Recently, I addressed four very important aspects of the financial system affected by negative interest rates and how they are sucking out the money from our pockets, those are:

1. Banks’ profitability and consequences for savers. 
2. Pension funds and impact on existing and future pensioners,
3. Insurance companies and their clients.
4. Stability of the financial system. 

I decided to divide this topic into three parts as it is a very comprehensive issue. In the first part, I will go through the banks and show how central banks’ current interest rate policy impacts hard-worked savers.

Most of us have been taught that if you put your money to a savings account, after some time your savings will go up. Unfortunately, the current financial conditions of banks substantially deteriorated due to central banks’ policies and forced them to pass costs of negative interest rates on the customers. It means that what we have been taught about saving accounts, in many cases do not apply anymore.


HOW NEGATIVE INTEREST RATES WORK

As a brief reminder, let’s recall first what is an interest rate.

“Interest rate is the interest percent that a bank or other financial company charges you when you borrow money, or the interest percent it pays you when you keep money in an account"

Interest rates are set by central banks and according to those, commercial banks decide the level of rates in their

Brief example:
In case of borrowing with positive interest rates, a $100 loan with a 5% rate means that one would have to repay $105 in the future. With the negative rates, it is the opposite, $100 loan with -5% rate means $95 to repay, so the borrower actually gains $5, excluding fees.


In case of keeping money in an account with positive rates, a $100 deposit (e.g., saving account) at 5% will give you $105 in the future (excluding tax). On the other hand, with 5% negative interest rates for a $100 put in the savings account will give you back 95$. It means that the depositor pays for the privilege of putting money into the bank, sounds abstract right?

If you like visualizations, here is a great video explanation, by CNBC’s Geoff Cutmore.


So, when that has actually started and how exactly affected banks and us, ordinary people?


BANKS’ PROFITABILITY

Since 2012 Japan, Eurozone, Denmark, Hungary, Norway, Sweden, and Switzerland - introduced negative rates (chart). 

source: kkr.com

There is an ongoing debate about whether negative rates are a drag on the banks' profitability. Before referencing academic and market evidence let’s recall the most common profitability measures (you can omit this part if you are not interested in technical formulas):

source: own elaboration

As you can see, there are many ways to assess banks’ ability to generate profits. Below it is shown how they have been affected, among others, by negative rates over the last few years.

In 2018 researchers of the Federal Reserve Bank of San Francisco issued a paper titled: Why Have Negative Nominal Interest Rates Had Such a Small Effect on Bank Performance? Cross Country Evidence where researchers examined the effect of negative nominal interest rates on bank profitability of more than 5100 banks in 27 countries (Europe and Japan) between 2010 and 2016. They concluded that despite the decrease in net interest income, there was a little overall impact of negative rates on banks profitability (using return on assets, ROA) compared to banks functioning within a low positive rate environment. This is because increased fees and capital gains on securities have offset the negative impact from rates. It is also worth to note, that the assets of European and Japanese banks fell over this period.


So if assets have fallen over time, so their net income (if return on assets stayed the same as the paper claims). It means therefore that banks' business has actually shrunk.

Another paper covering more data and prepared by the European Central Bank researchers in 2017, titled “Do negative interest rates make banks less safe?” examined 7,359 banks from 33 OECD member countries over the 2012–16 period. They concluded that in countries where negative interest rates have been implemented net interest margins and returns on assets have fallen 16.41% and 3.06%, respectively, compared to countries without negative rates. In other words, margins, and profits of banks in countries with negative rates fell in comparison to those without the negative rates.

What does tell us data of exchange-listed banks?

Earnings per share of 25 Eurozone banks included in the Euro Stoxx Banks index dropped 12.3% between 2014 and 2018 fiscal year and net income margin decreased 29% since the beginning of 2015. (Eurozone have introduced negative rates in June 2014, now -0.5%).
Below chart also shows that the net interest margin for the largest 15 Euro-area banks has dropped from 2.8% to 2.5% over the last 6 years (10.7% decline).




Of course, it had to be reflected in the banks' share prices which have declined almost 40% since June 2014, or the introduction of negative rates. At one point the discount was as much as 50%.


If one would said that it was due to a broader economic slowdown, here is the performance of the same EU Banking Sector as in previous chart (white line), S&P 500 Banking Sector in the U.S. (green) and EuroStoxx 50 Index, or index or the main index of European shares (yellow) since the introduction of negative rates in the Eurozone.


As you can see, the European Banking sector is definitely struggling. I want to also emphasize that there are more reasons behind banks' problems like fierce competition or issues with loans' quality but let's keep it simple for now.
What about Japanese banks?

Since the 2016 fiscal year (ending March) major and regional banks' net income has fallen by 22% and 34%, respectively. (25% if you put them together). Japan has introduced negative rates (-0.1%) on January 29, 2016.

source: Wall Street Journal

After the introduction of negative rates, Japanese banks' stock prices fell as much as 30% in several weeks, then recovered after implementing “Yield curve control”, and now trading 14% lower. Yield curve control is one of the instruments used by central banks which is supposed to support banks. As the chart shows it has not helped for so long.. However, this is the topic for another article.


As you can see, a drop in the banks’ profitability during negative rates period is evident, which makes investors anxious about the prospects of this sector. As it was not enough, even central banks’ and global financial institutions admit that the problem is significant and poses a threat to the financial system, here are a few quotes:

European Central Bank Financial Stability Report (November 2019):

Bank profitability prospects have weakened against the backdrop of the deteriorating growth outlook and the low interest rate environment."

“Overall, the prospect of weaker economic growth and lower interest rates is likely to weigh further on profitability expectations for euro-area banks in the period ahead,”

October 2019:

Euro zone banks face growing pressure on earnings from a maturing business cycle and their projections for lukewarm earnings in the coming years may still be too optimistic…
…low rates for even longer, along with intense competition, will further weigh on banks’ ability to generate income.”

Bank of Japan Governor Haruhiko Kuroda (November 2019):

“Regional banks’ core profitability has continued to fall due to prolonged low interest rates, a shrinking population and falling number of firms operating in regional areas of Japan.”

May 2019:

Prolonged monetary easing has strained Japan’s regional banks by narrowing the profit margins of their core lending operations.
Low rates and structural factors, such as a dwindling population, will likely weigh on regional banks’ profits.

Denmark’s Central Bank (November 2019):

The nations’ banks generally fared worse than in previous stress tests. One of the reasons is that earnings are weaker than in the last few years.

World Bank (August 2016)

“Adverse consequences of NIRP could include erosion of profitability of banks and other financial institutions and excessive risk-taking by investors.”

Thus, officials are fully aware of those issues but it seems like they naively believe that the continuation of their policies will somehow reverse the current harming trends.


SAVERS ARE HIT THE MOST

Now, as we are familiar with the banks' problems we can look closer into the main point of the article - savings. As I mentioned above, more and more banks decide to pass negative rates on their customers to offset the costs of negative interest rates. What does show us numbers? I am going to focus mostly on Germany as it is a country with substantial levels of savings.

At the end of September, Bundesbank (German central bank) surveyed 220 commercial banks asking whether they are charging negative rates on the clients' deposits, that was two weeks after the ECB has cut its rate from -0.4% to -0.5%. In response, 58% of German banks said that they imposed negative interest rates on the deposits of corporate clients and 23% are doing the same for retail customers. Stunning, but this is just the beginning. Below you can also see particular examples"

·       1. At the beginning of November, Deutsche Bank AG, the largest German lender announced that it will pass negative rates to large corporate clients and wealthy individuals. Thus, most retail clients of this bank can breathe a sigh of relief for now.

·       2. At the beginning of October Berliner Volksbank, German second-largest cooperative lender has started to charge retail clients with -0.5% rate on deposits exceeding 100,000 euros ($110,000).

·       3. Similar charges have been already implemented in Denmark by Spar Nord Bank A/S, and Jyske Bank A/S (second-largest listed lender) imposing -0.75% fee on deposits exceeding 750,000 kroner ($110,000). As well as Sydbank A/S, Denmark's third-biggest listed bank (-0.6% charge on retail deposits larger than 7.5 million kroner or $1.1 million).

·       4. In Switzerland, UBS will introduce -0.75% rates for clients holding more than 2 million francs ($2 million) and a yearly fee of 0.6% for its Swiss clients for deposits above 500,000 euros ($560,000). Credit Suisse plans to impose an -0.4% charge on euro accounts of more than 1 million euros ($1.1 million). Julius Baer and Pictet, smaller Swiss banks already charge some clients with large deposits.

·       5. Absolutely astonishing, however, was the announcement that Volksbank F├╝rstenfeldbruck, small German bank with 1.8 billion euros in assets, said that it will charge new clients of -0.5% rates on savings accounts with deposits of 1 EURO and above. This is the first German lender passing costs of negative rates on retail customers. The bank’s comments regarding this decisions are quite telling: “The negative rate is set by the ECB[European Central Bank],” “We have to park the new client money somewhere.”

·       6. In addition, as Frankfurter Allgemeine Zeitung recently reported, “Frankfurter Volksbank, one of the country’s largest cooperative lenders, is considering going even further and charging some new customers 0.55% for all their deposits”

To make you more aware of the figures we're talking about... 

German savers currently hold €2.38 trillion ($2.64 trillion) in retail bank deposits or 66% of the German GDP (Gross Domestic Product).
According to Bundesbank (German central bank), 25% of the total private households deposits and 79% of corporates' money put into banks in Germany are subject to negative interest rates.

That means $0.66 trillion of household deposits in Germany are charged by negative rates!!


Can we bring similar conclusions in case of the entire European Union? I think, yes and this is why.

In 2016, Intrum Justitia, surveyed 21,000 consumers in 21 European Countries asking where do they put their savings. The survey showed that 69% of Europeans put savings into savings accounts despite zero or negative interest. 26% kept savings in cash, while 16% in stocks.


In Denmark and Sweden, where rates are negative, almost 80% of people put their surplus cash in bank accounts. The same number applied to France, the U.K. and the Netherlands.

Will this trend with banks punishing customers continue? With the current central banks’ policies, it is very likely as there are signs that they are ready to cut rates even further in case the economy will not improve. The problem is that the lower the interest rates, the more people try to save for the future.


Since the beginning of 2018, despite the dramatic drop in 10-year German bond yields (they follow trends in interest rates – orange line), the households saving rate in 28 European Union countries have substantially increased (green line), diverging from the 10 years falling trend.

Thus, it looks like the idea of negative rates just exacerbates the problem. Instead of spending more (the lower the interest rate, the lower the cost of credit), they actually save more.


CONCLUSION

We are living in unprecedented times where prudent and safe money approach is punished whereas borrowing and debt piling is rewarded. Policymakers at all costs want to change people's spending habits in order to create economic growth. For some time it may work, but this is the consumer or an enterprise who decides when to spend money or when to save it. 


In one of the speeches, the European Central Bank President, Christine Lagarde said: "We should be happier to have a job than to have our savings protected". The problem is that economic growth and low unemployment will not last forever, and savings are the cushion that helps to get through the tough times.

Seb.

You can find the second and the third part of the work here:

https://www.sebinvestmentresearch.com/2019/12/how-central-banks-and-negative-interest_17.html

https://www.sebinvestmentresearch.com/2019/12/how-central-banks-and-negative-interest_26.html


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