A prolonged period of low interest rates will tempt banks to take greater risks and sound the death knell for final salary pensions, the International Monetary Fund has warned.
A new study from the IMF said a continuation of the cheap borrowing environment seen since the global financial crisis a decade ago would pose a “significant challenge” to financial institutions and force them to make fundamental changes to their business models.
Although interest rates have recently started to rise in the US, the IMF said Japan’s experience suggested an imminent and permanent end to the current low interest rate environment could not be guaranteed. Some economists, such as the former US treasury secretary Larry Summers, say the global economy is gripped by so-called secular stagnation, in which excessive savings and weak investment lead to weaker growth and lower interest rates.
The IMF, in a chapter from its forthcoming Global Financial Stability Review, said the decline in real (inflation-adjusted) interest rates since the mid-1980s had been caused by slow-moving structural factors such as weaker growth and the desire of an ageing population to save more for their retirement.
It was possible that the pace of innovation had slowed, while rising savings and an appetite for advanced-country financial assets in emerging nations had also put downward pressure on interest rates in the west over the past 15 years.
Japan has had ultra-low interest rates for almost three decades, while other developed countries cut borrowing costs aggressively in response to the deep financial and economic crisis that began almost a decade ago.
The Bank of England held borrowing costs at 0.5% for more than seven years before cutting them to 0.25% last August, the lowest level in its 323-year history. The European Central Bank has adopted a similar approach and its president, Mario Draghi, has said there would be no early rate rise for the eurozone.
The IMF said a low interest rate environment would hit the earnings of banks and pose “long-lasting challenges for life insurers and defined-benefit pensions funds”.
It added: “Smaller, deposit-funded and less diversified banks would be hurt most, which could increase the pressure to consolidate. As banks reach for yield at home and abroad, new financial stability challenges may arise in their home and host markets. These hypotheses are supported by the experience of Japanese banks.”
Life insurers and pension funds would probably need to raise more capital because permanently low interest rates would make it more difficult to make the returns needed to fund existing liabilities taken on when borrowing costs were higher.
The IMF said defined-benefit schemes – already under threat in many developed countries – would tend to become less attractive than defined-contribution schemes, where the risk is taken by the employee rather than the employer.
The study said ageing populations would mean a reduction in demand for credit but increase demand for health and long-term care insurance. Smaller banks would need to consolidate and policymakers would need to beware of calls for a softer touch regulatory regime.
“Prudential frameworks would need to provide incentives to ensure longer-term stability instead of falling prey to demands for deregulation to ease the short-term pain,” the IMF said.
It said efforts should be made not just to facilitate consolidation of smaller banks but also to “limit excessive risk-taking and avoid a worsening of the too-big-to-fail problem”.
The IMF’s view that low interest rates might be here to stay was challenged by the ratings agency Fitch, which said borrowers should prepare for a significant shift in the global interest rate environment over the next few years.
Fitch said it expected US real interest rates to increase to levels that were more closely aligned with the country’s economic growth potential, taking them close to pre-crisis levels.
“With the Fed having now achieved its inflation and employment objectives, becoming more focused on the risk of labour market tightening and starting to discuss the unwinding of its balance sheet, we expect interest rate normalisation will take place by 2020 and that the Fed Funds rate will reach 3.5% to 4%,” said Brian Coulton, chief economist at Fitch.
Markets currently believe the Fed will need to make only modest adjustments to official US interest rates in the coming years, with the Fed Funds rate unlikely to rise much above 2% by 2020. Fitch said it did not accept that there had been a lasting shift to a new equilibrium.
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