They undermine banks. To dodge the fallout, banks chase yield, buying stuff like CLOs, instead of lending. When loans go bad, banks may “evergreen” them.
Prolonged low interest rates are having significant negative effects on banks’ core business and role in the economy, the Bank of International Settlements (BIS) warned in a new paper, just weeks after the ECB reduced its policy rate deeper into the negative after a tumultuous meeting where ECB president Mario Draghi steamrollered a veritable palace revolt.
According to the BIS paper, which is based on a sample of all major international banks over a 22-year period from 1994 to 2015, if the benchmark interest rate falls from 3% to 0%, the average net interest margin declines from 1.42% to 1.31% of total exposure. That’s in the short term. The long-term effect is many times larger owing to the high auto-correlation of the net interest margin. Banks’ average interest income falls from around 60% of total income to around 40%.
This is just one of the problems highlighted by the BIS study. Another major concern is that many banks, in their desperate quest for profits, opt to shift their focus away from lending to their customers toward trading activities, which can generate higher yields and fee-based income. It also tends to boost stock, bond and real estate markets, as well as stimulate demand for professional portfolio management services.
In the short term, trading in stocks, bonds, derivatives and other financial instruments may allow banks to offset their declining profits on their interest spread. If the benchmark interest rate decreases from 3 to 0%, trading profits as a proportion of total income increase from 2.5% to 3.2%. But it also opens them up to greater risk, especially if they chase yields offered by more speculative financial products such as Collateralized Loan Obligations (CLOs) backed by corporate junk-rated leveraged loans.
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