Western Europe: Negative policy rates backfire

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Adair Turner, who famously took over as chairman of UK bank regulator the Financial Services Authority in September 2008, delivered a thoroughly depressing analysis of the slow and disappointing recovery from the financial crisis at the European Capital Markets Forum last month.

Tracing the origins of the financial crisis to the tripling of private domestic credit from 50% of GDP in 1950 to 170% by 2007, Turner bemoaned the failure of economists in the run up to the crisis to take account of the economic impact of money creation and lending by banks that shifted their activities from classic maturity transformation and lending to businesses for new capital investment in the 1960s towards funding the purchase of existing assets, principally real estate, in the decades that followed.

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Adair Turner

With that debt burden as yet unresolved by mass delinquency or write-offs, Turner suggests developed markets are still stuck in a post-crisis deflationary trap that it has taken most of the past seven years simply to recognize. We are at the point, Turner says, where rates may not simply be lower for longer, they may be lower for ever.

Turner spoke just days after the ECB had cut its deposit rate to –0.4%, its main refinancing operation rate to zero, expanded its quantitative-easing programme and promised any banks that manage to increase their stock of lending beyond a certain benchmark access to zero or negative-cost funding.

Turner is not alone in casting doubts over the capacity of small movements in funding rates to incentivize corporates already fearful of slow growth and their own high indebtedness to borrow even more to expand capacity. Transmission through the banking system remains blocked. Indeed, at negative rates, efforts to increase lending can backfire. Banks may discourage flighty, large-scale corporate deposits, but they remain extremely reluctant to pass negative rates onto retail depositors for fear of destroying their core raison d’être. 

With providers of equity and even debt capital to banks already panicky and prone to flight because weak profits undermine capital accumulation, banks in countries with negative policy rates are likely to increase lending charges to protect net interest margins. It may take a few more central bank lending surveys to deliver hard evidence of this, but anecdotal information from senior bankers in Germany, Scandinavia and Switzerland, where negative rates are firmly established, suggests that banks will now take any chance they can to pass on higher costs to borrowers to make up for negative policy rates. Not only do negative policy rates not help borrowers, they may hurt them. 

The only country where this does not seem to be happening is Germany only because of competition to lend at low rates from public sector and co-operative banks that are not answerable to conventional private shareholders.

Lone optimistic note

Turner’s only optimistic note was that the last battle has been fought and won, that banks are now so well-capitalized that a crisis emanating within the financial system is much less likely. 

Euromoney isn’t so sure. It is not only in lending to corporations that negative interest rates incentivize contrary behaviour. Banks now find themselves caught in a double bind on their hefty buffers of so-called high-quality, so-called liquid assets – HQLAs. Not only do banks now have to pay many of the highest-rated governments for the privilege of lending them 10-year money, they also have to carry up to 5% capital against those HQLA buffers, to comply with leverage-ratio constraints. What looks like liquidity is, in fact, an expensive form of balance sheet management. 

What is the banks’ response? Some privately admit that they are looking to improve returns on investment in HQLA buffers by shifting into periphery government sovereign bonds with positive yields. The problem there, of course, is that while quantitative easing has dragged down yields on those bonds, they clearly do carry credit risk. 

One former regulator told Euromoney recently: "At zero or negative rates, investors can’t discriminate between good and bad loans. Everyone can fund. You have to write off bad loans at some point. You can’t delay that process for ever."

Regulation designed to make banks safer is, when combined with extraordinary monetary policy measures, making them riskier and less useful to the real economy.

And there’s perhaps an even more worrying implication of negative rates. As the chairman of one of Europe’s leading banks told us last month: "The current crisis in the banking industry is not one of capital, nor is it liquidity: it is the chronic lack of profitability. Negative interest rates kill banking as they destroy money."