The Committee on the Global Financial System (CGFS) mandated a Working Group co-chaired by Ulrich Bindseil (European Central Bank) and Steven B Kamin (Federal Reserve Board of Governors) to identify and provide evidence for the channels through which a “low-for-long” scenario might affect financial stability, focusing on the impact of low rates on banks and on insurance companies and private pension funds (ICPFs).
Interest rates have been low in the aftermath of the Global Financial Crisis, raising concerns about financial stability. In particular, the profitability and strength of financial firms may suffer in an environment of prolonged low interest rates. Additional vulnerabilities may arise if financial firms respond to “low-for-long” interest rates by increasing risk-taking. The study resulted in a report which presents the Group’s conclusions about whether prolonged low rates induce fragility in the financial system because of repercussions on banks and ICPFs.
The first message is that while banks should generally be able to cope with solvency challenges in a low-for-long scenario, ICPFs would do less well. Banks can undertake a number of adjustments to shield profitability from low rates, whereas ICPFs are characterised by negative duration gaps that make them vulnerable to falling interest rates.
The second message is that even though the Working Group identified only a relatively limited amount of additional risk-taking by banks and ICPFs in response to low rates, a low-for-long scenario could still engender material risks to financial stability.
For example, even in the absence of greater risk-taking, a future snapback in interest rates could be challenging for financial institutions. Banks without sufficient capital buffers could face solvency issues, driven by both valuation and credit losses. ICPFs, instead, could face liquidity problems, driven either by additional collateral demands linked to losses on derivative positions or by spikes in early liquidations.
The adjustment of financial firms to a low interest rate environment warrants further investigation, especially when low rates are associated with a generalised overvaluation of risky assets. I hope that this reports provides both a sound rationale for ongoing monitoring efforts and a useful starting point for future analysis.