From low to negative rates: an asymmetric dilemma

With the expansionary monetary policy in several European countries continuing, the low interest rate environment is being increasingly replaced by a negative interest rate environment. We estimate a panel model to study the effects of prolonged low interest rates on banks in Austria. It shows that the profitability of banks declines in times of low interest rate environments. However, we are skeptical of extrapolating these findings to the negative environment. In a negative environment banks face an asymmetric dilemma: While the returns on many assets follow the decreasing reference rate (e.g. EURIBOR), costs of deposits are floored at zero and cannot follow this rate. In order to include this crucial nonlinearity and to estimate which banks are expected to suffer most, we amend our approach and employ an ARIMA model on a bank-by-bank basis. First, we find that small regional banks are hit hardest. These banks have a high share of deposits and are more sensitive to changes in the reference rates. Second, by only looking at data covering low interest rates (e.g. our panel approach) one would indeed underestimate the impact of negative rates on banks’ pro?tability. Third, we ?nd that a reference rate close to –2% would pose a substantial burden on banks’ profitability. The approach assumes little adaptation of banks to these extreme environments and therefore highlights the importance of banks’ adequate and timely reaction should interest rates continue to be negative.