ECB Research Bulletin: Further Easing of Loose Monetary Policy Can Hurt Banks
14 October 2021
By David Barwick – FRANKFURT (Econostream) – When monetary policy is very loose, further easing can pose threats to financial stability by harming banks more than it helps them, according to a research bulletin published Thursday by the European Central Bank.
The model presented in the bulletin proceeded from the assumption that low policy rates cut into bank profits via narrower interest margins as cash becomes more attractive, but at the same time leads to an appreciation of long-term assets owned by banks such as loans and other securities, which continue after policy easing to earn at the previous, higher interest rates.
Beyond the so-called tipping point at which the two effects precisely offset each other, further monetary easing would be harmful to banks; according to the bulletin, a US policy rate of 0.55% in August 2007 represented the tipping point.
‘Past the tipping point, an interest rate cut has a negative net effect on bank capital and may indeed result in bank insolvency’, the bulletin said.
When interest rates are normal, the positive, revaluation effect is greater, so that limited policy easing is positive for banks, the bulletin said. ‘However, the further the policy rate falls, the larger the adverse effect on the deposit franchise becomes.’
Determining the tipping point using the model presented can be done with a small number of observable variables, including banks’ interest margin and the average time to maturity of bank loans and other securities held by banks, according to the bulletin.
The bulletin made clear that ‘it would be wrong to attribute the value of 0.55% to the euro area or the United States today’, given different economic fundamentals.