The Unbearable Lightness of Low Rates
Insights on European Financial Services and the impact of low rates on banks.
- In this report we examine the impact of low rates on banks and what can be done about it. We will also follow up this publication with a report examining the impact of low rates on insurance and asset management.
- European banks have lived with low rates for more than a decade and they are here to stay.
- But management teams have not been as proactive in adjusting their business models:
Written by Ivan Zubo, Head of Research at Financial Services Capital and co-authored by Matthew D. Hansen, Founder, Chief Investment Officer, and Managing Partner, Financial Services Capital Partners. Reprinted with permission.
In what is perhaps his most famous novel, The Unbearable Lightness of Being, author Milan Kundera explores many of the deepest questions of happiness and the meaning of life taking place in the background of the Prague Spring and subsequent Soviet invasion of Czechoslovakia in 1968. While the three main protagonists do their best to escape the destructive geopolitical events happening around them, their effort is in the end, futile. European banks have resorted to similar futility in the face of a long period of low rates. In the years following the Global Financial Crisis (GFC), central banks in developed economies (most notably across Europe, the US and Japan) have kept policy rates at or close to zero. This alignment began to change in 2015 with the US Fed starting to hike rates while the European Central Bank (ECB) and later the Bank of Japan (BoJ) policy rates dipped into the negative territory for the first time, where they still remain. The Fed and the Bank of England (BoE) have slashed rates following the outbreak of COVID-19, however, they have not yet joined the ECB and the BoJ in their negative interest rate policy (NIRP) territory. This is of little comfort to banks who know they have to prepare for an extended period of low interest rates ahead.
In this report we examine what are the tools available to banks to make the best of what is not an ideal situation.
Chart 1: ECB Deposit Rate vs. Effective Fed Funds Rate
In theory, bank management teams are expected to react to the low interest rate environment by actively managing their business lines. In practice, the actual response depends on whether or not the environment is perceived to be long-lasting. And this is perhaps where central banks themselves have been guilty of overoptimistic guidance — even if this is unintentional. Based on central bank guidance, the normalisation of rates has been a few quarters away for some time now — but in the case of the ECB we have not seen a rate hike in almost ten years. The discussion of the normalisation of rate levels may have given European bank management teams false hope that things were going to return back to normal, therefore postponing any necessary restructuring initiatives.
Yet one can argue (admittedly with the benefit of hindsight) that the persistent low rate environment was all too predictable and hence bank management teams should have been preparing for rates to be ‘low for longer’ for quite some time now. Ultimately it is the job of senior management teams in banks to make long term strategic calls and they are, for the most part, very well compensated for this. Yet based on our research and the works cited in this publication, their track record is mixed at best.
Impact on Business Models and Bank Risk
According to a Bank for International Settlements (BIS) 2019 study, low interest rates affect bank intermediation margins, though it is not necessarily a linear relationship. The impact of low rates depends on the sensitivity and adjustment speed of loan and deposit rates to market rates (this is known as the repricing lag effect). For a given deposit rate, banks will tend to pass on lower interest rates to lending rates, particularly to customers with other financing options. All else equal, this compresses interest margins. Since deposit rates are priced as a markdown on market rates, reductions in this markdown will squeeze the bank interest margin (similarly known as the retail deposit endowment effect), according to the BIS study.
Lower interest rates also affect any profits generated in the non-retail segment. Bank profits on security portfolios are expected to increase in low interest environments through higher stock and bond valuations; this, of course, is just a one-off effect unless banks increase their exposure and trading activities. Bank fees and commissions, which are linked to lending and deposit activities (e.g. credit lines, transaction services) or investment banking-type activities (e.g. securities brokerage, trading, market making), may increase in low interest environments if there is more demand for such services. For a given level of risk, banks may have incentives to shift activities away from the loan segment to other businesses (e.g. securities underwriting, trading, or insurance). Banks can also reduce their lending activity and expand to other higher-yielding activities so as to meet the minimum profit constraints of shareholders if they prefer market share over profits.
For given macroeconomic conditions, lower interest rates should translate to lower loan losses. It is true, that low rates may induce more risk-taking on new loans through the risk-taking channel. But lower interest rates reduce the default probability of variable-rate loans, by decreasing debt servicing burdens. Since the stock of variable-rate loans is bound to be considerably larger than the flow of new loans, and the results of risk-taking are likely to take a long time to emerge, the overall impact of low interest rates on loan losses should be positive. Moreover, loan losses can also be lower because banks can more easily “extend and pretend” troubled loans given that the debt servicing cost is much more manageable in a low rate environment.
Impact on Funding Structure
Zero interest rate policy (ZIRP) and NIRP may lead banks to rethink their funding structure. For example, in the past, deposits tended to be some of the cheapest sources of funding for a bank (especially checking / demand deposits on which banks paid zero interest in the past even when the policy rates were higher). But this is no longer the case in Europe as banks may borrow from the ECB under the Targeted Long Term Repurchase Operation (TLTRO) at a rate of negative 1% assuming they do not shrink their lending to the SME sector. In a low rate environment, every basis point is crucial and so banks need to continually re-evaluate their funding structure to get the most out of it, leaving no stone unturned.
Does the Risk Appetite of Banks Increase in Response to Low Rates?
The ECB recently published a study on this topic and the answer is perhaps unsurprisingly yes. What is perhaps surprising is that there is a clear bifurcation between those banks that have a high deposit ratio and those that do not. The securities portfolios of banks with a high deposit ratio became riskier relative to those of banks with a low deposit ratio. Chart 2 provides an illustration of this result for banks with different levels of deposit ratios (calculated as deposits to total liabilities). Banks that are more reliant on customer deposits were more affected by negative rates and reached for higher yields, according to the ECB study.
Chart 2: Change in securities holdings after the introduction of negative rates (low-deposit banks shown on the left chart, high-deposit banks on the right chart)
But in which securities did banks invest after the introduction of negative rates? Bubeck et al. use the granular database at their disposal to answer this question. First, the analysis performed for asset classes shows that the increase in risk-taking was seen for all classes of debt securities, albeit at different levels of statistical and economic significance. High-deposit banks invested more in riskier debt issued by private financial and non-financial companies. Furthermore, among the most affected banks (i.e. high-deposit banks), it was the banks with less capital that displayed a stronger increase in the risk of their securities portfolios compared to their less deposit dependent peers.
Overall, the ECB’s findings suggest that negative interest rates have heterogeneous effects across financial intermediaries, leading some to take more risks than others depending on their funding structure. Whether negative interest rates lead to more risk-taking across the entire banking system, especially considering the effects of a prolonged period of negative rates, is an important open question that remains to be addressed.
Do Low Rates Hurt Bank Equity Values?
Perhaps somewhat surprisingly the answer is not a unanimous yes. In fact, according to a recent ECB research brief, the evidence on the effect of very low interest rates on banks is mixed. Heider et al, for instance, have found that negative interest rates reduce the net worth of some banks. Other studies, however, have found that they have a positive effect on bank profits and lending.
The ECB approach identified two methodological challenges. The first is to separate the cause from the effect — for example: if interest rates are often lowered when the economy is weak, and banks’ stock values also tend to decline when the economy is weak, then low interest rates and low stock values are bound to be observed together even if low rates do not lead to lower bank stock prices. But how does one distinguish between changes in banks’ equity values that are driven by the interest from those driven by underlying economic conditions? There is not necessarily a straight answer. The second challenge is that, if changes in interest rates are anticipated by financial markets, they will react in advance and it may be hard to observe any reaction at the time of a policy rate announcement. In order to solve these challenges, the ECB used high-frequency data in an event study approach, adapting the methodology first developed by Kuttner to the euro area setting. For detailed explanation methodology of ECB’s approach please see the report Do low interest rates hurt banks’ equity values? by the ECB.
Chart 3: Evolution of stock prices of high and low-deposit banks
In the first two periods, negative rate surprises had a positive effect on banks’ equity values, an effect that became stronger after the crisis started. In the pre-crisis period, a 25-basis point negative surprise resulted in an average increase of 0.76% in bank stock prices, while in the crisis period a negative surprise of the same magnitude boosted bank equity values on average by 1.3%. However, these effects reversed during the period of very low and negative rates. In this environment, negative rate surprises were detrimental to bank equity values. The ECB found that a 25-basis point negative surprise lowered bank equity values by 2.0% during this period.
Chart 4: Response of banks’ stock values to rate surprises: the role of deposits
The only truth that is pure and simple is that truth is rarely pure and never simple, is a quote attributed to the playwright Oscar Wilde and this very much sums up our conclusion. In a nutshell, while it is more difficult for banks to generate sustainable return on equity (ROE) in a low-rate rather than high-rate environment, managements do have quite a few levers at their disposal to improve profitability. But simply blaming low rates for underperformance for an extended period of time is not credible. The reality is that the low-rate environment requires a complete overhaul of incentive systems within banks. For example, while bank management teams traditionally think of asset growth as a good thing and something to be encouraged, this is not necessarily the case in a low-rate environment, unless those assets are indeed yielding enough to earn their cost of capital. Likewise, compensating staff on the basis of revenue rather than profits (a still all too common practice in the industry) is completely inappropriate for the current environment.
At FSC we believe that the fundamental transformation of the European financial services sector has to be driven by concentrated equity ownership and a highly dedicated team of operating professionals that are committed and incentivised to make transformation happen quickly, breaking up rigid and slow to react legacy management structures that protect the status quo. While the Prague Spring of 1968 was ultimately doomed, it was followed by the Velvet Revolution of 1989 which succeeded beyond the most optimistic expectations and become a model for a peaceful regime transition. We believe the opportunity in European Financial Services is vast and now is a perfect environment to apply FSC’s operating, financial and technological solutions to overcome these challenges.
 Bank intermediation activity in a low interest rate environment, Bank for International Settlements, 30 August 2019
 Borio, C, L Gambacorta and B Hofmann (2017): “The effects of monetary policy on bank profitability”, International Finance, vol 20, pp 4 63. Also available as BIS Working Papers, no 514, October 2015.
Bernanke, B and K Kuttner (2005): “What explains the stock market’s reaction to Federal Reserve policy?”, Journal of Finance, vol. 60, no 3
 Baumol, W (1959): Business behavior, value and growth, New York: Macmillan.
 Borio, C and H Zhu (2012): “Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?”, Journal of Financial Stability, vol 8, no 4, pp 236–51.
 Do banks invest in riskier securities in response to negative central bank interest rates?, European Central Bank, 21 April 2020
 Bubeck, J., Maddaloni, A. and Peydró, J.-L. (2020), “Negative monetary policy rates and systemic banks’ risk-taking: Evidence from the euro area securities register”, ECB Working Paper Series, No 2398, and Journal of Money, Credit and Banking
 Do low interest rates hurt banks’ equity values?, European Central Bank, 16 July 2019
 Heider, F., Saidi, F. and Schepens, G. (2019), “Life Below Zero: Bank Lending Under Negative Policy Rates”, The Review of Financial Studies, forthcoming.
Altavilla, C., Burlon, L., Giannetti, M. and Holton, S. (2019), “Is there a zero lower bound? The effects of negative policy rates on banks an Firms”, Working Paper Series, No 2289, ECB, June.
 Kuttner, K.N. (2001), “Monetary policy surprises and interest rates: Evidence from the Fed funds futures market”, Journal of Monetary Economics, Vol. 47(3), June, pp. 523–544.