Financial Stability and Low for Long
Speech given by
Sir Jon Cunliffe, Deputy Governor Financial Stability, Member of the Monetary Policy
Committee, Member of the Financial Policy Committee and Member of the Prudential
Regulation Committee
Society of Professional Economists Annual Conference, London
14 October 2019
I am grateful to Katie Low, Rand Fakhoury, Richard Harrison, Iren Levina, Ryland Thomas and Matthew Waldron
for their help in preparing these remarks.
Jane Austen's face appears on the Bank of England's latest £10 note, which entered
circulation in September 2017. But the Bank's association with one of the world's finest
authors goes back much further: as the meticulously kept records of the Bank show, the
successful novelist invested much of the proceeds of her writing in Bank of England
Annuities.
In July 1815, for example, she purchased 'Navy Five per Cent annuities' -
an undated
- with a face value of £300. 'Navy Fives' were a popular
Bank of England security
investment during the Napoleonic Wars, paying annual interest, as the name suggests, of
- research using the Bank's archives
5%. Jane did not purchase the stock at par value
-
has established that she paid around £250 making an annual nominal interest rate on
her risk free investment of nearly 6%1.
- -
Today, a comparable risk free asset a 30 year gilt is yielding around 1% nominal. And
had Jane been living in the euro area today, in Germany for example, she would only have
-
been able to invest for the long term at a negative interest rate the 30 year bund yielded
minus 0.27% in August.
Nominal interest rates do vary through time of course. Since the Napoleonic wars and
outside wartime, UK long term nominal rates moved mainly in a 2-5% range until the
decades of inflation following the Second World War, during which they rose above 15%,
before falling back as inflation was brought under control.
They have been falling ever since. The fall in long rates is a phenomenon that has been
building since the late 1980s, gathering pace after the financial crisis
(Chart 1).
During the past couple of months, UK long nominal rates have dropped to around, and
sometimes even below, 1%. They have not been this low in the past 200 years. The same
is true, more generally, for other advanced economies.
Some of this likely reflects low current and expected inflation. But it is a great deal more
-
than just an inflation story. Long term real rates in the United Kingdom and in other
-
advanced economies are extremely low and indeed are negative.
I want to look briefly today at why we are in a period of low interest rates and why we
- 'low for long' in other words.
might expect it to persist
- the implications of a 'low for long' world
I will then turn to the main issue I want to discuss
on financial stability and the interaction with monetary policy.
My colleague, Ben Broadbent, has argued in an excellent speech for the separation of
powers, with which I agree, between monetary and financial stability (or
'macro-prudential')
authorities.2 But monetary and financial stability, to some extent, depend upon each other
and I will look at the implications that 'low for long' has on those interdependencies.
(a)
Chart 1. UK long-term nominal interest rates
Percent
18
16
14
12
10
8
6
4
2
0
1753 1778 1803 1828 1853 1878 1903 1928 1953 1978 2003
Source: A Millennium of Macroeconomic Data (available at
https://www.bankofengland.co.uk/statistics/research-datasets) and Bank of England calculations
(https://www.bankofengland.co.uk/statistics/yield-curves).
The red line shows yields on new long-term issues of perpetuities and consols (a mixture of
month-end and monthly averages). The last remaining consols were repaid in June 2015. The
blue line shows the 30-year zero coupon spot rate (monthly average). The data are up to
September 2019.
Low for Long
What explains the current very low level of market interest rates in advanced economies?
It may partly reflect very low levels of current policy rates and any spillovers from that.3 It
may also reflect the term premia for inflation that are currently very compressed in some
countries, for example, the US and in the Euro area. And it may also be a symptom of a
- -
more entrenched pessimism an over-pessimism in my view about long-term economic
prospects, possibly due to fears of the de-integration of the global economy or concerns
about future effectiveness of monetary policy.
But, more fundamentally, the very low level of market interest rates reflects an underlying
- -
structural trend the fall in long-run real interest rates since the early 1980s4 that has
been the subject of a great deal of research.
-
The literature has identified a large number of candidate explanations both real and
-
financial for a structural decline in the long-run real interest rate. These include:
demographic trends and, in particular, increased longevity; lower trend productivity growth;
the liberalization of financial intermediation and an increase in the risk borne by individuals
and households.5
The long-run equilibrium real interest rates determined by these factors are, of course,
unobservable. There is a range of estimates for how far they have fallen. Bank of England
work suggests a central range of 0-1% for the long-run equilibrium real interest rate in the
United Kingdom.6 Widely cited estimates for the United States suggest that the long-run
3
In addition to affecting the market rates directly, monetary policy easing could lead to a further compression
in market rates because of spill-overs via exchange rates (in case of interest rate cuts) or compression of
term premia (in case of asset purchases). See Brainard (2017).
4
King and Low (2014) document a sizeable decline in market based measures of long-term real interest
rates in several advanced economies.
5
See, e.g., Eggertsson et al (2017), Gagnon et al (2016), Rachel and Smith (2017) on the role of
demographics and productivity growth and Vlieghe (2017) on the role of financial liberalization and increased
risk taking. Some very different candidate explanations have also been suggested. Borio (2017) links the fall
in long run real interest rates to monetary policy regimes, while Caballero (2017) links them to a shortage of
safe assets.
6
See Bank of England (2018), Box 6 on pages 39-43.
equilibrium real interest rate fell to close to zero during the crisis and has remained there
into 2016.7
Of course, the long-run real rate is not the only driver of real interest rates. Over the
business cycle, the real interest rate required to sustain output at potential and inflation at
target, can fluctuate around the long-run real rate as a result of shorter-term influences on
the economy.
At any given time, other factors like fiscal policy, uncertainty and global growth prospects
may push the real rate required to bring inflation back to target further above or below the
long-run real rate.
But given the slow moving nature of the underlying drivers of the long-run real rate, one
would expect the downward shift in the overall interest rate cycle to persist into the
foreseeable future.
It is this downward shift in the long-run real rate that has lain, in part, behind the Bank of
England's message that any future increases in rates will be limited and we should not
expect to see a return to the levels of policy rates we saw before the crisis. And this is
exactly what motivates me today to speak about the implications of this low rate
environment for financial stability.
Financial stability challenges of low for long: the financial sector
I want to look today at the three main challenges to financial stability that this environment
could pose and briefly consider possible policy responses.
The first challenge is that a slow or an unwilling adjustment to the lower returns implied by
low for long can lead both to greater risk taking and less resilience in the financial sector.
In the banking sector, lower interest rates across the cycle reduce the net interest margins
(NIMs) that banks earn from liquidity and maturity transformation. Moreover, NIMs would
come under greater cyclical pressure more frequently and for longer because a proportion
of banks' liabilities pay no interest and cannot therefore come down to match a reduction
in lending rates when the policy rate is cut.8
It is also possible that the yield curve will be flatter in a low for long environment as greater
proximity to the zero lower bound of interest rates will mean less interest rate variability on
average across the cycle leading to lower term premia. If so, this would further reduce
banks' earnings from maturity transformation.
In Japan, a prolonged period of low interest rates has contributed to falling NIMs for over a
decade. More recently, we've seen a similar -
albeit smaller - effect in other advanced
economies9.
The impact of lower NIMs on bank profitability is currently reflected in lower price-to-book
Arguably, in 'steady state', once expectations of returns have
valuations of banks.10
adjusted downwards to a low for long environment, target returns on bank equity will adjust
accordingly, though there is no evidence of this happening so far. We should expect, even
if only for a transitional period if expectations of returns do adjust, greater pressure on
banks to search for yield and move further out on the risk curve. To the extent that they
cannot meet target returns, it will be harder for them to accrete capital to build resilience.
Although the NIM effect has been present for some years now, we have not yet seen a
broadly based move by banks in advanced economies to push up returns by taking on
greater risk. Post crisis regulation has almost certainly played a role in constraining
aggressive search for yield behaviour, as perhaps have banks' memories of the crisis.
But more recently we started seeing some evidence of search for yield behaviour. One
notable example of this is the growth of corporate leveraged lending in many jurisdictions.
The Bank estimates that the global stock of leveraged loans has now reached an all-time
high of US$ 3.4 trillion, equivalent to 11% of total advanced economy credit to non-
financial corporates. The share of corporate debt owed by highly leveraged companies is
now very close to or above pre-crisis levels in major advanced economies.11
The growth of this market has been accompanied by a marked easing of underwriting
standards and compensation for risk. The share of new leveraged loans with no
maintenance covenants has tripled since 2007.12 Spreads have declined and remain
below their 2015 levels. And there has been growing use of accounting adjustments
that could understate
('add-backs') leverage13.
There are other examples. We have also seen an increase in sales of complex products
as investment banks try to boost their income in a challenging trading environment. And in
some countries, retail lending conditions have loosened. For example, in the United
Kingdom the proportion of mortgage lending at higher loan-to-value (LTV) ratios has been
rising over the past few years and is now close to its pre-crisis peak.14 At the same time,
interest rate spreads on high LTV lending have declined and are close to recent post-crisis
lows.15
Search for yield behaviour may have been more pronounced in the non-bank financial
sector.
11
For example, the share of corporate debt owed by listed UK companies with a ratio of net debt to EBITDA
greater than four was 35% in 2018, compared to 28% in 2007. And the share of debt owed by highly
leveraged US companies has reached pre-crisis levels of above 40%.
12
Globally, this share was around 60% on average in 2019Q1-Q3, close to record highs.
13
For example, PRA data indicates that the share of new lending with leverage above 7 times would
increase from 18% to 28% if add-backs and subsequent borrowing were included.
14
The share of new mortgages issued at LTV ratios of 90% or more was 20% in 2019Q2 compared to 22%
in 2006-07.
15
The spread of quoted 2-year fix rates at 90% LTVs over 2-year fix rates at 75% LTVs fell to below 0.5% in
2019H1, compared to a post-crisis average of more than 1.5%.
For insurance companies and pension funds the impact of low for long on the valuation of
their liabilities, combined with the rigidity of returns expected by some claimholders (and
specified in defined benefit pension schemes), puts pressure on their balance sheets.
This has led to changes in asset allocation, with greater investment in less liquid, lower
quality assets. For example, UK life insurers have increased their holdings of
higher-yielding assets such as long-term, non-traded real economy exposures like
property to back annuities.16
This increased risk taking may continue as insurance companies and pension funds adjust
further to low returns. From a financial stability perspective, a key risk is that insurance
companies and pension funds encounter higher losses in stressed markets and become
forced sellers or bystanders rather than buyers, so amplifying market vulnerabilities.
Other non-bank financial firms such as investment funds have also turned increasingly to
less liquid and riskier investments. Investment fund flows now account for one third of total
portfolio flows to emerging market economies (compared to one tenth before the crisis).17
Bank analysis suggests that non-banks now hold around 40% of the rapidly growing global
leveraged loan market. More than US$ 30 trillion of global assets are now held in
open-ended funds that offer short-term redemptions while investing in longer-dated and
potentially illiquid assets, such as corporate bonds.
This liquidity mismatch may lead to more frequent fire-sales of assets if funds are required
to meet large investor redemptions. Fund leverage could further exacerbate this, for
example due to margin calls on funds' derivative exposures.
In short, the adjustment to a low for long world is likely to lead to upward pressure on
financial sector risk taking and downward pressure on resilience. We have started to see
evidence of these effects in some sectors. One would expect such pressures to continue.
Financial firms will, of course, seek to adapt their business models to help adjust to a low
for long environment. From a financial stability perspective this could make some financial
services to the real economy unviable and shift risks to sectors less able to bear them.
Banks, for example, can pursue cost cutting and consolidation but, as an exploratory
of the major UK banks' illustrated, there are
stress test carried out by the Bank in 201718
limits to both strategies.
-
There may therefore be pressure for more significant shifts of business model for
example expansion into fee generating areas such as asset securitisation. The 2017 test
also suggested that under low for long pressure banks may reduce their balance sheet
share of less profitable activities, such as SME and corporate lending.
Low for long may also change business models in other parts of the financial sector.
Continued pressure on insurance companies' solvency and defined benefit pension fund
funding gaps will reinforce and accelerate current pressures that are shifting the insurance
industries further towards providing with a larger proportion of
and pension 'self-insurance',
pensioners retaining their own longevity and investment risks and less risk sharing.
Active asset management could also become less viable in a low for long world. Lower
asset returns put active asset managers under pressure relative to passive funds given the
higher costs of active management. We are already seeing this: since 2007, the share of
index tracking US equity funds has increased from about 20% to 50% of US equity assets
under management.
It is not yet clear what the impact in financial stability terms might be of greater passive
asset management, though some research19 suggests further acceleration of this trend
could result in more volatile markets with greater vulnerability to swings in sentiment.
Financial stability challenges of low for long: households and corporates
One of the main drivers of the downward shift in the trend real rate is demographics. An
ageing population is likely to lead to an expansion of both sides of the household balance
sheet. Even allowing for longer working lives, increased longevity is likely to lead to a
longer period in retirement and possibly longer in morbidity.
Households will need to accumulate more wealth over their working lifetimes to fund this.
This will tend to push down on real interest rates and push up on property prices. At the
same time, younger households will be able to service a higher level of debt to fund
consumption and higher housing costs.
A more leveraged household sector may not in itself generate a greater financial stability
risk: a higher level of debt is more sustainable in a low for long world.20 And, in aggregate,
higher debt would be accompanied by higher savings.
But low for long, for the reasons I set out earlier, may incentivise a loosening of
underwriting standards driving asset prices and debt levels above levels that could be
justified by lower trend interest rates. This could be exacerbated by amplification
mechanisms in the financial system such as an increase in collateral values.
A more leveraged real economy is also more vulnerable to macro-economic tail events.
Analysis since the crisis had demonstrated that more highly indebted households cut back
more heavily on consumption during downturns.21 And a shock to house prices, for
example as a result of a large adverse shock to employment, could generate strong
negative wealth effects.
One might expect to see similar effects in the corporate sector. And indeed, Bank staff
estimate that the share of corporate debt owed by highly leveraged companies has now
22
pretty much grown back to pre-crisis levels.
This is a risk because we know that more leveraged firms cut back on investment and
employment by more in a downturn.23
- -
All else equal therefore and crucially, absent policy a low for long world is likely to be
one with a less resilient and riskier financial system and a more leveraged real economy
that, as a consequence, is more vulnerable to macro-economic shocks.
Financial stability challenges of low for long: the risk of more severe downturns
-
And this brings me to the third challenge of low for longer for financial stability the risk
that in such an environment, economic downturns will on average be more severe.
Low for long makes demand management of the economy more difficult in downturns,
reducing the space for monetary policy easing with conventional tools. This is because, for
a given inflation target and with the reduction in long-run real rates, policy rates are closer
to their effective lower bound. Changes in the structure of the financial system as a result
of low for long may also weaken the transmission mechanism.
Monetary policy, to be clear, is not powerless at the effective lower bound. As post crisis
experience has demonstrated, 'unconventional' monetary
policy tools can and have
provided stimulus when interest rates are at or near the effective lower bound. These are
now very much a part of central bank toolkits.24
And the challenges are very different in different jurisdictions, not least because of
differences in the structure and effectiveness of monetary policy transmission
mechanisms.25
-
But, taken together with other changes in the economy such as changes in the labour
market which appear to have led to some flattening of the wage Phillips curve and
-
changes in the pass-through of labour costs to consumer prices the probability is that
demand management will need to use more tools to stimulate demand in downturns and
work harder to prevent macro-economic tail events.
There is a lively debate over the extent to which aggressive use of monetary policy tools to
stimulate demand creates financial stability risks by inflating asset prices and encouraging
risk taking and the build-up of debt. My own view is that this can be overdone. There are,
as I have said, deep-seated underlying structural drivers of low for long.
We have not seen an explosion of real economy debt in advanced economies in recent
years even with very low rates (Chart 2). Debt-to-GDP has not risen in advanced
economies, although there has been a rotation from private sector to public sector debt.
Prices of real assets like housing have been growing at a moderate pace in most
advanced economies. In the US, EA and UK house prices have broadly grown at or below
the growth rate of the economy, and real house prices have actually fallen relative to their
pre- global financial crisis levels.
Since the crisis, there has also been a marked reduction in financial sector debt as a share
of GDP, which suggests that reforms have reduced leverage and risk markedly within the
financial sector (Chart 3).
This is not to be complacent.
Aggregates can hide significant problems. In some advanced economies, particularly the
US, corporate debt has, as I have noted, been growing at a very fast rate accompanied by
a loosening of underwriting standards. And to the extent that financial asset prices are
being driven either by unrealistic expectations either of interest rates or of economic
growth, there could be a sharp correction.
Chart 2. Total debt stock in Chart 3. Financial sector debt in
advanced economies advanced economies
Japan US
Per cent of GDP
UK Euro area
400
Per cent of GDP
Mature markets
250
350
230
210
300
190
170
150
250
130
110
Excluding financial sector debt 200
90
Including financial sector debt
70
150
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
50
Source: IIF Global Debt Monitor. Source: IIF Global Debt Monitor.
Moreover, debt in emerging markets grew much faster than GDP between 2011 and 2016.
Chinese debt-to-GDP ratios have risen particularly sharply and are now very high.
Whilst the growth rate of the aggregated global debt stock has moderated more recently,
-
the level remains high by historical standards as one might expect in a low for long
world. While this may not in itself cause or presage a correction, it could well amplify one,
making the global economy more vulnerable to adverse macro-economic shocks26.
This perhaps illustrates that the risk to financial stability from monetary policy may come
not so much from the use of monetary policy tools to stimulate demand.
Rather, it may come from the risk that in a low for long world monetary policy does not or
cannot respond sufficiently vigorously to shocks to avoid macro-economic tail events that
would severely stress a less resilient financial sector and more leveraged real economy.
Perhaps the most important lesson we learned from the crisis is that financial stability is a
necessary condition for macro-economic and monetary stability. Over longer time
horizons there is no trade-off between the two.27
But there is also some truth in the converse. Financial stability depends in part on effective
demand management. It can be severely tested by macro-economic tail events even when
the financial sector itself is not the source of the shock.
Policy responses
Taken together, therefore, a low for long world is likely to be a more challenging
environment for financial stability.
The first and, in my view, most important policy conclusion to draw from this is the need for
active and powerful macro-prudential institutions and policy.
Effectively used, in relation to both lender and borrower balance sheets, it can constrain
risk taking or ensure that higher risk is accompanied by greater resilience. It can address
pockets of higher risk as they emerge, as for example the Financial Policy Committee has
done in the UK in relation to consumer lending.28 It can address mechanisms in the
financial system that could first encourage an overshoot in risk taking and then amplify
economic downturns.
It can also, through rigorous stress testing of the banking sector, ensure that banks have
the ability to absorb losses in macroeconomic tail events.
And it can operate counter-cyclically in downturns through the release of macro-prudential
capital buffers in the core banking system.
Releasing buffers can have a powerful effect in a downturn by reducing the pressure on
banks to cut back on lending and so avoid a credit crunch amplifying the macro-economic
shock.
Such buffers have been part of the macro-prudential armoury for some years now though
not all jurisdictions have used them. The question perhaps is whether that buffer needs to
be made more powerful in a low for long world given the greater risk of severe downturns.
The macro-prudential toolkit is not complete. In most jurisdictions it is far better equipped
with tools to identify and mitigate risks arising in the banking and insurance sectors than in
market based finance. This gap needs in my view to be addressed.
And macro-prudential policy cannot solve all problems. It may fall to other authorities and
policy instruments to respond to any adverse structural effect from changing business
models on the provision of financial services to some sectors of the economy, for example
credit to SMEs.
While it can create space for demand management by monetary policy authorities and
prevent the financial system from amplifying macro-economic shocks in a low for long
world, it is not in itself a demand management tool.
Whether and how monetary, and perhaps fiscal, frameworks should adapt to a world of
structurally low interest rates is a related but separate issue which is receiving
considerable attention from academic research and, more recently, policy makers in some
jurisdictions.29
Discussion is at a relatively early stage and these are, in my view, issues that would need
a great deal of careful deliberation. It is not my purpose today to enter that debate. I would
only make two observations from a financial stability perspective.
The first is that while I am a firm believer in the 'separation of powers', to quote my
colleague Ben Broadbent30, between in the conduct of monetary and macro-prudential
policy, the financial stability dimension needs to play a part in any discussion of demand
management. My intuition is that, from a financial stability perspective, not all demand
management frameworks are equal. And if there is a role for fiscal policy, then that also
affects the financial stability calculus31.
The second, and related point, is that the financial stability dimension needs to be taken in
the round. The impact of monetary policy on financial assets and leverage, for example, is
a very important consideration. But we should not, on the other hand, lose sight of the fact
that a world in which downturns may be more severe and more persistent because
demand management is less effective would also be a significant and perhaps a greater
challenge for financial stability.
Conclusion
Jane Austen's Navy
Fives, as I noted at the start, gave her nominal annual return of nearly
6%. But her real return, when she purchased them in 1815, was closer to 20%. Britain
was entering a severe recession that year at the end of the Napoleonic wars with deflation
than 10%. The annual return in 1817, the year of Jane's death, was actually
of more
negative 2% as inflation rebounded.
monetary standard by restoring Sterling's
A few years later Britain reverted to its pre-war
convertibility to gold. Over the following 50 years, nominal interest rates came down a little
but stayed in the 3-5% range.
But real returns on the Navy Fives and similar fixed rate securities continued to be highly
-
volatile reflecting the very large swings in inflation for much of period a period that was
punctuated by frequent financial crises.
That perhaps illustrates that there is a great deal more to stability - both financial and
monetary - than nominal interest rates.
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