## CHAPTER 4 BANkING SECTOR: LOW RATES, LOW PROFITS?

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### Chapter 4 — at a glance (summary findings)
- Over the past decade, very low interest rates have been associated with compressed bank net interest margins in several advanced economies, and this should continue over the medium term.
- The support to earnings provided by falling rates in recent years—stemming from gains on securities holdings and lower provisions—will fade in the medium term, putting sustained pressure on banks’ profits.
- Cost cutting and higher fee income should help, but these mitigating factors are unlikely to fully lessen pressures on banks’ profitability.
- There is a danger that profitability challenges could induce banks to take on excessive risks once the economy fully recovers.
- Once the COVID-19 emergency is resolved, a combination of structural and financial policies could help mitigate future vulnerabilities and ensure an adequate supply of credit to the economy.

### Banks’ historical profitability pressures and measurement
- Sample and scope:
  - Analysis covers about 12,000 banks for the econometric exercise; effective maturity profiles and forward-looking simulation rely on 1,000 banks.
  - A separate figure uses a sample of more than 5,000 banks in nine advanced economies.
- Key historical observations:
  - Bank profitability collapsed during the global financial crisis and recovered unevenly; North Atlantic banks (particularly Canada and the United States) recovered more where interest rates have been higher.
  - Large euro area countries showed less improvement amid the sovereign debt crisis, low economic growth, high operational costs, and debt overhang.
  - Low-interest-rate economies—especially Japan—have experienced weak profits for years, deepening as policy rates were cut further.
- Profitability measurement:
  - Cost of equity is measured as the ratio of a bank’s return on equity to the price-to-book ratio (based on the Gordon growth model).
  - The median market-implied cost of equity for each region has ranged from 8 percent to 14 percent since 2013.
- Implications:
  - Low profits slow capital accumulation, constrain credit provision, and reduce banks’ ability to absorb shocks and to raise new capital from the market.

### How low interest rates affect bank profitability — four channels
- Changes in net interest margins:
  - Replacement of maturing loans with new ones at lower rates and deposit/funding repricing affects net interest margins.
  - Between 2013 and 2015 deposit rates fell faster than loan rates (phase 1), cushioning margins; after 2015 deposit rates flattened while loan rates continued to fall (phase 2), squeezing margins.
- Declines in loan loss provisions:
  - Low rates can stimulate activity, increasing incomes/profits and reducing borrowers’ interest burdens, allowing banks to lower provisions.
- Higher credit growth:
  - Low rates stimulate credit growth, increasing revenues for a given net interest margin and potentially increasing return on equity if leverage rises and asset mix shifts toward customer loans.
- Higher noninterest income:
  - A more dynamic economy can raise fee income and securities portfolio gains as falling rates boost asset prices.
- Net historical outcome (2013–18):
  - Compression in net interest margins contributed to lower median net interest income but was partly offset by lower provisioning, higher noninterest income in some cases, and operating expense cuts.
  - Median return on assets rose in three economies, fell in four, and remained stable in two over 2013–18.

### Key econometric findings on rate effects and nonlinearities
- A 100 basis point decline in short-term interest rates reduces net interest margins (relative to assets) for the average bank by about 6 basis points in normal times (when short-term interest rates are positive).
- When short-term interest rates are negative, a 100 basis point decline reduces net interest margins by 12 basis points.
- A 100 basis point fall in the term spread leads to a decline in net interest margins (relative to assets), on average; the effect is nearly 21 basis points in a low-spread environment (when the 10-year minus 3-month spread is below 1 percent).
- A 100 basis point decline in the term spread is estimated to lead to a 15 basis point fall in provisions (relative to assets) in a low-spread environment.
- A 1 percent increase in economic growth is associated with a 1.2 basis point reduction in the ratio of loan loss provisions to assets.
- The interest rate environment played a sizable role in explaining the fall in net interest margins over 2013–18 for the average bank in the large euro area and low-interest-rate economies; its role was relatively lower in North Atlantic economies over this period.

### Simulation setup, assumptions, and channels incorporated
- Simulation horizon: five-year simulation starting from December 2018.
- Starting data point: December 2018; simulated values for 2019 use realized growth rates and interest rate data.
- Forecast inputs:
  - Growth forecasts correspond to the April 2020 World Economic Outlook.
  - Interest rates: effective rates until Q1 2020 and forward market rates for the 1-month, 3-month, and 10-year benchmark bonds prevailing at April 6, 2020.
- Countries covered: nine advanced economies grouped as
  - low-interest-rate economies = Japan, Sweden, Switzerland;
  - large euro area economies = France, Germany, Italy;
  - North Atlantic economies = Canada, United Kingdom, United States.
- Channels incorporated:
  1. Changes in net interest margins from repricing of maturing loans and deposits.
  2. Changes in loan-loss provisions from the interest rate and economic environment.
  3. Changes in credit growth associated with economic growth.
  4. Noninterest income.
- Effective repricing maturities:
  - Loans are repriced every three to six years, on average.
  - Deposits are repriced every two to three years, on average.
- Deposit-rate floor and sensitivity:
  - Deposit rates are assumed to have a floor at zero; relaxing the floor to –50 basis points does not significantly change results.
  - GSIBs are modeled with lower sensitivity of net income to interest rate movements.
- Other assumptions:
  - Credit growth derived from a Bayesian vector autoregression ensuring consistency with repricing estimates.
  - Potential gains on securities investments are held constant relative to assets.
  - Bank balance sheet composition is assumed unchanged (no endogenous asset/liability reallocation).

### Phased dynamics and simulated projections
- Phased description:
  - Phase 2: New loans issued at lower rates than maturing loans while funding costs remain relatively unchanged → continued reduction in net interest margins.
  - Phase 3: Deposit rates fall further until they hit the zero lower bound, reflecting monetary easing.
  - Phase 4: Another round of net interest margin compression as loan rates continue to fall while deposit rates remain around zero.
  - Phase 5: Loan interest rates start to increase gradually, and deposit rates increase in some countries.
- Simulated outlook and projections:
  - Investors expect short-term interest rates to remain at very low levels for a while and term spreads to recover gradually over the next few years, to levels below historical norms with different trajectories across countries.
  - Near-term: growth expected to experience a sharp contraction in 2020 and start recovering in 2021 (baseline IMF scenario), with considerable uncertainty and downside risks.
- Provisions:
  - The sharp economic contraction in 2020 leads to higher provision expenses in the simulation; over the rest of the simulation provisioning declines as growth recovers, though policy measures (loan guarantees, regulatory flexibility) could alter paths.
- Net interest income and profitability:
  - Medium-term dynamics are dominated by further compression in net interest income.
  - Lower net interest income is partly offset by lower provisions in some settings but not enough to prevent overall profitability declines.
- Return on assets (ROA) and return on equity (ROE):
  - Most banks in the simulation see a reduction in ROA by 2025 relative to their already-low 2018 levels.
  - Banks in low-interest-rate economies benefit less from recovery because provisioning and net interest margins are already very low and rates are not expected to rise by much.
  - In large euro area economies, a cutback in provisions and a small increase in noninterest income enable a fraction of banks (by assets) to increase profits relative to 2018, but ROA in 2025 remains below current levels for most banks.
  - North Atlantic economies also face profitability pressures largely driven by net interest margin compression.
  - The simulated distribution of ROE in 2025 is markedly to the left of the 2018 distribution and similar to the distribution simulated for 2020, indicating persistent profitability pressures beyond the immediate shock.
  - A large fraction of banks in the sample generate ROE below 8 percent—the lower end of current estimates for the cost of equity.
  - GSIBs: simulated ROE in 2025 is somewhat better than in 2020 but still deteriorating relative to 2018.

### Uncertainties and model limitations (caveats)
- Models for loan-loss provisions and fee income capture historical relationships and may not fully incorporate the unprecedented COVID-19 shock or the full implications of recent policy measures.
- Omitted or partially captured effects include:
  - Direct measures to support the banking sector or provide relief to borrowers (not explicitly modeled except via market interest rates).
  - Loan guarantees and fiscal support that could dampen provisioning needs.
  - Regulatory and accounting flexibility that could allow smoothing of provisions through the cycle.
  - Potential gains on securities investments are kept constant; as rates move, simulated profits may be overstated.
  - Bank balance sheet composition is held constant, ruling out endogenous behavioral responses.

### Substantial action required to fill the earnings shortfall
- Two main levers to mitigate structural profitability pressures from low interest rates:
  - Noninterest income (fees and gains on securities):
    - Gains on securities holdings will likely decline further when interest rates stabilize.
    - Fee income must provide most of any noninterest-income improvement.
    - From 2013 to 2018, fee income (relative to assets) was fairly flat across advanced economy banks on aggregate.
    - Fee income fell in Canada, Germany, Sweden, the United Kingdom, and the United States over 2016–18; it rose in France, Italy, and Japan.
    - Analysts forecast falling fee income relative to assets (2021 versus 2019E outlook for several countries).
  - Operating cost cuts (efficiency gains):
    - From 2013 to 2018, cost savings delivered about a 15 basis point improvement to median return on assets.
    - Analysts expect cost-to-assets ratios to continue to decline in some countries, generally by another 5–25 basis points of assets by 2021.
- Simulation exercise on restoring ROE to 8 percent:
  - North Atlantic economies: a fair proportion of banks expected to generate adequate returns by 2025; for others, feasible combinations of cost and revenue improvements exist.
  - Large euro area economies: virtually all banks would need to improve both cost and noninterest income, sometimes significantly; for some banks, cutting costs to zero would not suffice without increased noninterest income.
  - Low-interest-rate economies: many banks show little scope for further cost improvement (costs already quite low) and would require noninterest income rising from very low current levels.
- Hedging and size effects:
  - Larger banks have much larger interest rate swap books relative to total assets, suggesting heavier hedging engagement.
  - US data suggest smaller banks are more sensitive to a decline in rates than larger banks.
  - US banks’ net interest income has become more sensitive to changes in policy rates in recent years, with risk increasingly skewed to the downside as deposit rates approach zero.

### Risk of excessive risk-taking and empirical signs
- Medium-term profitability pressures could induce banks to increase credit, maturity, liquidity, or trading risks once the crisis recedes.
- Evidence prior to COVID-19:
  - Some banks shifted exposures from short-term instruments and marketable securities toward less liquid loans, raising loans as a percentage of total assets and taking additional liquidity risk (2013–18).
  - Estimated average loan maturity across reporting banks lengthened from 2013 to 2018, particularly where low interest rates pressured net interest margins.
  - Econometric analysis confirms banks in negative rate environments tended to increase loan maturity relative to behavior in normal times.
  - Some banks increased origination of riskier syndicated loans with risk ceded to nonbank financial intermediaries.
  - Some banks increased overseas exposures, potentially raising currency and liquidity risks—most evident in Canada and Japan; mainly available to large internationally active banks.

### Policy options, recommendations, and priorities
- Near-term priorities:
  - Rapidly employ policies that preserve financial stability, maintain soundness of institutions, and support economic activity.
  - Ensure adequate central bank liquidity provision and provide clear supervisory guidance on prudent loan renegotiation.
  - Use flexibility in existing regulatory frameworks to account for expected credit losses and allow use of existing buffers to absorb costs.
- Medium-term supervisory and macroprudential actions:
  - Incorporate lower-for-longer interest-rate scenarios into supervisory capital planning and stress testing; evaluate business model strength under persistent low rates.
  - Remain vigilant to prevent regulatory arbitrage that could reduce system resilience.
  - Deploy macroprudential tools if banks take excessive risks post-crisis:
    - Countercyclical capital buffer could be used in time to enhance resilience as systemic risk builds during loose financial conditions.
    - Borrower-based measures could limit rapid growth of mortgage portfolios if banks shift aggressively into these loans.
    - For banking systems expanding foreign operations, ensure foreign exposures are adequately diversified and monitor liquidity mismatches in foreign-currency balance sheets.
- Monetary policy guidance:
  - Monetary policy should remain data dependent and set to meet central banks’ macroeconomic targets.
  - Policy tools to offset adverse effects of negative rates (e.g., tiering schemes limiting application of negative rates to a portion of banks’ reserves) should stay in place while policy rates are negative.
- Structural reform and efficiency:
  - Authorities should assess benefits of domestic and cross-border bank consolidation while ensuring adequate competition and addressing potential too-big-to-fail issues.
  - Encourage banks to improve operating efficiencies via branch reduction where warranted, IT upgrades, and process outsourcing.
  - Balance cost reduction against financial inclusion, data protection and privacy, consumer protection in non-fee-income expansion, and local employment/community consequences.

### Box 4.1 — The experience with negative interest rate policies (selected findings)
- Rationale and observed effects:
  - Since 2014 several central banks set policy rates below zero when conventional stimulus room was exhausted (examples include the euro area, Japan, Sweden, Switzerland, Denmark).
  - Money market rates closely tracked policy rates below zero; longer-term yields fell, especially after initial cuts below zero.
  - Deposit and lending rates have fallen; deposit rate declines were more pronounced for corporate deposits.
  - Evidence suggests cuts helped lower lending rates in the euro area and Switzerland; for the euro area, negative rates seem to have had small but positive effects on inflation and growth; in Japan, support occurred through the exchange rate channel.
- Limits and risks:
  - There is an effective lower bound to how negative rates can go.
  - If rates become deeply negative, risks include wholesale moves into cash, declines in bank profits, and potential reversal of positive effects on lending.
- Tiered reserve systems (selected data and impacts):
  - Jurisdictions with tiering include Denmark, the euro area, Japan, Norway, Sweden, and Switzerland.
  - Tiering exempts part of reserves from negative charges and allows some arbitrage; effects are modest but meaningful.
  - The introduction of the two-tier system by the ECB at the end of 2019 is estimated to generate total savings for euro area banks of about €4.7 billion per year relative to a counterfactual without tiering.
  - In Switzerland, savings from the recent change in tiering introduced in November 2019 are estimated at about $0.7 billion per year.
  - These savings are equivalent to a few basis points of return on assets and are unlikely to fully offset the impact of low interest rates on profitability.
- Selected central bank tiering scheme parameters (examples preserved exactly):
  - Euro Area: Exemption Threshold = Six times the minimum reserve requirement; Interest Rate Applied to Nonexempt Reserves (percent) = –0.50; Date Tiering Implemented: Nov. 2019; Date Negative Rates Implemented: Jun. 2014.
  - Japan: Interest Rate Applied to Nonexempt Reserves (percent) = –0.10; Date Tiering Implemented: Feb. 2016; Date Negative Rates Implemented: Jan. 2016.
  - Switzerland: Interest Rate Applied to Nonexempt Reserves (percent) = –0.75; Date Tiering Implemented: Jan. 2015; Date Negative Rates Implemented: Dec. 2014.
- European Central Bank tiering scheme: estimated impact (selected figures preserved exactly):
  - Euro Area: Bank Deposits with Eurosystem (Billions of euro) = 1,818; Exempted Reserves (MRR * Multiple) = 807; Cost Savings for Banks (Billions of euro) = 4.00; Impact on Banks’ Return on Assets (percentage points) = 0.01.
  - Germany: Bank Deposits with Eurosystem (Billions of euro) = 622; Exempted Reserves (MRR * Multiple) = 241; Cost Savings for Banks (Billions of euro) = 1.10; Impact on Banks’ Return on Assets (percentage points) = 0.01.
  - France: Bank Deposits with Eurosystem (Billions of euro) = 261; Exempted Reserves (MRR * Multiple) = 600; Cost Savings for Banks (Billions of euro) = 0.80; Impact on Banks’ Return on Assets (percentage points) = 0.01.
  - Italy: Bank Deposits with Eurosystem (Billions of euro) = 021; Exempted Reserves (MRR * Multiple) = 100; Cost Savings for Banks (Billions of euro) = 0.40; Impact on Banks’ Return on Assets (percentage points) = 0.01.

*Source: CHAPTER 4 BANkING SECTOR: LOW RATES, LOW PROFITS?, International Monetary Fund | April 2020.*

### 2025. Once immediate challenges recede, banks could

### 2025. Once immediate challenges recede, banks could

### Chapter 4 at a Glance
- Over the past decade, very low interest rates have been associated with compressed bank net interest margins in several advanced economies, and this should continue over the medium term.
- The support to earnings provided by falling rates in recent years—stemming from gains on securities holdings and lower provisions—will fade in the medium term, putting sustained pressure on banks’ profits.
- Cost cutting and higher fee income should help, but these mitigating factors are unlikely to fully lessen pressures on banks’ profitability.
- Looking ahead, there is a danger that profitability challenges could induce banks to take on excessive risks once the economy fully recovers.
- Once the COVID-19 emergency is resolved, a combination of structural and financial policies could help mitigate future vulnerabilities and ensure an adequate supply of credit to the economy.

### Banks Have Faced Persistent Profitability Challenges
- Sample and scope:
  - Analysis based on a large sample of banks in nine advanced economies (the Group of Seven economies plus two other advanced economies that currently have, or have experienced, negative policy rates).
  - The econometric exercise relies on a sample of about 12,000 banks; the estimation of effective maturity profiles and the forward-looking simulation rely on 1,000 banks.
  - A separate figure uses a sample of more than 5,000 banks in nine advanced economies.
- Key historical points:
  - Bank profitability collapsed during the global financial crisis and has recovered unevenly: North Atlantic banks (particularly Canada and the United States) recovered more where interest rates have been higher.
  - Large euro area countries showed less improvement amid the sovereign debt crisis, low economic growth, high operational costs, and debt overhang.
  - Low-interest-rate economies—especially Japan—have experienced weak profits for years, deepening as policy rates were cut further.
- Profitability implications:
  - Low profits slow capital accumulation, constrain credit provision, and reduce banks’ ability to absorb shocks and to raise new capital from the market.
  - The chapter measures cost of equity as the ratio of a bank’s return on equity to the price-to-book ratio (based on the Gordon growth model).
  - The median market-implied cost of equity for each region has ranged from 8 percent to 14 percent since 2013.

### How Low Interest Rates Affect Bank Profitability — Four Main Channels
- Changes in net interest margins:
  - Replacement of maturing loans with new ones at lower interest rates and repricing of deposits/funding affects net interest margins.
  - Between 2013 and 2015 deposit rates fell faster than loan rates (phase 1), cushioning margins; after 2015 deposit rates flattened while loan rates continued to fall (phase 2), squeezing margins.
- Declines in loan loss provisions:
  - Low rates can stimulate economic activity, increasing incomes and profits and reducing borrowers’ interest burdens, allowing banks to lower provisions against expected loan losses.
- Higher credit growth:
  - Low rates and higher activity stimulate credit growth, increasing revenues for a given net interest margin and potentially increasing return on equity if leverage rises and asset mix shifts toward customer loans from securities/interbank assets.
- Higher noninterest income:
  - A more dynamic economy can raise fee income (e.g., from mergers and acquisitions) and securities portfolio gains as falling rates boost asset prices.
- Net historical outcome (2013–18):
  - Compression in net interest margins contributed to lower median net interest income but was partly offset by lower provisioning, higher noninterest income in some cases, and operating expense cuts.
  - Median return on assets rose in three economies, fell in four, and remained stable in two over 2013–18.

### Empirical and Simulation Findings
- Econometric analysis links bank net interest margins to bank characteristics, the economic environment, short-term interest rates, and the term spread between long- and short-term rates (details in Online Annex 4.1).
- Figure- and panel-based findings (as reported):
  - Median bank return on equity and median market-implied cost of equity were tracked across regions and time.
  - Banks’ net gains on securities (percent of assets) have been shrinking and this trajectory may continue.
  - The impact of a 100 basis point decline in the short-term rate and a 100 basis point decline in the term spread on net interest margins and provisioning is illustrated across different environments (normal times, negative-interest-rate environment, low-spread environment).
  - Contributions to the change in net interest margins were decomposed for large euro area and low-interest-rate economies.

### Risks, Policy Options, and Recommendations
- Risks:
  - As immediate COVID-19 challenges recede, banks may attempt to recoup lost profits by taking excessive risks, which could build vulnerabilities in the banking system and sow the seeds of future problems.
- Policy options to mitigate vulnerabilities and ensure adequate credit supply once the emergency is resolved:
  - Remove structural impediments to bank consolidation.
  - Incorporate a low-interest-rate-environment scenario into banks’ risk assessments and supervisory frameworks.
  - Use macroprudential policies to curb banks’ incentives for excessive risk taking.
  - Allow cost cutting and efforts to increase fee income, recognizing these measures may not fully offset profitability pressures.

*The authors of this chapter are Claudio Raddatz (team leader), Will Kerry (team leader), John Caparusso (team leader), Yingyuan Chen, Juan Solé, Tomohiro Tsuruga, and Yizhi Xu, under the guidance of Fabio Natalucci.*

### CHAPTER 4 BANkING SECTOR: LOW RATES, LOW PROFITS?

### CHAPTER 4 BANkING SECTOR: LOW RATES, LOW PROFITS?

### Key econometric findings on rate effects and nonlinearities
- A 100 basis point decline in short-term interest rates reduces net interest margins (relative to assets) for the average bank in the sample by about 6 basis points in normal times (when short-term interest rates are positive).
- When short-term interest rates are negative, a 100 basis point decline reduces net interest margins by 12 basis points, indicating a nonlinear relationship.
- A 100 basis point fall in the term spread leads to a decline in net interest margins (relative to assets), on average, and this effect is much larger—at nearly 21 basis points—in a period of low spreads (when the spread between the 10-year and 3-month rates is below 1 percent).
- A 100 basis point decline in the term spread is estimated to lead to a 15 basis point fall in provisions (relative to assets) in a low-spread environment.
- A 1 percent increase in economic growth is associated with a 1.2 basis point reduction in the ratio of loan loss provisions to assets.
- The role of the interest rate environment is sizable in explaining the fall in net interest margins over 2013–18 for the average bank in the large euro area and low-interest-rate economies in the sample; the role is relatively lower in North Atlantic economies over this period.

### Simulation setup, assumptions, and methodology
- Simulation horizon: the next five years (five-year simulation starting from December 2018 as the starting point).
- Starting data point: December 2018; simulated values for 2019 use realized growth rates and interest rate data.
- Forecast inputs:
  - Growth forecasts correspond to the April 2020 World Economic Outlook.
  - Interest rates correspond to effective rates until the first quarter of 2020 and to forward market rates for the 1-month, 3-month, and 10-year benchmark bonds of each sample country prevailing at April 6, 2020.
  - Market expectations of benchmark interest rates are used; consensus forecasts released April 9–14, 2020 produced similar results when tested.
- Countries covered: nine advanced economies (grouped as low-interest-rate economies = Japan, Sweden, Switzerland; large euro area economies = France, Germany, Italy; North Atlantic economies = Canada, United Kingdom, United States).
- Channels incorporated into the simulation:
  1. Changes in net interest margins resulting from repricing of maturing loans and deposits.
  2. Changes in loan-loss provisions resulting from the interest rate and economic environment.
  3. Changes in credit growth associated with economic growth.
  4. Noninterest income.
- Effective repricing maturities estimated from a model of bank interest income dynamics over 2005–18:
  - Loans are repriced every three to six years, on average, across the nine economies.
  - Deposits are repriced every two to three years, on average, across the nine economies.
- Deposit rates are assumed to have a floor at zero because negative rates have so far been applied only to part of banks’ deposit bases.
  - Relaxing the floor and allowing deposit rates to fall to a minimum of –50 basis points does not significantly change results.
- Global systemically important banks (GSIBs) are modeled with lower sensitivity of net income to interest rate movements than other banks.
- Credit growth is derived from a Bayesian vector autoregression model used to estimate effective repricing maturities, ensuring consistency between estimates.
- Potential gains on securities investments are kept constant relative to assets due to lack of data on banks’ securities portfolios.
- Bank balance sheet composition is assumed unchanged (no endogenous reallocation of assets/liabilities).

### Simulated interest rate and profitability dynamics (phased description)
- Phase 2: At the start of the simulation, new loans are issued at lower rates than maturing loans while funding costs remain relatively unchanged, resulting in continued reduction in net interest margins.
- Phase 3: Deposit rates fall further until they hit the zero lower bound, reflecting monetary easing.
- Phase 4: Another round of net interest margin compression as loan rates continue to fall while deposit rates remain around zero.
- Phase 5: Interest rates on loans start to increase gradually, and deposit rates increase in some countries.

### Simulation results and projections
- Investors expect short-term interest rates to remain at very low levels for a while and term spreads to recover gradually over the next few years, albeit to levels below historical norms and with different trajectories across countries.
- Near-term outlook: growth is expected to experience a sharp contraction in 2020 and start recovering in 2021 (baseline IMF scenario), but considerable uncertainty and downside risks remain.
- Provisions:
  - Based on historical relationships, the sharp economic contraction in 2020 leads to higher provision expenses in the simulation.
  - Over the rest of the simulation provisioning declines as economic growth recovers, but actual provision paths may differ given policy measures (loan guarantees, regulatory flexibility) and extraordinary fiscal support.
- Net interest income:
  - Medium-term dynamics of profitability are dominated by further compression in net interest income.
  - Lower net interest income is partly offset by lower provisions in some settings, but not enough to prevent overall profitability declines.
- Return on assets (ROA):
  - Most banks in the simulation see a reduction in return on assets by 2025 relative to their recent (2018) already-low levels.
  - Banks in low-interest-rate economies benefit less from the future economic recovery because provisioning and net interest margins are already very low and rates are not expected to rise by much.
  - In large euro area economies, a cutback in provisions and a small increase in noninterest income in the medium term enable a fraction of banks (by assets) to increase profits relative to 2018, but ROA in 2025 remains below current levels for most banks in the region.
  - North Atlantic economies also face profitability pressures largely driven by net interest margin compression.
- Return on equity (ROE):
  - The simulated distribution of ROE in 2025 is markedly to the left of the 2018 distribution and similar to the distribution simulated for 2020, indicating persistent profitability pressures beyond the immediate shock.
  - A large fraction of banks in the sample generate ROE below 8 percent—the lower end of the current estimates for the cost of equity.
  - GSIBs: simulated ROE in 2025 is somewhat better than in 2020 but still deteriorating relative to 2018.

### Uncertainties, limitations, and caveats
- The models for loan-loss provisions and fee income capture historical relationships and may not fully incorporate the unprecedented COVID-19 shock or the full implications of recent policy measures targeted at supporting borrowers or the banking sector.
- Examples of omitted or partially captured effects:
  - Direct measures to support the banking sector or provide relief to borrowers are not explicitly modeled (except insofar as they affect market interest rates).
  - Loan guarantees and fiscal support could dampen provisioning needs and thus alter simulated provision trajectories.
  - Regulatory and accounting flexibility could allow banks to smooth provisions through the cycle, affecting near-term provisioning estimates.
  - Potential gains on securities investments are kept constant; as rates remain low and later move up, simulated profits may be overstated because there are likely to be few gains on securities.
  - Composition of bank balance sheets is held constant, ruling out endogenous behavioral responses that would require a full model of bank behavior.

*Source: CHAPTER 4 BANkING SECTOR: LOW RATES, LOW PROFITS?, International Monetary Fund | April 2020.*

### CHAPTER 4 BANkING SECTOR: LOW RATES, LOW PROFITS?

### CHAPTER 4 BANkING SECTOR: LOW RATES, LOW PROFITS?

### Substantial Action Will Be Needed to Fill the Earnings Shortfall
- The COVID-19 downturn will likely hurt bank earnings through mark-to-market and credit losses; earnings challenges predate COVID-19 and are expected to extend to at least 2025.
- Two main levers to mitigate structural profitability pressures from low interest rates:
  - Noninterest income (fees and gains on securities).
    - Gains on securities holdings will likely decline further when interest rates stabilize.
    - Fee income must therefore provide most of any noninterest-income improvement.
    - From 2013 to 2018, fee income (relative to assets) was fairly flat across advanced economy banks on aggregate.
    - Fee income fell in Canada, Germany, Sweden, the United Kingdom, and the United States over 2016–18; it rose in France, Italy, and Japan (2016–18 changes shown).
    - Analysts forecast falling fee income relative to assets (2021 versus 2019E outlook for several countries).
  - Operating cost cuts (efficiency gains).
    - From 2013 to 2018, cost savings delivered about a 15 basis point improvement to median return on assets.
    - Analysts expect cost-to-assets ratios to continue to decline in some countries, generally by another 5–25 basis points of assets by 2021.
- Simulation question: what combinations of cost reduction and additional fee income would be required for banks to reach return on equity of 8 percent?
  - North Atlantic economies: a fair proportion of banks are expected to generate adequate returns by 2025; for others, feasible combinations of cost and revenue improvements exist.
  - Large euro area economies: virtually all banks would need to improve both cost and noninterest income, sometimes significantly; for some banks, cutting costs to zero would not suffice without increased noninterest income.
  - Low-interest-rate economies: many banks show little scope for further cost improvement (costs already quite low) and would require noninterest income rising from very low current levels.
- Hedging and size effects:
  - Larger banks have much larger interest rate swap books relative to total assets, suggesting heavier hedging engagement.
  - US data suggest smaller banks are more sensitive to a decline in rates than larger banks.
  - US banks’ net interest income has become more sensitive to changes in policy rates in recent years, with risk increasingly skewed to the downside as deposit rates approach zero.

### Banks May Take Excessive Risk in the Medium Term Once the Economy Begins to Recover
- Recent policy measures aim to help banks use risk-bearing capacity to support lending through the COVID-19 episode, but medium-term profitability pressures could induce banks to increase credit, maturity, liquidity, or trading risks once the crisis recedes.
- Evidence of risk-taking prior to COVID-19:
  - Some banks shifted exposures from short-term instruments and marketable securities toward less liquid loans, raising loans as a percentage of total assets and taking additional liquidity risk (2013–18).
  - Estimated average loan maturity across reporting banks lengthened from 2013 to 2018, particularly where low interest rates pressured net interest margins.
  - Econometric analysis confirms banks in negative rate environments tended to increase loan maturity relative to behavior in normal times.
  - Studies suggest banks may shift loan portfolios toward riskier borrowers; some increased origination of riskier syndicated loans is ceded to nonbank financial intermediaries, passing on credit risk elsewhere.
  - Some banks have increased overseas exposures, potentially raising currency and liquidity risks—most evident in Canada and Japan; tactic available mainly to large banks with extensive international footprints.

### Policy Discussion
- Near-term priorities:
  - Rapidly employ policies that preserve financial stability, maintain soundness of institutions, and support economic activity.
  - Ensure adequate central bank liquidity provision and provide clear supervisory guidance on prudent loan renogotiation.
  - Use flexibility in existing regulatory frameworks to account for expected credit losses and allow use of existing buffers to absorb costs.
- Medium-term supervisory and macroprudential actions:
  - Incorporate lower-for-longer interest-rate scenarios into supervisory capital planning and stress testing; evaluate business model strength under persistent low rates.
  - Remain vigilant to prevent regulatory arbitrage that could reduce system resilience.
  - Deploy macroprudential tools if banks take excessive risks post-crisis:
    - Countercyclical capital buffer could be used in time to enhance resilience as systemic risk builds during loose financial conditions.
    - Borrower-based measures could limit rapid growth of mortgage portfolios if banks shift aggressively into these loans.
    - For banking systems expanding foreign operations, ensure foreign exposures are adequately diversified and monitor liquidity mismatches in foreign-currency balance sheets.
- Monetary policy guidance:
  - Monetary policy should remain data dependent and set to meet central banks’ macroeconomic targets.
  - Policy tools to offset adverse effects of negative rates (e.g., tiering schemes limiting application of negative rates to a portion of banks’ reserves) should stay in place while policy rates are negative.
- Structural reform and efficiency:
  - Authorities should assess benefits of domestic and cross-border bank consolidation while ensuring adequate competition and addressing potential too-big-to-fail issues.
  - Encourage banks to improve operating efficiencies via branch reduction where warranted, IT upgrades, and process outsourcing.
  - Balance cost reduction against other concerns: broad access to financial services, financial inclusion for households and SMEs, data protection and privacy in technology upgrades, consumer protection in non-fee-income expansion, and assessment of local employment/community consequences.

### Negative Interest Rate Policies: Effects and Limits (Box)
- Rationale and implementation:
  - Since 2014 several central banks (mostly in Europe) set policy rates below zero when conventional stimulus room was exhausted; examples include the euro area, Japan, Sweden, Switzerland, and Denmark (Denmark operates a currency peg with the euro).
- Transmission and observed effects:
  - Money market rates closely tracked policy rates as they moved below zero.
  - Longer-term yields fell, especially after initial rounds of cuts below zero, reflecting concurrent asset purchases and forward guidance.
  - Deposit and lending rates have fallen; deposit rate declines were more pronounced for corporate deposits.
  - Evidence suggests cuts helped lower lending rates in the euro area and Switzerland, though confounded by other measures.
  - For the euro area, negative rates seem to have had small but positive effects on inflation and growth; in Japan, support occurred through the exchange rate channel.
- Limits and risks:
  - There is an effective lower bound to how negative rates can go.
  - If rates become deeply negative, risks include wholesale moves into cash, declines in bank profits, and potential reversal of the positive effects on lending.

*Source: International Monetary Fund | April 2020 — CHAPTER 4 BANkING SECTOR: LOW RATES, LOW PROFITS?*

### Box 4.1. The Experience with Negative Interest Rate Policies

### Box 4.1. The Experience with Negative Interest Rate Policies

### Deposit-rate pass-through and observed patterns
- After policy rate cuts, euro area corporate deposit rates have fallen, but pass-through has diminished over time.
- Euro area retail deposit rates have also fallen, but less so.
- In Sweden, corporate deposit rates have also fallen, with diminishing pass-through.
- Swedish retail deposit rates show the same behavior.
- Figures document changes in new short-term deposit rates for households and corporations up to 12 months following each of the 10 basis point cuts that the European Central Bank has made in its main deposit rate since June 2014 (euro area) and the three rate cuts made by the Swedish Riksbank since February 2015 (Sweden).
- NFC = nonfinancial corporation; repo = repurchase agreement.

### Tiered reserve systems: purpose and effects
- Several central banks have introduced tiered reserve systems to help counter the negative effects of low rates on banks’ profitability.
- Jurisdictions with some form of tiering system include Denmark, the euro area, Japan, Norway, Sweden, and Switzerland.
- Tiering delivers two benefits to banks:
  - Banks are exempted from paying interest (or receiving a less negative rate) on a portion of the reserves they maintain at the central bank.
  - Banks have scope to arbitrage the difference between the negative rate and the exempted rate by trading liquidity (possibly across countries).
- The introduction of the two-tier system by the European Central Bank at the end of 2019 is estimated to generate total savings for euro area banks of about €4.7 billion per year relative to a counterfactual scenario where tiering is not introduced.
- In Switzerland, savings from the recent change in tiering introduced in November 2019 are estimated at about $0.7 billion per year.
- While these savings help banks, they are equivalent to a few basis points of return on assets and are unlikely to fully offset the impact of low interest rates on profitability.

### Selected central bank deposit tiering schemes (Table 4.2.1)
- Euro Area
  - Description: Bank deposits below the exemption threshold pay no interest. Reserves above the threshold pay the deposit rate.
  - Exemption Threshold: Six times the minimum reserve requirement.
  - Interest Rate Applied to Nonexempt Reserves (percent): –0.50
  - Date Tiering Implemented: Nov. 2019
  - Date Negative Rates Implemented: Jun. 2014
- Japan
  - Description: Three-tier system at 0.1 percent rate for the basic balance, 0.0 percent rate for the macro add-on balance, and -0.1 percent rate for the policy rate balance.
  - Exemption Threshold: Amount of reserves charged at the policy rate varies in line with the Bank of Japan’s monetary base target.
  - Interest Rate Applied to Nonexempt Reserves (percent): –0.10
  - Date Tiering Implemented: Feb. 2016
  - Date Negative Rates Implemented: Jan. 2016
- Switzerland
  - Description: Negative interest is charged on the portion of banks’ sight deposits at the central bank exceeding the exemption threshold.
  - Exemption Threshold: Twenty-five times the minimum reserve requirement (revised up from 20 times exemption in Nov. 2019).
  - Interest Rate Applied to Nonexempt Reserves (percent): –0.75
  - Date Tiering Implemented: Jan. 2015
  - Date Negative Rates Implemented: Dec. 2014

### European Central Bank tiering scheme: estimated impact (Table 4.2.2)
- Euro Area
  - Minimum Reserve Requirement (MRR): 135
  - Bank Deposits with Eurosystem (Billions of euro): 1,818
  - Exempted Reserves (MRR * Multiple): 807
  - Cost Savings for Banks (Billions of euro): 4.00
  - Impact on Banks’ Return on Assets (percentage points): 0.01
- Germany
  - Minimum Reserve Requirement (MRR): 375
  - Bank Deposits with Eurosystem (Billions of euro): 622
  - Exempted Reserves (MRR * Multiple): 241
  - Cost Savings for Banks (Billions of euro): 1.10
  - Impact on Banks’ Return on Assets (percentage points): 0.01
- France
  - Minimum Reserve Requirement (MRR): 275
  - Bank Deposits with Eurosystem (Billions of euro): 261
  - Exempted Reserves (MRR * Multiple): 600
  - Cost Savings for Banks (Billions of euro): 0.80
  - Impact on Banks’ Return on Assets (percentage points): 0.01
- Italy
  - Minimum Reserve Requirement (MRR): 181
  - Bank Deposits with Eurosystem (Billions of euro): 021
  - Exempted Reserves (MRR * Multiple): 100
  - Cost Savings for Banks (Billions of euro): 0.40
  - Impact on Banks’ Return on Assets (percentage points): 0.01

### Additional notes from the box
- The author of this box is Juan Solé.
- Arbitrage between banks (for example, a German bank paying –0.30 percent to an Italian lender while facing –0.50 percent on its own excess reserves) can generate benefits, but estimated benefits from such activities are smaller than those from the introduction of tiering schemes.

*Source: Box 4.1, "The Experience with Negative Interest Rate Policies," ch4 - Box 4.1. The Experience with Negative Interest Rate Policies, International Monetary Fund | April 2020.*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2020/april/english/ch4.pdf_