Denmark, Japan, Sweden, Switzerland, ECB
Bhaskar Vijay Singh
EY Consulting Director | Financial Services specialist with a focus on Private Banking and Wealth Management | Business-led, Tech-enabled Transformation
What does Denmark, Japan, Sweden, Switzerland and the European Central Bank have in common? These economies house half a billion people (or a quarter of the world’s GDP) and are currently enduring a prolonged season of central bank interest rates that go below zero.
The what…
Negative interest rates. As an economic concept, this one is a biggie, and equally tough to wrap your heads around. This is like an alternate bizzaro universe where depositors have to pay and borrowers get paid. All classic theories of finance, economics and human behaviour seem to break down as almost all theories assume that the investors are rational human beings and expect a positive reward for the risks they undertake.
So what are the central banks smoking! As the world recovered from the overhang of the 2008 financial crisis, many advanced economies were left battling deflation, unemployment among other economic ills. Almost all conventional theories were tried to no great avail. With central banks cornered, they had to depart from the norm and try out the untested.
… and the why
When you want to spur growth and revitalize the economy, the one thing that you want foremost is to incentivize borrowing for productive (and unproductive as a side-effect) purposes. Negative interest rates reduce interest rates for both wholesale and retail customers and thus drive up the demand for loans and advances.
With negative rates, the risk always is that the policy may prod the depositors into holding onto their money. After all, what is stopping depositors from putting their money under the proverbial mattress or the good old safe. To prevent this scenario, some banks may be driven to absorb the costs of negative rates themselves, pinching their profit margins in the process. There are also some concerns which link negative rates to propagating currency wars. These scenarios present a very real risk of bank-runs and banking sector health.
Central banks’ rationale aside, why would an investor want to invest in an asset with a negative return, say, Germany’s 10-year bonds which were recently auctioned at negative yields for the first time (although by any calculation, there are currently over $8 trillion in negative yielding bonds in the world).
The typical range of rationale listed behind investing in such guaranteed-lossbonds are:
- Yields may go down further into the negative territory, enabling current investors to turn a profit from their investment
- As negative rate economies are suffering from deflationary pressures, real yields (post inflation adjustment) may turn up positive for such investors
- Regulatory prescriptions mandate most financial institutions to balance their portfolios with sovereign bonds, hence, so as to maintain regulatory compliance, some banks may not have an option to not invest in such negative yield bonds
- Preferable forex movements may result in positive returns for some foreign investors. For example, if Country A’s bonds have a higher yield than Country B’s negative yield bonds, but investors expect Country B’s currency to appreciate in value relative to Country A’s currency, investing in Country B’s bonds may result in higher returns.
- Safe haven investing. Investors from turbulent markets (and emerging economies) may want to pay the negative-rate tax to invest in bonds of European giants such as Germany
An alternate way to understand a negative yield asset is by comparing it with an insurance product (imperfect analogy but sort of makes sense). Insurance is an asset with an expected negative interest rate. Why do you buy insurance? You are paying money to the insurance company, which uses most of this money to invest on its own behalf. Seems like a raw deal! But you accept an expected negative interest rate for insurance as it pays off big when you need it the most (you may get a fat check from your insurer when you total your car).
Beyond macro
Once you begin to grasp the overall macroeconomic overview of negative interest rates regime, you are ready to dive into the convoluted mess of operational hazards. Talking to practitioners, the challenges can be bucketed into one of the three categories. 1) quantification issues, 2) legal issues, and 3) system issues
Quantification conundrum
Quantification (or modeling) issues are one of the more interesting challenges that negative rates bring to the fore. Negative interest rates tend to create chaos with established financial formulae and literature. Once the interest rates dip into negative territories, many finance textbook formulae produce results that are outright incorrect. Although, broadly speaking, finance theory requires only prices to be non-negative, so theoretically interest rates can dip as low as -100% (before prices turn negative).
Professor Jayanth Varma highlights these issues in his blog post on the topic.
Let us take a look at how many textbook results are no longer valid in this world:
· The formula for the present value of a perpetuity PV=1/r yields the absurd result that the present value is negative when r is negative. In fact, the present value is infinite (the geometric series diverges for negative r).
· Interestingly, the formula for a growing perpetuity PV=1/(r?g) is still valid under the text book assumption that r>g. But this requires negative g in a negative rates world. That is why the 1/r formula for the zero growth case fails.
· It is no longer true that the modified duration of a bond is slightly less than the duration; with negative rates, the modified duration of a bond is slightly more than the duration. Modified duration is given by MD=D/(1+r); if r is negative, the denominator is less than unity and the ratio is therefore more than the numerator.
· Negative rates have not so far generally translated into negative coupons. For example, the Swiss Government and German Government have sold bonds with non negative coupons at a premium to par to achieve negative yields. If this trend continues, then in a negative rates world, there will be no par bonds and no discount bonds, and the concept of a par bond yield curve becomes problematic.
· Over a period of time, probably negative coupon bonds will emerge. Warren Buffet’s Berkshire Hathaway sold a convertible bond with a negative coupon way back in 2002. With negative coupons, it is no longer true that the duration of a bond cannot exceed its maturity. It is also not true that for the same maturity, the zero coupon bond has the longest duration. For example, a simple calculation shows that a ten year par bond with a ?1% coupon and a ?1% yield has a duration of 10.47 years.
One common but wrong simplification is to simply set the negative rate in question as zero. Generally speaking, key impact is on products that require implicit lognormal distributions. Here, two solutions are possible:
- Use a model that implies just normal distributions. The disadvantage is, however, that the “real” or empirical distribution is probably not symmetric since it’s very improbable that interest rates ever become e.g. -5%. Hence, this approach makes sense only for short horizons.
- Another possible solution is by using shifted lognormal models. Here, the distribution is “shifted” by a certain parameter. This solution is normally used by financial institutions today. However, the main disadvantage is that a new variable?—?the shift parameter?—?is introduced. An explanation of the models can be found here.
For exotic derivatives, some new models may have to be developed which fully captures the effect of negative rates. Negative interest rates do affect vols which were traditionally quoted as lognormal (model traditionally used was Black76) but today more are quoted as normal or shifted lognormal. Additional problems can also occur with time series (which often don’t provide negative interest rates) or stress tests (which are often no longer real “stress” tests since reality became more extreme).
Legal lasso
Legal issues arise from the fact that the standard legal contracts (such as the GMRA, CSA, ISDA, etc.) have been drafted under the implicit assumption that the rates would only ever be positive.
For instance, when repo rates are negative, issues bubble up. Where parties have agreed to use a repo rate as the interest rate to be paid on cash margin, a negative repo rate creates a perverse incentive to the seller to fail to deliver collateral on the purchase date. Disagreements between parties, due to the novelty of negative interest rates in general, over the interest rate to be paid on cash margin are not uncommon. Hence, standard contracts are evolving to address the new reality of negative rates, and it will be some time before most legal issues are resolved.
Technical tango
Most banking software was conceptualized and written in an era when negative rates couldn’t be envisioned. As a result, most systems have a hard-coded impediment when implementing negative rates. Most systems require a thorough source code level review to remove all instances of useless validation checks which prevented the input of negative rates even when the processing engine (or models as talked about earlier) was smart enough to handle them. Other niggling issues may also spring their heads once the system starts getting fiddled at a fundamental level.
However, compared to the other issues, technical challenges would be trivial to overcome. Most of the impact of negative rates is concentrated across a few trading centers of any financial institution, and the number of such trades also very manageable, at least for now. It may be another ball game if banks start passing down the negative rates to the retail/ wholesale depositors as then all core banking software architecture may have to be tweaked.
Parting notes
The negative interest rate experiment is nearing two years, and most central bankers will tell you that it is still a little too early to tell if the experiment will work or not. The broad consensus among central bankers (and finance ministers) seems to be that the experiment has not spiralled out of control yet and the costs have been well within the breaking point.
As far as the economic pundits are concerned, jury is still out if the negative rate experiment is the evil-est social experiment. Depending on who you read and follow, commentary is mostly along the lines of negative rate regime is bound to fail; it will lead economies into a vicious cycle of rate wars; or desperate times call for desperate measures.
The Bank for International Settlements warned in a March 2016 report of “great uncertainty” if rates stay negative for a prolonged period. However, the fact that such tools have now been tested means they’re likely here to stay.
DISCLAIMER: This is a personal post. The opinions expressed represent my own and not those of my employers, past or present.