The impact of very low interest rates on bank profitability
This page contains information from the November 2019 Financial Stability Report.
Slowing global growth in recent years has led central banks internationally to maintain or adopt very low policy rates, including in New Zealand. Some have taken their policy rates to negative levels, including in the euro area, Denmark, Switzerland and Sweden. At the same time, global ‘neutral’ interest rates have also fallen, reflecting demographic and structural trends affecting the demand for and supply of savings. Low interest rates are likely a ‘new normal’ for the New Zealand and global economies for the foreseeable future.
Low interest rates can affect the stability of the banking sector through several channels. Low interest rates can encourage financial institutions to search for higher returns and increase their lending volumes, which are intended ways for monetary easing to stimulate the economy. However, higher bank lending may be achieved by investing in riskier assets, and reducing their lending standards. Low interest rates can also affect bank resilience by reducing their profitability, including by compressing net interest margins (NIMs). This box examines the impacts of low interest rates on bank profitability internationally.
On balance, international research has found that low interest rates tend to reduce the NIMs of banks.9 A portion of banks’ retail deposit funding is on-call accounts that generally pay little or no return, and are insensitive to monetary policy settings. A fall in interest rates tends to compress the lending margins associated with this funding. Furthermore, low interest rates tend to flatten the yield curve, which can be negative for net interest incomes, reflecting the fact that banks tend to borrow short term and lend long term.
Other effects of low interest rates can be positive for bank profitability. Evidence from the US, Europe, and other advanced economies suggests that low interest rates induce banks to shift from net interest incomes to non-interest revenue, including fee-based and trading activities. Each interest rate decline also provides a one-off boost to asset valuations, which has supported bank profitability. Borio et al (2019), using 1994-2015 data on 113 large banks in 14 advanced economies, estimate that on average each 1 percent decline in the policy rate is associated with an increase in income from fees and commission of 0.93 percent.
Further, a sustained period of low interest rates tends to lower credit risks, by reducing the debt servicing burdens for variable-rate and newly fixed loans. While low rates may encourage bank risk-taking on the flow of new loans, the effects of this on credit losses take time to materialise on the stock of lending. Therefore, low interest rates should reduce banks’ level of loan-loss provisions, which will support the profitability of the banking sector.
The balance of evidence suggests that the overall impact of low interest rates on bank profitability is broadly neutral.
There is relatively less evidence of the impact of negative interest rates on bank profitability, reflecting the small number of jurisdictions that have implemented negative rates to date. Negative rates may cause NIMs to contract further if banks cannot pass on negative rates to depositors. In countries where banks are sound, banks have generally been able to maintain similar funding spreads on corporate deposits as interest rates turned negative.10 In Switzerland and Denmark corporate deposit rates have been negative. Household deposit rates have also generally fallen. However, where the policy rate is heavily negative, for example in Switzerland, evidence is emerging that household deposit rates may be sticky at above zero.11 This suggests that households, which incur relatively low costs from holding cash, may be unwilling to accept a negative deposit rate.
On the lending side, banks have generally passed on the fall in funding costs to borrowers, leading to lower lending rates. Aggregate lending rates remain generally positive, although negative mortgage rates and short-term rates to institutional borrowers have been reported in Denmark and Switzerland respectively. Overall, those countries that have implemented negative interest rates have not experienced significant falls in bank profitability.
Many of the factors supporting bank profitability in a low interest rate environment in the international context would also apply to New Zealand banks. We expect lower NIMs to be balanced out by low credit loss expenses and potentially increases in other revenue sources. A negative OCR is not currently a central scenario in the Reserve Bank’s published forecasts. Given that unconventional monetary policy tools have not been used in New Zealand, we are less certain of the impacts of negative interest rates for New Zealand banks. The Bank is considering the potential impacts of unconventional monetary policy tools on bank profitability in its current preparatory work on unconventional monetary policy.
- 9 Borio, C., Gambacorta, and L., Hofmann, B. (2015), ‘The influence of monetary policy on bank profitability.’ BIS Working Papers, No. 514.
Borio, C., Brei, M., and Gambacorta, L. (2019), ‘Bank intermediation activity in a low interest rate environment.’ BIS Working Papers, No. 807.
Bikker, J., and Vervliet, T. (2017), ‘Bank profitability and risk-taking under low interest rates.’ International Journal of Finance Economics 23:1, pp. 3-18.
- 10 Altavilla, C., Burlon, L., Giannetti, M., and Holton, S. (2019), ‘Is there a zero lower bound? The effects of negative policy rates on banks and firms.’ ECB Working Paper Series, No. 2289.
- 11 Madaschi, C. and Pablos Nuevo, I. (2017), ‘The profitability of banks in a context of negative monetary policy rates: the cases of Sweden and Denmark.’ ECB Occasional Paper Series, No. 195.