf4bDPZGG0




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Negative interest rate policy is a simple ex-tension of “regular” monetary easing: another way—alongside cuts in the policy rate in pos-itive territory, “forward guidance” about the in-tended future path of the policy rate, and quan-titative easing—to exert downward pressure on the term structure of interest rates in order to ease financial and financing conditions and thereby buoy economic activity.

It is not obvious, without a little thought, that the central bank’s negative interest rate on all or part of the liabilities it requires financial insti-tutions in aggregate to hold will exert any more downward pressure on the yield curve than setting a zero interest rate would. It might be thought that the time value of money—the fact that lenders who engage in voluntary exchange will not lend at a negative rate—would make zero the anchor rate for influencing the yield curve. A negative policy rate then would just be a tax on financial institutions, with no incremental monetary easing benefits. The fact that it took so long for central banks to start to use negative interest rate policy suggests this is probably what they believed.

But it appears that a negative policy rate does put more downward pressure on longer term interest rates than a zero rate. This can be explained by thinking about the implications for asset market equilibrium: the set of asset prices in the economy that eliminates arbitrage opportunities.

Although financial institutions in aggregate must hold the total amount of reserves the central bank decides to create, the asset market

Indeed, it does, which is why negative interest rates really only exist in the world of central banks. Central banks usually operate monetary policy by setting a target interest rate in the overnight market in which financial institutions borrow and lend central bank reserves or de-posits among themselves. Because the central bank, by increasing or decreasing its assets, can control the total amount of reserves (a liability on its balance sheet), it can also set the price (interest rate) attached to those reserves.

Not much in the economy depends directly on the overnight interest rate in the inter-bank market. But the entire term structure of interest rates, which does influence lending and borrow-ing decisions in the real economy via arbitrage, takes its cue off this rate. By influencing the public’s expectations of the future path of the overnight rate, central banks can influence eco-nomic activity.

Pre-crisis, central banks such as the Federal Reserve or the Bank of England set a positive interest rate and adjusted reserves to be just in line with minimum reserve requirements (which they also set). Then, after the crisis, many central banks, after cutting their policy rate to or close to zero, started to expand their balance sheets, creating large amounts of excess re-serves (quantitative easing or QE).

It is but a short step from there for the central bank to apply a negative interest rate to the reserves it creates, as the Bank of Japan (since January 2016), the ECB (since June 2014), and several other European central banks have done.

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in order to earn a normal rate of return in such a situation.

But, as the BOJ has shown, in order to push down the yield curve, central banks need only impose a negative interest rate on the marginal reserves they are creating. The “tax” imposed is minimal and, with lower funding costs for banks and lowers borrowing costs for borrowers, the amount of bank lending generated over time is likely to be higher than it otherwise would be.

My criticisms of negative interest rate policy are different and two-fold.

First, negative interest rate policy may be too complicated and counter-intuitive to be worth the trouble. The efficacy of monetary policy rests largely on the central bank being willing and able to communicate clearly and effectively with the public. The Alice in Wonderland nature of the concept of negative interest rates, and the complicated nature of the schemes for imple-menting it, seem to be at odds with the canon-ical principles of modern central banking: keep things as simple and transparent as possible.

But, more to the point, if central banks need to resort to such a controversial, complicated and counter-intuitive tool as negative interest rate policy, this long after the Global Financial Crisis and the Great Recession, doesn’t this argue for fiscal policy to be mobilized much more actively to try to restore economies to full employment as quickly as possible? The more central banks venture into new uncharted monetary waters, the more compelling the case for expansionary fiscal policy becomes.

equilibrium associated with a negative interest rate being applied to those reserves will differ from the one associated with a zero interest rate (or a positive rate).

Take a 10-year government bond, for instance, and assume the policy rate is zero. In equi-librium, by definition, a financial institution holding that bond has to be indifferent between continuing to hold that bond and selling it to the central bank and receiving a deposit at the central bank in exchange. If the central bank now sets a negative interest rate on reserves, holding reserves becomes less attractive than before and holding 10-year bonds will have to become a little less attractive too—that is, bond prices will have to rise or yields fall—in order for asset market equilibrium to be restored. This yield-curve-depressing effect of negative interest rate policy has been so successful that in several countries long-term bond yields out to 10 years or more have been pushed into nega-tive territory.

A commonly-heard criticism of negative interest rate policy is that it represents a “tax” on banks and crimps bank profit margins. The possible re-sult could be counterproductive, leading banks to lend less, not more.

These arguments seem suspect. True, central banks could force banks to hold a very large amount of reserves and could impose a large negative interest rate on those reserves. Given that the zero bound is more binding on the liability side of the banking system’s balance sheet than the asset side, in competitive equi-librium banks might need to raise lending rates

Dr. Paul Sheard, PhD

Executive Vice President,

Chief Economist,

S&P Global.

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The negative interest rates introduced by a number of European central banks are one of several headwinds

that are materially dampening banks’ earnings prospects. “Less than zero” is combining with a lengthy list of challenges for the banking industry: restructuring charges, new forms of competition (e.g. FinTech), required investments in digital transformation, litigations, regulations, and modest economic growth, to name a few.Overall, negative interest rates are starting to weigh heavily on the net interest margins of many banks, including retail banks with large customer deposit bases. Those banks, so far, have refrained from passing negative rates to retail depositors. We don’t expect this erosion in the net interest margin to abate until the yield curve steepens again, especially as competitive

pressures in a number markets re-duce banks’ ability to re-price their loan portfolios.

On a more positive note for Eurozone banks, the European Central Bank announced in March 2016 a second-step initiative to alleviate some of the earnings pres-sure linked to the negative rates and the volatile market conditions

of the beginning of the year. The program is the second part of the targeted long-term refinancing operations (TLTRO II), following the original TLTRO of 2014. TLTRO II will take place in phases every quarter between June 2016 and March 2017. Under this initiative, banks may borrow money from the ECB at a negative interest rate of poten-tially up to negative 40 basis points under certain conditions. The bank not only receives funding to lend, but also a negative interest rate for the act of borrowing. (TLTRO I had low rates, but they were positive).

The amount of money a bank can borrow from the ECB under TLTRO II, and the size of the negative rate, are a function of several inputs, in-cluding the size of and growth in the bank’s corporate and non-mortgage retail loan book. Assuming fully re-paid funds from the first TLTRO, we estimate that eurozone banks could borrow up to €1.7 trillion under this new program.

Still, while the potential pre-tax boost is not insignificant

Plenty of incentives to loan out money aren’t offsetting the European banking sector’s many hurdlesBy Alexandre Birry

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We see the policy of negative inter-est rates supporting the economic recovery of countries like Ireland, Spain or Portugal for instance. Decreasing economic risks are evi-denced by the trends in our Banking Industry Country Risk Assessments.

However, in some other economies that have been stronger, we see a risk that a prolonged period of negative rates could contribute to the build-up of pockets of risk, whether it is in terms of rising asset prices or debt accumulation. Such a development is always possible in implementing common monetary policy in a group of countries that can otherwise have very different economic realities.

Could European banks increase activities with higher risk profiles to offset margin pressure? We don’t see at this stage any widespread signs of increased risk appetite although this may gradually mate-rialize. We remain concerned about a potential mispricing of risk that might go along with a new aggres-siveness to chase higher yields.

Negative interest rates may or can will lead to other steps as banks try to cope with reduced margins. Banks could introduce or increase fees and commissions to offset the margin pressure. But the biggest push, we believe, is that banks will

—especially considering funding conditions earlier this year—we estimate that this would only offset a small part of the overall drag of the negative rate environment on European banks’ earnings.

Despite the low rates, we haven’t yet observed any shift in customer savings away from bank deposits, in part due to the low yields also offers by alternative investments. However, cross-border interbank markets remain subdued, with amounts deposited by banks with the ECB on a materially upward trend again since mid-2015. This is in conflict with the goals of negative interest rates, which are specif-ically aimed at incentivizing any sort of lending and discouraging deposits with the central bank. But despite monetary union, the level of cross-border trusts remains strained in the Eurozone.

The silver lining of low and—more recently—negative interest rates is that the cost of risk of systems that suffered a material stress in the past few years has been decreasing sharply. For the European systems that weathered the crisis better, the cost of risk has reached cyclically low points. For the top 50 European banks, we expect loan impairment charges in 2016 to be more than 40% less than in 2013.

continue to place greater emphasis on cutting costs. They will do so at a time when the return on equity of the top 50 rated European banks averages a paltry 6%, with stricter regulatory capital requirement another material factor in this equation.

There also may be a consolidation phase in some markets. But that will be dependent on several fac-tors, including whether the current regulatory uncertainty around ulti-mate capital requirements abates quickly and decisively enough. That uncertainty will hinder what other-wise might be a robust M&A market in the banking sector.

Alexandre Birry

Senior Director banking sector, S&P Global Ratings, London.

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The impact of the negative interest rate policies implemented in Japan in January does not appear to

be producing the goals sought by the country’s central bank.

Although the negative interest rate policy was new when it was intro-duced in late January, it was imple-mented in a country that has had many years of ultra-low interest rates. The change was announced January 29 at noon when the Tokyo stock market was still open.

On that day, the 10-year JGB note was yielding 0.22%; that declined to 0.095% after the announcement. By mid August the rate stood at negative 0.1%.

Signs of a boost in the economy as a result of the shift have been diffi-cult to discern. The Nikkei 225 stock index stood at 17,041 one day be-fore of the announcement. It rose to

17,518 on the announcement date, but was below 17,000 by mid-Au-gust, while other indices, like the S&P 500®, were higher during that period.

There has been an increase in lend-ing by Japanese banks, but through March—the latest available fig-ures—lending is up only 0.2% since the introduction of the negative interest rate policy.

The conclusion of the Tokyo re-search team is that interest rates have not given any apparent lift to the Japanese economy. GDP (real) growth rate remains weak. At 2Q2016 (apr-Jun) it indicated +0.0% growth.

Meanwhile, CPI declined to -0.4% (Jun) from 0.0% (Jan), and the na-tion’s unemployment rate remain almost unchanged at 3.1% (Jun) while 3.2% in Jan.

We also believe the negative inter-est rates have had the unintended effect of creating uncertainty in both the household and corporate sectors, both of whom are carrying significant surplus savings. For example, that 0.2% increase in lending was accompanied by an increase in bank deposits of 5.6% during that period.

We have significant concern for the health of Japanese banks under the current interest rate structure. There are two impacts: direct and indirect.

We estimated in a paper earlier this year that the major Japanese banks’ decline in core profits as a direct result of the negative inter-est rate policy—which is defined as lower interest rates applied on current accounts with the Bank of

Japan’s negative interest rate policies show few signs of boosting the economyBy Ryoji Yoshizawa

20



Table 2: Standard & Poor’s Estimates Of Declines In The Core Profits Of Japanese Banks (Percentage And Amount)

Percentage Estimates

Major Banks Regional Banks

Initial phaseAfter the remaining

terms of existing bonds have lapsed



1. Percentage of decline in core profits—direct impact (lower interest rates applied on current accounts with the BOJ) (%)

-0.78% -0.78% -0.29% -0.29%

2. Percentage of decline in core profits—indirect impact (%) -7.60% -11.13% -14.85% -20.77%

2a. Decline in interest income due to reduced NIMs of yen-denominated loans -6.72% -6.72% -13.86% -13.86%

2b. Decline in interest income due to reduced NIMs of yen-denominated bonds -0.88% -4.41% -0.99% -6.91%

Total: Percentage of decline in core profits (operating profits before loan loss provisions) (%) -8.38% -11.91% -15.14% -21.06%

Percentage Estimates

Major Banks Regional Banks





1. Amount of decline in core profits—direct impact (lower interest rates applied on current accounts with the BOJ) (¥ Mil.)

-20,072 -20072 -3,709 -3,709

2. Amount of decline in core profits—indirect impact (¥ Mil.) -195,723 -286,644 -190,279 -266,215

2a. Decline in interest income due to reduction in NIMs of yen-denominated loans -172,993 -172993 -177,622 -177,622

2b. Decline in interest income due to reduced NIMs of yen-denominated bonds -22,730 -113651 -12,656 -88,593

Total: Amount of decline in core profits (operating profits before loan loss provisions) (¥ Mil.) -215,796 -306716 -193,988 -269,924

Operating profits before loan loss provisions (fiscal 2014; ended March 2015) (¥ Mil.) 2,574,900 1,281,700

Reference

Increase in unrealized gains on holding yen-denominated bonds.(These figures are for the initial phase. The figures will gradually become zero when the bonds mature at the end of their respective assumed durations.) (¥ Mil.)

283,702 309,610

Duration of yen-denominated bonds (year) 2.5 3.5

21



makes up a more significant part of their overall profitability compared to major banks.

Those banks already were dealing with issues of low profitability. A group of major banks tracked by S&P Ratings saw their consolidated net operating profits before loan loss provisions drop 5% year-on-year for the 12 months ended March 31. For a group of 15 rated regional banks, gross operating income during that period was down 1.9%, and pretax net income was down 1.3%. In both cases, an analysis shows that low interest rates and low NIMs were clearly major contributors to the poor performance, 10 months of which occurred before the introduction of negative interest rates.

Japan—would be 0.78%, immedi-ately and later.

But the indirect impact is far great-er. We are projecting that lower in-terest rates will squeeze the banks’ net interest margins from loans and bonds, and that the impact would be a negative 7.6% immediately, and 11.13% by the time various debt instruments have reached maturities. For regional banks, the impact is far greater: 14.85% im-mediately, and 20.77% by the end of all maturities. As we wrote in a report: “Further declines in NIMs from yen-denominated assets at Japanese banks will directly lead to further weakness in their profit-ability—the first pillar of loss-ab-sorbing capacity—unless banks increase income from noninterest sources, such as fees, or reduce expenses and other outflows.”

But the lack of many of those noninterest options is why we see regional banks getting hit harder. Their yen-based interest income

Ryoji Yoshizawa

Senior Director banking

sector, S&P Global

Ratings, London.

22



Money market funds (MMFs) are well-regarded by investors as an alternative to bank deposits for short-term

cash management. Investors benefit primarily from a diversified portfolio of high-credit, short dated liquid assets that seek to provide them with stability of capital, provision of liquidity and a return. Over the last eight years of ultra-low or negative interest rates, these objectives in major markets have been challenged. But for euro-denominated funds, it is business as usual, despite negative interest rates.Money market funds—seeking to provide a return slightly exceeding cash but with the idea of cash-like stability—can not control the actions of central banks. When those banks go to negative rates, all short-term investments follow suit. So what have European funds

undertaken to mitigate the effects of negative interest rates?

One of the key distinguishing characteristics of European MMFs is their valuation method-ology. A European fund can either be a CNAV (constant net asset

value)—which is the current basis for funds in the U.S.—or it can be a VNAV (variable net asset value) structure. (Later this year, U.S. rules will require that institutional money market funds be more like a VNAV, though the rule will not apply to retail funds.)

A CNAV MMF seeks to maintain an unchanging NAV (for example, $1, €1, or £1 per share) at all times, and uses amortized cost accounting to value all of its assets. A CNAV fund is also commonly linked to the phrase “breaking the buck,” a term that references when a fund’s NAV per share falls below 0.9950, as was the case for the Reserve Primary Fund following the Lehman Brothers collapse. But a VNAV MMF generally uses mark-to-market accounting to value its underlying assets, so seeing a declining share price is not considered a momen-tous failure, in the same way for CNAVs.

European-based CNAV funds, in order to try not to have the NAV drop below €1 in an era of negative

Pay me to give you back less than what you gave me: the new era for money market investorsBy Andrew Paranthoiene and Emelyne Uchiyama

23



interest rates, began in late 2013 to find ways to manage negative yields. Following shareholder ap-proval, “share cancellation” mecha-nisms were introduced to a majority if not all euro-denominated CNAV money market funds.

Share cancellation is a method used by operators of CNAV MMFs to stabilize the NAV of the fund at 1.00 per share when a fund is encoun-tering negative yields. The negative income rising from negative interest rates is transmitted to sharehold-ers in the form of fewer shares. For example, if a fund has a -0.10% negative yield, the fund could effect a share cancellation so that each investor in the fund would own 0.990 shares worth €1.00 per share instead of 1 share worth €0.990. With added disclosures in pro-spectuses, investors are now fully aware that their principal is being eroded by continued investment in negative-yielding, share-cancelling money market funds. (And if you add in management fees, the rate of that erosion accelerates).

For VNAV funds—generally is-sued with a NAV per share of €1,000.00—such steps were not necessary, as they had always allowed for market movements to be reflected in the NAV. In an envi-ronment of negative income being “earned” by the fund, the NAV will slowly trickle down to accurately reflect that yield.

It’s worth noting that not all MMF jurisdictions have allowed this CNAV share cancellation mecha-nism; regulators in the U.S., U.K and Japan have not granted approval. Many Japanese money market

number of high credit quality short-term issuers in Europe, by diversi-fying into assets from around the world.

The result? For those EUR-denominated rated MMFs, the aver-age net 7-day yield is -0.25%, still a better return than a bank deposit on a relative basis. The average ‘A-1+’ portfolio credit quality is 60%, with the remainder in ‘A-1’ invest-ments, indicating a significant level of safety and 7-day liquidity (level of assets maturing) averaging 30%, according to S&P Global data.

Money market funds continue to be attractive to institutional investors, despite negative yields, as investors have accepted negative market yields as a tax on savings. However, a long-term era (think “lost-dec-ade”) of negative returns could eventually see investors realize that investments need to have a positive return and will look elsewhere. For now, it’s business as usual.

funds, faced with the negative in-terest rates in that country, either have shuttered or are set to close operations and return money to shareholders.

But the flexibility provided in the VNAV structure has not protected all European money market funds. The universe of S&P Global Ratings MMFs denominated in euros has shrunk since the advent of nega-tive yields, primarily as sponsors rationalize their product offerings or choose to have a more flexible investment approach not suited to being assessed under our money market fund criteria.

Many MMF managers believe nega-tive rates will continue for the fore-seeable future and may fall further. Investors have become more accus-tomed to negative yields and thus, fund managers can concentrate on providing liquidity and a diversified portfolio. Credit quality has been maintained, despite a reducing

Emelyne Uchiyama

Associate Director, S&P Global Ratings, London.

Andrew Paranthoiene

Director, S&P Global Ratings, London.

24



Ultra-low to negative interest rates may have sweeping consequences for the business models of many European

insurers, especially traditional life players. Players in that sector offer savings products with guaranteed returns and rely heavily on investment returns to match those guarantees. Based on our analysis of the life insurers we rate in Europe, and given our economists’ interest rate expectations, we believe that the current interest rate environment will remain the number one source of risk the companies face for the next several years at least.

Such investment conditions grad-ually weigh on insurers’ investment returns. We estimate that overall, fixed-income running yields within Europe life insurers investment portfolios have fallen at an annual average of 10 to 30 bps over the past three years. At unchanged

asset allocations, this downward trend is likely to continue.

For European markets featuring high guarantees, investment re-turns for traditional life insurers so far have remained higher, on average, than guarantees to pol-icyholders. However, investment spreads above guarantees could decline further, prompting insurers to rely increasingly on other margin sources, such as fees and technical margins. For markets with lower average guarantees, profit-sharing with policyholders and competition are generally stiff, leading insurers

to retain narrow investment mar-gins once they allocate their annual share to policyholders.

As a consequence, the earnings potential and capital adequacy of insurers more exposed to interest rate risk in our view will continue to gradually trend lower. The risks are greatest for those insurers whose capital adequacy, earnings diversity, and management actions are likely to fall short in counteracting low interest rates. How each insurer’s products evolve in their features, pricing, guarantee structures and asset allocations will also play a major role in how they weather these conditions.

The life insurers that are most exposed to interest rates are those with a traditional long-term savings business with guaranteed rates. The higher and longer the guaran-tees offered, the greater the pres-sure on capital and earnings. Other factors that may make one insurer more vulnerable than another are asset-liability duration mismatch-es, product mixes, how prudently

European life insurers adjust to the reality of “lower for longer” interest ratesBy Lotfi Elbarhdadi

25



largely depend on the effectiveness of insurers’ management actions. Directly in response to interest rate risk, insurers in Europe have been reacting with a range of measures such as guaranteed rate reduc-tions on new business, a reduction in crediting rates on the inforce policies, the creation of additional reserve buffers, and policyholder reserve reinforcements. We are also seeing product shifts, for example, toward unit-linked busi-ness, as well as lower volumes on guaranteed business, new product development, and to some extent the increased use of hedging strat-egies. Not only that, but insurers are also exploring new investment allocations, albeit gradually, with more credit and market risk, such as investments in longer-term or less liquid assets.

Policymakers across Europe have also been working on several fronts to reduce potential risks to insurers’ solvency ratios, while fulfilling their consumer protection mandate. So far, their actions have been a mix, encompassing enforceable meas-ures to reduce guaranteed rates on new business, recommendations to take certain actions geared toward building stronger reserve buffers, incentives to protect port-folios against interest rate risk, and options to offer to policyholders conversion of guaranteed insurance policies into less capital consuming unit-linked ones.

each insurer manages its risks, and capital adequacy.

According to our estimates and market data, the countries with the highest and longest traditional savings guarantees in exist-ing business portfolios include Germany, Austria, Belgium, the Netherlands, Norway, Denmark, Finland, Switzerland, and Sweden. Countries such as France and Italy feature lower long-term guarantees on average. Spanish savings prod-ucts offer relatively high guaran-tees, but practices pertaining to the matching of assets and liabilities are stringent enough to limit rein-vestment risk. The U.K. life market has long been gearing toward unit-linked contracts where the policy-holder bears the investment risks, and consequently carries relatively low exposure to interest rate risks.

If ultra-low to negative interest rates persist at lower levels than our expectations, this could lead to further slides in capital adequa-cy assessments and ultimately to more pressure on insurance company ratings over the next two to three years. But the industry is not a monolith; looking at insurer balance sheets on a case-by-case basis, we see a wide variation in interest rate risk and balance sheet strengths.

The degree to which insurer fi-nancial strength remains resilient in the face of low yields will also

Lotfi Elbarhdadi

Analytic leader, Insurance sector, S&P Global Ratings, Paris.

26



Negative interest rates have the potential to force a significant change in the current business models of multiple financial in-

stitutions. In particular, issues of asset liability management (ALM) to compen-sate for low or negative interest rates have risen to a position of importance greater than usual as asset managers deal with this new world.

Under low and negative interest rates, ALM is becoming a challenge for all kinds of financial institutions. Banks, insurers and asset manag-ers need to properly model their assets in conjunction with liabili-ties. There are risks from depositors (bank runs), insurance policy hold-ers (the guaranteed rate of return) and investors in asset instruments (redemption, possibly in a rush). All these risks are different, but all cre-ate an impact on the liability side of the ledger.

Negative and ultralow interest rates are leading insurers to re-risk their investment portfolios to help off-set negative yields. This proactive attitude toward risk is increasing investment allocations to certain asset classes that are more illiquid and exposed to credit risk, such as high yield bonds, commercial real estate and private equity stakes, but which have a greater yield.

The threats to the current business model are plentiful. Take banking as an example. Negative rates—which

have not yet seeped down to the retail level in Europe or Japan, but can effectively show up in less transparent ways, like additional fees—can discourage customers from depositing funds in a bank. Depositors can favor the use of cash, more formally known as “cur-rency substitution.”

Deposits have always been consid-ered a cheap and stable funding source for the banking sector, far more attractive than raising funds in capital markets. It is a permanent and sizeable source of funding, constituting approximately 85% of their liabilities. But it’s threatened if banks start to pass on the cost of negative interest rates to their customers to a greater—or more transparent—degree than usual.

So European banks need a different approach to model the behavior of their depositors. Asset managers will need to rethink their business models to compensate for the low return on investment. One likely course: revisiting their management fee structures, and looking to other

Asset managers widen their scope of investments— and their risk appetite— to compensate for ultralow and negative interest ratesBy Cristiano Zazzara

27



Low returns and worsening liquidity in the corporate bond market can make asset sales difficult for man-agers. As a result, some investment funds that offer daily redemptions have expanded their investments in high-yield corporate bonds—which carry lower liquidity—in order to sustain returns. It’s a new risk di-mension in the funds industry, and if it leads to a temporary halt in re-demptions —a generally last-ditch step by an asset manager—it can propagate further systemic risk in the financial markets.

In the insurance sector, the funda-mental structure is that there are liability-driven investors seeking to generate returns in order to meet liability cash flows that are usually based on guaranteed policy rates. Asset managers need to manage a duration gap between assets and liabilities of 3-5 years on average, with the asset maturity being short-er than the liabilities. By definition, ALM risk is always a key factor, re-gardless of interest rate. The ability to re-risk will be determined in part on the insurer’s capital position, since the larger the company, the greater the regulation on their capi-tal positions.

The risks of longer maturity assets were very much on the minds of the Dodd Frank-created Financial Stability Oversight Council. In an April report, the Council noted the risks of funds holding less stable assets. “Investors in funds with

similar revenue-generating activi-ties. For example, advisory services could end up playing a more crucial role, and the quality of that advice would serve as a differentiator of an asset manager’s value.

Money-market funds have seen the impact of low interest rates in the Japanese sector starting in the 90’s, during the first phase of monetary easing there. After these many years, funds have not been able to successfully manage the transition, and most of them have disappeared; the remainder are struggling. Asset managers in Europe, and to a lesser degree the U.S., may now be forced to change their business models, hopefully with greater success than their Japanese counterparts, seeking to increase returns by extending the maturity—and by extension, the risk—of their mostly fixed-income holdings.

The concern for a fund manager going deeper into the curve and away from highly-liquid short term holdings, long the key asset for money market funds, is that faced with a request for redemptions, the market for longer-term debt instru-ments will be nowhere near as liq-uid as the assets traditionally held by these funds. Several funds, with illiquid holdings, have been recently liquidated due a large number of redemption requests; the demise of one of the Third Avenue funds is a prime example.

substantial holdings of less-liquid assets may have a greater incentive to redeem in periods of market stress,” the report said.

The report didn’t mention ultralow or negative interest rates. But the link can be drawn from its pages: low yields lead to more risk-taking which can lead later to redemptions of higher-yield instruments. Those redemptions may run into illiquid markets, and the contagion may spread. policies into less capital consuming unit-linked ones.

Cristiano Zazzara Head, Global Risk Services

Relationship Management,

S&P Global Market Intelligence,

London.

https://www.linkedin.com/pulse/what-high-yield-bond-fund-crisis-says-broader-market-john-kingston?forceNoSplash=true

https://www.linkedin.com/pulse/what-high-yield-bond-fund-crisis-says-broader-market-john-kingston?forceNoSplash=true


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