This is a comment that has been heard regularly in recent times: « negative interest rates are undermining the profitability of banks. » Is this statement true, and if so, what mechanisms are at work? In this insight, we review, point by point, the channels through which negative rates affect bank profits, both positively and negatively.
Theoretical channels through which negative rates increase bank profits :
– (as with any rate cut) Lower rates will increase the price of fixed-rate instruments held by banks (fixed-rate bonds, for example). Banks will therefore record gains when rates fall. This is a short-term effect and is only relevant at the time of the rate cut.
– (as with any rate cut) When rates fall, it becomes less difficult for borrowers to repay their loans, particularly in the case of variable-rate loans (also due to the relative improvement in the economic climate that is expected to follow). Banks therefore face fewer credit defaults, which has a positive impact on their profitability. This is a long-term effect.
Theoretical channels through which negative rates reduce bank profits :
– (as with any rate cut followed by expectations of low rates) When rates become lower and such low rates are also expected in the future, the spread between long-term and short-term rates (e.g., the spread between the rate on a 10-year bond and that on a 1-year bond) narrows. This is referred to as a flattening of the yield curve. It means that the bank’s business becomes less profitable in the long term, since it borrows in the short term to invest in the long term and the yield spread between these two maturities has narrowed. This is a long-term effect: it persists for as long as negative rates remain in place.
– (specific effect of negative rates) Banks may decide (or be required by law) not to impose negative rates on their depositors, simply for fear that they will withdraw their money and thus sever an important commercial relationship. Thus, while banks’ assets see their interest rates fall and sometimes become negative, financing costs do not fall to the same extent because of this constraint on depositor remuneration. In a banking system such as that of the eurozone, where deposits account for nearly 40% of banks’ funding on average, this effect can be very significant. It is an effect that weighs heavily in the long term.
Thus, the assertion that « negative interest rates undermine bank profitability » appears difficult to prove, given that countervailing effects that are difficult to quantify come into play over different time horizons. At this stage, however, the consensus seems to be that there is a negative effect on bank profitability, supported by various empirical studies (see Borio et al (2015) in particular).
Julien Pinter
Further reading:
Claudio Borio, Leonardo Gambacorta, and Boris Hofmann (2015) « The influence of monetary policy on bank profitability »
Benoît Coeuré (2016) « Assessing the implications of negative rates »
