Benoît Cœuré, Member of the Executive Board of the ECB, gave an interesting speech late last month at a Euromoney “The Global Borrowers & Investors Forum 2013“ Conference. Much of the speech was an argument that low interest rates can set up systemic fragility. We take a look at what he said.
Cœuré noted “In fact, since the Great Depression a number of financial crises have occurred after a prolonged period of exceptionally easy monetary conditions.” But he also cautioned about how financial markets react to rising interest rates and the fissures in the system that could cause. Sort of a “damned if you do, damned if you don’t” dilemma.
He spoke about how a lower market price of risk results in financial institutions taking on a greater amount of risk and that persistent liquidity sows the seeds for market turmoil. There are four problems that develop as a result of low interest rates:
1.) Asset substitution: “…a lower yield on safe assets will lead to a decrease in their weight in bank portfolios. Banks adjust their portfolio until risk-adjusted returns on risky and safe investments are again equalised. This results in a lower share of safe assets…”
2.) The search for yield: “…Financial institutions with long-term commitments (such as pension funds and insurance companies) need to match the yield they promised on their liabilities with the return on their assets. When interest rates are high, they can generate the necessary revenue by investing in safe assets. When rates are low, they are forced to invest in riskier assets to continue to match the yield on their liabilities…”
3.) Leverage ratios: “…If monetary easing boosts asset prices, then bank equity will increase and banks will respond to the fall in leverage by increasing their demand for assets. This reaction reinforces the initial boost to asset values, and so on. The result of this “leverage channel” is a more fragile banking system…”
4.) Expectation of strong policy response to negative shocks”: “…This…has sometimes been called the “Greenspan put”…” and “…Financial players can afford to take ex ante extra risks, as they can rely on central banks to mitigate the consequences in case those risks materialise ex post…” In other words, the banks take on risk because they will get bailed out when the market sours.
When interest rates turn, the long duration positions will crack. Cœuré said, “…an abrupt unwinding of these searches-for-yield – perhaps triggered by highly leveraged investors rushing for the exit – would be a source of concern for financial stability. However, the extent of the risk also depends on the degree of maturity transformation and the stability of funding…” Read: if the repo and derivatives markets have provided a lot of leverage to the system, an upward shock in interest rates will be magnified and could undo the house of cards. This might explain why the response to the Fed thinking about tapering was so cathartic. The short term U.S. funding markets appear to be stable, but it does not mean that margin calls on those long interest rate positions won’t inflict a lot of damage, which could then boomerang back to the repo markets.
He also said “…higher rates may negatively affect the balance sheet positions of some banks. If this reintroduces asymmetric information in the interbank market and adverse selection through the exclusion of less reputable counterparties, the current market fragmentation and relatively low trading volumes may persist or even be magnified…” Perhaps to put it more simply, higher rates will impact weaker actors first and the market will quickly punish those less healthy institutions. Unless investors can quickly distinguish between the weak and the strong, we could be back to not trusting anybody and the credit market freezes.
What can be done? While interest rates are still at low levels and before the real damage is done to fixed income portfolios, Cœuré suggested “…financial system should however be able to operate under a different constellation of yields. The current period of low interest rate should be used to prepare for it. A number of actions are needed that cut across policy domains and in many cases will take time to bear results. They should be high on the policy agenda…”
Those actions include stress testing of European banks after “…a credible backstop facility needs to be in place that can address potential capital shortfalls in banks’ balance sheets…”, and “…regulatory measures aimed at curtailing excessive bank leverage, mitigating duration risk and avoiding excessive maturity transformation are needed to complement capital adequacy rules…” This sounds to us like the ECB will be preemptively going after the financing markets, pushing banks to reduce the availability of leverage, as a precursor to any upward movement in rates.
A link to the speech is here.