Bank of England and rates

The threat of below zero rates rates continues to hover over the UK banking system with the issue raised again at the latest Bank of England monetary policy meeting.

For banking, negative interest rates are a bit like a stroll into the peculiar world of quantum mechanics, where subatomic particles often behave in strange and unexpected ways.

Across Europe, negative interest rates have prompted banks to engage in some curious practices. In Germany, banks have hoarded physical cash in vaults because it was cheaper than holding large balances at the central bank, some Irish credit unions have returned money to savers when above a certain threshold, and several banks in Denmark charge negative interest rates on some mortgages — i.e. pay the borrower interest.

The UK has so far avoided a negative interest rate policy (NIRP), with the Bank of England (BoE) holding the base rate at 10 basis points.

The shape of the yield curve is also important for banks with a positive one favoured, reflecting that banks often borrow on short-term interest rates, but make loans based on longer-term rates.

Most economists do not expect NIRP will occur in the UK, as social restrictions to stop the spread of Covid-19 look close to being lifted thanks to the success of the nation’s vaccine rollout. This should prompt a sharp initial economic rebound followed by steadier growth, therefore negating the need for further monetary stimulus.

Tackling operational risk

However, should there be an unfortunate twist in the pandemic saga — such as new viral mutations, which the current vaccines fail to protect against — then social restrictions will almost certainly return, likely leading to NIRP.

So, in the name of preparedness, the BoE told banks to get their systems in order, but stressed that this is not a signal that NIRP is definitely on the horizon.

The BoE’s minutes reiterated that the Prudential Regulation Authority (PRA) has been engaging closely with lenders. The PRA believes implementing NIRP in less than six months would increase operational risks. The minutes said most PRA-regulated firms need to tweak their systems for NIRP by implementing shorter-term fixes, involving workarounds on the periphery of core systems, along with overrides in downstream systems and customer communications.

Even with pervasive changes to core systems now off the table, banks will still be looking to implement some significant changes to their systems and processes to enable them to deal with negative rates

The Building Societies Association

“Even with pervasive changes to core systems now off the table, building societies (and banks) will still be looking to implement some significant changes to their systems and processes to enable them to deal with negative rates. Such change always involves the risk of unintended consequence, so will require careful implementation and substantial testing and review,” The Building Societies Association told Global Risk Regulator (GRR). The association added that it is not convinced that NIRP would stimulate the economy, or encourage households to reduce their savings or to borrow more.

“The banking and finance industry will work closely with the PRA to ensure it is in a position to implement negative interest rates over the next six months, should the monetary policy committee decide to deploy a zero or negative bank rate,” Simon Hills, director of prudential policy at banking association UK Finance, told GRR. “The introduction of negative interest rates would require considerable changes to bank systems, which is not without operational risk. To meet the six-month expectation our members will deploy tactical solutions to ensure that they are ready, should negative interest rates be introduced. A key consideration for the industry and the regulatory authorities will be to minimise any impact on customer service and the safety and soundness of the wider financial system.”

However, UK banks would at least have the benefit of learning from others, if NIRP occurs in the UK.

Seven-year slog

“The eurozone has had negative interest rates for seven years and it does have a negative impact on bank interest margins due to the inability to pass negative rates onto retail customers,” says Richard Barnes, credit analyst and senior director at ratings agency S&P Global Ratings.

However, it is not all bad news. Mr Barnes notes that in the eurozone NIRP has led to improved asset quality and more demand for loans, according to European Central Bank (ECB) research. Also, it does not affect all banks equally. He notes that those with more diversified businesses, with more products, who are more reliant on fees and commissions, with a presence in countries with positive rates and those involved in investment banking tend to fare better than those with much narrower retail deposit-based businesses.

And although Mr Barnes believes that NIRP will be a headwind for many UK banks, he still expects them to be able to generate sufficient earnings to maintain their regulatory capital buffers.

In an article published December 17, 2020 on the King’s College London blog, the Qatar Centre for Global Banking and Finance noted central bankers’ concerns about interest margins getting squeezed because banks do not want to pass negative rates onto retail customers.

However, the authors do not think this should stop the BoE pursuing a “modestly negative” bank rate if necessary. This is because household deposits only account for 19% of the UK banking systems’ total liabilities, compared with 30% for the eurozone banking system. This should mean that the adverse impact of NIRP should be smaller for UK banks than for their eurozone counterparts.

They also point out that central banks have found ways of alleviating the impact of NIRP, often by only charging negative rates on excess reserves. This could be significant for building societies, for example, that rely heavily on deposits, but are mostly small institutions. Yet another tactic is for the central bank to establish preferential rates for lenders that are directly linked to the provision of new credit to households and businesses. The ECB is already pursuing such measures.

Seeing an opportunity

Jaidev Janardana, chief executive of peer-to-peer platform and neobank Zopa, challenges the idea that all banks with deposit-taking models will necessarily suffer in the face of NIRP. “Negative interest rates are not the best thing to happen,” Mr Janardana acknowledges, but he sees a chance for Zopa to gain a competitive edge in a NIRP environment. He explains that being digital means that Zopa has a low cost base and can respond rapidly to changes in interest rates, so it can turn off the taps quickly if there is a sudden rush of savings by changing its deposit rates or closing itself off to new money. On the other side of the balance sheet, it primarily does unsecured consumer lending, which will likely retain positive interest rates — even in a prolonged period of relatively deep NIRP. Consumer loans tend to attract relatively high interest rates.

“We can control inflows of savings and lend most of it out,” says Mr Janardana. However, he thinks for banks hosting current accounts, it will be more difficult to maintain profit margins as they have continuous inflows of money from their customers to manage. Many of those customers also maintain current accounts and savings accounts at the same bank, for the sake of convenience. And this could be an issue for the big UK universal banks, particularly if Germany’s experience is any guide. In 2019, cash held in current accounts in Germany rose by 8.5%, compared with the year before, to €1.8tn.

But help might be at hand, ironically, thanks to a combination of technology and open banking — the later initiative forces banks to open themselves up so rivals can offer their customers financial products. It has not been overly popular with some big banks; however, NIRP might change their thinking.

“For us, it is interesting to work with large retail banks to enable them to have an alternative solution that doesn’t involve penalising customers or making life more difficult for them,” says Mark Davison, managing director for the UK and Ireland at Deposit Solutions, a provider of an open banking platform for savings deposits. He explains that some banks in Germany are using the solution to enable their customers to channel their deposits to other savings institutions through the bank’s own portal.

[Big banks] have a tool available that allows them to reduce the burden of excess liquidity that would attract negative interest rates

Mark Davison, Deposit Solutions

This has two key benefits: first, it means the bank retains the relationship with the customer, while the customer avoids the hassle of opening accounts with other institutions, i.e. going through numerous application processes to chase better savings rates. They can manage all these savings simply by logging into a single bank account. Second, each individual deposit is covered by national deposit insurance schemes, which is attractive to high-net-worth individuals (HNWIs).

“[Big banks] have a tool available that allows them to reduce the burden of excess liquidity that would attract negative interest rates,” says Mr Davidson, adding that it also benefits their customers who, according to numerous surveys, actually want to simplify their finances.

Deposits losing allure

In a report about European banks on February 2, S&P Global Ratings explained that whereas retail deposits were once a valuable source of revenue, for banks that no longer holds with NIRP. This is largely because banks have to absorb the costs of negative rates.

What has been happening with eurozone banks is that they have been steadily passing on negative interest rates to corporates and HNWIs.

The rating agency said banks are most likely to apply negative rates on euro deposits where customers are not using other products or services. It noted that banks are increasingly targeting the profitability of new lending, with pricing having shown greater stability since the pandemic hit. “However, lenders’ capacity to manage lending spreads is constrained by strong competition in most markets and customers’ ability to renegotiate interest rates and refinance with other lenders,” the report warned.

Other tactics include raising fees — all measures that UK banks could adopt if interest rates plunge into negative territory.

Indeed, could a long spell of NIRP reframe the UK’s retail banking market? More generally, it could see retail banks accelerate branch closures as the pandemic has pushed more banking online anyway. Banks could also raise fees on some services and overdrafts. Others might look to increase their product ranges, such as offering insurance products, possibly through open banking platforms.

However, a defining characteristic of UK retail banking is free current accounts for those holding positive cash balances.

Mr Janardana thinks a prolonged period of NIRP could end this practice. And even though banks do not particularly like offering free current accounts, introducing fees would be a politically charged issue. Mr Barnes thinks it would take a lot to end free retail current accounts in the UK: “They are so ingrained in the UK, it would be quite a leap to change that,” he says. Most UK banks would prefer for NIRP to never happen than be forced to contemplate practices that are alien to them, as some of their European counterparts have been doing.

This article first appeared in The Banker’s sister publication Global Risk Regulator.

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