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WASHINGTON Large banks will simulate their ability to weather both deflation and a recession among the annual economic scenarios provided by the Federal Reserve Board on Thursday for the central banks 2016 stress tests.
January 28 -
The Federal Open Market Committee Wednesday voted to raise federal interest rates from nearly zero for the first time since 2008, meeting market expectations but ushering in a new and uncertain normal for the banking industry.
December 16 -
The unprecedented accommodative interest rate environment has spurred banks to offer long-term loans at very low rates of return, and if the cost of funds goes up especially if it goes up more dramatically than expected it could put depository institutions in a tough position.
November 6
When central bankers discuss the prospect of negative interest rates, it sounds like the doctoral dissertations they wrote decades ago — highly theoretical and sometimes almost theological discourses on what would happen to growth and inflation, with nary a thought to financial stability.
But with some at least toying with the concept of negative rates to accelerate economic growth, and other countries already taking that step, U.S. bankers should begin reckoning with the impact.
To be fair, the chance of U.S. policymakers lowering rates below zero is low under normal market circumstances because most members of the Federal Open Market Committee want to keep rates well
By forcing banks to test their strength in the face of such simulated conditions, the Fed may think it has the financial stability problems tied to negative rates covered. But the impact on both profit and purpose of negative rates for banks both large and small is profound, with ripples that quickly would sweep through the rest of the financial system. Should the Fed want or be forced to set nominal negative rates, we need a clear assessment now of just what would happen to U.S. banks and other financial institutions.
It is easy to dismiss the warnings of the financial-stability implications of negative nominal rates, such as a
The Fed has been somewhat circumspect about the likelihood of the U.S. central bank ever lowering rates below zero. Although Fed Chair Janet Yellen
A few central bankers abroad have raised red flags about the consequences of negative rates, such as in an April
However, any care by the Fed or other central banks to try and comfort the bond markets isn’t working. Over just the past two or three weeks, traders have gone from pricing Treasuries based on a rate rise to betting on a dip below the ZLB.
What would negative rates mean for U.S. financial stability?
The real problem with nominal negative rates compounded by a flat yield curve is that they upset the fundamental premise of banking and, therefore, the role banks play in financial intermediation. When rates go negative, depositors pay bankers and bankers pay borrowers. If this simple scenario played out, then depositors will look for places other than banks to house their wealth and bankers won’t make loans. In a less simple scenario — the one that’s playing out now in Europe — the financial-intermediation equation doesn’t totally flip, but it still fundamentally changes. There, some depositors are paying their bankers even as they search for other depositories, and bankers are still getting interest from borrowers on new loans, although at rates that make profitability still more challenging. Bank funding costs are also either at zero or now negative, meaning that lower asset returns can’t be offset with lower funding costs.
Last Friday, Japan
Regardless of one’s opinion of banks, economies need financial intermediation and financial intermediation needs banks. If banks turn away deposits and try not to make loans — what is happening in other nations with negative-rate policies that could happen here as well — then capital formation will hit a very hard wall with unknown macroeconomic and financial-stability consequences.
Bankers fearful of the consequences of negative rates should be sure the Fed hears them loud and clear. If the Fed were to choose negative rates — especially if it is forced to do so under stress conditions — without a plan to protect market liquidity and ensure positive returns to bank funding sources, shockwaves with untold consequences could ripple through the financial system.
Karen Shaw Petrou is managing partner of Federal Financial Analytics.