Financial Stability Implications of a Prolonged Period of Low Interest Rates Steven B. Kamin Director, International Finance Division Federal Reserve Board October 2018 Disclaimer: This presentation represents my own views and not necessarily those of the Federal Reserve Board of Governors or its staff.
Advanced economy (AE) policy normalization expected to proceed slowly. 2
Implications of prolonged low interest rates for financial stability Might a further prolonged period of very low rates: • reduce viability of financial institutions? • incentivize risk-taking? • increase vulnerability to a subsequent snapback in rates? • threaten financial stability? 3
BIS Study Group • Bank for International Settlements (BIS) study group: • Input from 19 central banks; led by Ulrich Bindseil (ECB) and me. • Focus on two broad categories of financial institutions: • Banks • Life insurance companies and private pension funds (ICPFs) • Analysis applied to over 20 countries; I’ll be focusing on examples from U.S. and Japan. • Report available at: https://www.bis.org/publ/cgfs61.pdf 4
Effect of Low Rates on Banks 5
Channels Through Which Low Interest Rates Might Affect Banks • Squeeze net interest margin (NIM) if deposit rates are stickier than loan rates. • Lower profits may reduce capital and resiliency. • Shift to riskier loans (“search for yield”). • Could lead to future snapback in interest rates that triggers losses. 6
Effect of Low Rates on Bank Profits: 3 Scenarios • Baseline: rates gradually rise to more normal levels. • Low-for-long (L4L): continued weakness in demand and inflation keep rates low. • Snapback: rates later rise sharply in response to higher inflation. United States Nominal 3-month yield Nominal 10-year yield Percent Percent 5 7 Baseline Projection Snapback Projection 3 4 L4L Projection 0 0 2002 2005 2008 2011 2014 2017 2020 2023 2026 2002 2005 2008 2011 2014 2017 2020 2023 2026 CPI Inflation GDP Growth Percent Percent 6 6 4 4 2 0 2 -2 -4 0 2002 2005 2008 2011 2014 2017 2020 2023 2026 2002 2005 2008 2011 2014 2017 2020 2023 2026 Source: “Financial Stability Implications of a Prolonged Period of Low Interest Rates,” Committee on the Global Financial System, 5 July 2018.
Effect of Low Rates on Bank Profits: 3 Scenarios Japan Nominal 3-month yield Nominal 10-year yield Percent Percent 3 4 Baseline Projection 3 2 Snapback Projection 2 L4L Projection 1 1 0 0 -1 -1 2002 2005 2008 2011 2014 2017 2020 2023 2026 2002 2005 2008 2011 2014 2017 2020 2023 2026 GDP Growth CPI Inflation Percent Percent 6 6 5 4 4 2 3 0 2 1 -2 0 -4 -1 -6 -2 -8 -3 8 2002 2005 2008 2011 2014 2017 2020 2023 2026 2002 2005 2008 2011 2014 2017 2020 2023 2026 Source: “Financial Stability Implications of a Prolonged Period of Low Interest Rates,” Committee on the Global Financial System, 5 July 2018.
Projections of Bank Profits in Different Scenarios • Net interest margins (NIMs) would fall materially in a low- for-long (L4L) scenario compared with Baseline. • But overall profitability -- return on assets (ROAs) -- would not. ROAs NIMs Percent Percent 1.5 4 1.0 3 U.S. Japan U.S. 0.5 Japan 2 0.0 1 -0.5 -1.0 0 2001 2005 2009 2013 2017 2021 2025 2001 2005 2009 2013 2017 2021 2025 9 Baseline L4L projection Baseline L4L projection Source: “Financial Stability Implications of a Prolonged Period of Low Interest Rates,” Committee on the Global Financial System, 5 July 2018.
Limited Signs of Low Rates Encouraging Risk-Taking • Banks in some economies have shifted assets toward longer maturities (panel 1); also increased concentration in real estate loans. • But credit-to-deposit ratios have declined (panel 2), and bank credit- to-GDP ratios are also subdued. • Bank capital is up everywhere after the GFC. 3. Bank Credit to Private Sector 1. Weighted-Average Maturity of 2. Credit-to-Deposit Ratio Bank Assets Percent Percent of GDP Years 140 5.0 100 GFC GFC GFC 120 4.0 U.S. Japan U.S. 100 80 3.0 80 60 2.0 60 Other U.S. 40 Advanced 1.0 Japan Economies 20 40 0 0.0 1998 2002 2006 2010 2014 1963 1973 1983 1993 2003 2013 2000 2003 2006 2009 2012 2015 Source: “Financial Stability Implications of a Prolonged Period of Low Interest Rates,” Committee on the Global Financial System, 5 July 2018. 10
So, limited adverse effects of low rates, but some points of concern… • Concern 1: Rate sensitivity of bank profits stronger when: • Yields already low. • Banking more competitive. • Banks depend heavily on deposit funding. • Thus, regional banks in Japan. • Concern 2: Subdued risk-taking may not continue. • Recent experience reflects de-risking and tightening of standards and regulations in wake of the GFC. Net Earnings Projection: Switzerland 2016 = 100 250 Baseline 200 • Concern 3: Future snapback in 150 Low-for-Long interest rates could lead to 100 50 valuation and credit losses. Snapback 0 Snapback + Real -50 Estate Shock -100 -150 2016 2017 2018 2019 2020 2021 11 Source: “Financial Stability Implications of a Prolonged Period of Low Interest Rates,” Committee on the Global Financial System, 5 July 2018.
Insurance Companies and Pension Funds (ICPFs) 12
Key Findings for ICPFs • Low rates undermine ability of some insurance companies and pension funds to make promised payments, threatening their viability. • However, deterioration in condition will be gradual, allowing time to adjust business models and exit unprofitable activities. • Japanese insurers have already faced low-for-long rates, and systemic impact proved containable. • Insurance company bankruptcies of the 1990s addressed without significant contagion to the financial system. • Japanese insurers have adjusted business models so as to maintain viability. 13
Overall financial stability and policy implications of prolonged low interest rates • Financial institutions should generally be able to cope with prolonged low rates, • But this will require concerted attention and adjustment by firms’ management, • As well as close monitoring by regulators. 14
Thank you! 15
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