## CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ## Source details **Canonical URL:** [CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION](https://www.imf.org/-/media/files/publications/gfsr/2017/april/ch2.pdf) ## Other formats - [Markdown version](/-/media/files/publications/gfsr/2017/april/ch2.pdf.md) - [Structured JSON version](/-/media/files/publications/gfsr/2017/april/ch2.pdf.json) --- ### Context, purpose, and analytical contributions - Context and motivation: - Advanced economies have experienced low real and nominal interest rates for several years; interest rates have been less volatile and the yield curve has flattened considerably. - Economic growth has been persistently low over the past decade. - Two interpretations: (a) a large, long deviation from a higher equilibrium level of growth; or (b) a new steady state with lower potential growth, in which prevailing low rates are equilibrium natural rates. - Slow-moving structural factors cited: demographic changes (waning population growth, rising longevity); lower total factor productivity growth; steadily rising savings and growing demand for advanced-economy financial assets in emerging market economies over the past 15 years. - Purpose and approach: - Scenario analysis of a hypothetical “low-for-long economy” where nominal and real interest rates and growth are low and expected to remain low for the foreseeable future. - Abstracts from monetary policy reactions and temporary effects; considers a hypothetical equilibrium with low growth, low interest rates, and low expected returns on most financial assets. - Not a baseline or projection; an exercise to illustrate key issues and long-term implications. - Analytical contributions: - New analytical framework for the term structure of interest rates in an equilibrium with low natural rates. - Extension of a standard model of bank profitability to assess impacts by business model; comparison with Japan’s experience. - Empirical assessment of low-rate impacts on banks’ profits distinguishing prolonged low-rate periods from other periods. - Simulations for insurers and pension funds’ portfolios and viability of typical pension and insurance products in a low-natural-rate equilibrium. - Discussion of household asset-allocation changes, role of asset managers, and implications for financial stability. ### Key scenario findings - Yield curve and term premiums: - The yield curve would be flatter compared to an equilibrium with higher rates and growth. - Banks: - Although lower interest rates may boost banks’ earnings in the short term, they hurt profitability in the steady state once they fall below a particular positive threshold. - Smaller, geographically undiversified, deposit-funded banks would be hurt most. - Tail risk exposure could increase as banks undertake reach-for-yield strategies: - Smaller, deposit-funded banks typically take on more interest rate risk by increasing the duration of bond portfolios. - Large banks are likely to increase risk exposures in foreign countries offering higher returns (in particular, emerging market economies) and rely more heavily on wholesale funding markets. - Insurers and pension funds: - Life insurers and pension funds would face a long-lasting transitional challenge to profitability and solvency, likely requiring additional capital. - Some institutions would find it difficult to meet cash outflows on large stocks of existing liabilities contracted in past periods of higher interest rates by only altering asset portfolios. - Households and markets: - Major long-term changes likely to household demand for financial products, asset allocation, services offered, and the relative role of institutions versus markets in financial intermediation. ### Term structure of interest rates: mechanism and model insights - Slope of the yield curve equals the sum of: - Market expectations of how the short rate will evolve between today and the maturity date of a longer-term bond. - The bond’s term (risk) premium. - Around a steady state where the short rate is at its long-term equilibrium, the slope is driven entirely by the sign and magnitude of (nominal) bond term premiums. - Intuition for term premium: - If bond returns increase when economic shocks reduce other income, investors pay for the bond (negative term premium). - If bond returns decline in tandem with other income, investors demand a positive term premium. - Low-for-long features and implications: - Zero lower bound on short-term nominal interest rates (assumed central bank cannot or will not lower policy rates below zero) constrains central bank responses to negative shocks and makes bond returns more resilient to such shocks. - This resilience lowers term premiums and flattens yield curves. - Once short-term rates are near the zero lower bound and expected to stay there, sensitivity to macroeconomic news drops; investors are more willing to hold long-term bonds, lowering the term premium. - Results robust to modeling endowment and inflation shocks jointly and to calibrations based on Germany, Japan, the United Kingdom, or the United States. ### Banking in a low-natural-rates environment: theory, evidence, and heterogeneity - Theoretical augments: - With an unchanged yield curve, even permanently lower interest rates need not affect banks’ earnings. - A zero lower bound on deposit rates generates pressure on bank interest margins and profits in a low-natural-rate equilibrium. - Monti–Klein banking model key equations and implications: - Balance sheet identity: L + B = D + W + E (loans L, bonds B, deposits D, wholesale funding W, equity E). - Bank profit before dividends, π: - π = (R_L L + R_M B) – (R_D D + R_M W) – kL = (R_L – R_M – k) L + (R_M – R_D) D + R_M E, where R_L = loan rate, R_D = deposit rate, R_M = market interest rate, k = marginal cost of lending. - If lending and deposit rates adjust flexibly and R_M is high (growing economy), margins are almost independent of R_M. - Once the optimal deposit rate would be negative and the zero lower bound binds, lower R_M compresses deposit spreads and net interest margin, reducing profits; deposit inflows rise and leverage increases, but new deposits are invested in low-yielding bonds rather than higher-yielding loans in a low-growth environment. - If deposit rates at zero lower bound and g < 0, lending contracts further because R_M cannot match the natural rate, adding pressure on profits. - Empirical evidence on prolonged low-rate periods: - Definition (double-threshold): short-term yield below 1 percent AND on-the-run 10-year nominal bond yield lower than the historical average of short-term policy interest rates (Japan threshold for 10-year set at 2 percent in one definition). - Average bank profitability: - Sampled banks earn a 10½ percent return on equity on average overall. - In periods with prolonged low rates, average ROE falls to 7.8 percent. - Sensitivity estimates during prolonged low-rate periods: - A 1 percentage point drop in three-month rates is estimated to reduce bank profits by 31 percent below average estimated bank profits. - A 1 percentage point drop in term premiums is estimated to reduce bank profits by 8 percent below average estimated bank profits. - In contrast, a drop in interest rates tends to increase bank profits in normal times. - Heterogeneity and estimated impacts (one-standard-deviation changes during prolonged low-rate periods): - One-standard-deviation increase in bank size raises bank profits an estimated 67 percent relative to the sample average for such periods. - One-standard-deviation increase in the share of deposit funding is associated with estimated bank returns lower by 14 percent than the sample average for such periods. - One-standard-deviation increase in the share of loans in the asset portfolio is associated with estimated bank returns higher by 22 percent than the sample average for such periods. - Large, internationally diversified, wholesale-funded banks outperform deposit-funded domestic banks when interest rates are low for a long time; their estimated average profit is 2.2 percentage points higher than deposit-funded domestic banks with small lending portfolios. - Evidence from Japan: - Short-term rates close to zero since early 2000s (except 2007–08); long-term rates low since early 2000s and declined further after QE in 2013 and negative rates in 2016. - Deposit rates first approached zero lower bound in mid-2000s; net interest margins then gradually and steadily fell, particularly for regional and shinkin banks. - Major banks: asset growth largely via international loans and securities, expanded fee businesses, source about one-third of funding from capital markets, kept operational cost ratios almost flat. - Regional and shinkin banks: deposits constitute over 90 percent of non-equity financing; responded to margin compression with balance-sheet expansion, cost cutting, consolidation; increased maturity of sovereign bond portfolios. - Risk trade-offs: major banks’ strategies increased cross-border market and counterparty risk and reliance on wholesale foreign-currency funding; shinkin banks increased interest rate risk by extending bond maturities. ### Banking industry evolution, consolidation, and tail-risk exposure - Consolidation dynamics: - Small deposit-funded banks with limited international diversification face largest profitability hit, leading to mergers or exit. - Mergers could lower operational costs, increase diversification, and raise market power, potentially reducing incentives for excessive risk taking; caveat: mergers do not always achieve scale economies and can present integration challenges. - Tail-risk and funding shifts: - Smaller and less diversified banks may extend asset maturities, increasing exposure to large positive interest rate shocks and potential significant losses. - Banks may increase wholesale funding within regulatory limits; wholesale funding is more volatile than retail deposits and raises home and host country financial stability concerns during international expansion. ### Insurance, defined-benefit pensions, and solvency challenges - Core problem: - Large existing stock of guaranteed liabilities creates medium-term cash flow obligations that are difficult to meet given lower interest rates and flatter yield curves; many life insurers and defined-benefit pension plans may require additional capital. - Liability-driven investment (LDI) guidance: - Recommended for life insurers and mature or closed defined-benefit pension plans: find bond portfolios whose duration matches liability duration. - Trade-offs and recovery constraints: - Asset-allocation shifts alone cannot generally recover solvency without taking potentially unacceptable volatility risk. - Recovering adequate solvency margins by changing asset allocation appears feasible only by taking potentially unacceptable levels of volatility risk. - Regulatory constraints and risk-based capital requirements impose high capital charges for risky investments, limiting insurers’ ability to reach for yield. - Options and market adjustments: - Expand nonlife and protection businesses to generate earnings, though growth prospects in a low-growth, aging environment are uncertain. - Transfer pension obligations or risks to insurers after recapitalizing plans; pension risk transfers have boosted market growth and may be efficient if actuarially fair prices and supportive regulation exist. - Expect lower and less flexible guarantees, options to adjust guarantees at regular intervals, and regulatory/accounting reforms that require economic valuation of portfolios and full recognition of economic costs of long-term guarantees. - Regulatory/supervisory precedent: - Japan intervened with seven insurers whose losses on stocks of guaranteed return liabilities proved impossible to absorb, even after reducing guarantee levels on new contracts. - Table excerpt (capital charges for risky investments by insurers, percent): - Listed Equity221520 - Private Equity493020 - Non‑Investment‑Grade Corporate BondsUp to 37.5 (five year)30 (Class 6)30 - Real Estate251510 - Source: Financial supervisory authorities in euro area, Japan, and the United States. ### Asset managers, index funds, household allocation, and market finance - Household asset-allocation tendencies in low-for-long environment: - Demand for bank deposits should rise, especially once deposit rates hit the zero lower bound, because deposits enjoy a liquidity premium and are usually guaranteed. - Population aging may raise the share of bonds at the expense of equities; equity exposure tends to fall with age. - In the United States, older households tend to completely switch out of equities at annuitization and withdrawals. - Role of asset managers and index funds: - Share of asset managers in financial intermediation likely to increase as defined-contribution pensions channel savings through asset managers. - Insurers may lose clients to investment funds; financial technology may shift funding to market finance for nonfinancial firms. - Prolonged low rates may promote growth in average mutual fund size and index funds because low returns and fee pressure challenge smaller active managers. - Evidence (U.S.) cited: - Expense ratios of actively managed funds are significantly higher than index funds (basis points). - Growth in total net assets of index mutual funds (percent of total net assets of mutual funds) has been dramatic over two decades. - Risks from indexing and large asset managers: - Indexing can increase role of nonfundamental factors, detach asset returns from fundamentals, thwart price discovery, and encourage overweighting of high-beta assets via benchmarking. - Financial stability issues: - Need stronger oversight and liquidity risk management by mutual funds, especially if investors seek illiquid assets. - Larger fund sizes and passive investing reduce buy-side diversity and increase correlated responses to shocks. - Herd behavior among fund managers is a concern. - Asset-allocation snapshot (2015): - Pension funds (defined-benefit and defined-contribution combined), excluding Japan and the Netherlands, place less than a third of funds in bonds. - Life insurers consistently invest a majority of their portfolios in bonds. ### Policy challenges and recommendations - Prudential frameworks: - Should provide incentives for longer-term stability and resist pressures for deregulation to ease short-term pain. - Banks: - Facilitate consolidation for smaller institutions where desirable for efficiency and financial stability; allow liquidation of nonviable businesses where appropriate. - Contain incentives to increase exposure to tail risk from widening maturity mismatches, higher wholesale funding, and foreign-currency exposures. - Balance higher engagement in emerging market economies with containment of potential new financial stability risks in home and host countries. - Insurers and pension funds: - Provide incentives to undertake necessary business-model adjustments and contain “gambling for resurrection” by certain pension funds. - Strengthen the case for implementing economic solvency requirements that ensure recognition of the costs of guarantees and options embedded in insurance and pension products. - Transition to regulatory and accounting regimes requiring more economic valuation to ensure accurate pricing of long-term guarantees. - Asset management: - Strengthen surveillance and regulation as the industry’s share of the financial system grows. - Address potential financial stability challenges from strong growth of index investing. - Close significant data gaps to allow effective macroprudential surveillance of the sector. - Households and retirement policy: - Encourage better financial planning and more annuitization at retirement; options include clearer delineation of annuitization benefits and wider automatic enrollment in employee defined-contribution plans. - Pension regulation: - Implement economic solvency requirements promptly where absent. - Align liability discounting rules for public pension funds with corporate plan standards to safeguard solvency positions; note concerns about current U.S. public pension practices that allow discounting at expected asset portfolio returns. ### Data definitions and empirical identification (selected) - Low: Dummy for period with low interest rates, defined as the time when the 10-year government bond yield and the three-month short rate are below their corresponding thresholds. - Threshold for the 10-year bond yield (all countries except Japan): historical average of country-specific policy rates (for Japan, set to 2 percent) when the real rate adjusted by the inflation target is at zero. - Threshold for the three-month interest rates: 1 percent. - Source: Thomson Reuters Datastream and IMF staff calculations. - Surprise (9-year forward): Daily change in the forward rate of the one-year government bond yield, based on a no-arbitrage assumption and spot rates of 10-year and 9-year yields. Source: Thomson Reuters Datastream and IMF staff calculations. - Monetary Policy in Low (2 percent): Dummy for periods in low period when the 10-year government bond yield is below 2 percent and with monetary policy announcements. - Bank characteristic definitions and sources (selected): - Return on Equity: Earnings before interest and taxation divided by equity. Source: Fitch Connect. - Size: Logarithm of banks’ total assets. Source: Fitch Connect. - Deposit Funding Ratio: Customer deposits divided by total liabilities. Source: Fitch Connect. - Macroeconomic and market-variable sources: IMF databases, Thomson Reuters Datastream, Haver Analytics, Bank for International Settlements, Bloomberg L.P., central bank websites, and IMF staff calculations. *International Monetary Fund | April 2017* ### Introduction ### ch2 - Introduction ### Context and motivation - Advanced economies have experienced low real and nominal interest rates for several years; interest rates have been less volatile and the yield curve has flattened considerably. - Economic growth has been persistently low over the past decade. - Two interpretations: (a) a large, long deviation from a higher equilibrium level of growth; or (b) a new steady state with lower potential growth, in which prevailing low rates are equilibrium natural rates. - The secular decrease in real interest rates across advanced economies since the mid-1980s suggests natural rates may have fallen in response to slow-moving structural factors, including: - Demographic changes (waning population growth, rising longevity). - Lower total factor productivity growth. - Steadily rising savings and growing demand for advanced-economy financial assets in emerging market economies over the past 15 years. ### Purpose and approach of the chapter - Conducts a scenario analysis of financial intermediation in a hypothetical “low-for-long economy” where nominal and real interest rates and growth are low and expected to remain low for the foreseeable future. - Abstracts from monetary policy reactions and temporary effects of falling rates; considers a hypothetical equilibrium with low growth and low interest rates and low expected returns on most financial assets. - Not a baseline or projection; an exercise to illustrate key issues and long-term implications. ### Analytical contributions - Provides a new analytical framework to understand the term structure of interest rates in an equilibrium with low natural rates. - Extends a standard model of bank profitability to assess impacts on banks by business model and compares insights with Japan’s experience. - Empirically assesses impact of low interest rates on banks’ profits, distinguishing between periods when interest rates are expected to remain low for a long time and other periods. - Simulates implications for insurers and pension funds’ portfolios and viability of typical pension and insurance products in the low-natural-rate equilibrium. - Discusses effects on households’ asset allocations and the role of asset managers. - Discusses potential implications for financial stability. ### Key scenario findings (explicit) - The yield curve would be flatter compared to an equilibrium with higher rates and growth. - Although lower interest rates may boost banks’ earnings in the short term, they hurt profitability in the steady state once they fall below a particular positive threshold. - Smaller, geographically undiversified, deposit-funded banks would be hurt most in such a scenario. - Tail risk exposure could increase. - Banks adopt different reach-for-yield strategies depending on business model: - Smaller, deposit-funded banks typically take on more interest rate risk by increasing the duration of bond portfolios. - Large banks are likely to increase risk exposures in foreign countries that offer higher returns (in particular, emerging market economies) and rely more heavily on wholesale funding markets. - Life insurers and pension funds would face a long-lasting transitional challenge to profitability and solvency, likely requiring additional capital. - Some institutions would find it difficult to meet cash outflows on large stocks of existing liabilities contracted in past periods of higher interest rates by only altering asset portfolios. - Many other business lines may struggle to show profit in the tepid growth environment. - Major long-term changes likely to household demand for financial products, asset allocation, the menu of services offered, and the relative role of institutions versus markets in financial intermediation. ### Implications for financial intermediation and market structure - If population aging and rising longevity are key forces: - Major changes to demand for banking and insurance products. - Aging likely reduces household demand for credit and increases demand for transaction services from banks. - Increased longevity likely increases demand for health and long-term care insurance; implications for life annuities are ambiguous. - Retail demand for asset management products would continue to grow, particularly passive index investing aimed at minimizing management fees. - Pressure on smaller banks would lead to consolidation among themselves or with larger banks. - Credit demand would likely be lower given an aging population and lower productivity growth. - Domestic bank lending would likely shrink, focusing more on small businesses and less on households and large firms. - Business models in advanced economies would tend to evolve toward fee-based and utility banking services. - Insurers would likely cede some savings business to asset managers and banks because guaranteed products are relatively less attractive at low rates. - Insurers may switch focus to unguaranteed savings products but face competition from asset managers. - Health and long-term care businesses would likely grow strongly as people age and live longer. - Pooled management of household life cycle risks would likely decline more rapidly. - Employers expected to increasingly move away from defined-benefit toward defined-contribution pension plans, with variation across advanced economies. ### The term structure of interest rates: mechanism and model insights - The slope of the yield curve equals the sum of: - Market expectations of how the short rate will evolve between today and the maturity date of a longer-term bond. - The bond’s term (risk) premium. - Around a steady state where the short rate is at its long-term equilibrium, the slope is driven entirely by the sign and magnitude of (nominal) bond term premiums. - Intuition for term premium: - If bond returns increase when economic shocks reduce other income, investors pay for the bond (negative term premium). - If bond returns decline in tandem with other income, investors demand a positive term premium. - In a “normal economy” (higher equilibrium growth and rates not close to zero), the model implies an upward-sloping nominal yield curve. - The low-for-long economy features a zero lower bound on short-term nominal interest rates (assumed central bank cannot or will not lower policy rates below zero). - At the zero lower bound, the central bank cannot respond to negative (noninflationary) shocks by cutting rates, so bond returns remain more resilient to such shocks compared with a normal economy. - This resilience lowers term premiums and flattens yield curves. - Once short-term rates are near the zero lower bound and expected to stay there, sensitivity to macroeconomic news drops because central banks’ reaction functions are constrained; investors are more willing to hold long-term bonds, lowering the term premium. - These results are robust to modeling endowment and inflation shocks jointly and to calibrations based on Germany, Japan, the United Kingdom, or the United States. ### Banking with low natural rates - Two main augmentations to the literature: - With an unchanged yield curve, even permanently lower interest rates need not affect banks’ earnings. - A zero lower bound on deposit rates generates pressure on bank interest margins and profits in a low-natural-rate equilibrium. - Empirical literature shows: - Negative interest rate shocks increase bank profits in the immediate future—but the favorable impact dissipates the longer rates remain low. - Banks lose profitability from longer-lasting drops in interest rates in proportion to their engagement in maturity transformation and use of deposit funding. - Falling rates boost bank profits and equity values in the short term due to valuation gains on collateral and mark-to-market assets and lower default risk on loans repriced to lower rates. - Banks tend to respond to falling rates by increasing risk taking through higher leverage. - Open questions addressed: - Long-term impact on profits when banks operate in a low-for-long environment. - Whether impact strengthens as interest rates fall further. - Which bank business models are most affected. - Potential market-structure changes in the banking industry. - Methodology used: - New theoretical model of banking in a low-for-long economy. - Application of model insights to Japanese banks’ experience since 2000. - Empirical examination of impact on bank profitability and equity values across business models. ### Key policy challenges and recommendations - For banks: - Facilitate smooth consolidation through legal and regulatory frameworks while limiting excessive risk taking in an environment with lower expected returns. - Contain incentives to increase exposure to tail risk from widening maturity mismatches, higher wholesale funding, and foreign-currency exposures. - Balance higher engagement in emerging market economies with containment of potential new financial stability risks in home and host countries. - For insurers and pension funds: - Provide incentives to undertake necessary business model adjustments and contain “gambling for resurrection” by certain pension funds. - Strengthen the case for implementing economic solvency requirements that ensure recognition of the costs of guarantees and options embedded in insurance and pension products. - For asset management: - Strengthen surveillance and regulation as the industry’s share of the financial system grows. - Address potential financial stability challenges from strong growth of index investing. - Close significant data gaps to allow effective macroprudential surveillance of the sector. *International Monetary Fund | April 2017* ### 1. Normal Economy ### 1. Normal Economy ### Insights from theory - A simple model of banking shows how bank profits evolve in a low-rate equilibrium. - Bank profits fall significantly in a low-for-long economy if deposit interest rates are subject to a zero lower bound. - When banks can flexibly adjust loan and deposit rates, interest margins are (almost) independent of the level of market interest rates; once deposit rates hit the zero lower bound, banks cannot maintain spreads between loans and deposits, reducing net interest income under lower equilibrium market interest rates. - Predicted adjustments in bank business models: - Internationally active banks increase exposure to countries where rates of return remain favorable and increase reliance on wholesale funding in foreign currency (within existing regulatory limits). - Banks that raise a larger proportion of funding from capital markets will be less susceptible to the squeeze in interest margins and incomes induced by the zero lower bound. - Scale efficiencies in managing deposits imply incentives for consolidation. - Scale efficiencies in the costs of managing wholesale funding imply larger banks will be more inclined to seek wholesale financing. ### Lessons from Japan (real-world approximation of low natural rates) - Japan has faced low interest rates for more than a decade; short-term rates close to zero since the early 2000s (except 2007–08); long-term rates low since the early 2000s and declined further after quantitative and qualitative easing in 2013 and negative interest rates in 2016. - Econometric analysis indicates: - Banks’ interest margins fell primarily in response to narrowing funding spreads once deposit rates hit the zero lower bound in the mid-2000s. - Deposit rates first approached the zero lower bound in the mid-2000s; net interest margins then gradually and steadily fell, particularly for regional and shinkin banks. - Japanese banks did not introduce negative deposit rates or charge additional fees on deposits despite almost zero deposit spreads (Bank of Japan 2011). - Empirical patterns by bank type: - Major banks: - Almost all growth in major banks’ assets can be accounted for by increase in international loans and securities via foreign branches and M&A. - Expanded fee businesses outside Japan; share of income from international businesses has risen significantly. - Source about one-third of funding from capital markets. - Kept operational cost ratios almost flat for the past two decades. - Regional and shinkin banks: - Focused on growing loan portfolios in urban centers and expanding maturity of sovereign bond portfolios. - Have sought to counter margin compression through balance-sheet expansion, cost cutting, and consolidation. - Deposits constitute over 90 percent of their non-equity financing. - Cut operational costs substantially by rationalizing branch networks. - Consolidation: - Has raised profitability by cutting fixed operational costs and increasing monopolistic power in deposit and loan markets; regional banks have formed financial groups to enhance profitability. - Risk implications: - Major banks’ strategies maintained margins and profits at the cost of higher cross-border market and counterparty risk and higher reliance on wholesale foreign currency funding; adverse tightening in these markets could be costly. - Shinkin banks increased interest rate risk by extending average maturity of domestic bonds; risk-adjusted returns increased modestly given unusually low inflation and interest rate volatility. ### Theoretical predictions illustrated (Figure 2.3 and 2.4) - At low natural rates: - Deposit spreads are squeezed once deposit rates hit zero lower bound, compressing margins and profits. - Deposit inflows invested in bonds raise bank leverage. - Banks respond by expanding lending abroad to maintain margins and profits. - In normal steady states asset returns and funding costs adjust proportionally as interest rates fall; in low-for-long steady states asset returns fall significantly more once funding costs hit the zero lower bound, compressing net interest margins. ### Cross-country evidence on prolonged low interest rates - Definition of prolonged low-rate periods (double-threshold): - Short-term yield below 1 percent. - On-the-run 10-year nominal bond yield lower than the historical average of short-term policy interest rates. - Rationale: double threshold typically satisfied only when growth and nominal/real interest rates have been low for considerable time; distinguishes longer-term low equilibrium from temporary downturns. ### Impact of prolonged low interest rates on bank profits (empirical findings) - Average bank profitability: - Sampled banks earn a 10½ percent return on equity on average overall. - In periods with prolonged low rates, average ROE falls to 7.8 percent. - Sensitivity to rate changes during prolonged low-rate periods: - A 1 percentage point drop in three-month rates is estimated to reduce bank profits by 31 percent below average estimated bank profits. - A 1 percentage point drop in term premiums is estimated to reduce bank profits by 8 percent below average estimated bank profits. - In contrast, a drop in interest rates tends to increase bank profits in normal times. ### Resilience depends significantly on bank business models and characteristics - Banks that are smaller, rely more on deposit funding, and have fewer lending opportunities tend to suffer larger profit declines during prolonged low-rate episodes. - Estimated impacts (one-standard-deviation changes during prolonged low-rate periods): - One-standard-deviation increase in bank size raises bank profits an estimated 67 percent relative to the sample average for such periods. - One-standard-deviation increase in the share of deposit funding is associated with estimated bank returns lower by 14 percent than the sample average for such periods. - One-standard-deviation increase in the share of loans in the asset portfolio is associated with estimated bank returns higher by 22 percent than the sample average for such periods. - Clustering by business model confirms: - Large, internationally diversified, wholesale-funded banks outperform other types of banks when interest rates are low for a long time. - Their estimated average profit is 2.2 percentage points higher than deposit-funded domestic banks with small lending portfolios, which have the lowest estimated average profits during such episodes. ### How bank equity values respond to changing expectations about low-for-long scenarios - Method: changes in stock returns around monetary policy announcement dates are used to measure the impact of changes in forward interest rate expectations on banks’ franchise values via a linear factor model. - Findings: - Monetary easing surprises affect bank equity returns differently in normal times versus prolonged low-rate periods. - In normal times, unexpected monetary easing tends to boost bank equity returns (reflecting expectations of higher economic activity, higher asset returns, fewer nonperforming loans, and higher spread income on fixed-rate assets). - During episodes of prolonged low interest rates, lower forward rates in response to monetary policy decisions are more likely to imply bad news for economic conditions and bank earnings; thus monetary easing surprises can have a negative effect on bank equity returns in prolonged low-rate periods. *Source: IMF staff calculations; chapter excerpt "1. Normal Economy", Global Financial Stability Report: Getting the Policy Mix Right, April 2017.* ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### Banks: response, consolidation, and tail-risk exposure - Estimated impact of a 1 percentage point surprise decrease in forward interest rates (on monetary policy announcement dates) on daily bank equity returns differs across bank types, with only statistically significant impact estimates depicted as nonzero values in the analysis. - Findings on bank heterogeneity during prolonged low rates: - Larger, more diversified, and more-wholesale-funded banks are less sensitive to monetary policy news during periods of prolonged low rates—reflecting greater ability to adapt to changing domestic economic prospects and corresponding to theoretical predictions and the experience of Japanese banks. - Smaller, deposit-funded, domestically oriented banks exhibit greater sensitivity of equity returns to bad news about the domestic economy during prolonged low rates. - Long-term industry evolution in a low natural rates scenario: - Some consolidation in the banking industry is likely: small deposit-funded banks that are less internationally diversified tend to suffer the largest hit to profitability, leading to mergers or exit of nonviable institutions. - Merged banks could have lower average operational costs, greater diversification, and greater market power, potentially reducing incentives to take excessive risks and resulting in a more efficient and stable industry structure. Practical caveats: bank mergers do not always achieve desired scale economies and can face integration difficulties. - Tail-risk and funding profile shifts: - Over the medium term, especially smaller and less diversified banks may seek longer asset maturities, increasing exposure to large positive interest rate shocks and potential significant losses. - Banks may increase, within regulatory limits, their share of wholesale funding, a more volatile source of financing than retail deposits—particularly for larger banks incentivized to use capital market financing for international expansion. This could affect financial stability in home and host countries depending on expansion modality. ### Demographics, fintech, and shifts in bank business models - Structural forces shaping bank business lines under prolonged low rates: - Population aging with reduced income growth tends to reduce demand for household loans and increase deposits. - Advances in financial technology may erode banks’ preeminence in payment services and enable nonbanks to price corporate credit risk, potentially reducing banks’ market share in debt financing of larger companies. - Resulting business-model evolution for banks in advanced economies may shift toward fee-based and utility banking services and greater international exposure, especially to emerging market economies. ### Insurance and pensions: transitional challenge and likely business-model shifts - Core problem: - The large existing stock of liabilities offering guaranteed returns creates medium-term cash flow obligations that are difficult to meet given lower interest rates and flatter yield curves; many life insurers and defined-benefit pension plans may require additional capital. - Long-term structural shifts: - Market for traditional savings products is likely to shrink; insurers will focus more on protection products, particularly health insurance. - Defined-contribution pension plans will probably continue to grow in importance as employees prefer portability and avoid employer-provided defined-benefit plans with significantly lower future benefit levels. - Specific dynamics and ambiguities: - Population aging and rising longevity should raise demand for life annuities, but countervailing forces (precautionary savings, liquid asset demand for out-of-pocket health expenses, administrative costs of annuity portfolios at very low rates, and low voluntary annuitization take-up) make the combined effect on annuity demand ambiguous. - Life insurers may increasingly seek unit-linked products (investor bears asset price volatility); competitiveness of insurers in this market depends on comparison with retail investments by asset managers and on tax advantages of unit-linked products. - Demand for health and long-term care insurance and for new automated life-cycle insurance products may increase significantly. - Empirical note: - In Chile, following pension reform to defined-contribution plans, about 60 percent of retired workers opt for an annuity instead of a phased withdrawal option. ### Pension arrangements: shift from defined benefits to defined contributions - Long-term transition likely to continue from intergenerational collective risk sharing (defined benefits) to individual risk management (defined contributions) driven by lower population growth, aging, and prolonged low interest rates. - Portability advantages of defined-contribution plans make them attractive to younger employees and may accelerate the shift; hybrid systems and multiemployer defined-benefit plans (for example, traditional industry-level arrangements) may slow or temper this transition by offering portability within industries. - Countries with advanced transitions (United Kingdom and United States) are likely to see further acceleration due to tightening of reporting and solvency standards. ### Insurance companies, defined-benefit pension funds, and liability-driven investment - Vulnerability profile: - Non–life insurance businesses with short liability duration and underwriting income are relatively unaffected. - Long-term guaranteed-payout businesses (life insurers with guaranteed returns) are especially vulnerable because a negative duration gap increases the present value of long-term liabilities much more than assets when interest rates fall. - Defined-benefit pension funds with substantial vested obligations face particular stress: projected pension obligations resemble a large portfolio of long-term nominal (or real, if indexed) bonds. - Liability-driven investment (LDI) recommendation: - LDI is recommended for life insurers and mature or closed defined-benefit pension plans; it entails finding a bond portfolio whose duration is similar to the duration-like structure of liabilities. - Asset-allocation constraints and solvency recovery: - Life insurers and defined-benefit pension plans tend to enter low-interest-rate periods with reduced economic capital buffers or larger funding gaps, complicating financial risk management. - Institutions face a trade-off: minimize future market risk (especially interest rate volatility) via duration-matched bond portfolios versus closing funding gaps by seeking returns that exceed liabilities—potentially requiring riskier portfolios with heavier equity and alternative-asset exposure. - Scenario simulation (adapted from Leibowitz, Kogelman, and Bader (1995) and Leibowitz and Bova (2015)) finds that recovering adequate solvency margins by changing asset allocation appears feasible only by taking potentially unacceptable levels of volatility risk. The volatility life insurers and defined-benefit pension funds would need to absorb is very high, which would likely deter such a strategy. ### Asset allocation snapshot (2015) - Pension funds (defined-benefit and defined-contribution combined), excluding Japan and the Netherlands, place less than a third of funds in bonds. - Life insurers consistently invest a majority of their portfolios in bonds. *International Monetary Fund | April 2017* ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### Insurers, Defined‑Benefit Pensions, and Solvency Challenges - Asset allocation changes alone cannot adequately address solvency challenges posed by negative cash flows on current liability portfolios; insurers and sponsors of defined‑benefit pensions will likely need a fresh investment of equity capital to cover part of the loss. - Regulatory constraints limit insurers’ ability to reach for yield across broad asset classes or risk categories; risk‑based capital requirements impose high capital charges for risky investments. - Options for addressing losses: - Expand scale of nonlife and protection businesses to generate earnings and cover losses from savings business, though growth prospects in a low‑growth, aging environment are unclear. - Transfer pension obligations or their financial risk to insurers after recapitalizing plans to close funding gaps; pension risk transfers have boosted market growth and may be market‑efficient if done at actuarially fair prices. Regulation could facilitate these transactions. - Expect medium‑term business model adjustments in life insurance long‑term‑savings businesses, including lower and less flexible guarantees and options to adjust guarantees at regular intervals to reflect market conditions. - Regulatory and accounting reforms that require economic valuation of portfolios and full recognition of economic costs of long‑term guarantees would support transition to sustainable business models. - Supervisory precedent: Japan intervened with seven insurers whose losses on stocks of guaranteed return liabilities proved impossible to absorb, even after reducing guarantee levels on new contracts. - Table 2.3. Capital Charges for Risky Investments by Insurers (Percent) - Solvency II (standard approach) / U.S. Risk‑Based Capital Requirements / Japanese Solvency Margin Ratio - Listed Equity221520 - Private Equity493020 - Non‑Investment‑Grade Corporate BondsUp to 37.5 (five year)30 (Class 6)30 - Real Estate251510 - Source: Financial supervisory authorities in euro area, Japan, and the United States. ### Asset Allocation, Market Finance, and the Rise of Asset Managers and Index Funds - Households’ asset allocations in a low‑for‑long environment: - Demand for bank deposits should rise, especially once deposit rates hit the zero lower bound, because deposits enjoy a liquidity premium and are usually guaranteed. - Population aging may raise the share of bonds at the expense of equities; equity risk premium tends to rise with age because older households have limited ability to earn labor income to hedge wealth shocks. - In the United States, older households tend to completely switch out of equities at annuitization and withdrawals. - Share of asset managers in financial intermediation likely to increase because: - Defined‑contribution pension arrangements channel retirement savings through asset managers (mutual funds), more so than defined‑benefit plans. - Insurers may lose clients to investment funds. - Financial technology may shift funding to market finance for nonfinancial firms, with banks focusing more on small businesses. - Structural features favor quicker transition in countries with deep corporate bond markets and well‑developed retail investment products (for example, the United States). - Prolonged low rates may promote growth in average mutual fund size and the relative importance of index funds: - Low asset returns plus competitive pressure on fees make it difficult for smaller funds to survive. - Active managers face disadvantage relative to passive funds as excess returns may no longer justify fee differentials. - Figure 2.9 evidence (U.S.): - 1. Expense Ratios of Actively Managed Funds and Index Funds (Basis points): fees charged by active funds are significantly higher than those charged by index funds. - 2. Growth in Total Net Assets of Index Mutual Funds (Percent of total net assets of mutual funds): the share of index funds has increased dramatically over the past two decades. - Risks from growth of index funds: - Indexing can increase the role of nonfundamental factors in determining asset returns and comovement, potentially detaching asset returns from fundamentals and thwarting price discovery. - Benchmarking can motivate investors to overweight high‑beta assets. - Three financial stability issues from rising share of asset managers and index funds: - Need stronger oversight and liquidity risk management by mutual funds, especially if investors seek exposure to illiquid assets. - Larger fund sizes and increasing passive investing reduce buy‑side diversity and increase correlated investor responses to shocks. - Herd behavior among fund managers remains a concern. ### Policy Implications and Recommendations - Prudential frameworks should provide incentives for longer‑term stability and resist pressures for deregulation to ease short‑term pain. - For banks: - Facilitate consolidation for smaller institutions where desirable for efficiency and financial stability, and allow liquidation of nonviable businesses where appropriate. - For life insurers: - Transition to regulatory and accounting regimes requiring more economic valuation is appropriate; these regimes encourage accurate recognition of economic costs of long‑term guarantees in product pricing. - Policymakers should support implementation even under competitive and political pressure. - For households and retirement planning: - Encourage better financial planning and more annuitization at retirement given pressures on retirement security from lower returns and less collective risk sharing. - Options include clearer delineation of annuitization benefits and more widely available automatic enrollment in employee defined‑contribution plans. - For pension regulation: - Insurance and pension regulators that have not introduced economic solvency requirements should implement them promptly. - Align liability discounting rules for public pension funds with corporate plan standards to safeguard solvency positions; current U.S. public pension practices allow discounting at expected asset portfolio returns and have led to aggressive investment in risky assets with negative financial results. - For asset management oversight: - Strengthen surveillance, close data gaps, and implement macroprudential rules to address liquidity mismatch risks and contain systemic risk, especially if the sector continues to grow. ### Banking in a Low‑for‑Long Model (Monti‑Klein framework) - Model setup and balance sheet identity: - Bank assets: loans (L) and bonds (B); liabilities: deposits (D), wholesale funding (W), and equity (E): L + B = D + W + E. - Bank profit (before dividends), π, defined as: - π = (R_L L + R_M B) – (R_D D + R_M W) – kL = (R_L – R_M – k) L + (R_M – R_D) D + R_M E, in which R_L, R_D, and R_M are the loan rate, the deposit rate, and the market interest rate, respectively; k is the marginal cost of lending. - Key model assumptions: - Lending and deposit rates adjust flexibly and instantaneously in response to the market interest rate. - Because the economy is near steady state, R_M can be set equal to g (the economic growth rate). - Loan demand is a decreasing function of R_L relative to g; deposit supply is an increasing function of R_D relative to R_M. - Zero lower bound on deposit rates introduced because banks find it difficult to charge negative rates to retail depositors even when optimal. - Model implications: - When g is high and R_M is well above zero, loan and deposit spreads and volumes are almost independent of R_M; lower market interest rates have negligible effect on bank profits and excess return π/E – R_M is nearly constant. - Once g declines so that the optimal deposit rate becomes negative (zero lower bound binds), lower R_M compresses deposit spreads and net interest margin, negatively affecting bank profits. - Compression in deposit spreads makes deposits relatively more attractive, increasing deposit inflows and bank leverage as R_M falls. - The negative effect of lower net interest margins on profits dominates the positive effect of rising balance sheet size, because new deposits are invested in low‑yielding bonds, not higher‑yielding loans in a low‑growth environment. - If deposit rates are at their zero lower bound and the economy contracts in equilibrium (g < 0), lending will contract further because R_M cannot match the natural rate of interest (equal to g), adding pressure on bank profits. - Banks may attenuate adverse effects by expanding international lending and investment activities. - Notes and interpretations: - One interpretation of R_M is the interbank market rate; in countries with low loan‑to‑deposit ratio, R_M can be interpreted as the rate of return on government bonds. - The zero lower bound can alternatively be microfounded by a cash preference relative to deposits that is a function of relative returns. - In practice, leverage constraints will eventually force banks to raise capital or decline further deposit inflows. *International Monetary Fund | April 2017* ### Box 2.1. A Simple Model of Banking in a Low-for-Long Economy ### Box 2.1. A Simple Model of Banking in a Low-for-Long Economy ### Key model assumption and mechanism - Assumes economic growth in foreign countries is independent of growth in the home country. - Under this assumption, the model implies that the lending spread for foreign loans is independent of R_M. - Implication: under the low-for-long scenario, a bank can temper the decline in profitability of domestic businesses by increasing its portfolio share of foreign loans. ### Policy and research implications - Geographic diversification through businesses that operate internationally may mitigate the decline in banks’ profitability under the low-for-long scenario. - Richer models are necessary to provide more comprehensive guidance on the implications of the low-natural-rates scenario for banks, for example, regarding risk taking in the steady state. - Identified as an important area for future research. *Source: Box 2.1. A Simple Model of Banking in a Low-for-Long Economy — GLOBAL FINANCIAL STABILITY REPORT: GETTING ThE POLICY MIx RIGhT, International Monetary Fund | April 2017* ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### CHAPTER 2 LOw GROwTh, LOw INTEREST RATES, ANd FINANCIAL INTERMEdIATION ### Data definitions and identification of "low" interest rate periods - Low: Dummy for period with low interest rates, defined as the time when the 10-year government bond yield and the three-month short rate are below their corresponding thresholds. - The threshold for the 10-year government bond yield of all countries except Japan is set to be the historical average of the country-specific policy rates (for Japan, it is set to be 2 percent) when the real rate adjusted by the inflation target is at zero. - The threshold for the three-month interest rates is set to be 1 percent. - Source: Thomson Reuters Datastream and IMF staff calculations. - Surprise (9-year forward): Daily change in the forward rate of the one-year government bond yield, based on a no-arbitrage assumption and the spot rate of the 10-year and 9-year government bond yield (from yield curve values for constant maturity). - Source: Thomson Reuters Datastream and IMF staff calculations. - Surprise (9-year-forward orthogonal): Surprise that is orthogonal to market return, measured by the residual of the regression of surprise on market return. - Source: IMF staff calculations. - Monetary Policy in Low (2 percent): Dummy for period in low period and with monetary policy announcements. The low period is defined as a period when the 10-year government bond yield is below 2 percent. - Sources: Thomson Reuters Datastream, central bank websites, and IMF staff calculations. - Monetary Policy in Normal (2 percent): Dummy for period in non-low period and with monetary policy announcements. The low period is defined as a period when the 10-year government bond yield is below 2 percent. - Sources: Thomson Reuters Datastream, central bank websites, and IMF staff calculations. ### Bank characteristics (variable definitions and sources) - Return on Equity: Earnings before interest and taxation divided by equity. Source: Fitch Connect. - Size: Logarithm of banks’ total assets. Source: Fitch Connect. - Loan-to-Asset Ratio: Gross loans divided by total assets. Source: Fitch Connect. - Deposit Funding Ratio: Customer deposits divided by total liabilities. Source: Fitch Connect. - Trading Asset: Assets held for trading plus assets held at fair value. Source: Fitch Connect. - Trading Asset Ratio: Trading assets divided by total assets. Source: Fitch Connect. - Leverage Ratio: Total assets divided by equity. Source: Fitch Connect. ### Macroeconomic variables (definitions and sources) - Consumer Price Index Inflation: Year-over-year growth of consumer price index, percent. Source: IMF, International Financial Statistics database. - Credit-to-GDP Ratio: Private sector credit in percent of GDP. Source: Bank for International Settlements. - Real GDP Growth: Year-over-year growth of GDP, constant prices. Source: IMF, World Economic Outlook database. - Three-Month Interest Rate: Typically central bank bill/Treasury bill yield or interbank offered rate. Source: Haver Analytics. - Term Premium: Term premium estimated based on Wright 2011. Source: IMF, Global Financial Stability Report, October 2016. - Ten-Year Government Bond Yield: On-the-run 10-year government bond yield (from yield curve values for constant maturity). Source: Thomson Reuters Datastream. - Monetary Policy Rates: Short-term interest rates represent the monetary policy stance in a country. Source: Haver Analytics. ### Financial market variables (definitions and sources) - Equity Price Return: Log difference of equity prices. - Market Return: Difference of overall country-specific equity price indices. - VIX: Chicago Board Options Exchange Market Volatility Index. Source: Bloomberg L.P. - Oil Price: West Texas Intermediate crude oil spot price. Source: Bloomberg L.P. ### Annex scope and methodological notes - Yield and forward-rate computations use yield curve values for constant maturity and rely on a no-arbitrage assumption for forward-rate surprises. - Orthogonal surprises are constructed via regression residuals to isolate information orthogonal to market returns. - Low-period identification uses both an absolute threshold for 10-year yields (2 percent for some definitions) and relative, country-specific historical policy-rate benchmarks adjusted for real rates and inflation targets. - Data sources include Thomson Reuters Datastream, Fitch Connect, Haver Analytics, IMF databases (International Financial Statistics; World Economic Outlook), Bank for International Settlements, Bloomberg L.P., central bank websites, and IMF staff calculations. *Source: IMF staff.* --- _Source: https://www.imf.org/-/media/files/publications/gfsr/2017/april/ch2.pdf_