Fly You Fools! The Unintended Consequences of the Negative Interest Rate Policy

The aim of this doctoral thesis is to study the recent use of negative interest rates focusing on the impact that the negative interest rate policy (NIRP thereafter) has on bank profitability, lending and sovereign bond holding. After providing a definition and contextualisation of NIRP, this thesis addresses three different research questions. The first research question will focus on the impact of NIRP on bank profitability and consequently on financial stability. A cut in interest rates into negative territory may increase bank profitability if there is significant loan growth and margins are unaffected, or/and if banks boost fee and commission income on the back of greater lending. However, if banks are unable to reduce deposit rates to the same extent as loan rates then margins will be compressed, and if there is limited loan growth and/or cross-selling of fee and commission services then profits will likely fall. If the latter is the case, the decline in profits can erode bank capital bases and further limit credit growth thus stifling NIRP monetary transmission effects. The first paper addresses this serious concern. It examines whether or not, after the introduction of NIRP, banks margins and profits have been negatively affected. Furthermore, it investigates if negative rates have promoted a change in bank business model. The contraction of net interest margin could have affected banks business model promoting a switch from interest-based to fee-based activities. The second paper is strongly linked to the first. If NIRP decreases banks profitability eroding capital base, banks may be reluctant to lend limiting monetary policy potential and expected outcome. The second research question addresses this point. It tries to capture whether or not after the implementation of NIRP banks increased or decreased lending in comparison with a control group who has not been affected by negative rates. The effect of NIRP on bank lending may further be aggravated in the European context where banks have been facing slow economic recovery, historically high levels of non-performing loans, and a post GFC and European sovereign debt crisis deleveraging phase. In this economic environment, banks could have employed the excess liquidity provided by central banks unconventional monetary policy measures to buy corporate and government debt securities rather than lending. This behaviour links to the third research question. 7 The third research question investigates banks sovereign bond holding during the low and negative interest rate environment that has characterised the period after the 2007/2008 Financial Crisis and European Sovereign Debt Crisis. In such a situation, banks may prefer to hold sovereign bonds rather than lending for the following reasons. First, prudential regulation favours sovereign debt over loans as it assigns neither capital charges (zero-risk-weights) nor portfolio concentration limits. Banks with low capital ratio may increase return on equity by shifting from low to high yield sovereigns without altering regulatory capital requirements. Second, in a period with slow economic recovery, historically high level of non-performing loans, increasing loan loss provisions and low interest rates, sovereign debt can act as a substitute for credit affecting banks’ lending decision. The same reasons, as previously described, can negatively affect bank profitability suggesting that banks may have an incentive to purchase high yield sovereign debt securities to improve profitability conditions (carry trade hypothesis)