We’re Living in a Low Interest Rate World

Global and national events have resulted in interest rates trending downward over the past decade, says Dr. Patrick Honohan, the Central Bank of Barbados’ 4th Distinguished Visiting Fellow. Honohan, a former Governor of the Central Bank of Ireland, was speaking during a presentation to the staff of the Financial Services Commission (FSC).

First addressing the global trend, Honohan said that several factors had contributed to low interest rates, including overall saving and investment trends, low inflation, and deliberate efforts by central banks to jumpstart economic activity and to raise inflation to the desired level. He explained that when interest rates are low, it creates an incentive for investors and developers to borrow to finance projects and can induce the public to spend rather than save.

Honohan used the example of the United States of America and Germany as examples of countries where interest rates were deliberately driven down in the post global crisis era, noting that in Germany and other Euro-area countries there have even been negative interest rates, which means that customers were essentially paying banks to store their money. Honohan went on to reveal that when short term interest rates cannot be set any lower, central banks sometimes engage in quantitative easing, the practice of buying government securities so as to bring down the overall interest rate as well as to bring inflation back up to target.

The former central banker went on to explain why interest rates in some countries are much higher than what is typical now. In those countries, he said, perceived exchange rate risk or credit risk drive up interest rates. Returning to the euro area, Honohan detailed how, in the pre-common currency era, the potential for fluctuations in the exchange rates of national currencies resulted in countries having to pay higher interest to attract investment, and then how the perceived possibility of default during and after the European financial crisis had the same effect.

Moving on to the topical issue of wide interest rate spreads – the disparity between the interest paid on deposits and the interest charged on loans at banks and other financial institutions – Honohan identified four reasons that these occur. The first is credit risk. When banks have concerns about the potential for higher than expected levels of default, they often charge higher interest on the money they lend as a cushion against losses from non-performing loans.

The second cause relates to banks’ operating costs and their ability to generate the kind of profit that makes doing business worthwhile. Honohan noted that this is especially true in small economies, where banks, particularly those with headquarters in larger countries, have significant operating expenses but not the benefit of economies of scale. For these banks, while the difference in percentage might be substantial, the actual value is small relative to what is collected in other jurisdictions where the bank operates.

Honohan acknowledged that sometimes wide interest rate spreads are simply due to a lack of competition. Admitting that this assertion is difficult to prove, he said that when banks know that customers have few options for where to put their money, they recognise that they can pay less interest and charge more for loans without the threat of losing business.

Finally, he believes that cross-subsidization can play a role. When banks are involved in other lines of business that are less profitable, charging a premium for borrowing while paying low interest on deposits can become a means of recouping any losses.

Honohan told the audience that concern about wide interest rates spreads is universal and that suggestions have been put forward that governments or central banks should put a cap on the interest banks can charge for loans. He noted, however, that such a policy could discourage banks from setting up business as it automatically limits their potential profitability.

Asked about whether central banks should set a minimum savings rate to prevent banks from paying only negligible interest, Honohan reiterated that interest rates are very low the world over, then pointed out that such a policy could have a similar effect to the earlier proposal that there be limits on how much customers should be made to pay for loans. He concluded his presentation by saying that any prescribed minimum savings rate would need to be “in keeping with reality” or the jurisdiction would not be seen as profitable.

2017-03-29