Banks drink from NIRP’s poisoned well

NEW YORK: One clear implication of negative interest rates is that they are poison to banks' business model and securities prices.

The Bank of Japan joined the European Central Bank and others in instituting negative interest rate policy (NIRP) last week, and even the Federal Reserve is now modeling how banks would respond if it too took this particular plunge.

A look at market prices indicates that banks, their shareholders and bondholders do not like NIRP; no, not one little bit. Bank shares in Tokyo are down nearly 15 percent since rates went negative, and are down about 25 percent this year. European bank stocks are also plunging, down 23 percent year to date.

Credit Suisse shares plunged 11 percent on Thursday after it reported disappointing earnings. Deutsche Bank -linked securities have also fallen markedly, notably contingent capital bonds, a riskier type of bond which can convert to equity involuntarily if the bank is in distress.

There is a variety of underlying causes for the sudden investor revulsion over financial intermediation. Loans to energy and natural resource firms look dicey, as may exposure to China and emerging markets like Brazil.

The bigger picture is that interest rates globally look to be heading further into unprecedented areas and this will further diminish bank earnings and undermine their franchise as intermediaries.

Something on the order of 10 percent of the global supply of government debt, which banks are in varying degrees obliged by regulation to own, now carry a negative yield. Sure, the value of the bonds they already own goes up as interest rates fall, but this movement, from here, is not a business model with much long-term promise.

At the same time negative yields will further damage net interest margins - the gap between what banks must pay for financing and what they can charge their own borrowers.

The example of Switzerland, where NIRP has been in place for more than a year, is instructive. While the Swiss National Bank exercises great control over parts of the interest rate market, it does not and cannot compel private lenders to follow where it leads. As a result, the longer-term mortgage rate in Switzerland has actually risen, as banks' refinancing costs have not kept pace with the drop in market rates.

The classic model of how interest rates work on an economy holds that as rates drop, demand for loans increases. It is far from obvious that this is everywhere and always true. In Japan very low rates have not lit a fire underneath corporate borrowers because they can also do demographic math and realize that demand is unlikely to ratify new investment.In Europe too, low rates do not seem to have sparked a satisfying revival in bank intermediation, though clearly it has helped the prices of some of the assets which banks carry on their balance sheets.

Yet markets are telling you that the value of the banks' franchises as intermediaries is dropping more rapidly, and has further to fall, than the value of the bonds they may own is rising. At the point at which we see a bank stock rout like we've had, fewer and fewer banks will be extending credit and the negative spiral threatens to self-perpetuate.

Richard Koo, chief economist at the Nomura Research Institute, argues that much of the world is paying down rather than taking out debt, cleaning up balance sheets after years of excess.

That makes the old model of using interest rates as stimulant no longer valid.

"The theory that inflation is a monetary phenomenon that can be controlled by the central bank, since the central bank controls the supply of money, is valid in a world in which there is an ample supply of private-sector borrowers," Koo writes in a note to clients.

"But it is mere nonsense in the post-bubble-collapse world of a balance sheet recession, where this condition is not satisfied."

To be sure, it would be unwise to assume that we are in a re-run of 2008. Banks, while certainly still carrying some doubtful legacy loans, are better capitalized and more resilient than the creatures of the pre-crisis era. Banks do, though, face risks of disintermediation they did not face coming out of the crisis, both through technology and due to low rates.

The state of affairs does raise some difficult questions for banks. If banks aren't there to make loans and earn a margin, what is it that they do?