In reality, key economies have been at low, zero, or negative interest rates for some time as shown in Figure 1.
The impact on a bank’s balance sheet and customer behaviors can be material, so we need to understand these factors clearly. For example, in Denmark,1,2 many banks issue loans at negative rates but Switzerland offers negative rates3 for deposits or amounts over certain thresholds. Additionally, understanding changes in product pricing and customer behavior is vital to asset and liability management (ALM) modeling. The mix may also be shifting between net interest income (NII) and fee income as margin compression continues, with many deposit rates floored at zero. ALM modelers must pay special attention to these areas.
Regarding the effects of negative interest rates on stimulating growth, the European Central Bank issued a review of negative rates. On the economic benefits, they argue the following:
“The transmission of negative rates has worked smoothly and that, in combination with other policy measures, they have been effective in stimulating the economy and raising inflation.”4
Overview of negative interest rates
Negative interest rates are not new but are becoming more prevalent as entities in Switzerland, the Euro zone, and Japan already have experiences with negative interest rates. While the theory of negative interest rates is to stimulate growth, this has been difficult to achieve; consumers may see negative interest rates and stifle spending out of caution. In Japan, it is hard to know if low or negative interest rates alone provided economic stimulus; interest rates in Japan steadily increased before the Global Financial Crisis of 2007–2009.
There have been a number of negative rates in retail markets. Looking at the global context, banks in Germany5 and Switzerland have applied negative savings rates, and in Denmark, a negative residential mortgage rate has been available. However, despite a negative headline rate6 (-0.5% for years), Danish banks applied fees that were likely to ensure a positive overall return to the bank. Additionally, some Swiss banks charge for deposits over CHF 2 million.
One of the effects of low or negative rates is to reduce interest income due to a lower return on a treasury’s liquid asset portfolio. In the United Kingdom, the Bank of England stated it will use negative rates to stimulate the economy as and when necessary. As the nation prepares for negative rates,7 other central banks may do the same. What is unknown is whether the threat of negative interest rates affect an improving GDP (and inflation). The important takeaway here is the potential impact this may have on ALM net interest income sensitivities, and whether there will be any evidence of changing customer behavior or a change in the income mix for banks and financial institutions.
Figure 2 outlines some of the questions and key considerations that arise around negative interest rates.
Do contracts have embedded floors in savings and lending products?
- If not, can (or should) new terms be issued to customers?
- What are an institution’s contractual obligations?
What will commercial teams do with customer interest rates?
- Will lending be at a negative interest rate?
- Will negative interest rates for savings become the norm (as in Switzerland)?
- Will they apply to the entire deposit or for certain segments—that is, balances over a certain threshold? (This is especially pertinent where customers hold only one product with the bank and the net return for the bank is negative.)
- Can banks access the required data to able to charge negative rates on a portion of a customer’s balance accurately?
- Can banks truly assess the total customer return and assess whether to charge a negative rate for deposits, especially where the customer has no other business with the bank?
Will additional fees be charged?
- Will this mean an all-in positive return for the bank?
- Will the net result be clear regarding the total cost to customers?
- Will this adhere to the principle of treating customers fairly?
How will customers react?
- Will they save or spend in a low interest rate environment?
- Are negative interest rates somewhat counterproductive? (As seen in Japan, the fear of a recession—and the fact that a negative interest rate environment exists—can induce more consumer caution and less spending.)
Practical implications for ALM managers
Until the last decade, many countries did not experience negative interest rates and looked at Japan as an anomaly. However, the number of countries with negative rates is growing. Even if central bank rates have not dipped into negative territory, many market rates have done so to varying degrees. For example, in the United Kingdom, while the Bank of England base rate remains at 0.10%, the yield curve has dipped into negative territory. This is the result of perceived future interest rate decreases with Government debt issuances also taking advantage of the lower interest rate environment, and the regular UK Treasury Bill issuances frequently issued at negative interest rates.
From an ALM perspective, teams that forecast the bank’s NII are required to understand and explain those sensitivities. Historically, bigger, well-established banks have benefited from an extensive pool of current account customers who previously benefited from historic low interest rates. However, in the ever-lengthening period of low interest rates, the benefit to current account portfolios has decreased. Challenger banks looking to grow their balance sheets have had an advantage when there was less of a benefit to those current accounts—but when acquiring new deposits at the marginal rate eroded their margins, those banks were at a slight disadvantage. With negative central bank rates, the impact, modeling, pricing, and behavioral characteristics and the level of granularity and analysis required to truly understand the impact on the NII are only becoming more complex.
Negative savings rates
Will these become a reality? It already is for many customers, especially those with large balances where bigger deposits or amounts over a threshold attract negative rates in Switzerland, Japan, and Germany. For example, many Swiss banks are charging negative interest rates on balances over certain thresholds typically ranging from balances over CHF 50,000 to balances over CHF 2 million with interest rates up to -0.8%.
Regarding ALM, managers should take the following actions:
- Determining and validating the commercial pricing assumptions in a negative rate scenario
- Understanding if the commercial teams plan to introduce tiered interest rate pricing on individual savings accounts as in Switzerland
- Ensuring ways to model and analyze these new tiered interest rates
- Understanding how net interest income will change relative to fee income
For savings products, the cliff-edge effect of a very low-to-negative interest rate environment must not be underestimated. While many ALM managers have been modeling interest rate floors for a number of years, it is not clear what will happen to savings if a negative rate were applied.
Negative mortgage rates
There are already negative mortgage rates; Denmark was the first country to offer negative interest rates on a mortgage at a rate of -0.5% for a term of 10 years. To make such products commercially viable, banks can apply upfront fees to turn a negative interest rate to an overall positive rate. Lenders must ensure they are transparent with the all-in cost of a mortgage even if the headline rate is very low or negative. Also, they should make sure that where there are any negative rates, an APR that includes fees is clear and understandable by the consumer.
Negative rate impacts on unsecured personal lending
ALM managers need to understand what their institution’s response will be to a decrease in base rate, especially to negative rates. A financial institution should already be aware of the impact and floors in various scenarios of low and negative rates, including expected changes to customer interest rates, and default rates and prepayment changes (accelerating for loans without early prepayment fees). Unsecured personal loan rates tend to be well above central bank base rates, so loan interest rates are highly unlikely to be negative. The exception would be a significant negative interest rate, which again is unlikely; globally, rates have not moved further than 50 bps into negative territory to date.
Credit cards are typically another high interest loan facility, so the impact will probably be similar to unsecured personal loans. Some lenders may decrease the headline rate on cards slightly but will treat many cards like a semi-fixed rate product. The true effect will depend on lenders and their approach to passing on base rate moves. Banks usually pass on rates at varying degrees to different segments of their book, whether it is credit cards, or savings or loan pricing.
All banks hold high-quality liquid assets as a liquid asset buffer to ensure the institution has sufficient liquid resources to survive a severe but plausible stress. This means that if they cannot raise any new deposits, they use this cash reserve to pay their liabilities as they become due. The size of these liquid asset buffers varies from bank to bank depending on an organization’s risks and complexity, but buffers are typically a minimum 10% of the total balance sheet.
Many countries have seen negative rates in the wholesale markets, and bank P&Ls will have been impeded by lower central bank rates. Any subsequent interest rate reduction will only see returns fall further whether an institution holds high-quality liquid assets as funds at the central bank or has invested in government securities. A decrease is to be expected in either case. Banks that have invested in long-term instruments on a fixed-rate basis will have a higher return. As these assets mature and new investments are sought, then returns will decrease. Conversely, firms with substantial funds in their account at the central bank will see an immediate reduction in returns.
Derivatives and options
Many (if not all) banks have some form of derivatives and options to hedge and manage interest rate risk in the banking book. Banks should know if there are any embedded floors in the existing contracts and their effect on earnings—and when the derivatives are due to mature or reprice.
Defined benefit pension schemes
Entities that have current or legacy defined benefit pension schemes (even if they are closed) will have seen a significant impact on valuations. Right now, this effect may be offset by increased equity valuations, but there is a significant dependency on a consistent performance in equity markets. This market risk requires active monitoring to grasp the underlying risk to the bank.
Running scenarios and management actions
ALM teams know that running scenarios helps anticipate the possible outcomes of different future rate paths and their effect on management decisions. These include:
- Lower or negative savings rates and increased savings attrition
- Increased fee income
- Tiered interest rates depending on deposit amount
- Different pass-through assumptions in fluctuating scenarios, especially given likely or actual floors on savings products and low interest income lending products such as mortgages
- A redesigned ALM chart of accounts and data inputs to accomplish the following:
- Segmenting each deposit into multiple tiers and interest rates, and consequently different behaviors under various interest rate scenarios
- Acquiring more data to model and assess fee income and its effect on the bank’s overall return
- Lost income from decreased interest income on liquid asset buffers that are difficult to recoup from lower savings rates and higher lending rates (Note: To recoup and cover these lower returns, banks will be forced to look at lower savings rates, which are already floored; another alternative is to raise or at least maintain lending rates. Therefore, it is possible that negative rates may actually increase lending rates in the market as banks look to protect returns.)
Low and negative interest rates raise awareness of what will happen when or if interest rates rise. Analysts will watch how the savings market reacts, observe what the cost of funds will be, and see if the incumbent banks gain an ever-increasing advantage as current and back books start to provide significant margin benefits as a cheap source of low-cost funding.
What do customers do when faced with negative interest rates?
With lower interest rates, there has been a noticeable shift in investor appetite for returns. Despite increased retail deposits during the COVID-19 pandemic, this has been driven largely by restricted customer spending because of closed shops and travel restrictions, causing lower consumer confidence. It is a possibility that introducing negative rates to deposit products may reverse this trend as depositors move funds to other investments seeking higher returns. While it is highly unlikely that banks will start charging interest to their customers for all retail depositors, there may be charges for retail customer current accounts, especially due to the transactional costs of such accounts—or as in Switzerland, negative rates applied for balances over a threshold.
ALM managers must work with commercial teams to determine what actions to take in a negative interest rate environment. These actions can then be modeled in an ALM system to know how interest rate risk will be affected. For example, the teams may run several scenarios where all, some, or no customers would withdraw their funds.
Bank account charges are common in many countries. However, banks in some jurisdictions, such as the United Kingdom, tend to restrict charges to corporate/business accounts rather than retail accounts; in the event of negative rates, this might have to be reviewed. With negative rates, the effect for an ALM manager in this environment is the behavioral impact to deposit flows. An interest rate shock might inadvertently trigger a liquidity stress with mass withdrawal of funds. Considering the real risk to liquidity and the survival of the bank, the bank must perform analysis of these and many other possibilities. This will enable the ALM team to validate the expected effect of lower rates and management actions, and then work with commercial teams to refine the customer rate and fee application response.
What happens to fee income in a negative interest rate scenario? Some financial managers, such as the CEO of Mizuho Bank, state that fee income will increase.8 This may not be adequately covered in an ALM model. Fees may become a more important factor in the overall return for the bank, so it is essential for managers to know what fee characteristics are and how to model them correctly. In this situation, managers must consider the correlation between interest rate rises and fee income; that is, if a bank reduces fees on existing accounts, or only on new deposit products offered as a competitive advantage.
Additionally, managers must be aware of the behavioral characteristics assigned to the legacy book to determine if customers with low or zero interest rates with account charges are more likely to withdraw funds or move to other products within the bank. These are new areas in many markets, so the outcome will have to be estimated—although some assumptions can be applied from existing products and experience since the financial crisis.
It seems clear that for ALM managers, understanding the commercial team’s response and the subsequent expected customer reactions are essential in a negative interest rate environment. Can savings rates go lower, will lending rates decrease, or will there be no changes as banks cover the lost revenue from their liquidity portfolio? Whatever the circumstances, ALM managers must focus on anticipating commercial and behavioral assumptions and ensuring all scenarios are modeled accurately in the ALM system.
1 Christian Wienberg, Bankers Stunned as Negative Rates Sweep Across Danish Mortgages, Bloomberg, May 23, 2019
2 Emmie Martin, Danish bank offers mortgages with negative 0.5% interest rates—here's why that's not necessarily a good thing, cnbc.com, August 12, 2019
3 Swiss Banks with Negative Interest Rates, Moneyland.ch
4 Isabel Schnabel, Going negative: the ECB’s experience, European Central Bank, August 26, 2020
5 Kevin Helms, 300 Banks in Germany Charge Negative Interest Rates Including Deutsche Bank, Commerzbank, ING, Bitcoin News, November 15, 2020
6 Official Interest Rates, Dansmark National Bank
7 Letter from Sam Woods - Feedback: Operational readiness for a zero or negative Bank Rate, Bank of England, February 4, 2021
8 Gareth Allan and Shingo Kawamoto, Mizuho CEO Says Higher Fee Income Will Offset Negative Rates, Bloomberg, May 29, 2016