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A macroprudential perspective on the low interest rate environment

Presentation for the Belgian Finance Club Financial repression: risks and perspectives 28 June 2017 Hans Dewachter NBB, Prudential policy and financial stability

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Disclaimer: the views expressed in this presentation do not necessarily reflect the views of the NBB nor those

• f the ESCB.

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Overview

MacroprudentialReport NBB identified a number of risk factors

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Low interest rate environment againstthe background of moderate growth and potential search for yield

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Build-up of risks in the real estate market

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Cyber risks

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Point of attention: shadow banking This presentation focusses on 1. Low interest rate environment: structural versus cyclical views 2. Low interest rate environment: impact on the financial sector 3. Build-up of systemic risks in the real estate market

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The low interest rate environment: structural versus cyclical views

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The low interest rate environment: some perspective

Historical short and long-term interest rates

As reported by A. G. Haldane in a speech at the Open University Milton Keynes, 30 June 2015

Interest rates are historically low, literally !

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The low interest rate environment: some perspective

Trend-wise decrease of LT nominal and real yields

• 2

2 4 6 8 10 12 14 16 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 BE DE FR NL EA US JP

Sources: OECD, Thomson Reuters Datastream.

1 Difference

between nominal yield and yearly smoothed inflation rate.

• 2

2 4 6 8 10 12 14 16 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 Sovereign nominal yields 10 yr. maturity

(percentages, monthly averagesJan 2017)

Sovereign real1 yields 10 yr. maturity

(percentages, monthly averagesJan 2017)

Low interest rate environment not fully attribued to financial crisis: last 40 years characterized by decreasing interest rates both in nominal and real terms

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The low interest rate environment: some perspective

Structural view

Increased savings supply:

►

Ageing population and increasing post- retirment life expectancy increase need for additional savings

►

Increasing income and wealth inequality shifting resources towards richer households with higher savings ratios

►

Uncertainty: increased precautionary savings

Decreased investment demand:

►

Lower potential growth as a result of lower productivity gains and decreased population growth

►

Decreased public investment

►

Increased economic uncertainty

Structural explanations for trendwise decrease in equilibrium real rates: increased savings supply combined with decreased investment demand and lower potential growth

R* Real interest rate R* Savings supply Investment demand Saving/investment

R* = a. g* + S/I

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• 1.0
• 0.5

0.0 0.5 1.0 1.5 2.0 2.5 3.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Labor Capital productivity Growth potential (percentage points) Contribution:

The low interest rate environment: some perspective

Structural view

Factors explaining the reduced potential output growth:

►

Decreased productivity growth

►

Decreasing contribution of growth in labor force (participation)

►

Decreasing contribution from capital formation Very similar patterns for different EA members, including Belgium

Potential output growth has decreased trendwise and is expected to remain moderate for the coming years

Potential growth rate Euro area: breakdown by factors (percentage points)

Source: EC.

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Estimates of the (structural) equilibrium (real) interest rate are at a historically low level both for the USA and EA….

The low interest rate environment: some perspective

Structural view

• 2
• 1

1 2 3 4 5 6 1975 1980 1985 1990 1995 2000 2005 2010 2015 R* Trend of gdp growth

• 2
• 1

1 2 3 4 5 6 1975 1980 1985 1990 1995 2000 2005 2010 2015

Euro area USA

Bron: NBB based on HLW (2016).

Holston, Laubach & Williams (2016) estimate of the equilibrium real rate R*

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The low interest rate environment: some perspective

Cyclical view

Fall in equilibrium interest rate following the financial crisis:

►

Fall in potential growth

►

Increased saving supply (precautionary saving, ageing?...)

►

Decreased investment demand

Additional fall in aggregate demand

►

Inflation and output below equilibrium values

►

Need for conventional and non-conventional monetary policy responses to set real interest rates below the equilibrium rate

Accommodative conventional and non-conventional monetary policy may help to restore the long-run equilibrium by moving real interest rates below the equilibrium real rate

R* Real interest rate R*

Accommodating conventionaland non-conventional monetary policy Additional demand shortfall

Saving/investment R

R = a. g* + S/I + R – R*

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The low interest rate environment: some perspective

Cyclical view

The financial crisis generated important (and persistent) output and inflation gaps that justified conventional and unconventional monetary policy.

Bronnen: EC, ECB.

• 1

1 2 3 4 5 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Core inflation HICP inflation

• 4
• 3
• 2
• 1

1 2 3 4 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

GDP gap Unemployment gap

Unemployment and output gaps for EA

(deviation from potential, in percentage point)

Inflation for the euro area

(in percentage points)

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The low interest rate environment: some perspective

Cyclical and structural views combined

• 4
• 3
• 2
• 1

1 2 3 4 5 6 1975 1980 1985 1990 1995 2000 2005 2010 2015 R-R* R* Trend growth GDP

• 4
• 3
• 2
• 1

1 2 3 4 5 6 1975 1980 1985 1990 1995 2000 2005 2010 2015

Euro area USA

Bron: NBB based on HLW (2016).

Estimates of equilibrium (real) dynamics suggest that structural as well as cyclical factors underly the observed decreased in the (real) interest rates in US and EA

Holston, Laubach & Williams (2016) estimate of the equilibrium rate R*

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Source: Thomson Reuters.

1 Triple A countries only.lower

15 1-year forward yields

• 1

1 2 3 4 5 6 1 2 3 4 5 6 7 8 9 Years ahead

US EA1 Average 2002-2004 20 June 2017

The low interest rate environment: some perspective

Cyclical and structural views combined

Low for long? Most recent market data suggest yields substantially below average and FOMC central bankers indicate lower rates in the long-run

2 3 4 5 FOMC January 2012 FOMC March 2017 FOMC “dot chart “ representing members’ long-term expectations on interest rates

(in percentage points)

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The low interest rate environment: impact on the financial sector

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The low interest rate environment: impact on the financial sector

Banking sector

25 50 75 100 125 150

• 15
• 10
• 5

5 10 15 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Interest margin of banking sector on an unconsolidated basis

Growth of interest bearing assets (lhs) Interest margin (bps) (rhs)

Faster decrease in the funding costs brought the net interest rate margin at very high levels in 2015 and 2016

1 2 3 4 5 6 7 8

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

• Approx. Margin

Implied rate on assets Implied rate on liabilities

Implied interest rates on assets and liabilities

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The low interest rate environment: impact on the financial sector

Banking sector

Preserving future profitability?

Additional risk taking:

►

Search for yield: increasing fraction of high yielding assets (increase in duration, credit risk,…);

Commercial margins:

►

Counter decreases in commercial margins induced by strong competition

Cost reduction:

►

Additional restructuring of the sector

IRRBB projections suggest a downward pressure on net interest rate margins, almost independently of the scenario, pointing to important repricing backlog

11.5 12 12.5 13 13.5 14 14.5 15 Q4 2010 Q2 2011 Q4 2011 Q2 2012 Q4 2012 Q2 2013 Q4 2013 Q2 2014 Q4 2014 Q2 2015 Q4 2015 Q2 2016 Q4 2016 Q4 2018

NII in bn. (past and projected in baseline scenario) NII in bn. (+100 bps. rise scenario) NII in bn. (-100 bps. fall scenario) NII in bn. (+200 bps. rise scenario) NII in bn. ( no change scenario)

Net interest rate income and IRRBB projections

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The low interest rate environment: impact on the financial sector

Banking sector

While the economic environment is becoming more challenging, Belgian banks have sufficient capital buffers and start from a sound profitability

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Build-up of systemic risks in the real estate market

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Build-up of systemic risks in the real estate market

Three stretches

►Household (income) stretch: captures the

implications of household borrowers’ debt for their consumption and other behaviour:

• Trend-wise increase of household leverage :

debt-to-gdp ratio increased by more than 50% since 2005 (1.5% gdp per year): ►Collateral stretch: captures the price levels

and dynamics in RRE markets:

• Overall RRE price indicators have increased

and signals of (some) overvaluation appear (albeit subject to substantial uncertainty) ►Banking

system stretch: captures the potential impact of RRE developments on lenders

• Belgian banks remain exposed to residential

real estate risk (low risk weights and loose credit conditions)

Three types of vulnerabilities are currently building up, possibly resulting in increased systemic risk in the medium term (confirmed by ESRB warning November 2016)

Mortgage loans 10 20 30 40 50 60 70

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Belgium

Build-up of systemic risks in the real estate market

Household stretch

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Sources: EC, ECB, NBB (National financial accounts).

Household debt : development

(in % GDP, 1999Q1-2016Q4)

Euro area²

• f which:

Other loans

Belgian household debt ratio above EA average and households continue their trend-wise leveraging unlike most EA countries

AT DE EE ES FI FR LT LU LV MT NL PT SI

• 40
• 30
• 20
• 10

10 20

• 40
• 20

20 40

Debt-to-GDP ratio, total change (in ppt. GDP, 2010Q1-2016Q4) Debt ratio, change due to outstanding loan volume (in ppt. GDP, 2010Q1-2016Q4) EA ACTIVE DELEVERAGING PASSIVE DELEVERAGING ACTIVE LEVERAGING PASSIVE LEVERAGING

Active vs passive (de)leveraging1 by households

(in percentage points of GDP, 2010Q1-2016Q4)

BE

Build-up of systemic risks in the real estate market

Collateral stretch

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20 40 60 80 100 120 140 160 180

2/1/1982 2/1/1984 2/1/1986 2/1/1988 2/1/1990 2/1/1992 2/1/1994 2/1/1996 2/1/1998 2/1/2000 2/1/2002 2/1/2004 2/1/2006 2/1/2008 2/1/2010 2/1/2012 2/1/2014 2/1/2016

Nominal price index

Price (nominal) developments in RRE BE

House prices more than doubled since 2000. No price correction in financial crisis

• 15
• 10
• 5

5 10 15 20 25

/1982 /1983 /1985 /1987 /1989 /1990 /1992 /1994 /1996 /1997 /1999 /2001 /2003 2004 2006 2008 /2010 1/2011 /2013 /2015 /2017

Over-or undervaluation

Model-based over (+) and under(-) valuation

• f RRE in BE (in %)

Some signs of (model-based)

• vervaluation

20 40 60 80 100 120

2/1/1982 1 1/1/1983 8/1/1985 5/1/1987 2/1/1989 1 1/1/1990 8/1/1992 5/1/1994 2/1/1996 1 1/1/1997 8/1/1999 5/1/2001 2/1/2003 11/1/2004 8/1/2006 5/1/2008 2/1/2010 1 1/1/201 1 8/1/2013 5/1/2015 2/1/2017

Price index (2014 =100)

RRE Price-to-income ratio BE

Price-to-income ratio at historical high 5 10 15 20 25 30 35

2/1/1982 1 1/1/1983 8/1/1985 5/1/1987 2/1/1989 1 1/1/1990 8/1/1992 5/1/1994 2/1/1996 1 1/1/1997 8/1/1999 5/1/2001 2/1/2003 11/1/2004 8/1/2006 5/1/2008 2/1/2010 1 1/1/201 1 8/1/2013 5/1/2015 2/1/2017

Affordability

Affordability (interest-adj.) of RRE in BE (in %)

Real estate least affordable despite low interest rates

Sings of loosening credit conditions for mortgage loans, suggesting increased credit risk

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Build-up of systemic risks in the real estate market

Banking stretch

• Bank lending grows at

an average of 5%f

• Banks extend important

volumes of loans with high LTVs (and DSTIs)

• 30% of loans extended

in 2016 (35 % excluding refinancing) have LTVs above 90%

• 45% of loans extended

in 2016 (50 % excluding refinancing) have LTVs above 80%

• Over 15% of the total

loan stock is has an indexed LTVs above 90%

.

Build-up of systemic risks in the real estate market

Banking stretch

Increasing exposure of banks on commercial real estate

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Conclusions

Ø

Interest rates have been historically low and are expected to remain (relatively) low for some time going forward.

Ø Low interest rates can be explained both by structural factors and by (non-)

conventional monetary policies.

Ø Monetary policy interventions were key in stabilising/supporting the economy during

the crisis and have prevented further (deflationary) pressures.

Ø While overall important and supportive for the economy, low interest rates potentially

also generate financial stability risks.

Ø These financial stability risks arise from the pressure on profitability of banks and

insurance companies that may induce a search for yield

Ø While generalized search for yield is not yet observed in Belgium (Europe), systemic

risk is building up in Belgium, reflected in increasing indebtedness of households and the loosening of credit conditions

Ø Prudential authorities, and specifically macroprudential authorities, should monitor

closely these developments and intervene pro-actively

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Q & A session

Next meetings

19 September 2017 : Gala Event Marc Eyskens « Toward a post-economic revoution?» 6 November 2017 : « Some original proposals to anticipate the expected evolutions in real estate»