By Frances Coppola
For starters, the Bank for International Settlements (BIS) explains why negative rates can be bad for banks: “If negative policy rates are transmitted to lending rates for firms and households, then there will be knock-on effects on bank profitability unless negative rates are also imposed on deposits, raising questions as to the stability of the retail deposit base. In either case, the viability of banks’ business model as financial intermediaries may be brought into question.”2
Before explaining further, it’s important to understand a bit more about how banking actually works. The business of banking is to borrow relatively short-term and lend longer-term – a process known as “maturity transformation.” Banks take deposits or issue bonds to fund both short- and long-term lending, including trade finance and business finance for large international enterprises and SMEs. This is called “credit intermediation.” In practice, banks lend in advance of funding, then fund the drawdown of the loan by borrowing.3
Banks earn income on the spread between the interest rates they pay on their borrowing (funding) and the interest rates they receive on their lending. The spread is determined by the risk that the bank takes in lending: generally, the riskier the borrower, and the longer the period of the loan, the higher the rate. But interest rates are also partly determined by depositors’ and bondholders’ expectations.
It should in theory be possible for banks still to be profitable when rates are very low or even negative. As an example, imagine that prior to 2008, a bank paid 5 percent on a 7-day notice deposit account and provided 3-month trade finance at 8 percent. It would earn a net interest margin of 3 percent. Now, suppose that benchmark funding rates (e.g., Euribor) have fallen to negative 0.5 percent. The bank could pay zero percent on its 7-day notice deposit account and provide 3-month trade finance at 3 percent. It would still earn a net interest margin of 3 percent.
However, the BIS says that banks are reluctant to pass on negative rates to smaller (insured) depositors. When rates on deposits drop too far below zero, people stop putting money into bank deposit accounts and resort to using physical cash (notes and coins). This creates funding strain for banks and increases risk and inefficiency in payments.4
When interest rates are turning negative, therefore, banks can find their spreads diminishing. Depositors still receive positive interest rates, but the bank is expected to extend business finance and trade finance at ever-lower rates. If banks were to maintain higher rates on lending to preserve their margins, they would defeat the purpose of negative policy rates.
An obvious solution to this margin squeeze might be for banks to increase risky lending, for example, by providing more business finance to SMEs.5 The European Central Bank (ECB), which imposed negative rates on bank reserves in 2014, says that banks are indeed providing more business finance.6 But the recipients are mainly domestic.
The picture for global business and trade finance is gloomier. The BIS says lending for cross-border business finance has been shrinking.7 And the WTO says that banks are less willing to provide trade finance for SMEs, particularly in developing countries.8 The overall picture is one of risk aversion and domestic-focused bank lending, contrary to the “reach for yield” that perhaps might be expected in a negative-rate world.
Since the 2008 financial crisis, banks have been under regulatory pressure to build up capital and liquidity buffers to protect against bank runs and loan default losses.9 Because of the way risk weightings work for capital allocation purposes, riskier lending – for example, business finance for SMEs – requires more capital than forms of lending regarded as safer, such as residential mortgages. The BIS reports that banks have built up their capital buffers principally by retaining earnings, though reducing risky assets on their balance sheets and issuing more equity have also played a part.10
Negative rates contribute to the business finance chill experienced by SMEs in two ways. Firstly, falling share prices suggest that investors don’t believe that banks can make profits in a low-rate, low-growth environment, so are becoming reluctant to invest in them.11 As share prices fall, it becomes more difficult for banks to raise the capital they need to support riskier lending.
Secondly – and far more importantly – as bank profitability decreases, it becomes harder for banks to build up capital by retaining earnings. Increasing risky lending becomes a business impossibility when profitability is low and capital is expensive.
Consequently, global banks are pulling back from lending to enterprises working in developing markets, and they are limiting business finance to SMEs even in developed nations. The WTO says that in some large developed countries, up to a third of SMEs have difficulty accessing affordable trade finance. Globally, over half of SME requests for trade finance are rejected.12
By effecting bank profitability and investor confidence, negative rates can make it harder for banks to build up and maintain capital buffers. This can force them to limit lending perceived by regulators as risky, such as business finance for SMEs, especially those working in developing market countries. SMEs may increasingly need to turn to alternative providers to fund business investment and trade finance.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Trade finance and SMEs: bridging gaps in provision”, World Trade Organization; https://www.wto.org/english/res_e/booksp_e/tradefinsme_e.pdf.
2. “How have central banks implemented negative policy rates?”, Bank for International Settlements; http://www.bis.org/publ/qtrpdf/r_qt1603e.pdf.
3. “Money creation in the modern economy”, Bank of England; http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf
4. "How have central banks implemented negative policy rates?", BIS; http://www.bis.org/publ/qtrpdf/r_qt1603e.pdf
5. “Assessing the implications of negative rates", Benoit Coeure, ECB; https://www.ecb.europa.eu/press/key/date/2016/html/sp160728.en.html
6. “Results of the July 2016 Bank Lending Survey”, ECB; https://www.ecb.europa.eu/press/pr/date/2016/html/pr160719.en.html
7. "Highlights of financial flows”, BIS; https://www.bis.org/publ/qtrpdf/r_qt1609b.pdf
8. "Trade finance and SMEs: bridging gaps in provision", WTO; https://www.wto.org/english/res_e/booksp_e/tradefinsme_e.pdf
9. Basel III: international regulatory framework for banks, BIS; http://www.bis.org/bcbs/basel3.htm
10. "How have banks adjusted to higher capital requirements?", BIS; http://www.bis.org/publ/qtrpdf/r_qt1309e.pdf
11. "European banks uneasy over deeper negative interest rates", Financial Times; https://www.ft.com/content/2ed4d1ae-cf48-11e5-831d-09f7778e7377
12. "Trade finance and SMEs: bridging gaps in provision", WTO; https://www.wto.org/english/res_e/booksp_e/tradefinsme_e.pdf
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