Explaining the Endowment Effect

In response to the negative economic impact of Covid-19 central banks globally have cut interest rates to record low levels. As a consequence, the earnings outlook for banks have deteriorated. Pressure on bank earnings are still expected over the next few reporting periods despite "the worst being behind them" in terms of impairments and provisions raised. This piece offers a high level overview of the endowment effect and its impact on bank earnings.

Low interest rates have a negative impact on net interest margins (NIMs)

A portion of banks’ retail deposit funding is on-call accounts that generally pay little or no return and are insensitive to monetary policy settings. A fall in interest rates tends to compress the lending margins associated with this funding because there is little room to adjust these on-call deposit rates lower.

Even on deposits paying higher interest, it is difficult to adjust these lower in-line with a cut in benchmark interest rates or lending rates since banks need deposit funding to cover their activities. Very low deposit rates may result in a move away from the bank and into higher-yielding instruments.

Furthermore, low interest rates tend to flatten the yield curve, which can be negative for net interest incomes, reflecting the fact that banks tend to borrow short term and lend long term.

But they are generally positive for non-interest revenue (NIR)

Under normal conditions, low interest rates can be positive for bank profitability. Evidence from the US, Europe, and other advanced economies suggests that low interest rates induce banks to shift from net interest income to non-interest revenue, including fee-based and trading activities. 

Borio et al (2019), using 1994-2015 data on 113 large banks in 14 advanced economies, estimate that on average each 100 basis points decline in the policy rate is associated with an increase in income from fees and commission of 0.93%.

Each interest rate decline also provides a one-off boost to asset valuations, which supports bank profitability. 

It also results in lower credit risk

Again - under normal conditions, a sustained period of low interest rates tends to lower credit risks, by reducing the debt servicing burdens for variable-rate and newly fixed loans. 

While low rates may encourage bank risk-taking on the flow of new loans, the effects of this on credit losses take time to materialise on the stock of lending. Therefore, low interest rates should reduce banks’ level of loan-loss provisions, which will support the profitability of the banking sector.

On balance?

Borio, Gambacorta and Hofmann (2015) looked at 109 large international banks headquartered in 14 major advanced economies between 1995 and 2012. They found a positive relationship between the level of short-term rates and the slope of the yield curve (the “interest rate structure”, for short), on the one hand, and bank profitability (return on assets) on the other. This suggests that the impact of the interest rate structure on net interest income dominates the impact on loan-loss provisions and on non-interest income. They also find that the effect is stronger when the interest rate level is lower. 

Bikker and Vervliet’s (2017) findings suggest that in the US a low interest rate environment impairs bank performance and compresses net interest margins. But they also show that banks tend to shore up their overall level of profits, due to lower provisioning, which in turn may endanger financial stability. 

In the South African case, the results are quite nuanced, but most banks seem to experience declining ROAs with declining interest rates. The data set is limited, however, and the significance of the results are therefore low. 

All this suggests that, over time, unusually low interest rates and an unusually flat term structure erode bank profitability. Economic pressure will in all likelihood offset the positive impact of lower interest rates on credit risk. Non-interest revenue will also come under pressure due to lower transaction volumes and a downturn in other activity.

Sources:

Bikker, J., and Vervliet, T. (2017). Bank profitability and risk-taking under low interest rates. International Journal of Finance Economics 23:1, pp. 3-18.

Borio, C., Gambacorta, and L., Hofmann, B. (2015). The influence of monetary policy on bank profitability. BIS Working Papers, No. 514.

Borio, C., Brei, M., and Gambacorta, L. (2019). Bank intermediation activity in a low interest rate environment. BIS Working Papers, No. 807.

The Reserve Bank of New Zealand. (2019). The impact of very low interest rates on bank profitability. Financial Stability Report, November 2019.