How Banks Can Survive Negative Rates in the Global Financial System

Today’s deteriorating economic outlook and unconventional monetary policies threaten banks and setting off dangerous and erratic feedback loops. At the same time, fears are increasing as such measures, particularly negative interest rates, threaten the stability of the financial system.

The advanced-country central banks’ policy interest rates are stuck at uncomfortably low levels. As the experience of banks in Japan and Europe has drawn, the process follows a predictable pattern. Low growth, low inflation, output gaps, unemployment, and underemployment – combined with financial instability, mainly volatile asset prices – first prompt central banks to lower rates below the zero bound. Inflation in the US, Europe, and Japan continue to undershoot official targets. And measures of the natural rate of interest consistent with normal economic conditions have been going downward for years.

Currently, estimates of the natural rate for the US put it in the range of 2.25-2.5%. As interest rate margins contract and profits are squeezed, banks raise fees or turn to other revenue measures to bolster earnings. That will keep actual borrowing costs relatively high, undercutting the whole point of negative rate policy. So, the objective is to expedite borrowing to finance consumption and investment, thus setting off a self-sustaining growth cycle.

Negative Rates Power Risks 

Considering the report, since the economy continues to sputter, desperate policymakers cut rates more and more deeply. Government bond yields rise gradually negative and the profit curve flattens. Also, banks that hold substantial amounts of government debt, see their profits decline even further.

Besides, weak earnings impact share prices of banks and raise doubts about future dividends, buybacks or capital returns. This perversely lessens the amount of credit available, which again reduces consumption and investment. And instead of expediting the economy, negative rates augment uncertainty about the future. Households, worried about saving for retirement and other goals, spending less.

Slowing growth upsurges the number of non-performing loans, and erodes bank profits and minimizes lending. It also increases borrowing costs for banks, which results in higher credit margins for borrowers. Indeed, struggling banks have less demand for government bonds that limits the countries’ ability to finance their activities.

However, there are also a few alternatives. For instance, Germany is scrutinizing whether to foil banks from charging most retail clients for deposits. In addition, other alternatives are generating special safe assets or savings accounts that ensure positive rates. Both measures would dent negative-rate policies.