The interest rate cut by the Swiss National Bank (SNB) is not complete, and it is entirely possible that we will have to deal with negative rates again soon. After a first text last week, this second article shows that if Swiss banks have suffered pressure on their margins, they have adopted strategies to cope with it. Furthermore, negative rates reflect deeper developments and alternatives are not necessarily more attractive.
Impact on Swiss banks
Danton and Jokipii (2024) look at the situation of 93 Swiss banks, focused on the domestic market, and show a contrasting situation. When the interest rate is positive, a reduction in the SNB rate increases the banks’ interest margin, but the opposite occurs once it moves to negative rates. This asymmetry is more marked among banks financing themselves more through deposits, and with a lower share of mortgages in their assets. However, we should not extrapolate the interest margin situation to profitability as a whole – measured by return on assets – which is not sensitive to the interest rate.
Banks facing pressure on their margins have reacted in several ways. They have increased the maturity of their investments, thus taking a greater risk of exposure to future rate movements. If this trend is observed for all, it is particularly marked for those facing greater pressure on their margins. A second strategy was to increase the share of mortgages, especially for banks initially less present in this segment. Finally, banks financed heavily by deposits have limited their growth.
Analyzes show that negative rates are a tool that works, perhaps with a reduced effect, but which leads to risk-taking. They must therefore be accompanied by a vigilant policy regarding financial stability tools.
Given these side effects, one might be tempted not to want to resort to negative rates. But we need to understand why we are in this situation, and what the options are.
A special situation
The presence of negative rates is a consequence of deeper developments. A starting point is to estimate the interest rate that would prevail in the absence of inflation and in a balanced economy.
The BNS has published an estimate of this rate, called “r*” in the graph below (Jordan 2024). While the estimate unsurprisingly includes a margin of error, we see a clear downward trend, with the value currently close to zero. An approach based on the Confederation yield curve leads to a similar observation. This downward trend reflects several structural factors, such as the aging of the population and the appetite for risk-free investments in francs.
The second step of the reasoning is to evaluate the nominal equilibrium rate by adding to these values that of long-term inflation. If we take the middle of the SNB’s target range, we arrive at a rate of 1%. The rate actually chosen by the central bank will fluctuate around this value depending on the economic situation. Consequently, the downward trend in the real rate r* shown in the graph translates into a similar trend in the nominal rate, and therefore a need to move to negative rates in bad economic times.
What alternatives?
Adopting a negative rate can be unpleasant, but then what is the alternative? In the Swiss case, it consists of substantial interventions in the foreign exchange market, with an increase in the balance sheet of the SNB. While this is technically feasible, the balance sheet is already high and fluctuations in exchange rates and markets lead to volatile profits for the SNB, as we have seen clearly in recent years. We could certainly live with it, but the fact remains that the alternative to negative rates also has problematic aspects.
Another approach is to compensate for the fall in the real interest rate r* by an increase in the inflation target. For example, if the SNB targeted inflation of 2%, in line with several advanced countries, the equilibrium nominal interest rate would be 2%, thus leaving more room before reaching negative rates.
References:
Jayson Danton, Terhi Jokipii (2024), «A decade of low interest rates: impact on Swiss bank profitability», SNB Working Papers 10/2024.
Thomas Jordan (2024), «The natural rate of interest (r*) as a reference point for monetary policy – a practitioner’s view», Keynote Speech at the 2024 Bank of Korea International Conference.
