The Madness of Negative Interest Rates and Why You should Care05.16.2016
Two prevalent items have surfaced in the first quarter of 2016 – market volatility and questions on negative interest rates. The two are very much interrelated and have become a hot subject for discussion with credit union management teams, directors and even members. This article will simplify the complex topic of a negative interest rate policy (NIRP) by discussing who, what, how, and why at a macro level.
Question: Why are we hearing about negative interest rates?
The possibility that at some point over the next few years our economy will slow and reenter recession cannot be ruled out. Sure, the U.S. economy is currently growing, jobs are being created and inflation seems to be moving in the desired direction. However, three noteworthy events have occurred since the FOMC voted unanimously to hike short-term rates in December 2015: 1) the European Central Bank further cut rates into negative territory; 2) the Bank of Japan adopted negative interest rates; and 3) the Federal Reserve Bank published their annual stress tests for the largest institutions which included a severely adverse scenario with negative interest rates here in the U.S. These three items are eye-opening in magnitude and present meaningful downside risk to the economic health of the U.S.; hence the market volatility thus far in 2016. Vigilance is clearly warranted given that these risks could serve to further erode credit union margins.
Who has adopted negative interest rates?
The central banks of major economies including Japan and Europe have adopted a negative interest rate policy (NIRP). Several countries have even gone into “more negative territory,” such as Switzerland where the policy rate is now at -75bp. Negative rates have even spread to longer-term securities; in Germany, government debt carries a negative yield out to maturities approaching eight years. Also of note, there is currently a whopping $7 trillion of global debt that is at negative interest rates.
A NIRP is clearly not just a theory—these are certainly very significant economies and they are under extreme pressure to stimulate economic growth and move above recessionary levels. It is also important to understand that negative interest rates are being adopted in conjunction with very accommodative quantitative easing programs that mimic those utilized here in the U.S. during the great recession (recall QE1, QE2) and are expected to last for several more years.
The Federal Reserve Bank has NOT adopted negative interest rates and, as we all are aware, has been striving to do just the opposite and push rates higher. What has changed in 2016 is the severity of the stress-test scenarios required for the largest, most significant financial institutions and are created by the FRB once a year. The FRB recently published the annual stress-test scenarios as required under the Dodd-Frank Act, which include three scenarios—a baseline, adverse and severely adverse. While only applicable by law to the largest institutions, it is important to recognize that the revisions to the adverse scenarios for this year now include more significant deterioration both globally and here in the U.S., with a severely adverse scenario that includes negative interest rates (-0.50%) on short-term U.S. treasuries. The FRB does a great job within the publication of alerting readers that the two adverse scenarios are NOT a forecast, but they do represent a notable amount of added stress (deflation, higher credit losses on a wide range of assets, increase in unemployment) in comparison to the 2015 publication. The current publication also highlights the weakness that has occurred since the 2015 publication, additional accommodative measures taken globally, and also that the FRB is going to be looking at the ability of the largest institutions within the banking industry to withstand a significant economic downturn that includes negative interest rates on the short end of the curve (also of note: the Prime rate is assumed to keep its 300bp correlation with Fed Funds and as such declines to 2.50%).
How do negative interest rates work?
Many credit unions hold excess cash reserves on deposit at the FRB. In practice, a negative interest rate policy would mean that instead of the credit union receiving interest on the reserves they hold with the central bank, they would be charged a fee (essentially a safekeeping fee). The expectation is that to avoid the fee for keeping money on deposit, credit unions would shift to other forms of investment or lend the money out. Ultimately, the efforts of credit unions and others to avoid negative returns on holding free and idle cash should lead to declines in a broad range of interest rates, such as mortgage rates and the yields on securities, while also promoting additional extension of credit to consumers and businesses. This is precisely what has occurred since 2008 and has pushed yields lower on securities, reduced mortgage rates, increased competition for commercial loans, flattened the yield curve, and the list goes on.
What does this mean for my credit union?
There are a lot of questions that come to mind regarding a negative interest rate policy. Would moving rates below the ¼ and ½ percent range we are in today really do anything further to sustainably stimulate the US economy? How negative can interest rates go? Would members withdraw share deposits from credit unions and hoard cash? Would credit unions decide to or need to hold more cash and how much would it cost to store large quantities in their vaults? Would there be significant disruptions in the wholesale/non-member funding markets?
While not all-encompassing, these are several of the questions we, at DCG, have encountered and recently discussed with groups of all sizes and shapes. And while certainly great points to think through, these questions will remain unanswered until experienced in practice. In the meantime, as managers of risk, each credit union should understand the impact to earnings (and therefore its ability to add back to net worth/capital) not only of higher interest rate environments—on which you have likely been focusing for many years now—but also lower rates. All too often we find that credit unions focus their strategies and energies on managing earnings under rising rate scenarios, which produce positive results more often than not, with little discussion around the potential greater risk to earnings—falling rates.
In looking at net interest income, net income and capital projections at your credit union this quarter, you are likely finding that the recent loss of slope in the yield curve has had a negative impact on your results compared to just last quarter (assuming you have appropriately updated your intermediate to longer-term loan and investment rates to today’s less attractive market). While many management teams and even Board members thought that longer-term interest rates would climb higher given the short-term rate hike in December, just the opposite has occurred. Somewhere between a 50-75bp of slope in the yield curve has disappeared since December given the aforementioned global volatility. As a result, yields on loans and investments have tightened. Before going to the extreme of looking at negative interest rates (which the largest financial institutions are just now beginning to do), strategically examine and discuss a down 50bp or 100bp rate scenario, wherein long-term rates decline further from today’s levels, forcing lower reinvestment rates on asset cash flows. While this will not capture the full impact of negative interest rates on the short-end, you will find: 1) it to be painful and 2) that it will concisely capture the major problematic circumstance for this industry, which is the reinvestment of dollars from loan and investment cash flows to even less attractive rates.
Assuming you want to protect against your downside risk, think through your strategic options (which by the way should also bode well under a negative interest rate scenario). You will likely need to reassess your strategies for desired investment mix, asset allocation, loan growth, loan promotions, member share pricing and structure and wholesale funding mix. Credit unions should put on the table for discussion sufficiency of fee structures on the loan and deposit front, prepayment penalties on member business loans, as well as floors and spreads on floating and adjustable rate loans.
While at this juncture, the probability that negative interest rates will be a tool used in the U.S. to combat a recession/stimulate growth is fairly low, management teams and Board members should be aware and remain updated on this topic while also recognizing that credit unions with solid earnings, capital, access to liquidity and strong credit quality will best weather potential storms.
Keri Crooks is managing director for Darling Consulting Group, a Newburyport, Mass.-based provider of asset liability management (ALM) solutions for financial institutions.