How Banks Can Deal with the Implications of Negative Interest Rates
Michael Canale, John DelPonti and Joseph Sergienko
Here’s what financial institutions need to know if the Fed decides to push rates into negative territory
Faced with the pandemic-induced economic crisis already unfolding, banks and financial institutions need to prepare in case we see negative interest rates in the coming months.
For the executives leading those businesses, that means thinking about how their customer bases—retail and commercial—would react and whether the systems and models they have in place can handle this possibility. U.S. Federal Reserve Chairman Jerome Powell, in the early days of the COVID-19 crisis, said negative interest was not “appropriate” policy—but with millions of Americans out of work and businesses shuttered, who’s to say what will happen next.
For bankers, it’s time to chart a course.
How consumers would react to negative interest rates
The Fed’s key interest rate is already near zero, and rates on one- and three-month Treasury bills fell into negative territory in late March. But if the Fed decides to push its rates into negative territory—which would force banks to follow suit—one thing’s certain: Retail consumers faced with effectively paying financial institutions to hold their money would pull it out. That’s what’s commonly called a “run on the banks.” Therefore, banks will likely floor rates for retail customers at zero to avoid such a scenario.
Things are a little different on the commercial side. Based on what we know about the negative interest rate environments in Asia and Europe, commercial customers need access to their money, so they will likely keep their deposits where they are, despite negative rates—provided they don’t dip too far.
Banking leaders need to think about how they would approach lending in a negative-rate environment. It’s unlikely that a Fed rate below zero would prompt banks to offer loans that low. But it’s possible that if they could only offer financing at 1 percent or 2 percent, it would significantly erode net-interest margins—that is, the difference between interest paid and interest earned—which could slow lending.
What banks should do to prepare
With the possibility of negative interest rates, understanding net-interest margins is crucial for financial institutions. Doing so is part of asset liability management, which is how banks manage risks generated by the possible mismatch of assets and liabilities. It’s critical in a negative interest rate environment, or in the days before one occurs, because a financial institution’s assets—its deposits—could shrink.
So bankers should watch consumer sentiment and behavior carefully. If possible, they should prepare to make decisions based on the percentage of customers who would pull money out amid sliding rates. This is especially important for core deposits. Banks should also analyze prepayment risk in loans.
Banks also should keep a close eye on deposit betas, which measure how deposits reprice according to market rates. And they should of course watch the key rates from the Fed and attempt to understand reputational risks stemming from legal and political matters.
If they haven’t already, bank leaders should conduct stress tests to determine what would happen to their deposits if rates were at or below zero. Beyond the consumer side, banks should try to determine the impacts on commercial margins.
They also should make sure their internal systems can handle intake of negative rates. Most can, but it’s best to find out now.
“With the possibility of negative interest rates, understanding net-interest margins is crucial for financial institutions.”
Finally, banks should build a liquidity contingency plan, which could include:
Focus on sound Asset Liability Management (ALM) fundamentals to ensure the structure of the balance sheet can withstand a period of negative interest rates; and consider the implications of changing that time period.
Projections under a variety of scenarios that demonstrate potential outcomes depending on which way the crisis turns.
Enhanced collateral monitoring to ensure collateral is free to post elsewhere, if necessary.
Identify replacements for deposits of customers that move their cash to earn yield.
Testing of identified contingency sources to ensure they are there when the bank needs them.
Formulate an effective governance model and risk-appetite framework for hedging strategies (e.g., use of derivatives, shifting to fixed-rate loans, applying zero-floor protections where applicable).
The good news is that negative interest rates are not here yet—and may never be. But it’s better to be prepared, so financial institution leaders should confirm their readiness.