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Negative rates and financial intermediation

What’s at stake: While negative interest rates might be needed from a macroeconomic point of view, they create important challenges for financial intermediaries, as it is not clear how they could maintain their spread business in the below-zero lower bound environment.

By: Date: March 16, 2015 Topic: Finance & Financial Regulation

What’s at stake: While negative interest rates might be needed from a macroeconomic point of view, they create important challenges for financial intermediaries, as it is not clear how they could maintain their spread business in the below-zero lower bound environment.

Financial intermediation with negative rates

Stephen Cecchetti and Kermit Schoenholtz writes that bankers run what is called a “spread business.” They rely on receiving higher returns on their assets than they pay on their liabilities. In the simplest case, that means charging borrowers a higher rate for loans than they pay customers for their deposits. That is their spread. This spread business usually doesn’t depend on the level of interest rates. The bank’s interest margin has several parts, including the cost of screening and monitoring borrowers, the return to the bank’s owners, and the cost of providing services to depositors. 

Bill Gross writes that a serious concern might be that low interest rates globally destroy financial business models that are critical to the functioning of modern day economies. Pension funds and insurance companies are perhaps the most important examples of financial sectors that are threatened by low to negative interest rates. Both sectors have always attempted to immunize their long-term liabilities (retirement, health, morbidity) by investing at a similar duration with an attractive yield. Now that negative and in almost all cases low short term rates are expected to persist, long term bonds and similar duration assets do not offer the ability to pay claims 5, 10, 30 years into the future.

Wolfgang Munchau writes that the impact of low rates could jeopardize the life insurance sector in Europe. These companies sell insurance products and annuities with guaranteed returns. They invest the money they receive from their policyholders in government and corporate bonds. For this to work, the average return on the bonds they hold in their portfolio has to be higher than the guaranteed rate they pay out. This currently remains the case because insurers are holding bonds they bought many years ago during times of higher interest rates. But as time goes on, the weight of low-yielding bonds in their portfolio will rise. For them the biggest danger is the length of time interest rates stay low.

Are interest rates artificially low?

David Beckworth writes that negative interest rates are often considered unsettling because they’re seen as another step by central banks to artificially push down interest rates. The premise is that central banks are causing interest rates to remain low. But this premise assumes too much. It could be the case that central banks over the past six years were adjusting their interest rate targets to match where the market-clearing or ‘natural’ interest rate was going.

Brad DeLong writes that if interest rates are low but if planned savings at full employment exceed investment, then interest rates are not “artificially low”: they are naturally low. If they are “artificially” anything, they are artificially high. Antonio Fatás writes that to make the argument that periods of unusually low interest rates create confusion in investors and markets (what some call "search for yield"), one needs to first understand the global nature of this phenomenon that suggests that the reasons for low interest rates extend beyond the particular actions of a central bank. And then we need a theory of financial markets, their irrational behavior and how the central bank can influence this behavior.

Search for yield and flight from loss

Ben Bernanke said in his May 2013 Congressional testimony that a long period of low interest rates has costs and risks. One that we take very seriously is the possibility that very low interest rates, if maintained too long, could undermine financial stability. For example, investors or portfolio managers dissatisfied with low returns may reach for yield by taking on more credit risk, duration risk, or leverage. Martin Feldstein writes that extremely low interest rates have fueled increased risk-taking by borrowers and yield-hungry lenders. The result has been a massive mispricing of financial assets. And that has created a growing risk of serious adverse effects on the real economy when monetary policy normalizes and asset prices correct.

Gabriel Chodorow-Reich writes that low interest rates may spur risk taking by financial institutions beyond what the ultimate holders of the risk would prefer. Investment management poses a classic principle-agent problem, in which the incentives of managers may not align perfectly with the objectives of shareholders and debt holders. The definition of reaching for yield varies across authors. I use it to mean increases in risk taking for reasons other than the end-holder’s risk preferences.

Source: Gabriel Chodorow-Reich

Percival Stanion writes that the blanket search for yield will evolve into a flight from near-certain loss. It is doubtful that investors can put up with this for much longer. To avoid an almost certain loss, it is possible they will end up taking on more risk. There is a large body of evidence testifying to investors’ powerful aversion to loss. This was demonstrated more than 30 years ago by the behavioural economist and Nobel laureate Daniel Kahneman, who found individuals were prepared to take on more risk than normal if the alternative — doing nothing — meant accepting a loss. Tellingly, the pain of a $100 loss was found to be far more intense than the satisfaction from a $100 gain.


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