Financial firms’ strength and profitability may suffer
A prolonged low interest rate environment could affect a country’s financial stability, a new study by the Committee on the Global Financial System (CGFS) of the Bank for International Settlements (BIS). In particular, the profitability and strength of financial firms may suffer.
The BIS is a global organisation of central banks has revealed. In a recently published paper, the committee noted that the decade after the 2008 financial crisis has been marked by historically low interest rates across countries all over the world.
While yields have risen across several economies, the paper believes interest rates are generally expected to rise only slowly over the near to medium term, and to eventually stabilise below levels prevailing in previous decades.
To that regard, the paper identified several implications of a “low-for-long” scenario on financial institutions such as banks in both advanced and emerging market economies and on insurance companies and private pension funds (ICPFs).
“A key takeaway is that, while a low-for-long scenario presents considerable solvency risk for insurance companies and pension funds and limited risk for banks, a snapback would alter the balance of vulnerabilities," said CGFS Chair Philip Lowe, who is also Governor of the Reserve Bank of Australia.
"The first line of defence against these risks should be to continue to build resilience in the financial system by encouraging adequate capital, liquidity and risk management. But the report also underscores the need to monitor institutions' exposures in a comprehensive way, including through stress tests," Lowe added.
With banks, for example, low rates might reduce resilience by lowering profitability, and thus their ability to replenish capital after a negative shock, and by encouraging risk-taking. “These effects can be expected to be particularly relevant for banks operating in jurisdictions where nominal deposit rates are constrained by the effective lower bound, leading to compressed net interest margins,” the report added.
The report said low interest rates boost the present discounted value of both assets and liabilities of ICPFs. “However, because the assets held by ICPFs generally are of shorter duration than their liabilities (contractual payments on life insurance or pension policies), the present value of liabilities rises more than that of assets, thus undermining solvency,” it added. The paper also warned that the scope for claimholders to terminate life insurance contracts early (surrender options) can become a source of liquidity vulnerability for insurance companies if a period of low interest rates ends with a sudden snapback in rates.
