Negative rates to create new risks for banks

The Bank of England (BOE) and the Prudential Regulation Authority (PRA)’s recent announcement on the eventuality of a zero or negative rate will require banks to adjust risk policies.

Damian Hales, partner at Deloitte, says most models would not have anticipated the possibility that interest rates could go negative – a risk that banks will need to tackle.

“There’ll be a sort of implicit flaw. Banks are going to have to make sure their pricing models and hedging models can cope with negative rates. Quite a lot of models use a log-normal distribution and mathematically log-normal can’t go negative,” says Hales

Lack of preparation from banks could also skew the price of derivative contracts – putting them out of the money according to Hales.

“If they start to, in their fund transfer pricing, move the money they’ve borrowed in the market to their commercial and retail facing divisions, then again, if that model is wrong, then potentially you’re facing an under-pricing risk that they give the wrong price to your internal unit, who in turn, would potentially pass on the wrong price to that retail and commercial companies.”

In 2012, Denmark’s Nationalbank (DN) was the first to introduce negative policy rates of -0.2 percent on bank deposits at the DNB whilst maintaining a zero interest rate on the current account of banks. This was passed on to customer of commercial and retail banks.

Last year, Jyske Bank offered its customers a fixed-rate mortgage loan with a nominal interest rate of -0.5 percent.

However, lowering interest rates does not necessarily guarantee more spending from consumers – particularly in times of crisis.

Sam Pham, associate director at Smith & Williamson Investment Management LLP, says the biggest risk remains the ‘liquidity trap,’ in which despite negative rates, banks remain reluctant to lend due to economic uncertainty.

In 2014, although the European Central Bank (ECB) turning to negative rate policy, bank lending still did not surge.

Hales also believes switching from positive to negative mortgage rates to potentially positive rates again could present a concern as consumers will need to adapt to the interest rate shock, in which their spending habits will change, or mortgage defaults could arise.

The next challenge for banks will be around checking their model inventory to make sure their pricing models can handle the negative rates and start looking at strategic aspects.

For corporate treasurers, Pham says the key risk will be in mispricing the funding SATs, hedging strategy, or any derivate contracts.

“That misprice may cause you to have a loss in the future. It’s just making sure that your models can adequately quote from a mathematical perspective, with the idea of this particular funding going negative.”

Interest rates on government bonds will also go down as interest rates become negative.

The UK 2-year Gilt yields, for instance, dipped into negative territory for the first time in history due to expectation of lower BOE rates, according to Reuters, which reduced the income offered on UK gilts.

“Corporate treasurers will potentially have to find the closest alternative asset class depending on their investment guideline. However, in cases where banks must hold safe assets to meet capital requirements, negative rates do not have an impact on positioning,” explains Hales.