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Since the onset of the financial crisis in 2007, many central banks have implemented unprecedented standard and non-standard monetary policy measures, lowering key interest rates to approximately zero. To stimulate post-crisis economies characterized by low growth and low inflation, some central banks, including the European Central Bank (ECB), have even adopted negative policy rates. The rationale for negative rates is that they pro vide additional monetary stimulus, and in this way support growth and a return to target inflation.
Negative rates, by stimulating the economy, could be beneficial for financial institutions via an increase in loan demand, improved asset quality, and a reduced riskiness of loans. On the other hand, two main concerns have been voiced by critics of negative policy rates. First, negative rates could also put pressure on the profitability of financial institutions. Banks may therefore lend to riskier borrowers (‘risk shifting’). Second, a ‘search for yield’ among institutional investors could lead to a disproportional demand for high-yielding risky assets.
If so, the implied asset price inflation could impair financial stability.
Which types of banks are perceived by markets as more or less risky at negative rates is as yet unclear. In addition, it is currently unknown whether cuts to negative rates are ‘special’, for example because they imply a different financial stability impact than comparable cuts to low but non-negative rates. In this paper authors contribute to answering these questions. To do so, they study the risk impact as perceived by markets of three successive deposit facility rate (DFR) cuts by the ECB to negative values, each by 10 basis points (bps) on June 5, 2014, September 4, 2014, and December 3, 2015. Furthermore, they examine whether the impact of these cuts is qualitatively different from an earlier cut of the DFR from 25 bps to zero on July 5, 2012.
They focus on banks’ risks of being undercapitalized in a potential future stress scenario as measured by ‘SRisk’. SRisk is the estimated capital shortfall of a bank, conditional on a 40% drop in a world equity index over a six months-ahead horizon. The measure is modelled as a function of a bank’s equity market valuation, leverage ratio, the volatility of its stock price, and the correlation of its stock price with the world index. SRisk does not measure unconditional default risk, but instead mimics a market-based stress test. SRisk estimates are available for 44 listed euro area banks at a monthly frequency. To ensure a representative sample, and to include more banks in their analysis, they apply a matching procedure to infer SRisk for non-listed banks. Specifically, they match 67 non-listed banks to ‘nearest neighboring’ banks for which market data are available. The matching is based on accounting data, which are available for all 111 banks.
SRisk in the euro area falls markedly between mid-2012 and mid-2014, possibly initially sparked by the ECB’s announcement of Outright Monetary Transactions in August 2012 and subsequently driven by the gradual recovery in economic growth and improving bank capital buffers. Given pronounced variation in the level of SRisk for all banks, the impact of the three DFR cuts to negative rates is of a relatively small(er) magnitude.
Using panel regressions authors find that after a cut to an increasingly negative interest rate, some, but not all, banks are perceived as more risky, i.e., more prone to become undercapitalized in a potential future financial crisis. The risk impact depends on banks’ business models. Banks with sufficiently diversified income streams are perceived to be less (systemically) risky. Such banks appear to benefit in net terms from negative rates.
By contrast, banks that rely predominantly on deposit funding are perceived by markets as potentially more risky. The documented heterogeneity is in line with other studies that argue that bank characteristics become an important determinant of monetary policy transmission at negative rates.
Finally, a ‘placebo’ DFR cut from +25 bps to zero in July 2012 triggered different SRisk responses than the 2014 and 2015 cuts below zero. This suggests that cuts to negative rates may be ‘special’ in that they have a different financial stability impact than more conventional cuts to non-negative rates.
Their regression results remain qualitatively similar if only listed banks are included in the sample. The differential effects, however, become statistically insignificant in this case. The results for non-listed banks should therefore be taken as tentative.