The Long-Term Impact of Negative Interest Rates on the UK Banking System

By Tony O'Sullivan, CFA | European Banking | 2020-12-18

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The Long-Term Impact of Negative Interest Rates on the UK Banking System

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The Bank of England is currently assessing the impact of negative rates and has acknowledged they are in its toolbox. What would be the impact if rates cross the zero bound in the UK? And what can we learn from the experience of other countries?

These are just some of the questions we try to understand at Carraighill.

The movement to negative rates is global & unprecedented

To better understand the current global interest rate position, it is important to review the historical context. The book “A History of Interest Rates” by Sidney Homer and Richard Sylla combines data from different sources since 3000 BC. It shows that nominal interest rates never crossed the zero bound over the last five millenniums, that is until now.

Seven major central banks have pushed their main policy rate into negative territory, starting with the Sveriges Riksbank, Sweden back in 2009 (although reversed in 2019).

The broad motivations for negative rates include: 

  • Tax banks’ excess liquidity to increase credit supply.
  • Lower financing costs (for banks and borrowers).
  • Increase supply and demand for loans.
  • Influence the demand for a country’s currency.
  • Raise asset prices

The banks asymmetry as we approach zero

Banking is not a level business but rather a spread business. Banks earn interest on their loan and bond portfolios and pay interest on their deposits. 

In general:

  • Negative interest rates reduce the net interest margin (NIM) in the absence of significant loan growth. As loan rates fall (a key objective of a negative interest rate policy), household deposit costs cannot be lowered below zero.
  • The decline in NIM has generally led to an increase in banks’ risk-taking (higher portion of consumer loans and the purchase of non-sovereign bonds).
  • If the net interest margin (NIM) continues to decline (likely) so will the net interest income return on bank assets (NII ROA). This would then lower the pre-provision profit, even allowing for some additional fee income. 
  • If the NII return on assets (RoA) is falling, over time banks will become more susceptible to a provision cycle.

The UK system NII trend is not your friend.

Carraighill has examined the evolution of interest paid and received in the UK since 1996, segmenting it into two distinct periods: (a) 1996-2008 and (b) 2008-2019.

This longer-term perspective allows us to navigate future periods with a better frame of reference.

1996-2008: This era can be characterized by a rising bank top line, growing profitability and rising bank share prices: 77% of total economy debt originated in the private sector by 2008 (up from 70% in 1996). The loan rate charged averaged at 5.5% over this period. Total interest paid was £63bn in 1996, rising to £95bn by 2000 and £176bn by 2008.

2008-2019: The structure of the banking system changed. The private sector share of total economy debt fell progressively to a current 58.5% of total. Government debt share has risen sharply (41.5%), both in absolute terms and as a share of total economy leverage. The rate charged on an average household loan fell from 6.7% in 2008 to 3.2%. For the NFC sector it has compressed to 2.3%. Total private sector interest paid has fallen by 44% since the 2008 peak to £98bn. The Domestic banks have however, lowered deposit costs significantly such that the net reduction in their top line since 2010 is only £3bn.

What to expect in the period after 2020: If the trend of lower rates persists for the banks, and there is limited change to UK productivity, it is likely that the banking system’s NII will fall. This is already evidenced in persistent lower new lending pricing relative to the back book (in particular for NFC lending). As banks are unlikely to lower deposit costs below zero, the outlook for NII should weaken persistently if interest rates remain low or turn negative.

Earnings power is falling globally for banks in Japan, Germany, Italy and Sweden (defined as NII RoA).

Academic literature highlights that negative rates are generally a headwind for bank profitability.

To corroborate and better understand this, we reviewed the interest paid and received by the private sector and government sectors in Japan, Germany, Italy and Sweden (all of whom have recently operated with negative rates):  In particular:

  • The NII on debt held in each economy continues to fall progressively. However, this NII RoA was falling prior to the introduction of negative rates, and a breach of the zero bound did not appear to change the long-term trend.
  • A falling NII RoA has a direct effect on bank earnings power. A sample of banks reviewed in Europe shows that on average 63% of their total revenue is derived from net interest income (as opposed to fees etc.). If NII is falling, it increases the sensitivity of profits to a higher provision charge (for no change in debt composition). In addition, the loan rate on new lending is lower than the current back book rate, suggesting the pressure on NII will continue. 
  • The direct impact of falling rates on the RoE of the banking system is inconclusive. This is due to the fact that the provision charge in Italy, Japan and Europe fell progressively over the period when rates approached the zero bound. 
  • Sweden is the only country where the private sector loans-to-deposits ratio has remained elevated (related to their covered bond funding structure). It also retains the highest RoE of the systems reviewed. The Bank of England already notes that a greater level of retail deposits is more likely to result in profitability pressure (evident in Germany, Italy and Japan).

Conclusion

Negative rates in the UK would be a headwind for banks NII and pre-provision earnings. This is important as it increases the UK banks vulnerability to any provision cycle. However for households, lower rates translate into lower debt repayments and improved affordability. The factors that are driving the move towards negative rates in the UK are persistent and consistent. The precise timing is unclear, but the probability is high that this occurs in the coming 24 months. This view ultimately influences how we think about available investment opportunities.

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