Fed warns against risks of long-term low interest rates

Long-term low interest rates may jeopardize the profitability of US banks and encourage bankers to engage in risky behavior, which could jeopardize financial stability, the Federal Reserve said in a new report published on Friday.

In this semi-annual report, the central bank provides an overview of all risks to economic stability, similar to the report the Dutch central bank publishes every six months. One of those risks is that the low interest rate encourages banks to lend more money, even to less creditworthy customers.

“If interest rates were to remain low for a prolonged period, the profitability of banks, insurers, and other financial intermediaries could come under stress and spur reach-for-yield behavior, thereby increasing the vulnerability of the financial sector to subsequent shocks.

To be sure, the profitability of banks is currently strong. However, the fall in long-term interest rates has the potential to compress net interest margins and thus weaken the profitability of banks. The interest rates that banks earn on loans are typically set at a spread over an interest rate benchmark and are therefore likely to come down as benchmark rates decline. By contrast, the interest rates that banks pay to depositors are already quite low and unlikely to decline much further.

Taken together, falling loan rates and largely unchanged deposit rates could compress the net interest income of banks. Moreover, the pressures on profitability among banks could encourage reach-for-yield behavior, including an erosion of lending standards and an increased willingness to extend credit to firms with weaker balance sheets and households with lower credit ratings.”

Risky investing

The central bank is warning against negative consequences of continued low interest rates for pension funds and institutional investors.

“Low interest rates may also increase risk-taking among some financial institutions. In addition to the pressures on banks and insurance companies, low interest rates could affect pension funds and other institutional investors who offer pre-specified returns for policyholders that are significantly higher than the general level of interest rates.

In order to meet the specified yield, these asset managers may hold riskier investment portfolios, which are expected to generate higher returns. Furthermore, this decision could artificially increase the price of risky assets.”

Central bank chairman Jerome Powell said earlier this week that low interest rates could become a permanent element of the economic landscape. This development is driven by structural developments. Therefore, there is not much reason to believe the situation will change soon.

Less liquidity

The Fed also warns of a decrease in liquidity on the financial markets. The liquidity of both equities and bonds has been rather poor lately, also in a historical perspective.

Illiquidity spiked during the financial crisis and, more recently, rose in early 2018, late 2018, and August 2019, coinciding with increases in the VIX. As with Treasury securities, equity illiquidity is higher when asset price volatility is higher.

In contrast to U.S. Treasury securities, the relationship between the two appears to have changed since 2018, with illiquidity since then unusually high relative to its past relationship to volatility. This change suggests that liquidity has become more fragile over time—it tends to disappear when it is needed the most, when asset price volatility is high.

The Fed also points to the risks of a historically high level of indebtedness among US companies, the amount of leverage in hedge funds and the potential danger of the Brexit.

Europe is also struggling with low interest rates

The extremely low interest rates also cause many problems in Europe. Banks are under pressure, as are coverage ratios of our pension funds. According to the CEO of Deutsche Bank, negative interest rates could even ruin the entire financial system. The ECB’s decision to cut interest rates even further was therefore heavily criticized in October.

De Nederlandsche Bank also sees low interest rates as an important risk to financial stability. It removes the incentive to reduce debt and distorts price formation on financial markets. Investors are taking more risks in order to achieve returns, which can lead to new bubbles.

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