Yves Mersch: The challenge of low interest rates for banks within the
banking union
Speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank,
at the Public Roundtable at the University of Luxembourg on "Banking Union - Quo Vadis?",
Luxembourg, 3 October 2016.
* * *
We are sitting here tonight in a room that was named after the first president of the University
of Luxembourg, the late Professor François Tavenas. He once said "change is mandatory,
survival is optional; choose wisely"1.
Even though Tavenas was speaking about the impact of globalisation on universities, what
he said also holds true for the euro area and its recent history.
When the financial crisis struck, it was clear that things could not go on as they had in the
past. Change was mandatory. The banking union was the euro area's response - the most
significant step towards closer integration in Europe since the creation of the single currency.
This means that the euro area now has common banking supervision and a single resolution
mechanism with harmonised rules and procedures. A European deposit insurance scheme is
still under discussion.
Establishing the banking union has made the euro area financial system safer, but since it
was proposed in 2012 its implementation has been challenging for banks, especially as it
coincided with unprecedented monetary policy action and regulation.
Tonight, my fellow speakers will discuss the design and the achievements of the banking
union in greater detail. I would like to focus on the other challenge banks are facing: an
environment of low and negative interest rates.
Costs and benefits
Over the past eight years, central banks worldwide have had to go to extremes to honour
their mandates to safeguard price stability and shield their economies from the fallout of the
financial crisis.
In the euro area, the ECB started providing banks with abundant liquidity, also through
longterm refinancing operations. We launched an asset purchase programme of unprecedented
size, cut interest rates to record-low levels and embarked on forward guidance to give
markets a clearer signal about our future policy path.
Among the major central banks, the ECB was the first to introduce negative interest rates on
its deposit facility in June 2014. It now stands at -0.4%. No other central bank has gone as
low without putting a multi-tier system in place. These very decisive policy measures have
one objective: to fulfil our legal obligation, i.e. to ensure price stability defined as an inflation
rate below, but close to, 2% in the medium term.
Our policy is working. Lending is gradually increasing as a result. In August, lending to
companies grew by 1.9% year-on-year while household lending grew by 1.8%, both
unchanged from July's reading. A broader measure of money circulating (M3) rose to 5.1%
from an upwardly revised 4.9% in July.
Also, banks have considerably eased access to financing for the private sector. Between
June 2014 and July 2016, the composite cost-of-borrowing indicator for new corporate loans
fell by 152 basis points in Italy, 130 basis points in Spain, 40 basis points in Luxembourg,
and 95 basis points in the euro area as a whole.
Although slow, economic recovery is under way. Unemployment is decreasing, economic
growth is picking up, and inflation is expected to rise to 1.6% in 2018. When our next set of
projections, which includes 2019, is published in December we might be broadly in line with
our mandate of below, but close to, 2% over the medium term. We are on the right track.
We are aware, however, that in particular our non-standard policy measures come with side
effects. Therefore, it is important to consider the combined effect of the full package of our
policy measures when assessing the impact of our monetary policy action on banks.
Low rates put pressure on banks' profitability, particularly on banks which are very reliant on
net interest income. Analysts forecast that negative interest rates will significantly reduce
banks' profitability over the next five years, with the return on equity in some cases falling
from 6.5% to 2%.
Obviously, our monetary policy package consists of other measures as well and ECB staff
estimates show that the overall impact on bank profitability of recent monetary policy actions
is net positive, compared with a scenario with no monetary policy action2. But we cannot
ignore such analyses. And yet, one also has to ask if a bank that cannot weather headwinds
over a few years still has a sufficiently robust business model to stay in the market.
A negative outlook for banks weighs on banks' share prices, thereby raising their cost of
capital and ultimately decreasing the net return on lending. This may cause banks to become
more conservative in their lending to euro area companies and households, which is key for
the transmission of our monetary policy.
We already see that the low interest rate environment has sparked increasing competition
from the non-banking sector. "Shadow banks" - an unfortunate label - or non-banks have
increasingly moved into financial intermediation in the euro area since the financial crisis.
Between the end of 2008 and the fourth quarter of 2015, non-banks expanded their share of
financial assets held by euro area financial corporations from 42% to 57%3. This may
suggest an improvement in the transmission of our monetary policy as these institutions are
to some extent more flexible than banks because they are less strictly regulated and
supervised. But at the same time, we need to be mindful that non-banks are also likely to
retrench more rapidly in times of crisis.
Moreover, technological innovation and the search for yield in a low-interest environment are
likely to intensify competition for credit and deposit-like savings products. The risk is that this
will lead to lower lending standards, higher leverage and insufficient shock-absorbing buffers.
Last but not least, a protracted phase of very low interest rates weighs heavily on the
profitability and solvency of financial companies which promise minimum nominal returns
over the longer term, e.g. life insurers and pension funds. If this phase lasts for too long, it
could challenge the viability of return guarantee business models. There is evidence that the
insurance and pension sectors have already been moving from guaranteed-return to
unitlinked business models. This shows that the industry is adjusting.
We need to monitor such risks, the side effects and the long-term impact of our monetary
policy measures carefully. And we need to keep in mind that the longer our non-standard
policy measures remain in place, the more pronounced their side effects will become.
Interest rates have to stay low until the economic recovery in the euro area has gained
sufficient momentum to lift the inflation rate to a level in line with our definition of price
stability. This is, however, taking longer than we had hoped, mainly because the necessary
political changes to make economies more competitive and flexible are lagging behind. The
sooner these reforms are implemented, the stronger and more sustainable the recovery will
be.
Although the notion of a "zero lower bound" no longer stands, there is a limit to how low
interest rates can go - the point at which the costs of lower rates incurred by the banking
sector outweigh the benefits. Many consider that we have reached the "effective lower
bound" or that it might be not that far from the current deposit facility rate of -0.4%4.
This level I would still deem to be "mildly negative" - but I would shy away from moving into
"wildly negative" territory. Cutting interest rates even more would come with increasing risks
as reactions to such cuts might not always be linear5. This needs to be taken into account
when doing a cost-benefit analysis.
Conclusion
Let me conclude. Over the course of the crisis, the ECB acted decisively and in line with its
mandate. Change was mandatory and the path we chose is helping the euro area economy
to return to growth and price stability. But interest rates can only stay very low over the short
term. The longer they remain low, the more pronounced the negative side effects will
become.
So far, we do not see any developments that could give rise to major concern. The positive
impact on the economy outweighs any drawbacks there may be. But we need to be mindful,
even as the upsides of our monetary policy prevail, because of the multi-pronged approach
of our unconventional, and by definition temporary, monetary policy.
Our unprecedented policy reaction to the crisis has clearly added to the list of challenges
banks are facing today. But what we did was necessary to preserve price stability in the euro
area, which is what we have been mandated to do. As such, we are fully aware of the crucial
role banks play in transmitting monetary policy to the real economy. That is why we pay
close attention to how banks are coping with all the challenges they face.
The banking union marks a significant change in the euro area financial system and it comes
with a series of one-off adjustments for banks. Unlike the banking union though, our
monetary policy measures lead to constant adjustments by the banking sector, especially the
longer the current measures stay in place. It is therefore in everybody's interest to ensure
that we can leave this period of low interest rates behind sooner rather than later. But it's not
solely the responsibility of the ECB. It will also require courageous, far-sighted and sensible
action by other policymakers to bring the euro area back to sustainable growth. May they
choose wisely.