Andreas Dombret: The ECB's low-interest-rate policy - a blessing or
a curse for the economy, consumers and banks?
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank,
at the Sparkassen-Gesprächsforum, Witten, 1 February 2017.
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1. Introduction
Mr Heinemann
Ladies and gentlemen
Almost exactly a month ago, at the beginning of January, one of my colleagues told me about his
aunt, whom he had seen at Christmas. She is 63 years old and lives in Dagersheim, a small
village outside Böblingen in deepest Swabia - a region whose inhabitants are, stereotypically, the
paragon of thrift. As a doctoral graduate and chemist at a major cosmetics manufacturer, she
has built a nice little nest egg that she intends to live off well into retirement.
My colleague's aunt invests this wealth. For around 30 years, she has also used part of this
money to trade in the markets - and she has not suffered a single loss in all that time. So when it
comes to money matters, this lady is not to be underestimated. However, she has invested the
bulk of her money more conservatively - in call and fixed-term deposit accounts, for example.
But what has long rankled this lady is the fact that call and fixed-term deposit accounts earn
practically no interest anymore. With a nephew who works at the Bundesbank, it was, of course,
inevitable that the topic would come up over a meal of Christmas goose and red wine. Various
questions cropped up: where should we be putting our money in times such as these? Aren't
such low interest rates dangerous? And how long will - and I quote - "this Mr Draghi" carry on
like this?
The story I heard at the start of the year is still fresh in my mind. It tells me two things. First, that
interest rates remain an important topic of conversation across much of society and, second,
that even those who are well versed in financial matters find it hard to fully grasp the issue.
So, if you ask me, the savings bank here in Witten made an excellent choice when putting
together this evening's programme. What's more, the fact that this hall is so packed further
underscores the level of interest in this topic.
Interest rates - and policy rates, in particular - hold enormous sway. It is not for nothing that we
have a whole system of central banks in Europe, with the European Central Bank at its core, that
engages in setting policy rates. Interest rate changes have a direct impact on economies.
However, that's a fact that's only dawning on many people now that interest rates have been
unusually low for so long.
In Germany, the media coverage of the low interest rates tends to be negative. So, in terms of
the title of my speech, the general public appears to view low interest rates more as a curse than
a blessing. Let me make one thing clear from the get-go: I see this as a more nuanced matter.
But first things first. I would like to address, in turn, three key groups that are affected by the low
interest rates: banks, consumers, and the economy as a whole. Furthermore, I would like to take
a crack at answering the question of how long this phase of low interest rates will keep going on.
2. Effects of low interest rates on banks and savings banks
Let's begin with the effects of the low interest rates - to be more precise, their impact on banks
and savings banks.
By now, word will have surely got around that representatives of financial institutions are not very
happy with the current low-interest-rate environment. Yet at first glance, the conditions in which
the banks are operating would appear to be perfect. After all, the European Central Bank (ECB)
is - in return for the appropriate collateral - lending them unlimited amounts of money. The cost:
0%. And if the banks lend heavily to enterprises and households as well, they even receive a
premium on the funds borrowed from the ECB. Just to remind you, up until a few years ago,
policy rates were much higher, and far tighter restrictions were placed on money borrowed from
the ECB.
The problem for banks and savings banks is now quite similar to the one facing my colleague's
aunt: where to put their hard-earned money if they still want a decent return.
2.1 Interest-driven business models no longer fit for purpose
This is, to all intents and purposes, a matter of life or death. After all, credit institutions' business
models - and hence their earnings, too - are heavily reliant on interest income, especially when it
comes to small and medium-sized institutions. This is, to a certain extent, a natural
consequence of the function they perform in the economy, but is also a strategic decision in
some cases.
There are two main factors behind the income squeeze. First, higher-yielding legacy loans are
maturing and being replaced by ones generating lower returns. Second, profits are falling
because the spread between short-term and long-term interest rates is currently relatively
narrow. Added to this is the fact that deposit-based funding is significantly less attractive than it
once was. The reason? While market interest rates continue to dwindle - even dipping into
negative territory for some shorter-term maturities - the fierce competitive environment makes it
very difficult for banks and savings banks to pass negative interest rates on to retail customers.
Corporate clients, too, are anything but thrilled by this idea. We can therefore conclude that
profitability is exceedingly weak among German banks and savings banks, even by international
standards. That's nothing new, but the low-interest-rate environment is exacerbating the
situation.
2.2 No silver bullet in sight
But in the current situation, reversing the slow downward trend and putting income back on a
more sustainable footing is no easy task. Broadly speaking, banks have five levers that they can
use to increase their profit margins. Let's briefly go through these five options and examine how
well they would work in the current climate.
The first lever is to utilise interest rates at the short and long end of the yield curve. Typically, the
interest rate on an investment will rise as its tenor increases. So banks can boost their returns by
issuing longer-term loans or making longer-term investments. We are currently seeing this effect
in Germany in the case of mortgage lending. Up until around three years ago, long-term
mortgages - that is to say, those with terms of more than ten years - made up around 30% of
new business. By the end of last year, the share of long-term mortgages had already crept up to
around 45%.
However, this move comes with two disadvantages. First, if banks use short-term funding but
lend over the long term, they could run into difficulties as soon as interest rates rise again.
Longdated, mark-to-market assets would then lose value, while funding costs would mount on the
liability side. In a nutshell, institutions would be exposed to heightened interest rate risk. Second,
since long-term interest rates are likewise very low at the moment, the effectiveness of this lever
is very limited. As you are no doubt aware, the yield on ten-year Federal bonds (Bunds) slipped
into negative territory in the middle of last year - for the first time ever, incidentally. So, to
generate one percentage point more of yield, banks today need to extend maturities to a
considerably greater extent than previously - with corresponding consequences for interest rate
risk.
The second lever: banks can consciously put money into riskier assets. Higher risk means a
higher rate of interest, and thus higher returns. This is another strategy that German banks and
savings banks are pursuing. We can see this in the liquidity reserve, for example, where, since
2011, the share of prime assets has been reduced in favour of those with lower ratings. The
drawback of this lever is obvious: go too far and the riskiness of the assets will become so great
that financial stability may be endangered. To stop that from happening, supervisors intervene
early on and curb banks' risk appetite.
The first two levers can thus be summed up as ways of salvaging the interest-driven business
model over time. But, as we have seen, that only works after a fashion in the medium to long
term.
With that in mind, let's move swiftly on to lever number three, which tackles the problem in a
rather more hands-on manner: find new sources of income. In practice, this usually means
raising fee and commission income. Perhaps the savings bank sends you, its VIP clients, its
annual financial report? If it does, the latest edition will tell you that the Savings Banks Finance
Group raised its net fee and commission income by almost 9% between 2014 and 2015. This
served to offset the simultaneous decline in net interest income.
But perhaps you don't need to leaf through the financial report to know what I'm talking about.
Maybe you have already experienced increases in bank charges first-hand. If you have, I expect
you weren't impressed. But you will have to get used to it - we all will. There's no getting around
the fact that bank services incur costs. And after many a year in which banks could
crosssubsidise these costs by means of interest income, we now have to get used to the idea that
banks and savings banks will invoice them directly.
Talking about costs, that brings us straight to lever number four. After all, it is far from clear
whether credit institutions can make up for the drop in interest income on a lasting basis by
ramping up their commission income. That is why German banks and savings banks also need
to tackle their costs. They currently have a cost/income ratio of 73% - that is to say, they have to
spend 73 cents, on average, to earn one euro. That's the highest level in the entire euro area, so
there is room for improvement on this score. One problem, however, is that many cost-cutting
measures can't be rolled out overnight and that it will take time for them to impact positively on
the bottom line. All the more reason, then, to waste no time in getting to grips with the issue of
costs.
Germany's banking sector doesn't just have a relatively poor cost/income ratio by European
standards - it's also one of the continent's largest. And that brings us to the fifth and final lever:
consolidation among banks and savings banks. It's a topic that has many facets - institutions
downsizing by streamlining branch networks, merging with other institutions or even exiting the
market altogether. Eliminating slack in the banking sector can help ease competition, boost
efficiency and improve profitability.
Capacities are being reduced in Germany, but progress is lagging behind the European average.
Let me give you an example. Germany's banking sector scaled back the number of branches by
14% between 2008 and 2015, compared with a rate of 17% across the euro area as a whole.
Some countries have made far more progress on this score. Spanish banks, for instance, rolled
back their branch networks by a third. There's probably no getting around a degree of further
consolidation in Germany, because the sector there still has slack dating back to the pre-financial
crisis era.
At this point, some of you might interject that more consolidation and merger activity won't
necessarily translate into better credit institutions, and you would be right. Indeed, predicting just
how much potential there is left to harness through mergers in Germany's banking sector is
anything but easy. After all, a merger between two institutions running similar business
franchises - as we have often seen in the savings bank and cooperative bank sectors - does
nothing to address their reliance on net interest income. Putting two weak institutions together
won't create one strong one. Also, savings banks and cooperative banks have, for the most part,
already pooled their computer centres at the highest tier of their respective networks. So many
synergies have already been leveraged.
Ladies and gentlemen, as you can see, mergers are not a silver bullet. And as we have already
seen, the same can be said about the four other levers which banks and savings banks can
adjust in response to the low-interest-rate setting.
2.3 Everything's under control (for now)
So how bad, exactly, are things for the German banking sector in the environment of low interest
rates? Despite all the problems, I can sound a cautious "all clear" for now, and that goes
especially for the small and medium-sized institutions. It's true that the low rates have clearly
eaten into their profitability - I spoke about the effects earlier on - but their effects are still
bearable for the bulk of credit institutions. Let me put it clearly: capital adequacy and liquidity
levels in the German banking sector are beyond dispute. But things might get tight over a
medium-term horizon if interest rates persist at their current low levels. The Bundesbank intends
to stay abreast of developments, so it will be running another low-interest-rate survey this year
among the institutions it supervises, following on from similar exercises back in 2013 and 2015.
In this survey, we will venture to look to the future and simulate a number of different interest rate
scenarios so that we are ready to intervene at short notice should any genuine problems arise.
The results of this survey also have a bearing on our dialogue with these institutions.
But the current situation and the risks which a persistent spell of low interest rates presents for
institutions aren't the only factors we need to keep an eye on - what happens when a phase of
low rates comes to an end also needs to be investigated. Because when interest rates change
direction, they can potentially be a source of major risk. Especially if rates were to climb abruptly
following a protracted spell at low levels, the short-term response would probably be a sharp fall
in bank earnings. We can get a rough idea of this interest rate risk using a metric known as the
Basel interest rate risk coefficient, which states how much equity capital, in percentage terms,
would be eliminated by a two-percentage-point shift in the yield curve. This measure has been
increasing continuously since back in 2011. It reveals that more than half of the savings banks,
and roughly two-thirds of the credit cooperatives, are now exposed to heightened interest rate
risk. I'm not saying that's necessarily a bad thing - after all, taking on that kind of risk is one of the
functions they perform in the economy. But it does indicate just how important attentive risk
management and capital adequacy are in the banking system.
Ladies and gentlemen, I believe one thing has become clear. There's no love lost between banks
and low interest rates, and that's never going to change. Those low rates are shaking financial
institutions' business models to the core and eroding their earnings. The five traditional levers
which institutions could adjust to fight back against their malaise do work, but their effectiveness
is limited. That's why credit institutions are so keen to see the back of the low-interest-rate
setting. But the exit will need to be managed carefully if banks are to emerge unscathed.
3. Impact on consumers: is there any point in saving anymore?
You could say the situation that credit institutions find themselves in answers the question I
mentioned earlier in my speech - the question my colleague's aunt raised, remember, about the
risks presented by low interest rates. But let me now turn my attention to consumers. It would
make sense to split consumers into two groups, though they may well overlap, of course:
borrowers and savers.
Let's begin with the borrowers. The house builders among you won't be the only ones who know
that credit terms are exceptionally favourable at the moment. That, too, is an outcome of the
lowinterest-rate setting. One need only consult the mortgage lending statistics to see that this has
gone down very well among consumers. Mortgage volumes have seen substantial growth since
2009, and the rate of increase even accelerated over the last two years.
It makes perfect sense to harness today's attractive credit conditions if you are already planning
to make a major investment in the medium term like building a house. But just like credit
institutions, consumers, too, should always have one eye on the end of the low-interest-rate
period, and consider their capacity to service their debts once interest rates start picking up
again.
That brings me to the group of savers who, it's safe to say, have been attracting the most
attention recently in the public debate over low interest rates. People are increasingly wondering
whether there's really any point in saving with interest rates at such extremely low levels.
Let me first of all say that I can very much appreciate the concerns of savers. That said, the
nominal rate of interest - the one we see on our account statements and which is very low at the
moment - isn't the variable we should be focusing on. What really counts is how the purchasing
power of savings moves over time. For instance, the extent to which provisions made for old age
will help cover the cost of living in retirement is determined by how the purchasing power of that
pension evolves over time. And at the end of the day, purchasing power developments are driven
by the real rate of return - that is, the nominal rate of interest with inflation netted out. So if you
are wondering how far your savings will go later in life, a 3% interest rate with inflation at 3% will
produce exactly the same outcome as interest rates of zero and no inflation.
Inflation here in Germany bounced back recently to a level that is well clear of zero. Projections
suggest that it will climb to 1.3% in the euro area this year. The Bundesbank expects inflation in
Germany to come in at 1.4%, and the increase might even be around half a percentage point
stronger if the oil price stays at its current level. But for the sake of honesty, it should also be said
that the particularly safe savings deposits held at credit institutions once attracted a higher rate of
interest, but then again, the rate of inflation at that time was much higher, too. Compared with the
past 20 years, the real rate of return on savings deposits today isn't exceptionally low - in fact,
savers had to make do with even slimmer real returns between 2011 and 2013.
It is also worth noting that Germans don't just stash away their financial assets under their pillow
or in a bank account. In fact, more than half of their wealth is made up of claims on insurance
corporations and securities holdings, and that figure is broadly on the rise. The real rate of return
on these assets eclipses the real rate of return on particularly safe bank deposits. Plus, German
household financial wealth saw steady growth in the low-interest-rate environment as well.
To sum up, then - saving still makes sense, even if there's no getting round the fact that it used
to be a more lucrative endeavour. And neither savers nor credit institutions are exactly tickled
pink by low interest rates - and understandably so. But if we are to make a fair and equitable
assessment of the situation, we also need to consider the alternative to a policy of low interest
rates. And that brings us to the impact on the economy.
4. Impact on the economy: low interest rates as a "necessary evil"
Indeed, the low interest rates have cushioned the impact of the crisis and are propping up the
gradual economic recovery sprouting in Germany and Europe. Admittedly, the European Central
Bank does not gear its monetary policy towards these factors - its target is inflation. But
economic activity and price developments are closely linked. Because when enterprises reduce
slack, prices generally go up. And as it happens, the accommodative monetary policy is proving
to be particularly rewarding for export-oriented economies such as Germany's, because it tends
to push down the value of the domestic currency, thus boosting export activity.
Monetary policy, then, has created an investment-friendly environment for enterprises.
Consumers are benefiting, too, as their jobs tend to become more secure, tax revenue is brisk,
and general government's interest burden declines. And of course, banks and savings banks
also prefer to do business in a stable economic environment.
But that's certainly not to say that the ECB's ultra-loose monetary policy is free of risks. It even
has serious side-effects, mainly in that it becomes less effective over time and its costs
increase.
Persistently low interest rates are making it more difficult for businesses to honour their defined
benefit obligations under occupational pension schemes because the amount of provisions they
put to one side is based on the average interest rate over the past few years. That means, the
longer interest rates remain low, the more pension provisions they will have to set aside.
The short-term impact of the low-interest-rate policy on the economy is positive. But the
magnitude of the side-effects inflicted by the zero-interest-rate policy will only emerge much later
down the line. Speaking at the World Economic Forum in Davos two weeks ago, the respected
American economist Nouriel Roubini called the low interest rates a "necessary evil". Given the
points I have raised over the last few minutes, I would say that's a good way of putting it.
5. Exiting the low-interest-rate environment: what happens next?
The "64 million dollar question", however, is how long this "necessary evil" is supposed to last.
This brings us to the last of the questions we still need to answer - how much longer will things
go on like this?
First, let's take a look at inflation. As you know, the inflation rate has been very low over the last
three years, even slipping below zero in some months. There were several reasons for this, one
being the sharp decline in energy prices since the middle of 2014; another, the fact that the
euroarea economy is only recovering gradually, with some countries still battling the after-effects of
the financial and sovereign debt crisis.
That being said, inflation has gone up again recently, largely because oil prices have bounced
back. If oil prices remain static, the inflation rate might even rise to just under 2% over the next
few months. So we're now a considerable distance away from the deflationary risk that some
people perceived in the last few months - and if you ask me, these warnings were always
somewhat overstated in any case.
The ECB currently projects that it will take until 2019 for the inflation rate in the euro area as a
whole to return to its target level of below, but close to, 2% on a lasting basis. So as far as the
outlook for inflation is concerned, it makes sense to leave monetary policy in expansionary mode
because the economic upturn in the euro area continues to be drip-fed by monetary policy.
But what's also clear is that while it's all well and good to disagree over the scope and design of
the monetary policy measures, it is vital for the Eurosystem to tighten the monetary policy reins
again when the time is right. Once we are within striking distance of the inflation target, we must
act quickly.
Ladies and gentlemen, as you have probably already guessed, I cannot tell you exactly when
interest rates will start to rise again. That's partly because the central bank can't just go it alone
and set interest rates "willy nilly", as it were. We set the policy rates and thus indirectly control
the interest rates in the economic cycle, that's true, but long-term interest rates, in particular, are
driven by other factors as well.
And they do not depend solely on inflation - or inflation expectations, to be precise - but also on
the real interest rate, which is driven primarily by growth expectations. After all, it is ultimately
enterprises and house builders, of course, that pay interest. And they can only do that if they are
in a good economic position. Only then are lenders - meaning banks, savings banks, mutual
funds or private investors - in a position to charge higher interest rates.
Unfortunately, however, longer-term growth expectations are not as upbeat as they were a few
years ago. This is partly because growth in some countries was driven by excessive lending
before the crisis. Cast your mind back to the credit-fuelled real-estate bubbles in Spain and
Ireland, for example, or the enormous levels of debt in countries such as Portugal and Greece
which made it possible for public and private-sector consumption to go overboard. We will
probably not return to growth rates of the kind seen in the run-up to the financial crisis for the
foreseeable future.
But it wouldn't do any harm for growth to be slightly stronger than it is right now. This is where
governments need to step in. They need to adopt reforms that encourage job creation in the
productive sectors of the economy. The eagerness to embrace reform was strong immediately
after the crisis, but it quickly waned, regrettably, once the dust began to settle.
So bearing that in mind, politicians have a major role to play in determining when interest rates
start to rise again. However, we must be patient. The imbalances that helped trigger the financial
and sovereign debt crisis, and which are still curbing growth even now, unfolded over many
years. We cannot expect these imbalances to be resolved in the blink of an eye.
6. Summary
Ladies and gentlemen, so - should we consider low interest rates a blessing or a curse? If you
ask me, the answer is a clear "neither".
There are good reasons why the European Central Bank has a very clear mandate to keep
inflation at a rate below, but close to, 2% over the medium term. It pursues this objective by
setting the policy rates. Its accommodative monetary policy bolsters economic activity, and that's
in the interests of banks, savings banks, consumers and enterprises. But it is also true to say
that the measures have considerable side-effects which will only strengthen over time. We have
discussed the impact of these side-effects on all those involved.
Europe won't find a way out of the low-interest-rate environment for good if we just point our
finger at the central bank. Returning to a sustainable path of stable growth and stable prices will
require others to make an effort, especially the governments of the euro-area countries. They
must make the necessary reforms in order to achieve sound government finances, competitive
economic structures and a functioning public sector.
Ladies and gentlemen, I have reached the end of my speech, but I still haven't really answered
one of the questions we asked at the start - where's the best place to put the money? I hope you
will appreciate that providing investment advice is a matter for banks and savings banks, and as
a central banker and bank supervisor, I am not allowed to encroach on their turf.
Thank you very much for your attention.