Part 1: Effect on Banks and Financial Institutions
In an increasingly desperate landscape, central banks around the world are scrambling to provide support to the economy. The possibility of negative interest rates, although noted as a last resort, is on the table, with the Bank of England open to the possibility of implementing it. Negative interest rates are essentially a below 0% target rate from central banks with the aim of stimulating spending and lending. How does this impact the financial sector, economy and markets in general? And more importantly, how is this going to affect the everyday investor? In Part 1 of this blog series, we’ll be going through the impact of negative rates on banks/financial institutions. Given that it is not a popular measure used by central banks historically, we will be relying heavily on the case studies done on Japan and Europe.
If central banks introduce negative rates, banks will be charged interest to maintain reserves at the central bank, which will ultimately reduce their income. Central banks do this to force banks to increase their lending activity and to hold non-cash assets, increasing the flow of funds through the economy. Theoretically, this process works, however when we analyse the impact of negative rates implemented by the European Central Bank (ECB) and Bank of Japan (BOJ) in the past, we will see that the theory does not play out as expected.
On 5th of June 2014, the ECB lowered the MRO rate to 0.15% and the DF rate to -0.10% and on the 16th of February 2016, BOJ dropped its CDF to -0.1%. Two of the ECB’s instruments include the Main Refinancing Operation (MRO) and the Deposit Facility (DF). The MRO provides the bulk of the liquidity to the banking system by steering short-term interest rate, and the DF is the rate banks use to make overnight deposits. Similarly, BOJ uses a Complementary Deposit Facility (CDF) to charge financial institutions on excess reserve balances.
As a result, there were three main effects on banks: negative impact on earnings, net interest margin squeeze and increased risk-taking.
Impact on Earnings
Negative interest rates push consumers and institutions to pull their deposits from banks or otherwise incur a fee. Freeing savings and deposits and spurring investment increases the money supply and flow of funds through the economy. However, when the ECB cut rates, not a single bank in Europe charged deposit fees to household and only a few banks charged non-financial corporations. The banks instead chose to internalise the costs by paying depositary fees out of fear customers will move their deposits into cash, causing liquidity issues for the bank. The banks had to forgo interest income and take up additional costs.
Similarly, in Japan, the negative interest policy implementation in 2016 saw banks pay on average ¥95m on central bank reserve fees, between 2016-2018. The underlying theory did not work; the banks did not pass on the costs to depositors, resulting in no flow of funds, no increased investment, and no increased spending. Consumers and institutions were too focussed on covering short term losses with the added fear of the expectancy of future income. We see market sentiment forces outweighing the theoretical benefits of negative rates.
Net Interest Margin (NIM) Squeeze
As rates get lower, a growing proportion of banks’ deposits are paying nothing (or close to), impacting their interest income. This is an adverse effect of cutting interest rates in general. We saw that when ECB cut rates, net interest margins were cut by almost 50%, increasing the vulnerability of banks and negatively impacting its earnings. Similarly, BOJ had been implementing various QE measures from the early 1990s, which saw the NIM gradually decreasing. Bank margins fell from 0.49% to as low as 0.22%, making it difficult for banks to earn profits forcing banks to look for profits elsewhere.
Similarly, following the financial crisis in 2008, the federal funds rate was cut to near-zero, forcing banks to operate under subdued net interest margins. As a result, the average NIM for banks in the USA shed nearly a quarter of its value before finally picking up again seven years later in 2015.
Increased Risk-Taking Activities
Negative policies drove a wedge between deposit and non-deposit funding costs, forcing banks to look for profit elsewhere. When JOB cut rates, Japanese local financial institutions lost their profit opportunities in the domestic market. Banks started exploring other markets in Emerging Asia, rather than those in advanced economies, where risks and the potential reward was higher. Japanese banks ended up financing firms with at least 16% higher ROA volatility and a 13% reduction in overall lending.
Net purchases of long-term foreign securities by life insurance companies in Japan almost doubled after the negative interest rates were implemented. The average monthly foreign spending was always around ¥50-100bn, but doubled to approximately ¥200bn following the implementation of negative rates.
Potential Impact on Australia
Cutting interest rates into the negative territory will see not only the big four banks, but other banks such as Macquarie Group and Bank of Queensland suffer given the direct effects of negative rates. The also directly impacts the broader market given that these large financial institutions have a combined market capitalisation of approximately $300bn and make up the top ASX stocks. They collectively employ approximately 170,000 people, hold roughly $2t in loan book for Australians and pay approximately $11.5bn in tax. They are also a core intermediary between other international institutions. Upon studying the impact on financial institutions in Japan and Europe, and also considering that banking is one of the largest industries in Australia, it is highly unlikely the RBA will cut rates to below 0%.