The Impact of Low Interest Rates on the EU Financial System
The topic of low interest rates has been at the forefront of policy and academic discussions for a while now. The first question is why rates are low. The second is how long they will remain such. The debate sees two opposite views. Advocates of the "financial cycles" hypothesis (Borio, 2012; Lo and Rogoff, 2015) claim that nominal rates are reduced in response to financial shocks such as extensive deleverage. Advocates of the "secular stagnation" view argue that structural factors such as adverse demographic trends and low productivity cause excessive saving over investment, thus depressing growth and interest rates. According to the former, interest rates may remain low for long, but they will restore to normal values once cyclical factors vanish. According to the latter, by contrast, interest rates have declined permanently, and they will remain low even when the cycle recovers.
A related but less discussed question concerns the implications of low interest rates for financial stability. While helping (at least in principle) boost the economy through lower cost of debt and improved debt service, low nominal interest rates, if persistent over a prolonged period of time, may negatively affect the profitability of financial institutions, thus potentially threating the sustainability of "traditional" business models. In response to such threats, financial institutions may change their strategies and risk profiles with the consequent building up of new vulnerabilities and trends in the financial system.
To address these important issues, the European Systemic Risk Board (ESRB) has conducted in the last 18 months a lengthy study on the effect of low interest rates for macroprundential policy and the structural changes in the EU financial systems. The study culminated in a report jointly prepared by the Advisory Scientific and Advisory Technical Committees (ASC and ATC, respectively) of the ESRB and the Financial Stability Committee (FSC) of the European Central Bank and published in November 2016. The report, which was co-chaired by Elena Carletti (Bocconi University and ASC), John Fell (European Central Bank and FSC) and Jacek Osiński (National Bank of Poland and ATC, ERB), had the objective to analyze the effects of (a prolonged period of) low interest rates on financial stability and the future developments in the European financial system. In line with this, the report analyzes all major sectors in the financial system as well as cross-sectoral spillovers and contagion channels.
The report identifies three main areas of risks for financial stability related to prolonged low interest rates: (1) the sustainability of certain financial institutions' business models; (2) broad-based risk taking; and (3) the move towards a market-based financial system. These risks are interrelated and their magnitude varies across financial sectors and Member States.
The first area is mostly concerned with threats to the profitability of certain financial institutions. In an environment of prolonged low interest rates and weak economic growth, the profitability and solvency of financial institutions that offer guaranteed returns (notably life insurers and pension funds) and of banks due to reduced net interest income may come under pressure. The second area relates to financial risks arising from financial markets and excessive risk taking. These risks may increase in the low interest rate environment because of a search for yield, crowded positions in some categories of assets (including real estate) and uncertainty about fundamental asset price values. The third category refers to the structure of the financial system. In a prolonged period of low interest rates the financial system is more likely to become more market-based. While this is a welcome development in line also with the capital market union initiative, it may also lead to the emergence of new financial stability risks and to an accentuation of those risks that are less prominent in a banking-based financial system.
These findings are important for various reasons. First, they suggest that the (net) effects of low interest rates on the economy have to be analyzed carefully. Even withstanding their positive effects on economic activity and growth, they may entail financial risks and lead to important structural changes in the financial system.
Second, there is already evidence that financial institutions providing longer-term return guarantees such as life insurers and pension funds are increasingly moving away from guaranteed-return to unit-linked business models. This means that the financial system is withdrawing from the provision of longer-term return guarantees, thus shifting the implications of low interest rates in terms of lower and more uncertain returns onto households and investors.
Third, facing profitability pressures and growing competition from non-bank sectors, banks may try to boost their returns by relaxing credit standards and engage in riskier activities. As a result, asset quality may deteriorate further, although low interest rates should increase the debt servicing capacity of borrowers. Due to the already high level of non-performing loans especially in countries like Italy, the implication of protracted low interest rates on banks' profitability and asset quality is of outmost importance.
Finally, the shift of activities to the non-banking sector may call for changes in the design of financial regulation. In particular, it requires enhanced supervision of risks stemming from bank-like activities in the non-bank sector and the developments of activity-based regulatory instruments. Overall, this would lead to increased regulation for non-bank institutions performing banking activities and may thus contribute to restore, at least partly, a better level playing field in the financial system.