The Study the ECB Should Read as it Discusses Rates
(Bloomberg View) -- The European Central Bank is set to decide on Thursday whether to move closer to withdrawing its extraordinary stimulus to the euro zone economy or delay it for a little longer.
A key argument for hurrying up with a monetary tightening is that negative rates have hurt bank profitability, restricting lenders' ability to give credit to families and firms. But is it really the case? How low can interest rates go before they become a drag on the economy?
A new way of thinking about this problem comes from a working paper by Markus Brunnermeier and Yann Koby at Princeton University. The two scholars believe there is a "reversal interest rate" below which a central bank prompts lenders to cut back on their lending, instead of increasing it. This boundary creeps up over time, setting a limit to how long central banks should keep interest rates low.
Central banks face a trade off when they cut interest rates towards zero or below. On the one hand, they reduce the cost of funding for banks to a level well below the rate of return on the assets they hold. Think, for example, of a bank which had bought Italian government bonds when their yield was significantly above where it is now. The lender can refinance itself at a very cheap rate with the central bank and enjoy a hefty profit on its legacy assets.
On the other hand, however, low rates reduce the profit margins banks make from their classic activity of intermediation between depositors and lenders. For example, in the case of negative rates, lenders are reluctant to charge depositors for the privilege of holding a current account. Meanwhile, there is only so much they can charge on their loans. This reduces their profitability - which is precisely the reason why many banks complain about negative rates.
These conflicting forces determine how low a central bank can go without hurting the economy. A bank which is making hefty profits from its asset portfolio while losing only a bit on its credit intermediation business will be better equipped to provide loans to consumers and businesses. Conversely, those banks that see their credit margins shrink dramatically while gaining only a bit from the bonds they hold will be more reluctant to lend.
The study points to how the lowest boundary for interest rates depends on the business models banks have. However, it also shifts over time. The positive impact on the asset portfolio from low rates tends to fall, as lenders are forced to replace old securities carrying very high returns with new ones offering lower yields. Conversely, the losses on credit intermediation stay constant. The "reversal interest rate" creeps up over time.
Unfortunately, the model designed by Brunnermeier and Koby cannot answer the question of whether the ECB's policy rates are too low, as some banks complain, or adequate. That would depend on the exact balance sheets of Europe's banks. The ECB's own research shows that the stimulus has not affected lenders' profitability significantly. Meanwhile, lending in the euro zone is on the up.
However, the ECB may face the unpleasant reality of having to raise borrowing costs sooner than it thought. As Brunnermeier and Koby show, over time, keeping rates to a record low will be more costly than it once was.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg View. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.
To contact the author of this story: Ferdinando Giugliano at fgiugliano@bloomberg.net.
To contact the editor responsible for this story: Therese Raphael at traphael4@bloomberg.net.
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