Negative rates give banks a negative fate

October 12, 2020 • Estimated Reading Time: 6 minutes

Let's kick today's piece off with the article that spurned its writing.

What a pointless survey.

See, the BoE don't have to conduct a survey of UK banks to know what the effect of negative rates are on commercial banks' business.

They simply have to look at the evidence from around the world to know what the effect will be.

Take a look at the chart below.

In blue is BKX, the US bank index.

Orange is EXV, the European bank index.

And in yellow is the Topix bank index for Japan.

What do we notice?

The two economies which are pretty deep into negative rates have seen absolutely no resilience in the ETF price of their respective financial sectors.

The US has done better, but without breaching the pre-Great Financial Crisis high.

The US has had a declining base rate since post GFC, but of course, they haven't gone negative like the former two economies.

Surely that in itself is enough evidence for the BoE?

I'll repeat this again to ensure understanding.

Bank revenue is based on net interest margin.

That is, the measure of the difference between the interest income generated by banks or other financial institutions and the amount of interest paid out to their lenders (for example, deposits), relative to the amount of their (interest-earning) assets.

If the base rate compresses, it means that they earn less interest on loan origination...

But there's another issue.

And that is that low rates encourage excessive risk taking because risk profiles of borrowers become distorted...

Here's an excerpt from this short paper by the ECB.

Empirical evidence shows that when short term interest rates are low, banks relax their lending standards and grant new loans with higher credit risk, but reduce the associated loan spreads. This suggests that low interest rates increase banks’ appetite for risk. Despite this increase in risk-taking, low interest rates are found to reduce credit risk in the very short run since they reduce refinancing costs and increase borrowers’ net worth, thereby lowering the credit risk of outstanding bank loans. As the volume of outstanding bank loans is greater than that of new loans, low interest rates may make banks loan portfolios less risky in the very short run. In the medium run, however, interest rates that are too low encourage bank risk-taking which increases credit risk, thereby adversely affecting financial stability, especially if interest rates then return to or rise above average levels.

What I am arguing for his is not that low rates will lead to banks blowing up - much the opposite.

Instead, what happens is that banks end up trudging along, as do those who they lend to.

See, if a borrower were to be deemed to risky to lend to if rates were at 5%, but because rates are now negative, they are accepted, doesn't that show an issue with excessive risk taking?

Why should someone be lent to just because the cost of borrowing is cheaper?

Their credit risk has changed to the extent that they can just about finance their operations...

But the borrower isn't a productive firm if they are simply hitting breakeven.

Banks don't care though.

Why would they?

They see loan origination and interest revenue as their bread and butter business...

The only threat to their books is if rates rise quickly and aggressively, which indeed could be the case if we see an aggressive rise in inflation).

Back at the start of this year (pre pandemic), I was of the opinion that governments would increase fiscal spending drastically, to do exactly what central bankers have been pressuring them to do and that inflation would tick up in a big way.

I mean, they have done that/are doing that/will do more of that...

Have a watch.

The 10 year breakeven inflation rate is showing that inflation expectations have pretty much recovered from the deflationary quagmire that we saw back in March.

A risk?

Perhaps.

But my thinking is that more monetary stimulus and lower rates could in fact counter the intended aims of central bankers...

Which is pretty much why the BoE and Fed seem to be averse to going lower.

They know that the theory of lower rates and more QE don't actually end up feeding through to the inflation measure.

They do much of the opposite.

By encouraging unproductive participants to borrow and not putting a premium on lending, to me that sounds at best disinflationary and worst, deflationary.

It's the same old story, really.

Banks want to make money.

They make bad choices to make more money.

Firms which should have failed, don't.

And we're left with an economy left on life support for a decade or longer.

So, Bank of England, you don't need to survey anyone.

Just look at the evidence available already.

Of course, the question of financial stability arises too.

If central bankers believe that a sustained provision of liquidity will enable indices to be propped up, to bolster the wealth effect of rising property prices (very UK specific here) and to allow businesses to think that the debt they are taking on is good for the economy and being put to productive use (it rarely is)...

Then we will probably see negative.

Plus more QE.

It makes sense in their funny little heads, but doesn't make much sense for many other people, even land owners.

So Bank of England, enjoy the survey.

I hope it makes you happy.

Dear lord, what a sad little life, Bailey.

You ruined my night completely so you could have the survey and I hope now you can use it on lessons in grace and decorum.

Because you have all the monetary policy grace of a reversing dump truck without any tyres on.