Will destination zero-bound buoy markets and kick-start economic growth?
by Douglas E. Johnston, JrMr. Johnston is a financial expert witness and global banking and business consultant. He is a former US bank president who later became EVP-Finance & Administration and a ‘Founding Father’ of Platinum Equity, LLC, the largest private company in Los Angeles. He has lived and worked across the US and Europe, and lives in Santa Monica.
For seven years, U.S. and European central banks have carefully nurtured global markets with ‘Quantitative Easing’ (QE) stimulus and open-market bond purchase programs designed to keep interest rates edging ever lower toward the ‘zero bound.’
At a high level, the approach has been clear enough – if low interest rates buoy markets, then perhaps actual negative rates will foster greater global economic growth. So the Basel-based Bank for International Settlements, known as the central bank for central bankers, introduced negative rates as the ‘new frontier’ in monetary policy to help stimulate
However, as negative rates have moved from theory to fact, their full impact and related consequences have been less clear. With global negative rate bonds now capturing about $7 Trillion of European markets (approximately one-third of the Government bond market), and with Japan and Sweden also committing to negative rate structures in early 2016, the early results still remain decidedly mixed.
A guaranteed loss of principal?
While negative rates remain an enigma to the average man on the street (‘Why would anyone agree to a guaranteed loss of principal at maturity?’) central bankers are also closely gauging their impact in financial markets.
They remain a market phenomenon without established textbooks or historical precedent to guide regulators or participants. European bank stocks have dropped 30% since the debut of negative rates, and the Fed and US banks are monitoring a scene which even John Maynard Keynes, the architect of much of the global monetary system, did not anticipate.
At the present, the US Fed is moving in the opposite direction of Europe, with Chairman Janet Yellen recently announcing the first rate rise in nearly ten years in December 2015. But with the resulting 12% downward correction in the US equity markets in early 2016, will the Fed again reverse course? Are negative rates also coming to US community banks?
The goal of negative rates is to stimulate the economy by influencing the day-to-day intermediary role of commercial banks. Policy-makers intend for negative rates to accomplish two primary objectives:
- 1) encourage more commercial bank lending and
- 2) discourage traditional savings
A slowdown creeps along
In times of pending economic slowdown (now emerging across the globe) a bank would normally shift toward investing a higher percentage of its surplus funds into ‘safer’ low-risk government and corporate bonds – rather than make higher-risk loans – as the economy weakens.
But in an emerging negative-rate environment, the bank is mathematically ‘penalized’ if it remains invested in low-risk bonds – because it will realize either super-low or even negative yields on the funds it does not lend. Negative rates are thus intended to encourage far more aggressive commercial bank lending activity because they effectively penalize banks which do not lend to businesses in sufficient volumes to promote desired growth.
The mathematical penalty kicks in at a point in the business cycle where a normally bullish bank traditionally wants to ‘pull in its horns’ by avoiding riskier loans, and where its profits may already be under pressure.
By adding a mathematical penalty in the form of negative interest on significant portions of a bank’s bond portfolio, the new paradigm thus has added bank management implications which appear to run directly opposite to the risk-averse Basel I-III bank capitalization and risk guidelines which were introduced globally in 1985.
These so-called ‘Basel Accords’ now carry the effective weight of core bank regulatory guidelines for banks around the world. These guidelines already well known and widely followed by and among the FDIC and metropolitan banks, as well as by virtually all community banks across the US. Changing the risk-averse focus of bank lending guidelines which have been built steadily and by global consensus over the past thirty-five years is certainly no small thing to consider. The entrenched cultures of bank risk aversion and bank investor expectations thus appear to be in the crosshairs of negative rate policies.
Negative Interest ‘Rent’
At the same time that bank management sees that the bank must choose to make more higher-risk/higher-rate loans rather than invest in low-rate (or negative rate) bonds, the bank’s depositors will also see their own penalties in the form of ultra-low or even negative rates on their CDs and MMAs.
The average depositor is faced with the prospect of effectively paying negative interest ‘rent’ just to have an account, instead of being rewarded for thrift and savings. In this regard, negative rates encourage spending over saving, and thus they may herald changes at the very heart of the capitalist role of banks. In a parallel development, negative rates may also pave the way for the advent of a theoretical ‘cashless’ economy.
Significantly, the European Central Bank and former US Treasury Secretary Lawrence Summers have recently called for the abolition of large-denomination E500 and $100 bills within the European and US economies.
Eurofi, a European-based think tank chaired by former IMF Director Jacques de Larosiere, has focused on the negative rate phenomenon, and with the support of European Central Bank President Mario Draghi. In remarks prepared for the April 2015 Eurofi High-Level Seminar, former BIS Deputy General Manager Herve Hannoun addressed the growing phenomenon among a ‘Who’s Who’ of central bankers, international banks, insurance companies, financial market makers, rating agencies and regulators.
New growth-oriented lending
Among its initiatives, Eurofi is addressing the technological and regulatory framework for new growth-oriented lending and capital market mechanisms across Europe. Given the recent emergence of crowd-funding, P2P (Peer-to-Peer) financial activities, and other new technology and delivery platforms, one possibility is to reconsider the traditional role of how commercial banks have functioned as intermediaries between depositors and business borrowers.
Negative rates may accelerate a watershed change of of delivery systems toward computer-access securitization markets – rather than traditional bank ‘bricks-and-mortar’ platforms – for small to medium businesses seeking debt and equity funding.
As Hannoun noted in his remarks, “The main aim of an ultra-low interest rate policy is to deter saving and encourage borrowing.” Interested US-based banks and institutions were amply represented at the Eurofi meeting, and they will no doubt give due consideration to growth mandates and possible day-to-day banking changes on this side of the Atlantic as well.
As noted, the full implications of negative rates are still unfolding, and US banks will be following this story closely as the Federal Reserve contemplates additional stimulus policy options. ◊