Negative rates are no longer off the table in the UK. After the MPC indicated that it is considering them alongside other monetary policy tools to tackle the economic consequences of COVID-19, the PRA has today published a letter to CEOs requesting information on firms’ operational readiness for a zero or negative Bank rate. In this blog we consider the potential implications for banks.
Whilst responses are voluntary, the letter underscores the PRA’s hope (expectation) that firms will respond. In our view, now is the time for banks to assess their readiness for negative rates anyway - not just for the operational challenges, but also the potential strategic and regulatory issues, including the impact on customers. Indeed, the PRA letter makes clear that the PRA will also be considering the wider business implications of negative rates in due course. Although negative policy rates have been set in other countries, it would be a first for the UK.
Outside the UK, the overall impact of negative rates on banks has not been clear-cut. There are benefits as well as costs; and the effect on individual banks depends on their business models and financial health, while the effect on the sector as a whole remains a matter of debate.
By undertaking diagnostic work now, banks will be able to explore the challenges fully, and plan potential changes to systems, processes, governance, pricing, and beyond. The PRA letter is clear that firms are not being asked to begin taking steps to ensure they are operationally ready. However, there are several ‘no regret’ actions that banks could consider, which we set out at the end of this blog.
Operations, risk, and compliance teams should consider several issues in relation to the PRA letter and beyond. These can be addressed by asking a range of ‘diagnostic’-type questions to identify potential gaps or shortcomings in current capabilities, outlined below.
Banks will need to review their systems – technology platforms and operational processes. They need to determine whether they have the capabilities required to incorporate negative rates into decision-making, and if necessary to pass on negative rates to customers. Some banks are likely to lack these capabilities in at least some parts of their business. The PRA wants to understand the extent of any operational challenges, as well as the potential cost of remediation. The PRA letter notwithstanding, it would be prudent for banks to invest time in identifying gaps and understanding how they can be bridged; rushed IT solutions further down the line may increase operational and conduct risks. The technology challenges Danish banks encountered paying customers negative interest provide useful lessons here.
The PRA letter is focused on technological issues. However, banks could think beyond technology and look at how pricing, risk or regulatory capital models may need to be adjusted. Some modelling techniques do not function with negative rates – some pricing and hedging models, for instance, incorporate lognormal probability distributions that can only be calibrated with positive rates. Even if negative rates are not introduced in the immediate near term, banks may still want to consider whether they will need to be able to model the impact of negative rates in the medium term.
Key questions include:
- Do IT systems have the functionality to implement negative rates across different customers and product types?
- Does the bank have the capability to incorporate negative rates into its existing risk, regulatory capital, pricing or hedging models? Have relevant models already been developed elsewhere in the business, for example, to deal with negative rates in other currencies?
Strategic and business challenges
Banks will need to manage the interplay of several factors when assessing the impact of negative rates on their businesses. In general, negative rates reduce interest income from lending. When rates remain (sufficiently) above zero, margins on lending can be maintained through corresponding reductions in the interest paid out to depositors. However, as rates approach zero, the ability or willingness of banks to cut deposit rates is reduced, compressing margins.
Outside the UK, many banks have been unwilling to pass negative rates through to households, creating a de facto lower bound for retail deposit rates. Smaller banks with high deposit ratios and simpler, less diversified business models, are hardest hit by this dynamic. However, negative rates also ease customer debt burdens, enabling banks to reduce loan loss provisions and non-performing loans. Some banks may also be able to compensate for the loss of interest income with increases in fees and commissions, or offset compressed margins through growth in volumes.
Key questions to consider include:
- How (if at all) might the bank look to pass negative rates through to customers? How would this vary by customer and product type? What are the potential behavioural consequences?
- What levers are available to the bank to compensate for reduced interest income? For instance, how might fee income be increased?
- Do existing products’ terms and conditions create any obstacles for the bank in terms of permissible responses, for instance through clauses that restrict changes in interest rates outside certain parameters?
- What would negative rates mean for the ongoing viability of free-if-in-credit banking?
Regulatory challenges: prudential and conduct risks
Banks’ responses to negative rates could generate both prudential and conduct risks.
Prudential risks arise from the pressure that negative rates will create for profitability and long-term prudential health. Negative rates may ease customers’ debt burdens, and thereby reduce provisions for loan losses, but it remains unclear whether this compensates for reduced interest income over time. Furthermore, negative rates may skew perceptions of the riskiness of loans, and the long-term impact of negative rates on underwriting standards remains unclear. Banks will therefore need to consider the relationship between negative rates and risk appetites.
Banks may also want to consider the behavioural implications for different depositor and loan types to understand the potential for significant shifts in credit demand and funding flows. For instance, retail customers could withdraw material volumes of deposits in the event that negative rates were passed through to them, which in turn would feed through to banks’ assessments of liquidity and funding risks.
With banks currently operating with large liquidity portfolios, it will be important to understand the impact of negative rates on their large portfolios of liquid assets and associated hedges, as excess liquidity will be penalised by negative rates. The introduction of negative rates may also entail more active use of macroprudential tools as regulators look to manage the consequences, which banks may therefore need to factor into capital forecasting.
Key questions to consider include:
- Is the bank’s risk appetite framed in a way that can accommodate the novel pressures of negative interest rates? For instance, how will the additional squeeze on margins feed into ‘search for yield’ behaviour?
- How would changes in customer behaviour flow through to important regulatory metrics such as the liquidity coverage ratio?
- How would the bank manage the strategic challenges of squeezed margins with regulatory pressure to maintain lending?
Conduct risks may also be created by a negative interest rate environment. UK banks will need to be mindful of how negative rates might interplay with the FCA’s conduct of business expectations around good customer outcomes and customer vulnerability. There are also potential reputational risks of passing on negative rates to customers. It may be the case that many UK banks determine categorically that they will not look to pass negative rates on to (retail) customers, in which case conduct risks of various kinds may be reduced. However, countries such as Denmark and Sweden did indeed see negative rates get passed on to retail customers in various ways (e.g. through negative savings rates), and banks may want to work through the potential implications.
Negative rates will in any case – as with any interest rate cut – entail the need for product repricing, and banks will need to consider which customers and product types will be affected, and ensure that outcomes are fair and consistent. Furthermore, banks may want to revisit the terms and conditions of some of their products where those T&Cs were not drawn up with the possibility of negative rates in mind. There is also a possibility that negative rates will increase customers’ risk appetites (because of the low/negative cost of borrowing), and banks will need to remain vigilant to the possibility of customers taking excessive investment risks in search of returns.
One way banks may look to mitigate margin pressure is to increase fee income to compensate for the erosion of their interest income. Increased fees have been observed in other markets experiencing negative rates, but the ability to increase fees is itself dependent on the products that a bank provides. Banks will also need to think through the potential conduct risk implications of fee increases, and be mindful of the FCA’s general concerns in recent years around transparency and fairness of fees (for instance in connection with packaged bank account, and overdraft fees).
Key questions to ask include:
- What would the conduct risk implications be of increasing fees across different customer and product types?
- Are there any latent conduct risks created by product T&Cs that need to be addressed?
- How would the bank communicate the impact of negative rates to customers in a clear and concise way?
- How will the bank mitigate any risks associated with increased customer risk-taking?
‘No regrets’ actions
The PRA letter to CEOs provides an immediate impetus for banks to engage with the implications of negative rates, and only a month in which to provide a response. More generally, negative rates are now sufficiently plausible for the UK market that banks should understand what they would need to do to implement negative rates - and the consequences of doing so. In the near-term there are a handful of ‘no regrets’ actions banks can undertake to determine their readiness:
- Review IT capabilities to determine whether systems can accommodate negative interest rates (e.g. in Finance to reverse interest charged and received). If not, work to understand the scope and scale of any remedial work.
- Review models (e.g. risk, pricing) to determine whether they are geared to operate with negative rates. Again, identify the scope and scale of remedial work. Consider whether any remediation work can be factored into existing model development or review plans.
- Review risk appetite frameworks to determine whether these are set up to accommodate the unique pressures of a negative interest rate environment, and ensure they remain useful tools when considering strategic options.
- Review product terms and conditions in order to understand whether negative rates would pose any challenges (for instance, if there are restrictions on the ability to pass on a negative rate), and consider any related need to contact customers.
- Carry out product re-pricing scenarios to determine the potential impacts of passing through negative interest rates to different customer segments and product types, and the capacity of the bank to generate fee income. Ensure this work is suitably informed by an awareness of both prudential and conduct risks.
- Ensure the board and senior management are well briefed on the issues, including having an overview of how interest rate pass-through is being factored into different products and customer segments, in order that they can take a view as to whether the overall approach is leading to good customer outcomes.
For a negative Bank Rate to be effective as a policy tool, the financial sector – as the key transmission mechanism of monetary policy – would need to be operationally ready to implement it in a way that does not adversely affect the safety and soundness of firms.