A new report from PwC has outlined how banks and lenders should prepare for the possible introduction of negative interest rates. In the report, PwC says that "noises from the Bank of England suggest the chances of it dropping its base rate below zero have gone from “don’t count on it” to “anything’s possible” and for banks, that’s a big deal.”
PwC says there is a "very real prospect" of negative interest rates (NIR). Following the most recent policy announcement, the Governor told the media that the BoE’s Monetary Policy Committee was “assessing the case for negative rates in this country”. Minutes of an 18 June meeting show some Committee members want the Bank ready to cross that bridge in the event of a second wave of Covid-19. Meanwhile in the markets, traders appear to believe a further drop in rates is possible; in May, money-market contracts linked to the BoE’s policy rate in 2021 entered negative territory, reflecting investor expectations that rates could fall below zero.
PwC argues that "should the global trend towards lower, and even negative, rates continue, it is hard to imagine the UK standing alone in resisting". It says that for banks and their boards, NIR is far more than just a ‘tail risk’ or topic for crisis planning. Instead, "it is a likely possibility under many plausible scenarios in the short and medium term. They must plan accordingly".
The report says that "there is a ‘Y2K’ aspect to being ready for negative rates", as an enormous number of models, reporting systems, contracts and processes were designed by people who believed interest rates could only ever be positive. PwC says it potentially includes every major area and system in the bank – front office, back office, customer communications, documentation and contracts – and every category of risk.
Residential mortgages make up a large proportion of the balance sheet for every major UK bank, and PwC says a move to negative nominal rates could "profoundly change the operation of the housing market".
In 2019, Danish bank Jyske became the first bank to offer a 10-year mortgage at negative 0.5% (not counting charges and fees), with other Scandinavian banks announcing plans to follow.
Jyske earns income from issuing mortgage-backed covered bonds, so needs mortgages to issue them. Danish mortgages are a safe store of value, cost 0.25 bps less than reserve deposits, and the spread to the negative bond rate still allows them to earn a profit, plus fees charged for services to the borrowers with whom they establish or maintain a relationship.
However, given the importance of regular payments, PwC says a negative mortgage rate may be incompatible with an interest-only mortgage, unless there is a significant monthly fee. As a result, interest-only borrowers may find their monthly payments go higher if required to transition sooner than expected to principal and interest.
PwC also urged banks to consider how negative interest rates were going to work in practice, asking: "For pricing, should a negative rate be offered as a payment, or a reduction in principal? How would one treat an offset account? Can institutional and corporate customers be charged more than consumers and small businesses for deposits, given their more limited options?"
It also said lenders should consider how they would support customers likely to be especially vulnerable in a scenario of low to negative rates such as insurers, pension funds and asset managers. Additionally, it noted that anti-money laundering may require a different allocation of focus in a world where one pays to deposit but can get paid to take out a loan. PwC says there are three steps to prepare for NIR: ensuring readiness, getting fit to compete, and positioning to thrive.
A NIR-driven cut in interest income would elevate the importance of fees and other non-interest income. This will be less of an issue for the largest UK banks, who already generate more than half their income from commission, fees, trading and other non-interest sources. But for mid-tier and challenger banks, and even more so for building societies, PwC says changing their income mix "will require the more rigorous application of traditional disciplines such as pricing, segmentation and value articulation to non-lending services".
In its conclusion, PwC says: "In the post-Covid-19 environment every customer will be facing their own challenges. Given banks’ natural advantages in balance sheet and cash flow management, it’s an opportunity for them to bring creative solutions to customers which could be extremely valuable.
"As inflation expectations, return expectations, and interest rates continue along their current trajectory, more and more markets are confronting the fact there is nothing impossible about negative rates. They will have profound – and in many cases destabilising – effects on banks and other institutions who are not prepared. Those who are best prepared will find the next era as full of opportunity as the ones gone by."