'Low-for-long' interest rates may make banks vulnerable, central banks find

Overall financial stability and individual financial institutions are at risk of potential vulnerabilities brought about by a prolonged scenario of low interest rates, according to a report by the Committee on the Global Financial System, a central bank forum.

Historically low interest rates have defined the decade following the financial crisis. Financial firms may see dampened profitability and strength due to such a situation, potentially causing vulnerability for the financial system. Additionally, further vulnerabilities could be engendered by low rates given their impact on firms’ incentives to take risks.

In particular, the committee said that a “snapback,” or a sudden and unexpected increase in market rates from currently low levels, could create liquidity issues for insurers and pension funds as well as impact banks’ solvency. The committee said, however, that the scenario would be harder on insurers and pension funds than on banks.

"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 Philip Lowe, chairman of the committee and Governor of the Reserve Bank of Australia.

"The first line of defense against these risks should be to continue to build resilience in the financial system by encouraging adequate capital, liquidity, and risk management,” he said. “But the report also underscores the need to monitor institutions' exposures in a comprehensive way, including through stress tests."

Recent stress test by the Federal Reserve found that households and businesses can continue borrowing even during a severe global recession given the strong capitalization at the largest bank holding companies in the US. Additionally, Fed Chair Jerome Powell said that the federal funds rate may continue to see gradual increases given broad support for hikes.

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