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Low & Negative Interest Rates Get Broadsided by the BIS

Summary:
They undermine banks. To dodge the fallout, banks chase yield, buying stuff like CLOs, instead of lending. When loans go bad, banks may “evergreen” them.  By Nick Corbishley, for WOLF STREET: Prolonged low interest rates are having significant negative effects on banks’ core business and role in the economy, the Bank of International Settlements (BIS) warned in a new paper, just weeks after the ECB reduced its policy rate deeper into the negative after a tumultuous meeting where ECB president Mario Draghi steamrollered a veritable palace revolt. According to the BIS paper, which is based on a sample of all major international banks over a 22-year period from 1994 to 2015, if the benchmark interest rate falls from 3% to 0%, the average net interest margin declines from 1.42% to 1.31%

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They undermine banks. To dodge the fallout, banks chase yield, buying stuff like CLOs, instead of lending. When loans go bad, banks may “evergreen” them. 

By Nick Corbishley, for WOLF STREET:

Prolonged low interest rates are having significant negative effects on banks’ core business and role in the economy, the Bank of International Settlements (BIS) warned in a new paper, just weeks after the ECB reduced its policy rate deeper into the negative after a tumultuous meeting where ECB president Mario Draghi steamrollered a veritable palace revolt.

According to the BIS paper, which is based on a sample of all major international banks over a 22-year period from 1994 to 2015, if the benchmark interest rate falls from 3% to 0%, the average net interest margin declines from 1.42% to 1.31% of total exposure. That’s in the short term. The long-term effect is many times larger owing to the high auto-correlation of the net interest margin. Banks’ average interest income falls from around 60% of total income to around 40%.

This is just one of the problems highlighted by the BIS study. Another major concern is that many banks, in their desperate quest for profits, opt to shift their focus away from lending to their customers toward trading activities, which can generate higher yields and fee-based income. It also tends to boost stock, bond and real estate markets, as well as stimulate demand for professional portfolio management services.

In the short term, trading in stocks, bonds, derivatives and other financial instruments may allow banks to offset their declining profits on their interest spread. If the benchmark interest rate decreases from 3 to 0%, trading profits as a proportion of total income increase from 2.5% to 3.2%. But it also opens them up to greater risk, especially if they chase yields offered by more speculative financial products such as Collateralized Loan Obligations (CLOs) backed by corporate junk-rated leveraged loans

The one thing many banks are not doing is precisely what the central banks want them to do: lend more to businesses. This “credit intermediation” is the essential role commercial banks perform in the economy by taking short-term deposits from business and retail customers and lending the cash out long-term. Put simply, they “intermediate” between people who have money to lend and people who want to borrow money. A bank puts its depositors’ cash to work in the economy by making loans to finance the construction of, say, a factory or an office building or the purchase of a house. But it is this function that low and negative interest rates are making less and less profitable, while decimating savers along the way.

Banks, long accustomed to making money on the spread between the interest rate they pay on deposits and other funding sources, and the interest rate they charge, realize that most retail customers won’t accept negative interest rates on their deposits. Rather than paying for depositing their funds or savings, they’ll take their money out. The German government, in a bid to placate the country’s legions of long-suffering and increasingly irate savers, has even threatened to outlaw negative deposit rates altogether.

The result is that banks cannot lower the rates they pay on deposits any further, which puts a floor under the cost of funding for banks. But at the same time, the banks face growing competitive pressures to lower the interest rates they charge on loans, such as mortgages, and the spread further contracts, making it harder and harder for banks to extract profit, particularly in the retail segment.

Capital-challenged banks are particularly liable to cut lending when interest rates fall, perhaps in order to restore — or at least try to restore — their regulatory capital ratios by shifting their exposure from loans with high risk weights to investments that carry a lower risk weight such as sovereign bonds. Some studies have suggested that corporate loans are more sensitive to the interest rate environment than mortgages and consumer loans.

Another way banks are offsetting their shrinking interest rate margins is by ramping up fees on the basic services they offer, including lending to businesses and households, with the result that actual borrowing costs in the economy remain relatively high even as the benchmark rates fall, negating one of the ostensible aims of the central banks’ low or negative rate policies: to boost lending. According to the BIS report, if a benchmark interest rate decreases from 3% to 0%, average fee income increases in the short term from 14.2% to 15.2% of total income.

But ramping up fees is a short-term solution that can’t mitigate the banks’ gradual loss of their core business model: their credit intermediation role. As this model is further eroded away by the central banks’ low and negative interest rates, many banks get weaker. Ominously, the report warns, provisions against losses on lending have fallen, which may indicate that potential problem loans are being repeatedly rolled over (referred to as “evergreening”) as a means of obscuring the rising risk on their balance sheet.

The sample period of this BIS study ran to 2015, meaning that the problems identified in the study are likely to be even worse today, especially as interest rates have plumbed new lows in some jurisdictions. In its conclusion, the BIS report suggests that national central bankers should be alert to the risk of evergreening, but even as lenders in Europe and Japan scream for an end of the negative-interest-rate policy, the report fall short of cautioning those same central banks against cutting interest rates any lower. By Nick Corbishley, for WOLF STREET.

A gigantic spike in three years. Read… Interest Rate Derivatives Trading Explodes to $6.5 Trillion/Day

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Low & Negative Interest Rates Get Broadsided by the BIS

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