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Forthcoming challenges to banking regulation (sovereign risk, RWA variability, trading book…) - Resilience of the EU financial sector in the global context - Uncategorized

What are the consequences of lasting close to zero interest rates for banks and their customers?

By Bordenave Philippe - Chief Operating Officer, BNP Paribas

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In recent years the ECB has been forced to adopt an increasingly expansionary policy using conventional and unconventional tools. The ensuing low interest rate environment is clearly challenging for banks and has huge implications for bank customers. Several factors have been quoted to explain this evolution: the lasting effects of the Great Recession, the sovereign crisis, a less supportive global environment, etc. Importantly, the reduced effectiveness of monetary policy is mostly explained by an ever tighter regulatory environment which weighs on the ability of banks to play their key role in the monetary transmission process. Given the high pressure on European banks, more so than their American peers (RoE of 7.3% and 9.6% at S1 2015 respectively), a pause in regulatory changes would be welcome in order to sustain the economic recovery of the Eurozone, which, as is well known, is a predominantly bank-funded economy.

Impact on banks’ customers
Low interest rates penalize savers while they favour borrowers. Savers might shift towards non-remunerated deposits (sight-deposit) as their opportunity cost decreases, at the expense of remunerated savings. They could also pursue higher expected returns by taking more investment risk. On the other hand, some savers might actually increase their savings rate in order to meet their future liabilities, so on balance the net impact on the volume of households’ savings is uncertain. Corporates with excess cash may feel the strain of the current rate environment even more strongly. Borrowers are the big beneficiaries of low rates as it reduces their financial burden. However, when borrowing costs have reached a certain floor it will be harder for banks to entirely pass on the decline in interest rates to borrowers because they have to be mindful of their cost-to-income ratio as well as of the risk they are taking. This may entice corporates to rely more on market-based financing.

The reaction of households, whether they are savers or borrowers, also depends on the evolution of their labour income: subdued or no wage growth and weak economic growth could make them feel uncertain about their job. One would expect this would make them reluctant to invest in riskier asset classes whereas as borrowers, it would make them less reactive to a decline in interest rates. A similar reasoning can be applied to companies where profit growth and its volatility will influence how they react to low interest rates. In addition, the negative deposit rate policy of the ECB, to the extent that it leads to negative interest rates on large corporate deposits, can influence companies in various ways: via their financial revenues, via their dividend policy, via decisions in terms of balance sheet structure (share buybacks).

Impact on banks

The ongoing decline in interest rates and the significant flattening of the yield curve weigh on profits of retail banks that traditionally benefit from maturity transformation activities. Interest margins are narrowing because on the asset side maturing loans at higher rates are replaced by new loans at lower rates, all the more as low interest rates boost renegotiation of interest rates, even on the non-maturing backbook (in particular on mortgage loans in many European countries). This reduces progressively the average rate on the outstanding loan book. On the liability side, banks can lower interest rates on interest bearing deposits but only to a certain extent as interest rates generally have a zero floor.

The margin pressure from low interest rates forces retail networks to cut costs and to charge for services. Banks in general will need to optimise their business portfolio from a capital and liquidity requirement perspective. In this respect securitisation and an ‘originate to distribute’ approach will become increasingly important although the road towards a full-fledged Capital Markets Union will be long.

It should be emphasized that the impact of low rates on banks varies widely according to the underlying business model. The low interest rate environment is more favourable for consumer lending, investment banks and fixed income activities.

To conclude, although the Eurozone is slowly growing, the economic environment remains challenging. Monetary policy has been and remains the key instrument to foster growth but this has necessitated an ever less conventional policy, with a considerable impact on banks and their customers. Going forward, this makes it all the more important that the effectiveness of monetary policy is not further hampered by additional tightening of banking regulation.