Speech
Embargo
24 November 2016, 6.15 pm
Negative interest rates: necessary from a monetary policy
perspective - but with what risks for the banks?
Volkswirtschaftliche Gesellschaft des Kantons Bern
Fritz Zurbrügg
Vice Chairman of the Governing Board*
Swiss National Bank
Berne, 24 November 2016
© Swiss National Bank, Berne, 2016 (speech given in German)
Ladies and gentlemen
Thank you for inviting me to speak at your annual general meeting. It has become something
of a tradition for members of the Governing Board of the Swiss National Bank to appear
before your society, the Volkswirtschaftliche Gesellschaft des Kantons Bern, and I am
honoured to continue this tradition. In November 2012, my colleague Thomas Jordan began
his speech by citing a few figures to underline just how much the world had changed since the
financial crisis. The Swiss franc exchange rate to the euro had fallen from 1.65 to 1.20,
shortterm interest rates had decreased from 2.5% to almost zero, and the yield on ten-year
Confederation bonds was just 0.5%. Who would have thought that, four years later, we would
be confronted with an even stronger franc and even lower - indeed negative - short and
longterm interest rates?
These extraordinary developments are ultimately a consequence of the global recession which
hit the economy after the credit bubble on the US real estate market burst in 2007. As slide 1
shows, the banks around the world were, and continue to be, especially hard hit by this crisis
and its consequences; since then, their share prices have performed significantly worse than
those of other companies.
This is principally due to the fact that many banks are still engaged in cleaning up their
balance sheets and, where necessary, adopting costly restructuring measures.
Furthermore, banks have been obliged to implement stricter regulatory requirements in the
wake of the financial crisis. These requirements, which are needed to ensure systemic
stability, are aimed at curbing excessive risk-taking. From the banks' point of view, however,
today there are lower potential returns in areas which were previously often lucrative but also
highly risky.
Banks are also faced with structural challenges. The accelerated pace of change in
information technology and altered customer behaviour require high levels of investment. At
the same time, the increasing digitalisation of distribution channels has stiffened competition,
since it is easier for new rivals to enter the market.
Another significant challenge for banks is the current economic environment. Weak global
growth and persistently low interest rates in recent years are weighing on profitability in the
banking sector.
What repercussions does the latter aspect - low interest rates - have on banks in Switzerland
in this generally difficult environment?
This is the question that I would like to address in detail this evening.
I will begin by briefly explaining why the negative interest rate in Switzerland is currently
necessary from a monetary policy perspective. I will then show the extent to which this
interest rate environment has influenced the profitability of Swiss banks. I will conclude with
a discussion of the associated risks to financial stability, which require special attention.
Negative interest rate as a monetary policy imperative given low rates
worldwide
To answer the question of why the negative interest rate in Switzerland is currently necessary
from a monetary policy perspective, it is worth looking somewhat further into the past.
The last 30 years have seen interest rates around the globe trending downwards, as illustrated
by the rates on ten-year government bonds in Switzerland, Germany and the US (slide 2). A
key explanation for this downward trend is that both inflation rates and their volatility have
declined worldwide. Consequently, investors require less compensation for the risk of a fall in
the value of money due to inflation. The literature gives further reasons for the general decline
in interest rates since the mid-1980s.1 The propensity to save has increased overall, while at
the same time the demand for investment capital has receded. This combination of higher
supply of and lower demand for capital exerts downward pressure on interest rates. Since the
onset of the financial crisis in 2007, the prolonged slump in global growth and valiant efforts
by central banks have pushed interest rates even lower.
As a small open economy, Switzerland cannot decouple itself from these global
developments. On the contrary, exceptionally low interest rates around the globe have
farreaching consequences for our economy.
In the past, Switzerland has invariably had lower interest rates than its trading partners,
namely the euro area countries, as shown in slide 3, where the blue shaded area depicts the
difference between short-term interest rates in euros (yellow) and Swiss francs (red). This
interest rate advantage primarily reflects the lower average inflation rate in Switzerland
compared to other countries, although political stability, sustainable fiscal policy and credible
monetary policy also play a role. Investors have therefore traditionally been willing to hold
Swiss franc investments at lower yields. This interest rate advantage was for a long time the
'natural' state of things in Switzerland.
However, in the wake of the financial crisis, this advantage came under mounting pressure.
Monetary policy easing on the part of the European Central Bank resulted in a narrowing of
the EUR/CHF interest rate differential. In 2014, yields on short-term government bonds in
Switzerland were, at times, even higher than in Germany. This caused upward pressure on the
Swiss franc to intensify.2
From a monetary policy perspective, Swiss franc appreciation calls for monetary policy
easing, since the exchange rate has a substantial influence on inflation and economic
developments in Switzerland. Initially, appreciation places downward pressure on prices of
imported goods and services, which account for around 25% of the basket of commodities
used to calculate the Swiss consumer price index. An appreciation of the Swiss franc therefore
translates into a decline in the inflation rate. Furthermore, appreciation impairs the price
competitiveness of the domestic export industry and dampens foreign demand for Swiss
goods and services. This, in turn, adversely affects domestic growth and therefore also
indirectly weighs on inflation.
As you are aware, the SNB has a statutory mandate to ensure price stability while taking due
account of economic developments. Thanks to the introduction of the negative interest rate in
Switzerland, the original interest rate differential to the euro area could at least partially be
restored. This - along with the SNB's willingness to intervene in the foreign exchange market
- has helped to relieve pressure on the Swiss franc. The effect of the negative interest rate on
the exchange rate is currently playing a decisive role in enabling the SNB to fulfil its
monetary policy mandate. It allows the SNB to counter the aforementioned consequences of
the Swiss franc appreciation on economic developments and inflation. Without the negative
interest rate, inflation and economic growth in Switzerland would be lower.3
Low interest rates and Swiss banks' profitability
The negative interest rate thus remains indispensable from a monetary policy perspective, and
has, as explained, achieved the desired effect. A monetary policy geared to price and
economic stability is also a precondition for a profitable, stable financial system. An
environment of decreasing prices and low growth would lead to reduced demand for banking
business and increased credit defaults, losses and write-downs.
At the same time, the exceptionally low interest rates are fraught with significant challenges.
Above all, over time they can have economically undesirable consequences for financial
stability.
We have arrived at the main topic of my remarks today, namely, how does the SNB assess the
effects of low interest rates on financial stability?
The answer to this question largely depends on the extent to which low interest rates affect
banks' profitability. If the impact on profitability is substantial, it can over time undermine the
robustness and integrity of the banking system as a whole, since only a banking system that is
profitable in the long term can maintain and further build up its resilience. And only a resilient
banking system is capable of seamlessly fulfilling its core economic functions. Furthermore, a
decline in profitability could lead to banks taking excessive risks in an attempt to reach
earnings targets, which - again - is undesirable from a financial stability perspective.
To assess the impact of low interest rates on the Swiss banks, it is useful to start by
considering the business activities with which banks generate their income and how these
activities are impacted by exceptionally low interest rates.
First, let us consider the earnings. There are three key 'pillars' or sources of income in
banking: interest business, commission business and trading business.
In simple terms, interest business consists of granting interest-bearing loans and financing
them with lower-interest deposits or by issuing debt certificates, such as bonds. This is classic
banking business.
Commission business principally stems from fees charged for the provision of services, such
as asset management or advising companies on bond or share issues. Trading business mainly
consists of purchasing and selling securities on behalf of clients or for the bank's own
account.
The current low interest rate environment can affect these three pillars in different ways.
On the one hand, lower interest rates could plausibly benefit commission and trading
business. Customers might be inclined to shift their portfolios into riskier investments, which
would be conducive to earnings in these business areas. At the same time, a decline in interest
rates leads to one-off valuation gains on securities in the balance sheet.
On the other hand, it is likely that exceptionally low interest rates negatively impact banks'
interest rate margins. Put simply, the interest rate margin is the difference between banks'
interest income and interest expense, shown as a percentage of banks' assets.
To better understand the relationship between the interest rate level and interest rate margin, it
is worth looking at the composition of the latter. The interest rate margin can be divided into
three components, namely the asset, structural and liability margins (slide 4).
The asset margin is the difference between the interest rate charged on loans and a market
interest rate of equal maturity. The liability margin is the difference between a short-term
market interest rate and the interest paid on deposits and other sources of financing. And
finally, the structural margin is the difference between longer and short-term market interest
rates - essentially the compensation the bank receives for maturity transformation.
Exceptionally low rates weigh on interest rate margins largely as a result of liability margins
coming under pressure, as slide 5 illustrates.4 This is because deposit rates (yellow) that are
already close to zero react less strongly to an interest rate cut than market rates (red) - indeed,
in extreme cases, deposit rates do not react at all. The main reason for this is that in such
cases, banks do not pass on lower interest rates to private customers, or only to a very limited
extent, since doing so would expose them to the risk of customers withdrawing deposits and
investing them at another bank, or hoarding them as cash. Banks wish to avoid this, because
otherwise they stand to lose a source of financing for their business activities which is stable
and convenient in the long term.
The negative interest rate has put renewed pressure on liability margins, which have since
even turned negative, as shown in the blue shaded area on this slide.
To sum up, it is conceivable that banks could profit from the low interest rate environment in
commission and trading business. However, earnings on interest business are expected to
come under pressure, especially if interest rates are below zero. Therefore, the extent to which
the current interest rate situation weighs on profitability depends not least on the degree to
which a bank or banking system is geared towards interest business.
In practical terms, what does this mean for the Swiss banks?
For the Swiss banking sector as a whole, interest and commission business are of roughly
equal importance as sources of revenue, with both contributing around 35% to net earnings in
recent years (slide 6).In comparison, as this table shows, banks in the euro area generate more
than half of their earnings from interest business. The banking system in Switzerland is thus
generally less dependent on interest business than elsewhere. This is a consequence of the
comparatively greater importance of commission and trading business at the big international
banks and the asset management-focused private banks.
Then there are the domestically focused banks - essentially the regional, cantonal and
Raiffeisen banks. As is clear from their income statements, these institutions are principally
active in interest business. Net interest income - i.e. the difference between interest income
and interest expenses - accounts for almost 70% of their earnings. It is therefore to be
expected that the impact of low interest rates on profitability will, on average, be greater for
these banks than for others with a different business focus.
Stabilised interest margins of domestically focused banks
I shall therefore concentrate on domestically focused banks in the following remarks.
The profitability of these institutions has fallen - in some cases significantly - since the
beginning of the low interest rate period, primarily due to declining margins on interest
business. The average interest rate margin fell substantially between 2008 and 2014, as this
chart illustrates (slide 7).
However, the chart also shows that interest rate margins have stabilised since the introduction
of negative interest. Furthermore, current business figures from domestically focused banks
suggest that they have absorbed the negative interest rate relatively well to date, despite
growing pressure on their liability margins. Negative interest has thus so far not caused a
further erosion of banks' profitability.
At first sight, this result seems remarkable. How can it be explained?
First: Overall, negative interest has hitherto had no material direct cost implications for
domestically focused banks. This is due to the fact that the SNB grants an exemption
threshold before the negative interest rate is applied. In practice, negative interest is only
charged on sight deposits that exceed 20 times the minimum reserve requirement. The sight
deposits of most domestically focused banks are below or at this threshold.
A second - and important - explanation can be seen in the red shaded area of this chart
(slide 8). Domestically focused banks have reacted to the decline in liability margins by
increasing asset margins by around 50 basis points. Specifically, following the introduction of
negative interest, they raised rates for long-term mortgages (shown here in blue), while
returns on long-term market investments (illustrated here using the ten-year swap rate in
yellow) continued to fall. The banks have since managed to keep asset margins high,
notwithstanding the fact that market rates have continued to decline.
But there is another, equally important explanation for the limited impact of the low interest
rate environment on the profitability of domestically focused banks: these institutions have
increased their risk appetite. This applies particularly to affordability risk (typically measured
using the loan-to-income ratio) in lending and to interest rate risk from maturity
transformation.
Let's take a closer look at the current risk situation with respect to domestically focused banks
in Switzerland.
Affordability risk refers to cases in which a borrower can no longer afford to make interest
and amortisation payments for a loan under unfavourable conditions.5 A representative
quarterly survey conducted by the SNB indicates that a substantial share of new mortgages
exhibit high loan-to-income ratios. Moreover, this share has been rising since 2013.6
Put simply, interest rate risk is the risk that banks will suffer losses as a result of rising
interest rates. Such risk results from the maturity transformation process mentioned above -
that is to say, from the fact that loans extended by banks are typically tied up for longer than
customer deposits. Banks can increase interest rate risk exposure by, for instance, extending
repricing maturities.7
This chart illustrates how the banks' appetite for interest rate risk has increased since the
beginning of the low interest rate period (slide 9). It shows the net present value loss which
the domestically focused banks would incur on average if the interest rate level were to rise
by 200 basis points. This loss is considered in relation to the banks' equity capital. The chart
underlines that this loss potential has been very high for several years. It also makes clear that
these banks have taken on additional interest rate risk since the introduction of negative
interest.
The SNB regularly conducts simulations to gauge the significance of this interest rate risk
exposure for financial stability.
As set out in this year's Financial Stability Report, these simulations suggest that the Swiss
banking system is well positioned to absorb a gradual normalisation of interest rates under
current conditions.8 Indeed, the banks even stand to benefit from such a scenario, as a
moderate interest rate rise would relieve pressure on interest rate margins. This is due to the
fact that the first effect of a moderate rise in interest rates would likely be a normalisation of
liability margins.
If, on the other hand, we assume a scenario in which interest rates rise very sharply, this
would have a significant adverse impact on the banks. This outcome is attributable to the fact
that, in such circumstances, structural margins would decline substantially - in other words,
losses associated with maturity transformation would materialise. It would not be possible to
offset this effect with improved liability margins.
In this context, I should emphasise that the domestically focused banks have been
accumulating capital in recent years and now hold sizeable capital surpluses that significantly
exceed regulatory minimum requirements. Currently, they could even absorb the kind of
losses that a sharp rate rise would entail. The introduction of the countercyclical capital buffer
- which requires banks to hold capital beyond minimum requirements if momentum on the
Swiss mortgage and real estate markets is deemed excessive - has played a role here. A
capital buffer of this kind has been in place - specifically with respect to mortgage-backed
loans for financing residential real estate in Switzerland - since the end of September 2013.
So overall, as things stand today, we may draw three conclusions. First, exceptionally low
interest rates are putting pressure on interest rate margins and this is weighing on the
profitability of Swiss banks. This is particularly true of the domestically focused banks,
whose operations are heavily geared towards interest business. Second, the negative interest
rate per se has not thus far caused an additional erosion of these banks' profitability. This is
due in part to the fact that, thanks to the exemption thresholds granted by the SNB, for most
domestically focused banks negative interest has not yet resulted in any material direct costs.
At the same time, these banks have responded to profitability pressure by raising asset
margins. Third, they have further increased their risk appetite. The risk exposure of the Swiss
banking system is nevertheless manageable at the moment, thanks to the capital surpluses
currently available.
Low interest rate environment - all players should be cautious and alert
So much for the current situation. But how does the SNB see low interest rates affecting the
banking system in the future?
First, it is worth reminding ourselves that the authorities, the SNB and the commercial banks
jointly adopted a balanced package of measures back in 2012 to help mitigate the financial
stability risks associated with persistently low interest rates.
Alongside the countercyclical capital buffer referred to above, adjustments to the
selfregulation rules for banks in the area of mortgage lending are particularly worthy of mention.
Banks now require of borrowers that at least 10% of the loan value be provided from funds
that do not stem from the second pillar. Furthermore, borrowers must gradually pay down the
mortgage to two-thirds of the loan value within 15 years.
As interest rates will have to be kept low for the foreseeable future for reasons of price
stability, all players should remain especially cautious and alert.
The longer the exceptional interest rate situation persists, the more likely it is that banks will
experience higher profitability pressure. Over time, competition between banks may cause
interest rate margins to narrow further still. Additional competitive pressure may come from
insurers and pension funds, which are increasingly seeking to position themselves as direct
providers on the mortgage market.
Ongoing profitability pressure creates an incentive for banks to step up their exposure to
interest rate risk and adopt an imprudent attitude in their affordability assessments. Equally,
banks may react to earnings pressure by expanding the volume of credit.
Together, such developments would cause prices on the Swiss real estate market to gain
momentum again, following a recently slowdown. This is particularly relevant given that real
estate remains relatively attractive, not just to households but to investors searching for yield.
The net result of this would be a renewed rise in imbalances on the real estate and credit
markets. This would make borrowers and banks more vulnerable - to an unexpected future
interest rate rise, for instance. In particular, it would increase the magnitude and overall
economic impact of a price correction on the real estate market.
In the spirit of a cautious, forward-looking approach, it is essential given the current interest
rate environment that banks apply conservative principles in their lending activities.
This is particularly necessary when it comes to assessing the sustainability of loans. Based on
experience from the crisis in the 1990s, banks now typically assume an interest rate of 5%
when assessing affordability risk; this is the approximate historical average of long-term
mortgage interest rates.9 The level of this imputed interest rate is not set by the regulator and
varies between banks. However, if this interest rate were to be lowered in the current
environment, borrowers, banks and the economy as a whole would face significant risks.
It is especially important when assessing affordability and the relevant interest rate to
remember that real estate is normally purchased over a long time horizon of several decades.
Interest payments for a mortgage will thus be incurred for the duration of this period, in the
course of which rates may well be significantly higher than they are today. While a sharp
interest rate rise is unlikely in the short term, there is considerable room for a substantial
upward correction in the medium term. It is worth bearing in mind that long-term interest
rates are currently about 300 basis points below what was considered normal during the
pre2008 era. It is thus vital that borrowers and banks do not exclude the possibility of a sharp
interest rate rise in the medium term and, that they ensure their ability to cope should such a
scenario come to pass. In short, they should not assume that today's favourable financial
conditions will endure for their entire planning horizon.
Concluding remarks
Ladies and gentlemen, let me now wrap up.
The negative interest rate charged on banks' sight deposits at the SNB is indispensable from a
monetary policy perspective. Given low interest rates around the world and the difficult
global economic situation, negative interest - coupled with the SNB's willingness to
intervene in the foreign exchange market - serves to ease upward pressure on the Swiss franc.
Negative interest helps to maintain price stability and support economic activity in
Switzerland. Of course, the banking sector ultimately benefits if prices are stable and the
economy thrives.
However, the low interest rate policy is also associated with side-effects. It can have
economically undesirable consequences for financial stability. Thanks to measures taken to
date and the capital surpluses that banks have in place, these risks are currently manageable
for the financial system.
Looking to the future, ongoing low interest rates are likely to continue weighing on banks'
profitability; this, in turn, will create an incentive for them to take on more risk. At the same
time, imbalances on the Swiss real estate and mortgage markets could be exacerbated over
time. Such developments would render the banking system and the economy more vulnerable.
It is thus all the more important that banks put aside sufficient capital surpluses and adopt a
conservative mindset when assessing the creditworthiness of borrowers. For its part, the SNB
monitors developments on the credit and real estate markets continuously and reassesses the
need for an adjustment of the countercyclical capital buffer on a regular basis.
Thank you very much.
Negative interest rates: necessary
from a monetary policy perspective
- but with what risks for the banks?
Fritz Zurbrügg
Vice Chairman of the Governing Board
Swiss National Bank
Volkswirtschaftliche Gesellschaft des Kantons Bern
Berne, 24 November 2016
Slide 1
2 24/11/2016 Volkswirtschaftliche Gesellschaft des Kantons Bern | Fritz Zurbrügg | © Swiss National Bank
Slide 2
3 24/11/2016 Volkswirtschaftliche Gesellschaft des Kantons Bern | Fritz Zurbrügg | © Swiss National Bank
Slide 3
Introduction of
negative interest
4 24/11/2016 Volkswirtschaftliche Gesellschaft des Kantons Bern | Fritz Zurbrügg | © Swiss National Bank
Slide 4
COMPOSITION OF BANKS' INTEREST RATE MARGIN (STYLISED)
Mortgage rate (10-year)
Asset margin
Capital market rate
(10-year)
Interest rate
Structural
margin
margin
Capital market rate
(3-year)
Liability margin
Interest rate on deposits
Slide 5
Introduction of
negative interest
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Slide 6
CONTRIBUTIONS BY BUSINESS AREAS TO NET EARNINGS 2015
Swiss
Swiss European domestically
banks banks focused banks
Interest business 37% 58% 67%
Commission business 35% 27% 19%
Trading business 13% 9% 9%
Other 14% 6% 5%
Slide 7
Introduction of
negative interest
8 24/11/2016 Volkswirtschaftliche Gesellschaft des Kantons Bern | Fritz Zurbrügg | © Swiss National Bank
Slide 8
Introduction of
negative interest
9 24/11/2016 Volkswirtschaftliche Gesellschaft des Kantons Bern | Fritz Zurbrügg | © Swiss National Bank
Slide 9
Introduction of
negative interest
10 24/11/2016 Volkswirtschaftliche Gesellschaft des Kantons Bern | Fritz Zurbrügg | © Swiss National Bank
Thank you for your attention.
© Swiss National Bank