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CHRONIC INVESTOR BLOG

Our light-hearted take on the world of investing

The unbearable lightness of interest rates

By Ian Smith , 28 July 2016

"The drugs don't work/They just make you worse." The Verve's anthem of the late twentieth century feels more and more applicable to the markets of the twenty-first. Here the drugs are ultra-low interest rates, even negative rates, coupled with asset purchasing. It is only fair to say they provided an initial fillip to the patient, by boosting asset values and encouraging lending, but the longer-term effect has been to threaten the profitability of Europe's major lenders, not to mention inflate the cost of employers' pension obligations.

It remains to be seen whether the Bank of England will cut its base rate below zero, following its counterparts at the European Central Bank. But the Royal Bank of Scotland (RBS) has contacted 1.3m of its commercial customers to inform them that it could, in that event, decide to charge interests on credit balances.

As we presaged in our cover feature 'Surviving Sell-Offs' (3 March 2016, pages 22-31), central banks' decisions to keep monetary policy loose, or loosen it further, has the effect of flattening the yield curve for government gilts, reducing the gap between longer and shorter-term debt.

This hurts banks which borrow short and lend long, by tightening the net interest margin that can be made. In the event that central banks charge lenders to hold on to their money, those banks either take the risk of passing that cost on to the customer, or accept a hit to that core retail banking measure.

This is not an immediate or comprehensive effect: tracker mortgages maintain their margin, and fixed-rate mortgages do what they say on the tin, but as these loans mature and as house owners overpay their current loans (so-called 'prepayment risk'), the funding challenge is revealed. A flatter yield curve also makes it more difficult for banks to make profits by playing the yield curve via their treasury departments.

But this squeeze is not the whole story, argue economists at the ECB. They have calculated that the harm done by negative rates to the net interest margin is more than offset by capital gains, meaning the higher value of the debt assets held by lenders, and the improved credit quality resulting from the lower interest rates. The dealer is high on the supply, but then of course so is the customer, so as long as the party keeps going, everything will be fine.

If the banking patient is deteriorating, the insurance patient has not escaped unharmed. Low rates have suppressed the fixed income available to insurers from the assets they are forced to buy, but this is certainly an industry where the pricing is passed straight on to the customer, with low yields meaning pathetic annuity income. For company pension schemes that guarantee a level of income in retirement, it is even worse: lower for longer interest rates feed through to higher for longer liabilities. A senior actuary at Willis Towers Watson's Frankfurt office has called it a "slow poisoning" of the pensions industry. Expect pressure on companies to pay more into their pension funds, at a time when they can ill-afford to do so.

These things together weakened Germany's Commerzbank in the six months to June. Fuller figures will be out in the next few days, but preliminary data showed weaker profits and a decline in the capital ratio, as a result of higher pension liabilities and industry-wide tweaks to the calculation of risky assets.

Over the next week we will measure the Brexit and low-rate pain for the major lenders at home. But keep in mind the time period reflected. TSB, now owned by Spanish lender Banco de Sabadell (ES:SAB), doubled its adjusted profits in the six months to June 2016, as it grew its share of new accounts while posting an impressive net interest margin of 3.3 per cent. But boss Paul Pester has cautioned on the future impact of lower-for-longer rates on its profitability: unsurprising, given its huge deposit base. For the moment, the patient will be kept on the drip.

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Ian Smith

Ian Smith is companies editor of Investors Chronicle

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