The International Monetary Fund has expressed fears that persistently low interest rates pose a threat to the global financial sector. In a new study, the IMF warns of struggling banks taking more risks and the demise of final salary pensions.
The IMF said a period of prolonged cheap borrowing costs would “present 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 United States, the IMF said Japan’s experience suggested an imminent and permanent end to the current low interest rate environment could not be guaranteed.
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, in a chapter from its forthcoming Global Financial Stability Review, 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”.