The Covid 19 crisis calls for radical thinking. Health, business, government and finance have had to think laterally about options available to them to fight the outcomes of Covid 19 and the impact from the decisions taken to cope with the virus.
One item that has raised its head is the prospect of negative interest rates. In this blog I will talk a little bit about negative rates, whether they will happen and what that might mean for borrowers.
What are negative interest rates?
A negative interest rate is where the lender pays the borrower for their loan. For example, you have a $1,000,000.00 loan from the bank on a negative interest rate of 1% then the bank would pay you $10,000.00 p.a. to have that loan with them.
Negative interest rates would be set by the Reserve Bank of New Zealand (RBNZ) in the form of the Official Cash Rate (OCR). They would lower the OCR, currently sitting at 0.25% below 0%. The OCR is the rate at which the RBNZ either pays or charges banks to deposit or borrow money with the RBNZ. It is therefore a direct factor in the cost of borrowing for consumers as it makes up part of a banks cost of funds.
By setting the rate low (or negative) the central bank is encouraging banks to lend money. Why not get 1% lending money rather than pay the central bank 0.25% to hold the cash on deposit for you. It is a strategy to encourage spending and economic activity & inflation.
Negative interest rates carry some risks. Firstly, is the erosion of bank margins. The banks end up with interest rates closer to 0% (emphasis on the closer not negative) whilst are required to continue to hold capital against loans (which is more costly) to offset the risk of those loans this results in lower margins. This may lead to banks taking on riskier loans (not always good) and higher fees.
Greater risks if unchecked could cause systemic issues in the banking system. Banks charge more for riskier loans. Erosion of margin and negative rates may prompt them to take riskier loans to chase better margin. If margins are low, banks may seek to make up the lost profitability through fee income.
Secondly, banks may seek to pass that cost onto their depositors through negative margins on savings accounts (i.e. a storage charge to have money in the bank). Risks here are threefold, the first the cost to actually saving money, never a good thing. The second is that it may cause a run on banks as people seek to withdraw their money (your mattress doesn’t charge any fees!). The third is an asset bubble as people seek a hedge against the costs of holding capital in the bank and funds flow into assets.
Will negative rates happen?
A recent NBR article warns that negative rates may be coming soon. The article refers to a recent meeting in which “The rhetoric from the Reserve Bank to the registered banks is to get their affairs in order a lot quicker than maybe they have been.”. which may indicate they might come about.
Personally I don’t think we will see negative rates in the near term and that the RBNZ is likely to shift to 0% and watch to see the outcome and movement in the economy. I think (see below) the Reserve Bank will consider that it is unlikely to have a great effect on the lending policies from the major banks and therefore the market in general.
What would they mean for borrowers?
Let’s assume we get a negative OCR, what does that mean? I have touched on this above, a negative OCR will not lead to negative interest rates for borrowers in New Zealand. Each banks cost of funds is made up from a variety of sources additional to the Reserve Bank effectively giving a floor to interest rates.
Banks will be seeking margin on their lending and won’t be willing or able to squeeze this too much. I would expect to see a floor on interest rates around 2% (a lot lower than they are now) and higher for riskier assets.
I suggest that this won’t have a huge impact on the lending policies of the banks across NZ. As has been seen with LVR restrictions removed and the lowering of the OCR to 0.25% banks have retained and in some cases tightened their lending policies in response to C-19. Over the next 12 months I don’t expect this to loosen significantly (if at all) even if we were to see negative rates. Market risk is what will be driving lending appetite for the near future.
The one positive we might see if negative rates occur is the development and growth of the non-bank sector in New Zealand. The availability of credit in New Zealand outside of the traditional big 5 banks is slim and it may be with a negative OCR, low borrowing costs and negligible savings rates there might be growth in the non-bank sector in NZ.
We were starting to see this pre-Covid-19 with organisations such as FMT seeing substantial growth in their deposit (and therefore lending) books over the last 36 months as savings rates fell. Banks have also been shifting their risk off balance sheet to non-bank lenders lowering their overall returns but ensuring they continue to have exposure to riskier assets. Negative interest rates will if nothing else expedite this process as banks and consumers look for ways to continue to put their capital to good use whilst retaining higher returns.