Wednesday, December 7, 2011

Dangers of Low Interest Rates: The Future of Banking #1

Thorstein Beck has edited an e-book for Vox on "The Future of Banking." It consists of 12 short and highly readable essays by expert economists, based on their academic research. The book is packed full of interesting and relevant analysis. This is the first of three posts on a few of the ideas that jumped out at me. The topics of the three posts are:

1) The dangers of persistently low interest rates
2) The misguidedness of a financial transactions tax
3) The rise of global banks in emerging markets 

The Federal Reserve and central banks all around the world dropped interest rates to rock-bottom levels. This step made good sense in the depths of the financial crisis from 2007 into 2009. But now it's late 2011, and the policy of super-low interest rates continues on with no end in sight. Such a policy isn't risk free.

One issue is raised by Steven Ongena and José-Luis Peydró in their essay: "Loose monetary policy and excessive credit and liquidity risk-taking by banks." 

"Recent theoretical work has modelled how changes in short-term interest rates may affect credit and liquidity risk-taking by financial intermediaries. Banks may take more risk in their lending when monetary policy is expansive and, especially when afflicted by agency problems, banks’ risk-taking can turn excessive. ...

 Our results in Jiménez et al (2011) suggest that, fully accounting for the credit-demand, firm, and bank balance-sheet channels, monetary policy affects the composition of credit supply. A lower monetary-policy rate spurs bank risk-taking. Suggestive of excessive risk-taking are their findings that risk-taking occurs especially at banks with less capital at stake, ie, those afflicted by agency problems, and that credit risk-taking is combined with vigorous liquidity risk-taking (increase in long-term lending to high credit risk borrowers) even when controlling for a long-term interest rate."

A similar point is made by the IMF in its Global Financial Stability report last June

Low interest rates in advanced economies are promoting pockets of re-leveraging by lowering the “all-in” cost of debt capital for corporate borrowers. This is encouraging investors to use financial leverage to generate sufficiently attractive returns on equity. Although credit spreads are still higher than before the crisis, ultra-low short-term interest rates mean that the cost of debt is now lower, both for floating-rate and fixed-rate debt. This lower cost of borrowing renders debt servicing ratios more favorable, even at higher debt loads, thereby enabling companies to operate with more financial leverage ...

As leveraged loan prices recover (after the deep discounts of 2008–2009) and yields fall, investors are increasingly turning to financial engineering to achieve double-digit returns. Both new and refinanced private equity transactions suggest that related corporate balance sheets are quickly approaching pre-crisis leverage multiples. Though the aggregate amount of financial leverage provided remains far less than before the crisis, high-yield corporate bond and leveraged loan investors have recently been borrowing at higher earnings multiples, not much below 2007 levels.

Notwithstanding recent market jitters, the “search for yield” is also spurring flows into emerging markets, notably corporate debt markets. These inflows, although volatile, are often magnifying already ample domestic liquidity. These conditions, if they continue, risk stretching valuations and raising worries that some countries could be re-leveraging too quickly. Flows into mutual funds for emerging market debt have been strong (behind only high-yield and commodities funds as a percent of total outstanding amounts). Even record amounts of EM corporate bond issuance cannot keep up with demand, and investor due diligence is waning.
Much of the discussion about the ultra-low interest rates seems to be based on an assumption that the only danger is a re-emergence of inflation, and as long as inflation is comfortably around the corner, then the low interest rate policy can persist indefinitely. But if the low-interest rate policy is promoting excessive leverage, tricky financial engineering, and a waning of due diligence in other assets, this set of risks also needs to be taken into account.

I would also add that when central banks use a combination of low interest rates and the "quantitative easing" policies where they purchase large quantities of government and private-sector debt, the central bank is setting up a situation where if or when interest rates rise, the central bank will face enormous losses on the low-interest rate financial assets they are now holding.