The Bank of England (BoE) is preparing the City for the possibility of a shift into negative territory for the first time in its 325-year history. Mohamed Dabo reports on the potential challenges negative interest rates would bring
BoE governor Andrew Bailey has said that negative interest rates are now under “active review”, a U-turn from the bank’s previous position.
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Since 2009 and the last major financial crisis until as recently as 2019, the BoE under previous governor Mark Carney maintained that “the effective lower bound is close to zero, but positive”. As recently as March of this year, the current governor also indicated that he did not consider negative interest rates a “plausible tool” for the UK.
A couple of months later, however, the full impact of Covid-19 on the economy has materialised and there has been a shift in tone.
Covid-induced change
Bailey told the Treasury Select Committee in May that negative rates were “one of the potential tools under active review” should the monetary policy committee decide that “more stimulus” is needed to hit the 2% inflation target. The governor later told bankers that the committee would consider the effectiveness of negative rates elsewhere in the world, given their “varied” record, implications for the banking system and how households would view them.
Bailey also noted that an unprecedented move into negative territory – where the central bank would charge commercial lenders to store reserves – would be “a significant operational undertaking for firms”. Many would need 12 months to change computer systems, update financial contracts designed for a world of positive interest rates, and work out how to communicate with clients, Bailey noted.
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By GlobalDataThe governor also held a meeting with bank bosses at the end of June where negative rates were discussed. One person present said the governor made it clear that “every tool they have is on the table”. The BoE has already pumped £745bn ($950bn) into the economy through quantitative easing, and cut rates to a record low of 0.1% in response to the Covid-19 crisis.
Three kinds of readiness
Negative rates present the financial system with a number of potentially unintended consequences involving almost every customer, counterparty and stakeholder.
To be ready, according to a recent PwC report, banks should prepare in three ways: technical, financial and strategic readiness. Following this, the next imperative is to prepare the franchise, operating model and balance sheet for resilience in the face of challenges to come.
Cost structure and operating model
Cost is already a key focus for bank executives – many banks having pushed their plans back even further as a result of Covid-19. However, accelerated margin erosion, driven by rate changes, may impact the equations for tradeoffs that are accepted today.
What additional costs could be outsourced, consolidated into industry utilities, or
simply discontinued if they had to be? What opportunities to streamline the product offering, operational architecture and operating model exist already? How much more urgent would negative rates make them?
Credit portfolio
There will be a need to reassess exposures in light of the challenges to come, especially for pension funds, insurers, asset managers and other holders of long-dated assets.
This is especially true for businesses leveraged to assets such as commodities (especially precious metals), real estate, farmland or other assets (such as patents or trademarks) whose value can vary significantly with changes to the money supply and inflation expectations.
Balance sheet
As with credit, many aspects of balance sheet management may also merit reconsideration. A move towards negative interest rates may change the growth orientation for the balance sheet overall, from asset gathering to deposit gathering, as was the case in the immediate aftermath of the global financial crisis.
Most importantly, the entire balance sheet will have to be stress-tested under multiple scenarios.
Positioning to thrive
Decisions must be made to ensure that the bank can thrive in the new environment. This includes identifying services to generate sustainable fees and other operating income for customer segments aligned to the franchise, as well as ensuring partnership and capability in place to deliver.
Fee and service offer
A negative rate-driven cut in interest income would elevate the importance of fees and other non-interest income. This will be less of an issue for the largest UK banks, which already generate more than half their income from commission, fees, trading and other non-interest sources.
Partnerships and capability – including regulatory
Finally, the new environment will bring challenges few banks are equipped to address alone. In many cases, third parties will disintermediate banks from customers, but still offer banks an opportunity to partner and share value in the provision of nonlending services.
