The Committee on the Global Financial System, chaired by RBA governor Philip Lowe, has warned that leaving interest rates too low for too long could increase risks in the financial system.
A new report released by the Committee on the Global Financial System – which monitors international financial markets for central bank governors – has outlined the dangers and risks of leaving interest rates low for a prolonged period of time.
“The profitability and strength of financial firms may suffer in an environment of prolonged low interest rates. Additional vulnerabilities may arise if financial firms respond to ‘low-for-long’ interest rates by increasing risk-taking,” the report said.
While banks would have some capacity to cope with low interest rates, insurance companies and private pension funds (ICPFs) would struggle more, it said.
In aiming to predict how banks and ICPFs would handle prolonged low interest rates, the report presented three scenarios: ‘baseline’, ‘low-for-long’ and ‘snapback’.
The baseline scenario is “consistent with mainstream economic forecasts and central bank inflation targets” and “involves a gradual rise in interest rates to more normal levels”.
This scenario is based on projections in the International Monetary Fund’s October 2017 World Economic Outlook; however, as projections only go to the end of 2022, the committee extended the scenarios to 2027.
The ‘low-for-long’ scenario is based on “weakness in economic growth and inflation” and “entails an interest rate trajectory that is materially lower than in the baseline”, further depressing structural drivers such as demographics and productivity.
In this case, banks would “likely be able to make adaptations to maintain overall profitability, including by cutting costs, shifting to fee-based activities, and increasing the riskiness and duration of assets”.
However, a low-for-long scenario would leave ICPFs more vulnerable, according to the report.
“Because of their negative duration gaps, falling interest rates would push up the present value of their liabilities more than that of their assets, leading some ICPFs to experience more pronounced reductions in profitability and balance sheet positions,” the report said.
But this would occur over a longer period of time, which would allow more space to adapt. Nonetheless, there were still “material risks” to financial stability under the low-for-long scenario, the report pointed out.
“Even if a prolongation of low interest rates would not engender a global surge in bank distress, it could certainly create problems for some banks,” it said.
A ‘snapback’ scenario sees interest rates, having been kept low for a period of time, rise sharply and thus increasing the vulnerability of financial entities to such a rapid rise.
“Because of valuation losses on long-duration assets and credit losses on loans, banks without sufficient capital buffers could experience solvency issues, particularly if deposit rates were to increase more rapidly with market rates than they have historically and erode the profitability gains from higher rates,” the report said.
Banks in emerging market economies would be particularly vulnerable if high interest rates in advanced economies resulted in “a reversal of capital flows and sharp sell-off in [emerging market economy] assets”.
Furthermore, ICFPs could face could also be grappling with liquidity issues in a snapback scenario on top of solvency problems.
“A surge in interest rates could cause losses on derivative positions that triggered additional collateral demands, and higher interest rates might also lead policyholders to surrender their insurance contracts,” the report said.
Regulators must play a part
The report also outlined a number of actions that regulators could take in order to mitigate the risks of long-term low interest rates.
“The first line of defence by prudential authorities should be to continue to build resilience in the financial system by encouraging adequate capital, liquidity, and risk management,” it said.
“Strong and resilient banks, insurers and pension funds will be better positioned to weather a wide range of adverse shocks, including the low-for-long and snapback scenarios explored in this paper.”
The report recommended “enhanced monitoring” by regulators through stress tests as well as adopting a “consistent valuation approach across assets and liabilities”.
Additionally, more data should be collected and analysed in order to monitor such risks and exposures, it said.
“One challenge is that firms’ financial statements may not provide enough detail to accurately identify common trends, vulnerabilities and possibly spill-overs across jurisdictions,” the report said.
Prudential authorities have to prepare for the eventuality that “some life insurers may come under enough stress to eventually fail”, the report concluded.