Why Banks Need to Know About Negative Interest Rates and Deflation

By Leonard J. DeRoma, Invictus CFO

Talk about negative interest rates and deflation became a bit more real when the Federal Reserve introduced the concept as part of the CCAR/DFAST stress testing exercises for 2016.  This article looks briefly at some of the implications.

The U.S. has not had any major deflation post World War II,  and, when it did occur, it was short-lived, and industry or geography specific.

Short-lived deflation is not a problem.  Protracted “deflationary spirals” are.  The impact falls disproportionately on real assets, particularly if the asset is debt-laden and needs to be sold.  The spiral occurs in a situation where homeowners seeing prices decline try to “jump ahead” of the market and sell, leading to more downward pressure on prices.  Recent vintage mortgages and CRE loans made at high collateral values would be most at risk.  In a deflationary spiral, buyers wait on the sidelines for prices to fall.  Economic activity slows further. Industrialized societies usually cope with deflation by inflating the money supply.  However, the Fed has already done that,  which leads us to the concept of negative interest rates.

Negative interest rates have occurred occassionally overseas and in a few arcane sectors of the U.S. financial markets.  While banks have coped with a zero interest rate policy (“ZIRP”) watching loan yields decline, they were blessed with deposits that are also interest rate sensitive, which mitigated narrowing spreads.  In a NIRP (“negative interest rate policy”), gross interest income declines and inelastic non-interest expenses could continue to increase, implying a reset in what are considered “good” efficiency ratios.  If rates go negative, banks need to prepare.

How to Prepare for Negative Interest Rates

Make sure you have bank rate floors built into your loans. Variable rate loans made by community banks that are priced on a spread differential from an index will most likely still yield a positive number.  But what about narrow spread commercial loans that may have been  originated with a minimal number of basis points above Libor?  Ensure that your core processing system can handle a rate less than zero.   The expectation is that low rates will encourage consumers and businesses to borrow and spend. However, if low rates are coupled with deflation, this might not happen.  Anticipatory selling could cause prepayment of mortgages.

Impact on Securities

Bank management of securities portfolios could also become a victim of the lower/negative rates.  And banks have less control over securities than loans. The inclination with bankers, like most bond investors, will be to reach for yield—either lower quality credits, longer maturities, or riskier alternative investments.  Although at first  bank bond portfolio managers will pat themselves on the back for being smart as portfolio prices increase, the new lower credit, longer maturity securities will create other problems. Lower quality credits don’t count as much for liquidity purposes.  When rates do rise, bond prices will decline, causing a drag on earnings.  Lower quality bonds or longer duration bonds will be more difficult to sell.  Having to recognize AOCI losses or OTTI losses will be exacerbated by the general lack of bids that exist in a bond bear market now complicated by Volcker rule trading regulations.   Moving bonds into the “Hold to Maturity” category virtually eliminates the possibility of selling the bond, thus sticking the bank with a potentially long-dated, low-yielding asset.  Paying more attention to liquidity will be crucial in the negative environment, which leads us to deposits.

Deposit Quality Becomes Key

While some of the larger banks have imposed a “balance sheet usage charge” (read this as negative interest rates) on large financial counterparty customers, it will be difficult to impose such a charge on consumers and small business.  The public relations angle would be a debacle.  Bankers are already odious to much of the population.  Charging consumers to keep their money in your bank may be theoretically possible, but that’s why theorists don’t run banks.

Banks will need to be more discerning about the “quality” of the deposits.  In the new Basel III liquidity calculations (not required for community banks, but a very good metric),  deposits are grouped into categories:  stable, less stable, operational, wholesale, etc.  Stable deposits are the “best” from a liquidity perspective because they are the stickiest.  These are deposits of your most loyal customers and probably the ones you least want to disturb.  On the other hand, municipal deposits are generally competitive among the local banks AND they generally require high quality collateral—collateral that is no longer available to service emergency liquidity needs.  Aside from the political ramifications—are these deposits worth it?  Good question for bank management to ask.

How much disintermediation will occur in a negative rate environment?  As rates rise, disintermediation generally occurs.  But it could also happen in a negative interest rate environment.  Customers might just decide to keep the money in a mattress.  So look for more cash transactions and more demands for currency.  There’s no precedent for this. 

Look for more IRA withdrawals.  An aging population and zero interest rates will force more invasion of principal.

Unintended Consequences

This is always the wild card.  Let’s consider a ticking time bomb: unfunded pension liabilities.  Many community banks have defined benefit retirement plans, guaranteeing a fixed payout based on service and salary.  The amount of money needed in the retirement trust is based on the expectation of returns from stocks and bonds.  While bond yields have been low recently, the stock market has provided a reasonable return, allowing actuaries to adjust their numbers and thus masking the low returns on bonds.  If bonds go lower AND we have the expectation of deflation implying contracting equity prices, it is possible for banks to get hit with a payment notice to top up their unfunded pension liability.  This could be a substantial number given the unprecedented environment.  Additionally, bank corporate customers that also have defined benefit plans (including municipalities) will find themselves in the same boat.  Part of the underwriting process in this environment for corporate customers should include understanding their pension requirements.   Chances are that hasn’t been a critical line item in the loan package recently. 

Whatever happens, this promises to be a very interesting next several years.