"Low for long" rates threaten economic stability

by Paolo Taruc02 Aug 2018

Although low interest rates bode well for borrowers, a new study warns that Australia’s “low for long” approach could have negative implications on overall economic and financial stability.

A report published by the Committee on the Global Financial System (CGFS) of the Bank for International Settlements (BIS) claims the practice may even dampen the profitability and strength of financial firms.

The committee noted that the decade after the 2008 financial crisis has been marked by historically low interest rates across the world. While yields have risen across several economies, the paper‘s authors believe interest rates are generally expected to rise only slowly over the near to medium term, and to eventually stabilise below levels prevailing in previous decades.

To that regard, the paper identified several implications of a “low-for-long” scenario on financial institutions such as banks in both advanced and emerging market economies, and on insurance companies and private pension funds (ICPFs).

“A key takeaway is that, while a low-for-long scenario presents considerable solvency risk for insurance companies and pension funds and limited risk for banks, a snapback would alter the balance of vulnerabilities," said CGFS Chair Philip Lowe, who is also Governor of the Reserve Bank of Australia.

"The first line of defence against these risks should be to continue to build resilience in the financial system by encouraging adequate capital, liquidity and risk management. But the report also underscores the need to monitor institutions' exposures in a comprehensive way, including through stress tests," Lowe added.

With banks, for example, low rates might reduce resilience by lowering profitability, and thus their ability to replenish capital after a negative shock, and by encouraging risk-taking. Low interest rates also boost the present discounted value of both assets and liabilities of ICPFs.

Australia’s cash rate has been on hold for 23 months with the next RBA announcement due on August 7. Despite this, banks are under pressure to raise their own interest rates. According to data from Canstar there were around 170 out of cycle rate changes in July.


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