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05/20/2015

Negative Interest Rates

An analysis of how the combination of a struggling economy and aggressive central bank action has led to government bond yields going below zero and how it can impact Belgian banks’ bottom lines.

Introduction

After the financial and economic crisis, central banks and governments were urged to take a number of measures aiming at economic revival. This has led to increasingly unconventional monetary policies with quantitative easing in both the US and Europe being one of the most notable ones. Such measures have had a strong impact on the financial markets and global economy. While stock markets are reaching all-time highs, bond yields have been steadily decreasing over the last few years. Recently, this has led to an interesting phenomenon that many economists did not even consider possible in reality: a world of negative interest rates.

A negative interest rate environment

Getting to a negative interest rate environment

First of all, interest rates are driven by the simple economic laws of supply and demand. The poor economic outlook that prevailed in Europe after the crisis has made many investors reluctant to risky investments. This risk averse behavior increased the demand for government debt, which has been especially the case for government bonds of well-run northern European countries that are generally considered as ‘safe’ investments.

This escape to safer, low-yielding products did not facilitate the economic recovery the ECB was hoping for after the crisis. On top of that, large parts of Europe were struggling with falling inflation (or even deflation). Therefore, policy makers had to find ways to force investors to take more risks again and support the economy. Aggressive central bank actions, such as quantitative easing, are explicitly set up with the aim to decrease interest rates in the hope that more money would flow to the real economy again. The combination of risk-averse behavior after the crisis and these central bank actions, has ultimately led to interest rates going below zero.

The below figure illustrates this for government bonds of a set of European countries. After the start of QE in Europe, we can notice that interest rates, even for longer-term maturities, are already below zero for a large number of European countries. With a negative interest rate on government bonds with a maturity of 5 years, Belgian government bonds seem to be considered as a safe investment by investors

Sustaining a negative interest rate environment

To understand how such a situation can be sustained, it is important that we ask ourselves the question who would be willing to invest in a product with a negative interest rate. Although it may not seem to be the best investment opportunity at first sight, there are some very good reasons why these products are bought on the market.

A first obvious explanation is the fact that certain institutions, such as pension funds and mutual funds, have rules in place that obligate them to hold a certain percentage of these “safer bonds”. Obviously these rules were not designed at a time that a negative interest rate was considered possible, yet these institutions have to deal with the realities of today. But banks face a similar problematic. As banks are not allowed to store their “excess cash” on a regular bank account, they tend to deposit it at the ECB. Since the interest rate for deposing money at the ECB is even lower (more negative) today, banks have a good reason to invest in government bonds with low or even negative yields.

Apart from these more legally-driven incentives, there are also investors that deliberately opt to invest in these products. A number of reasons can be identified why someone could consider it interesting to invest in negative yield bonds. First of all, some investors anticipate the fact that QE will make the ECB buy a large amount of European government bonds, pushing the prices of these products higher and allowing them to reap a capital gain that offsets the negative yield. Secondly, the ultimate yield for investors also depends on the inflation. If inflation is expected to be below bond yield, investing in bonds with a negative rate could still be a rational investment. Finally, the currency in which these bonds are issued can also affect capital gains. Investors looking for exposure to a currency which is expected to appreciate, are potential buyers of government bonds with a negative interest rate.

Opportunities and risks related to a negative interest rate environment

As already mentioned, central banks reinforce the general decrease in interest rates as it supports economic recovery by stimulating borrowing and consumption and discouraging savings. On top of that, keeping interest rates low can help to ease the public debt burden as governments benefit from lower borrowing costs.

On the other hand, (artificially) creating such an environment also entails several risks. Low interest rates do make it easier for governments to borrow but this “cheap access” to more funds can also foster state indebtedness. It may give national governments the false impression that local economies are recovering again, hence taking away the incentive to conduct the necessary structural reforms. Moreover, allocating billions of euros in bonds with a negative interest rate might not be the only alternative. Instead, policy makers should try to direct (at least part of) the available cash to projects that stimulate economic growth and job creation. Lastly, encouraging investors to take additional risks may help to form asset bubbles. In Belgium and the rest of Europe, stock markets have been soaring over the last few months and it is only a question if the current valuations can be sustained.

Impact on the profitability of Belgian banks

An important value driver for most retail banks is the net interest margin. The net interest margin, or yield spread, is the difference between the yield at which a bank borrows in the short term and the yield at which it issues long-term loans and makes investments. A decrease of this margin will negatively affect a banks’ profitability as the difference between the interest it is receiving and the interest it is paying out decreases. Interesting to notice is that a low (or negative) interest rate environment tends to reduce the net interest margin and consequently the banks’ profitability.

The graph below illustrates this principle. To clearly demonstrate it, we have used extreme values by taking on the one hand the yield on Belgian government bonds with a maturity of 1 year (short-term) and on the other hand the yield on Belgian government bonds with a maturity of 20 years (long-term). In this case, we can notice that interest rates have been steadily decreasing over the last few years, leading to a yield spread of 1,3% in May 2015 compared to 3,8% in May 2009. In other words, a decrease in margin between both products of almost 300%! Although such an extreme figure cannot be generalized for all products, it should be clear that a low interest rate environment can have a significant impact on the overall net interest margin and consequently the profitability of Belgian banks.

However, there are positive elements too from a bank’s point of view. Banks also take advantage of the positive economic consequences of such an environment thanks to increased borrowing and consumption by the public. This effect is likely to outweigh the negative impact on profitability caused by a decreasing net interest margin. However, by decreasing the net interest margin, we have to be careful that banks’ profitability does not take a too large hit at first which could discourage them to lend more money and would ultimately have a reverse impact on the economic recovery. The ultimate impact of an interest rate change on banks’ bottom line is likely to differ significantly from one bank to the other. Banks that heavily depend on the interest margin for profitability and for which an interest rate change does not significantly impact other income sources, will be more impacted than banks that are characterized by a more diversified revenue model or even hedge their interest rate risks.

This study aims to increase banks’ awareness of the consequences and risks of a long-lasting low interest rate environment. Although banks have already countered this evolution by charging higher fees or decreasing the interest rates on deposits, Sia Partners believes that banks should also look for more sustainable strategies to remain profitable in today’s economic environment. It is important that banks find the right balance between being compliant to capital requirements (e.g. Basel III) and reducing excess cash reserves. Furthermore, banks will have to play a central role in reducing the excess liquidity in the banking system. By borrowing less from the ECB, banks could put upward pressure on interest rates in the interbank and bond market and counteract the decrease in interest rates caused by aggressive central bank action such as quantitative easing.

Sia Partners

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