Unintended Consequences III - The Banking Sector

Updated January 2017

The International Monetary Fund recently released its quarterly Global Financial Stability Report for the third quarter of 2016 and its contents form the perfect posting for my ongoing series on the unintended consequences of central banks and their prolonged experiment with the economy.  In this report, it examines the risks to global financial security and notes that the global banking sector is having to adapt to a new reality; a prolonged period of very low and negative interest rates which are having a significant impact on profitability.  It is this erosion of profitability that will erode the banking sector's buffers that have been built up since the global financial system nearly collapsed in 2008.  Here are some interesting facts from the IMF's October 2016 Global Financial Stability Report that will help us better understand where the global economy is most at risk.

While the IMF notes that short-term risks to global financial stability (i.e. Brexit) have moderated over the past half year, they note that the medium-term risks have risen as central bankers grasp the fact that credit risks are increasing as banks and insurance companies in developed economies that have traditionally relied on higher interest rates as a key part of their business planning find themselves mired in a low-growth, low interest rate environment.

Let's start by looking at a graphic which shows what has happened to real yields in the global bond market using the yield of inflation-linked bonds since 2004:

In the euro area and Japan, markets are expecting that yields will remain negative as far out as five years from now as shown on this graphic which looks at how expectations of future central bank interest rates in 2020 have declined over the past year:

Among the handful of the world's most influential central banks, the Federal Reserve stands alone when it comes to predictions of higher interest rates in the future.  This suggests that there is very little confidence that the global economy will experience a return to the higher economic growth rates of the past and higher levels of economy.  This, apparently, looks like our new economic normal.

Here is a graphic showing the share of sovereign bond markets with negative interest rates:

In total, 30 percent of sovereign bonds among developed economies are in negative yield territory as of September 2016.  In the cases of both Japan and Switzerland, all of their sovereign bonds out to ten years are in negative yield territory.  Finland, Germany and the Netherlands have sovereign bonds with negative yield out to eight years.  

Not only are yields on sovereign bonds low, the yield spread between one year and ten year sovereign bonds is extremely compressed as shown on this graphic:

In the case of the United States, the yield spread between one year and ten year Treasuries has fallen from around 225 basis points between January 2010 and June 2013 to its current level of around 100 basis points.  That is a very small premium for accepting the risk that the yield on a ten year Treasury will not rise.

What this prolonged period of low interest rates has done is push investors into longer duration bonds as shown on this graphic which shows the average thirty year yield for sovereign debt from the United States, United Kingdom and Japan in green and the global bond portfolio duration in red:

Bond investors who are desperately seeking a decent return on their investments have increased the average duration of their bond holdings from around one year in 2003 to nearly 7 years in 2016 thanks to low interest rates.  The problem with this approach is that longer bonds tend to suffer greater declines in value when interest rates rise when compared to shorter-term bonds.  

What has created the erosion in bond term premiums?  Here are the reasons given by the IMF:

1.) Central bank bond purchases have flattened yield curves and pushed term premiums further into unprecedented negative terri- tory. Anticipated future demand from central banks has also caused additional compression of term premiums, as investors know that a reliable buyer will prevent sharp increases in bond yields.

2.) Increased demand for longer term bonds from pension funds and insurance companies which may reflect population aging and demographic shifts that result in higher demand for safe assets.

3.) Political and central bank policy uncertainty are higher and since bonds act as a form of insurance against potential calamity, higher demand pushes prices up and yields down.

4.) Concerns over secular economic stagnation due to a lack of corporate investment and productivity growth plus the added issue of stubbornly low inflation.

Let's look at a graphic which shows how central banks have created a dilemma for the world's fixed income markets:

Let's summarize the impact of all of what you have already read.  Central banks may yet prove to be their own worst enemies.  While a low interest rate environment has traditionally been the medicine that cures economic woes by prodding the private sector to borrow until it hurts, the prolonged period of low interest rates and central banks' purchases of their domestic sovereign debt has pushed yields and term premiums to all-time lows.  This has an immediate impact on the stability of the banking sector since banks traditionally rely on the interest rate spread between their loans and their deposits for their profitability.  Without those profits, the banking sector in the world's developing economies will find itself less able to sustain capital levels which are necessary during adverse economic cycles when high provisioning for loan losses can consume capital buffers.  This will have a very significant impact on investors as equity prices come under pressure and the banking sector's ability to pay dividends comes under pressure.  Here is a graphic which shows the impact of a one-off 20 percent decline in the prices of bank shares on lending:

A 20 percent one-off fall in bank share prices pushes lending down by six percent 18 months after the 20 percent decline in equity prices and is still felt three years after the equity price shock.  This will obviously have a very significant impact on economic growth levels.

As I've noted before, there are many unintended consequences to poorly executive central bank policies; as the IMF's most recent Global Financial Stability Report shows us, the global banking sector could be the canary in the coal mine when it comes to a clear expression of what can go wrong in the current near-zero interest rate environment.  The IMF's predictions of at least another five years of subdued economic growth and suppressed interest rates suggests that the banking sector will be under significant stress over the next half decade, a factor that should concern bank shareholders.