Banking in a negative rate environment

Today, the ECB will meet to discuss its monetary policy and it as virtually certain that the Governing Council will cut interest rates into negative territory (and lower the deposit rate even more into negative territory). The goal of lowering interest rates is obviously to reduce the cost of borrowing and incentivise banks to lend more to businesses and households. But the evidence keeps mounting that this may be exactly the opposite of what is happening as I have noted here.

Now, the Bank for International Settlement (BIS) has chimed in with a paper looking at the profitability of banks in times of low and negative interest rates. The problem for banks is that the traditional lending business relies on the interest rate differential between long- and short-term rates because banks raise capital through deposits (which are short-term in nature) and lend it out in the form of business loans and mortgages (which are typically long-term in nature). But if central banks reduce short-term interest rates to zero or lower and move long-erm interest rates to zero as well, then there are two risks for the traditional lending business of banks. First, they might face a massive bank run if they pass on negative interest rates to deposit holders and charge them for the privilege of holding money at the bank. Second, the net interest margin gets squeezed dramatically and it makes no longer sense to engage in lending because it is not compensated well enough for the risk involved. 

I have written a blog post here about the first problem and how the risk of a bank run can be avoided. But the second problem isn’t that easy to fix. What happens in a low interest rate environment according to the research of the BIS is that traditional net interest income declines substantially (no surprise there) and that this net interest income is increasingly replaced by non-traditional income sources such as fees and commissions. In effect, banks try to incentivise their clients to trade more and engage in other activities that provide fee income to compensate for the dwindling interest income.

Now here is a bright future. Just when central banks are getting more concerned about the state of the economy and cut interest rates into negative territory, banks have an incentive to put their clients into riskier products that generate higher fees or induce them to trade more and churn their portfolios to increase commission income. The technical term for this is unintended consequences” but I have another two words for it. And it’s not “happy birthday”.

Interest rates and bank income structure

Source: Fitch Connect, BIS.