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Banking in a low and negative interest rate

environment

ING Group www.ing.com

Banking in a low and negative interest rate

environment

Banks carefully balance the interests of all parties—customers, shareholders, employees and the

community—every day. An environment of persistent negative interest rates demands a new

balance between these stakeholders. This document outlines the current situation (sections 1 to

6) and then sets out the trade-offs that banks face (section 7). The concluding section 8 lists some

considerations for the Central Bank.

Contents

1. History ................................................................................................................................................... 3

2. Positive effects of negative interest rates ..................................................................................... 4

3. The current interest rate environment and the policy response raise many questions ... 5

4. Monetary policy and professional markets .................................................................................. 6

5. Monetary policy and retail markets ............................................................................................... 7

6. The challenges for banks .................................................................................................................. 8

7. What can banks do to meet these challenges?........................................................................... 9

8. An exit strategy for the Central Bank? ........................................................................................ 12

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1. History

Since the crisis of 2008 and the recession of 2012, economic growth and inflation have been low

in many developed economies and not least in the eurozone. Consumption is recovering, but

high levels of unemployment and reduction of debt continue to press down on households in

many countries. Private sector investment remains weak as businesses see limited

opportunities for growth while some, in particular in the SME segment, are dealing with

weakened capital positions. Export growth is hindered by poor performance elsewhere in the

world. A number of European governments have given priority to putting their finances in order

and so were often unwilling or unable to give a short-term stimulus to the economy. Reforms

that will promote growth in the longer term are often difficult to implement because of the

short-term costs they involve.

Against this background, the ECB has decided to boost the economy by gradually reducing its

policy interest rates, currently to below zero, and taking unconventional policy measures such as

purchasing government and corporate bonds (quantitative easing - QE). These measures are

designed to increase demand so as to generate growth and inflation.

Markets currently expect that today’s low/negative interest rate environment will continue for

some years.

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2. Positive effects of negative interest rates

Partly as a result of the ECB’s policy, the cost of credit has fallen, lending terms have been

relaxed and demand for borrowing has increased in the eurozone since mid-2014. This has

contributed to economic growth. Low interest rates and economic growth have furthermore

ensured that households, businesses and government have been able to bear their debt burden

more easily. As a result, the number of non-performing loans has fallen at most banks and

financing or refinancing them has become cheaper.

Nevertheless, economic growth in the eurozone will still not take off and inflation is still

particularly low.

Note: Comparable data on non-performing loans before 2014Q4 are not available

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3. The current interest rate environment and the policy response raise many questions

Questions enough. About whether monetary policy can boost growth and inflation in the current

situation and the effectiveness of economic governance in the eurozone. And even about the

usefulness of the ECB’s 2% inflation target in times of low growth, overcapacity and an aging

population.

Here, we are concentrating on the effects of unconventional policy on the financial services of

banks and other financial institutions.

QE and the ECB’s negative deposit interest rates (currently -0.4%) have had some positive effects,

for example by weakening the euro and so improving Europe’s competitive position.

In our opinion, however, continuing this policy for too long or making interest rates too negative

is not effective and could even be counterproductive for the following reasons:

i) The collateral damage for individual and institutional savers is increasing. Actual and

expected returns on investments are not only falling for institutional savers (pension

funds and insurance companies) but at the same time the value of future liabilities on

their balance sheet are rising.

ii) At some point, banks may stop passing on low and negative interest rates in full to the

rest of the economy (see below).

iii) Consumers and businesses may not respond to negative interest rates or may react in

unexpected and undesirable ways. The possibility of a bubble in financial markets cannot

be ignored (see below).

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4. Monetary policy and professional markets

In the professional market, banks have already started to pass on negative interest rates to

customers. Increasingly, they are charging interest on credit balances held by financial

institutions and large companies.

At the same time, banks are discovering that some of their services are loss-making when

interest rates are low. In consequence, they may decide to end some services. This ‘unbanking’ is

an unexpected and often, from a social perspective, undesirable effect of negative interest rates.

Example: bank balances held by large businesses or financial institutions

The balances that large businesses or financial institutions hold at banks are often volatile: this

money rarely stands still for long. As a result, the bank cannot invest these funds in long-term

lending. The regulators will also not allow this. Consequently, the bank can do little else than hold

the money at the ECB at a negative interest rate. And, of course, this money held at the ECB is still

part of the bank’s balance sheet on which a percentage of capital has to be maintained.

The cost to the bank of these corporate balances:

0.4% negative ECB interest rate

0.4% cost of capital (4% unweighted capital ratio multiplied by an assumed 10% required

return on capital)

0.044% bank tax (rate for current liabilities)

The bank has already lost 0.84% in costs on these balances before a single euro of operating costs

have been incurred.

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5. Monetary policy and retail markets

While the ‘transmission’ of monetary policy is beginning to happen in professional markets, there

are obstacles that make this doubtful in retail markets. Applying negative interest to savings is

illegal in Austria, Belgium, France, Italy, Poland and Romania. In Germany it is legally

controversial (for existing accounts).

In addition, applying negative interest rates may be undesirable: this is a unique and possibly

destabilising experiment. The banks’ deposit base, always regarded as stable financing, may

shift. Customers are searching for alternatives to avoid negative interest rates and may end up

with less accessible or higher risk alternatives. The real issue is whether households will spend

their savings if they are faced with negative interest rates, which is in fact the aim of the ECB’s

policy. In fact, households may instead save more to make up for the lower return (the

behavioural response is determined partly by the question of what target and time horizon is

applied) or people will keep their money under the bed or invest en masse, possibly leading to a

bubble on the financial markets.

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6. The challenges for banks

Traditionally, the heart of banking is borrowing short and lending long. Demand or short-term

savings accounts often carry a variable interest rate that moves with the short-term money

market rate. Banks have longer term lending on the asset side of their balance sheets, often at

interest rates that are fixed for a number of years.

The difference in maturities between assets and liabilities is an interest rate risk. Long-term

interest rates on assets are, therefore, partly hedged: the interest rate risk is covered by interest

rate swaps. This hedging is not total, however, for example because the bank assumes that some

people will repay their mortgages early because of moving house or refinancing. As a result, even

after hedging, there is still a maturity gap between loans and advances and liabilities. Part of a

bank’s income comes from the interest margin between its short-term liabilities and its long-

term lending.

The LCR (liquidity coverage ratio) and NSFR (net stable funding ratio) ratios introduced recently by

regulators are putting this earnings model under pressure and the interest rate environment

adds the following challenges:

i) As the yield curve becomes flatter, the margin that a bank can earn between long-term

lending and short-term liabilities gets smaller;

ii) The ECB’s purchases of bonds has also cut the premiums on higher risk loans;

iii) Charging negative interest rates on bank balances is a novelty with unknown effects and

that faces legal obstacles in some places.

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7. What can banks do to meet these challenges?

Faced with a flat yield curve and negative market interest rates, banks can choose from a menu of

options:

Accept lower profitability

Investors are still demanding a return of about 10% (see for example, EBA survey and CAPM

analysis, p.58). If banks accept a lower return, this could cut off access to the capital market.

Lower profitability may also weaken the capital position in the medium term and adversely

affect banks’ lending capacity.

Cut costs

Many banks are busy with this, and the process has not yet ended. But of course there is a limit

to the scope for further cost reductions before service levels are affected.

Cut retail savings interest rates to or below zero

Banks are inclined to put this off as long as possible due to the stability of bank balances as a

source of financing and in the interests of savers. But if other options run out and negative

market interest rates persist, at some point banks will have no other choice.

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Increase lending fees

This is already happening in the Swiss (see BIS, How have central banks implemented negative

policy rates?) and Swedish mortgage markets and means that monetary policy focused on lower

interest rates will not, in the end, be passed on in banks’ interest rates on loans.

Find compensation from non-interest rate-related income

It is difficult to introduce charges if customers do not think they are getting better service in

return. In addition, these types of charges reduce transparency in the market, which would be an

unfortunate reversal of the trend of recent years.

Alter the composition of the balance sheet

Banks can change the risk and return profile of their assets, for example by focusing on different

types of credit or altering the geographical mix of the balance sheet.

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End certain services (‘unbanking’)

This would affect customers who have little requirement for borrowing but merely, on occasion

or permanently, want to hold money at a bank. These include, for example, private banking

customers who wish to spread their funds over several banks and, in the professional market,

investment funds that occasionally want to hold large sums of cash (see the above example).

Banks could move to pricing these deposit products unattractively for these customers or

imposing ceilings.

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8. An exit strategy for the Central Bank?

Recent comments by members of the ECB’s Executive Board (for example, Yves Mersch on 3 October)

indicate that the ECB is not planning to expand its unconventional monetary policy. It at least looks

as if it does not intend to reduce deposit interest rates further. The monthly purchase programme

currently runs until March 2017 and it is expected that it will be extended and that policy interest

rates will not go up for a considerable time thereafter. Even so, there is the issue of when and how

the ECB could phase out its current loose monetary policy. A number of questions play a role in this:

Although the loose monetary policy has probably contributed to boosting economic growth, the

ECB’s inflation target of “below but close to 2%” is still a long way off. Is an exit possible while

growth and inflation are not recovering across the eurozone?

The policy has several facets: a negative deposit interest rate of -0.4% for money that banks hold

with the ECB, monthly bond purchases of €85 billion and special ‘refinancing operations’ for

banks. In what order should these be phased out? How quickly? And how?

Will the positive effects of this policy referred to above go into reverse if the policy is phased out?

Specifically for banks: will credit losses start rising again?

How would phasing out the various policy elements affect the eurozone economy? Would the

positive and negative effects on the economy and financial system be spread evenly across the

eurozone countries (in particular between ‘north’ and ‘south’)? Are expectations on this affecting

wishes on ECB policy?

Sources of data: Macrobond, ING calculations. Data updated on 25 November 2016.

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