Is there a limit to the battle between borrowers and depositors?

As interest rates fall around the world to historic, even negative, levels, both public and technical debates are alive about the implications for banks.

As rates come down, there are winners and losers - good for borrowers, bad for savers. But when they come right down there is the further complication of the real world and theoretical world clashing.

" Even where bank profits are on the nose, near zero interest rates pose some radical new challenges."
Andrew Cornell, BlueNotes managing editor

In Europe and Japan, where official rates are negative, the major debates are on the implications for official monetary policy and the practical constraints of actually enforcing a negative rate. In the US, where rates are low but the economy more healthy, investors are becoming more tolerant of risk and hence intolerant of the extremely low rates on bank deposits, shifting funds into deposit alternatives.

In Australia, where the popular debate for the last couple of decades has privileged borrowers with a standard variable mortgage loan, the plight of depositors and the returns to shareholders take a much lower priority.

Depositors, who outnumber mortgage borrowers about four or five to one, or investors (whether direct or via superannuation funds) don’t receive the same support (which the banks also hope would deflect some of the criticism of lending rates).

But even where bank profits are on the nose, near-zero interest rates pose some radical new challenges.

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One is disintermediation. Australian bank chiefs (including ANZ boss Shayne Elliott) have made the point banks can’t just look after borrowers at the expense of lenders (depositors) because the lenders are needed to finance the borrowers.

As global regulation has changed in the wake of the financial crisis, domestic deposits, particularly longer term domestic deposits, have become much more valuable to banks as they are more stable (and hence given higher security ratings by regulators).

That means banks have been prepared to pay relatively more for deposits – although, because interest rates have fallen, nominal deposit rates have also fallen, just not as much as lending rates.

That sounds like good news for borrowers and – again relatively – less bad news for savers. Of course, savers are still not happy with the very low rates.

But now at near zero, market distortions are also coming into play. While it is theoretically possible to charge a negative interest rate on deposits – that is force savers to pay a bank to hold savings – in practice it has proved almost impossible.

That means as lending rates head down more, deposit rates start to level out. The result is less margin – and profits – for banks. But as Elliott and others have pointed out, depositors in such a situation might still elect to chase higher returns elsewhere and those deposits are needed for a bank’s key stable funding ratio.


But banks also make money from what is called ‘maturity transformation’ – they borrow their funding short term (this is the liability side of a bank balance sheet) and lend longer term (loans are the asset side).

Normally, shorter term interest rates are lower than longer term ones, often by a pronounced amount as longer term rates reflect the inflation expected over the next one, three, five, 10, 20 years.

So banks make money on the ‘spread’ between the lower and higher rates. But with inflation tending to zero (along with interest rates), this interest rate ‘curve’ is flattening out. That too means banks are making less from maturity transformation.

Like or loathe banks, healthy banks are essential for a healthy economy. The US’ pragmatic moves to stabilise its banks in the wake of the financial crisis, forcing them to write off bad loans and recapitalise, is a major factor in that economy outperforming Europe where the European Union didn’t take such tough measures and continues to have an anaemic banking system.

The complexities facing the banking system were laid out by Benoît Cœuré, European Central Bank executive board member last week.

“Low (and negative rates) have both a one-off short-term impact and more persistent effects on a bank’s profitability and capital,” he said. “And bank capital matters for credit provision and for financial stability, as low bank capital means high leverage.”

Cœuré ran through the snakes and ladders, noting falling rates raise the value of bank fixed-income asset holdings and also interest margins – but only initially.

“If the decline in rates is accompanied by a flattening of the yield curve, the margin between lending and borrowing eventually compresses, reducing net interest income,” he said.

Cœuré then discussed the “lower bound”: “Even for a given slope of the yield curve, a low level of interest rates can also compress net interest margins for banks reliant on retail deposits. The reason is that retail deposits tend to have low and sticky interest rates, and banks are reluctant to charge negative rates on them.

“As market rates decline, the yield on bank assets will eventually drop, but this funding source will still cost the same to banks, resulting in a decline in net interest margins. The decline in present and future net interest margin reduces the forward-looking measure of bank capital, hence the risk-bearing capacity of the bank, and its supply of credit.”


When banks lose income on their normal business, the response historically has been to take more risk in search of higher returns – something the central banks and bank supervisors are not keen to see happen.

“Challenges to financial stability could potentially materialise if banks were to increase their exposure to lower quality counterparties in order to boost returns,” Cœuré argued.

Cœuré then addressed the conundrum of disintermediation: banks face a choice between paying up for deposits and suffering margin decline; or not paying up and potentially seeing deposits flow out of the banking system. For the moment, he said, banks are electing to pay.

“This risk (of disintermediation) is not materialising mainly because rates on retail deposit seem to have a zero lower bound.”

He might also have added that the price of alternative assets to deposits has risen as interest rates have fallen – that is, whether it be hybrids or cash-alternative funds or other fixed income products, as more would be depositors look for alternatives and demand increases, prices go up and the yield on offer comes down. Such are market forces.

Critically though, Cœuré and others believe disintermediation, if it does loom, could have negative consequences.

“One might argue that disintermediation may have benign effects if non-bank entities are equally capable of collecting and channelling savings, while being less vulnerable to the adverse effects of negative interest rates,” he said.

“But there is a limit to this argument. Non-banks are also affected by very low rates: for example, fixed net asset value money market funds may not be able to maintain the value of their shares close to par, while asset managers and insurance companies face the same shrinking margins as banks.”

The banking sector tends to argue it needs to look after savers and investors as well borrowers when criticised in public. But financial stability too is at risk when the balance between the three stakeholders is distorted.

Andrew Cornell is managing editor at BlueNotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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