A lot has changed in monetary policy circles since the Bank of Japan surprised markets by taking policy rates into negative territory earlier this year.
That decision, and the counter-intuitive reaction from forex traders which drove the yen higher against the US dollar and other currencies, ignited a debate about the efficacy of the current state of central bank policies.
That’s prompted the BoJ itself to undertake a “comprehensive review” of monetary policy, Bank of England governor Mark Carney to rule out negative rates, and the Fed – at Jackson Hole – to do the same.
Markets, investment banks, economists, traders, and investors are increasingly coming to the view that negative interest rates, and QE programs that drove long bonds below zero per cent, can’t last and don’t work.
In particular, one of the big questions has been about the impact of negative rates on the real economy and in particular on banks’ ability to function in that environment. And it’s one addressed by the “central bankers’ central bank”, the Bank of International Settlements (BIS).
In its quarterly review the BIS, in a special box discussing “Negative rates and bank business models”, said:
Market valuations indicate that investors remain sceptical of banks’ ability to generate earnings in a low-rate, low-growth environment…Flattening yield curves and low long-term rates are among the factors that markets are weighing more closely as they ask whether, and how, banks’ profitability can recover.
They note the key problem with negative rates and quantitative easing is that it flattens the yield curve which might be helpful at the outset because banks’ “portfolios of securities benefit from one-off capital gains, and also if funding for the banks becomes cheaper”.
But longer term, the problem is that “the flattening of the curve can drive down returns from maturity transformation and compress net interest margins”.
Net interest margins, the difference between the interest paid on deposits and the price charged on loans, are a bank’s bread and butter.
The BIS added this is a problem because:
“As interest rates decline and move into negative territory, repricing banks’ liabilities in lockstep with assets in order to protect margins will become increasingly difficult. Banks appear reluctant to pass negative short-term rates to depositors. Thus, pressures on net interest margins are particularly pronounced in countries with negative interest rates.”
Again, a bank’s bread and butter.
This is important because an inability to make money under this environment threatens not only banks’ profitability but the very role banks play in an economy. Why intermediate between depositors and borrowers when you can’t make money?
The BIS says that different banks trapped in different countries under different interest regimes may react differently. And it says that the hope of these negative rates is that in the long run “stronger economies will allow banks to expand the volume of their traditional lending activities”.
Yet while the world waits for that, the BIS says banks will just have to satisfy themselves “for part of their lost revenues by relying on alternative sources of income such as trading and fee-generating services, while others may be able to reap efficiency gains, for example by addressing overcapacity or by bringing down cost-to-income ratios”.
Yes, the central bankers’ central bank said trading and cost cutting are the new black. Not the business of banking itself.
No doubt the global banking boffins in Basel will be applauding the steepening in the global yield curve. They are just more voices in a long line of commentators who recognise negative rates and a flat curve is failing the global economy.
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