Finance & economics | Buttonwood

Slow suffocation

The financial system isn’t designed to cope with low or negative rates

EVERY time commentators say that bond yields cannot go any lower, the markets take delight in proving them wrong. After Britain’s shock decision to leave the European Union, yields dropped again: the income on ten-year Treasury bonds reached a record low, and German and Japanese yields headed further into negative territory (see chart). The prospect that monetary policy would remain accommodating also helped shares on Wall Street reach new highs.

Interest rates are the oil in the financial system’s engine, helping capital to flow from one area to another. There is a reason that rates have been positive for the past three centuries, despite world wars and the Depression. The system isn’t designed for a world of ultra-low, let alone negative, rates.

The traditional business of banking is to take money from depositors (a bank’s liabilities) and lend it, at higher rates and over longer periods, to borrowers (its assets). So an important driver of profits is the shape of the “yield curve”—the chart of interest rates for different durations. The smaller the gap between short- and long-term rates (the flatter the yield curve, in the jargon), the harder it is for banks to make money. The problems become even greater as bond yields near zero. Banks face resistance from depositors if they try to charge them for the privilege of having money in an account. Even as the return on banks’ assets declines, it is hard for them to reduce the cost of their liabilities.

When a central bank imposes negative interest rates on the reserves commercial banks keep with it, as those in Europe and Japan have done, it is thus very hard for the banks to pass this cost to depositors. Negative rates act as a tax on bank profits.

According to Jason Napier, an analyst at UBS, there is another factor at work. Many commercial banks own portfolios of government bonds, in part because regulators require them to keep a stock of liquid assets on hand. The interest payments on those bonds used to be a handy source of income. But as older, higher-yielding bonds mature, they are being replaced with much lower-yielding assets.

Mr Napier estimates that this factor alone will cut European bank profits by 20% over several years. Offsetting this effect will be hard. Either costs will have to be cut by 10% or banks will have to charge their borrowers an extra 0.3% a year. But pulling off the latter trick would not be economically helpful; central bankers are trying to reduce, not increase, the cost of corporate borrowing.

Banks are not the only institutions to be affected. Insurance companies used to follow the Warren Buffett model for making money: collect the premiums upfront, invest them wisely, and use the returns to create a cushion against bad news on the underwriting front. These days, thanks to regulations, insurers have very little exposure to risky assets like equities. They buy bonds to match their assets with their liabilities. But insurance companies in Germany and Switzerland are stuck with savings products they sold in happier times, which guaranteed returns well above current yields. A similar problem hit Japanese insurers in the 1990s and 2000s.

Insurance companies that have asset-management arms have some protection from this pressure. The savings products they sell are not guaranteed, instead offering returns linked to the financial markets. But the impact of low returns is slowly squeezing asset managers too: clients tend to notice the impact of fees much more than they did when returns were in double digits. New business is gravitating towards low-cost exchange-traded funds and index-trackers. A similar problem afflicts private banks, whose wealthy clients are starting to wake up to the impact of fees.

In a way, each sector’s problem is a manifestation of the same phenomenon. Short-term interest rates and government-bond yields are the risk-free rates that form the basis of all financial returns. The expected return on equities comprises the risk-free rate plus a premium to allow for the volatility of the stockmarket and the risk of capital loss. A good chunk of the income of financial-services companies is the “cut” they take out of these returns. Now there is simply less return to share around.

The irony is that low rates were initially devised as a policy to save the financial sector, and through the mechanism of higher lending, the rest of the economy. Many voters protested about the bailing out of the very institutions that caused the crisis. Those protesters can take only cold comfort that the same policies are now slowly suffocating the industry.

Economist.com/blogs/buttonwood

This article appeared in the Finance & economics section of the print edition under the headline "Slow suffocation"

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