Mar 17, 2020
Is it time for banks to evolve their strategies for a world in which rates are consistently at - or below - zero? For over a decade banks have been grappling with how to generate returns in a low interest environment – while waiting for an increase in rates to provide relief. But if there was any doubt before this month, the impact of coronavirus (COVID-19) on the global economy and the Bank of England’s (BoE) emergency rate cut - and an even more drastic move by the US Federal Reserve, taking its benchmark rate to near zero – has eliminated all hope for a tightening of monetary policy in the near future.
Even prior to this coronavirus outbreak, it appeared that low interest rates were here to stay. The EU, Switzerland, Japan, and the Nordics each took their rates negative in the past five years. Contrary to prior speculation, a recent European Central Bank whitepaper proved that conventional monetary policy does remain effective below the zero lower bound. This won’t have gone unnoticed by the BoE.
Low rates are less of an issue in wholesale markets, where the European experience has shown corporate clients are willing to accept negative rates on their deposits. And in the private banking market, prominent European providers have begun passing on negative rates to high net worth clients, with the dual benefit of improving net interest margins (NIMs) and channelling clients towards fee-generating asset management products.
The bigger challenge is in the retail market, where banks have resisted passing on negative deposit rates. However structural reform is driving intense competition in mortgage lending and compressing margins. Many banks are struggling to turn a profit, let alone cover their cost of capital – a challenge UK banks also contend with even with interest rates in positive territory.
It seems clear the current approach is unlikely to provide acceptable returns in the long term. So how should banks transform their strategies to ensure their sustainability in this environment?
One ‘no regrets’ move for all banks is to renew and heighten their cost focus, freeing up capital to reinvest in digitising and automating functions. Even when rates eventually rise, the industry will have fundamentally changed, and margins banks previously enjoyed are unlikely to return.
Banks could improve how they use data to recommend products to existing customers – in an appropriate and responsible way. This would unlock additional revenue with lower acquisition and overhead costs. In doing this, banks should take a hard look at their current income mix, identify opportunities to diversify away from NIM, and grow products with low capital intensity (e.g. wealth management and advisory). This may even entail exiting mortgage markets – either partially, or entirely – as some retailer-owned banks have done.
But for larger banks, and particularly those with well-developed wholesale businesses, there may be another answer. In 2019, Danish-based Jyske bank launched a negative interest rate mortgage, a world first. This is possible because rather than relying on retail deposits, the lender accesses funds from wholesale money markets.
In this model banks do not rely on interest margins to make a profit. Instead they focus on generating revenue via origination and administration fees – effectively acting as brokers – while issuing covered bonds at low or negative rates.
Understandably, UK bankers who witnessed the 2008 financial crisis and the collapse of Northern Rock may be justifiably wary of this and similar models. But post Basel reforms, large UK and international banks of today – with diverse balance sheets and deeper liquidity pools – are better positioned to utilise covered bond issuances, securitisation, or forward flow programmes (to institutional funds) than the versions that helped cause the 2008 crisis.
If the BoE does push rates even lower, a rebalancing towards those types of models may become an increasingly attractive option. In fact, if margins in the mortgage sector continue trending downwards, it may be one of the few options banks have left.