The negativity of negative interest rates

That’s because short-term interest rates are normally much lower than long-term ones and banks profit on the spread. Hence the old bankers’ joke about the 3-6-3 rule: borrow money at 3 per cent, lend it at 6. Be on the golf course by 3pm.

" Because inflation is so low and central banks are printing so much money, there is very little spread between short and long term rates."
Andrew Cornell, BlueNotes managing editor

Of course, plenty can go wrong. Loans can go bad. There can be a run on deposits, draining cash reserves. And today there is another issue: because inflation is so low and central banks are printing so much money, there is very little spread between short and long term rates.

It’s the negative 1-1-0 rule: borrow at less than nothing, lend for almost nothing. And no golf.

This Wonderland of negative interest rates is hitting bank profitability. Meanwhile, even though central banks are the ones driving rates negative in a bid to lift economic growth, those same banks are wary of unintended consequences, collateral damage and policy binds.

(Increasingly too, central bankers such as the US Federal Reserve’s Janet Yellen or the Reserve Bank of Australia’s Glenn Stevens are debating whether such low rates are even working as a basic stimulus.)

RESTORE HEALTH

During the savings and loans crisis in the US in the 80s in the United States, which saw massive insolvencies in the banking sector, regulators were able to use the interest rate spread to help restore health. They lent otherwise sound banks money at low rates, those banks were then able to place the money in other highly secure assets and rebuild their balance sheets on the spread profits.

Negative rates then are becoming a systemic challenge. As the global banking lobby, the Institute of International Finance (IIF) outlined in a recent paper, they hit bank and other financial institution earnings and valuations in a number of ways.

According to the IIF:

• Bank net interest margins are compressed pressuring income, leading to lower market valuations, which raises the cost of equity.

• Insurers face rising re-investment risk. For insurers with duration mismatches, low rates could impact their ability to generate the income needed to meet long-term liabilities.

• Pension funds face growing funding deficits as interest rates fall to very low levels. Ultimately, negative rates could render the whole concept of saving for retirement unworkable, potentially requiring some form of public policy assistance to retirees.

European Central Bank executive Benoît Cœuré addressed the dilemma in a recent speech.

“It has been suggested that at some point the level of rates can become low to the extent that the detrimental effects on the banking sector outweigh the benefits of lower rates,” he said.

That point is known as the “reversal rate” and at that point bank profitability will fall, reducing capital generation via retained earnings, which is “an important source of capital accumulation, and thereby eventually restricting lending”.

That is, at that point, low rates which are intended to boost investment would have the opposite effect.

There have been volumes written on whether money printing and zero or negative interest rates will actually work and Keynes’ famous description of “push on a string” comes to mind.

Last week, two public companies, Henkel and Sanofi, issued bonds at negative yields. In theory, they should now spend the money raised investing but there’s no indication they will. Meanwhile those who bought the bonds – guaranteeing they would cost themselves money – presumably assumed there’s no growth on the horizon and other options would cost even more.

Even in Australia, where the latest economic growth figures were promising and the official interest rate remains well (ish) above zero, the market is analysing the impact on bank profits.

DAMAGE

Credit Suisse’s Jarrod Martin produced a research note last week outlining the damage zero interest rates in Australia would do to bank profits. CS’s conclusion is zero rates would cut major bank earnings by 9 per cent.

“We see this easing cycle (in the official overnight cash rate) as being different from the past four - it has been sustained for a far greater period and looks to continue further; we believe that negative earnings impacts for banks become more pronounced with each incremental step towards the zero bound.”