Thinking Through the Implications of Negative Rates
May 20, 2020
10 minute read – Negative rates have been a topic of much discussion this year as interest rates have dropped to historic lows and the economy faces extreme pressure as a result of the COVID-19 pandemic. Much of the discussion is about trying to understand the implications of negative rates on the economy.
When asked about the implications of negative rates in the US, Warren Buffett responded, “I would say that’s the most important question in the world and I don’t know the answer.” He followed up by saying, “They [negative rates] puzzle me, but they don’t scare me.”
While Buffett’s comments highlight that no one can really know what the implications are, there are some things financial institutions can think about when it comes to negative rates.
One way to understand the implications is to look to other countries. In this case, we are going to use Germany, which has experienced negative rates starting in 2015, as a case study.
Note that while using Germany and other countries as case studies is helpful, there are some big differences between those countries and the US that you’ll want to keep in mind.
A question often asked about negative rates is, Would deposit rates be negative? Looking at Germany, the average bank deposit rate is 0.12% as of March 2020. Banks are generally not charging consumers a negative rate, rather they are mostly flooring their deposit rates at 0%.
It is important to note, however, that there are some examples where banks are charging negative interest rates for high deposit accounts. In these examples, the bank is taking the approach of charging a negative interest rate, if a consumer wants to keep large dollar amounts at the bank for safety.
One way to think about negative deposit rates is that they are, in essence, fees. They are just fees proportional to the size of the account balance, versus a flat fee, like an account maintenance fee. As institutions evaluate their financial structure, negative rates and fees may be an area to consider to help with revenue.
The key would be for institutions to think through how negative rates and account fees fit with their overall philosophy on fee income. This includes how they would communicate their approach to members and being clear on the potential reputation risk. Credit unions would also want to check the capabilities of their systems to ensure they can implement whatever decisions are made.
For the loans, there are a couple of points to consider. First, loan yields are not negative in Germany, even though the 10-year bond rate is. There is still a positive spread over the government bond rate. It’s not surprising that the rate is much lower, which puts pressure on the margin.
Second, given the pressure on the margin due to low loan rates, financial institutions may reach for yield through credit risk or make up for low rates in loan volume. Interestingly, it does not appear banks in Germany took on more credit risk. In fact, it looks as if the opposite has occurred with the number of non-performing loans declining, at least through 2018.
When it comes to loan volume, negative rates do encourage lending because the investment alternatives may not be as attractive. In this case, financial institutions would need to have a lot of loan volume to receive some kind of margin. Importantly, this means they would also need to be very careful and strategic with expenses in order to have some level of profitability.
Even with the pressures of negative rates, German banks have shown an ability to generate earnings, albeit lower than what US financial institutions have seen on average over a similar time period. From 2015 to the end of 2019, the ROA for German banks has fluctuated between just above breakeven and roughly 20 bps. Whereas, credit unions in the US have seen an ROA between 0.80%-0.90% and banks have seen between 1.00%-1.40%.
There is one important difference to keep in mind when comparing banks in Germany and financial institutions in the US. German banks had the option to invest in US Treasurys. This gave German banks the option to invest in assets that provided a positive spread and no credit risk.
For example, through almost the end of February 2020, a German bank could have a deposit at 0% and a 6-month US Treasury at ~1.50%. This helps offset the pressure on the margin and the bottom line due to low loan rates.
Critically speaking, US financial institutions would not have that option if interest rates are negative, likely putting more pressure on the bottom line compared to German banks.
Again, no one knows the implications of negative rates in the US. While thinking through what could happen, keep in mind you have 5 main levers you can pull to impact your ROA. Ask yourself, what other levers would you need to pull in this environment, and how would your measures of success change? Answering these questions might open different views on fee income and other sources of earnings that could be opportunities today.