Negative interest rates are flipping the script for banks. Instead of paying interest to depositors, they might have to charge it; instead of charging for lending, they might have to pay out.
It’s a topsy turvy, crazy world and it’s the new reality in Germany, Switzerland, Denmark and Sweden, where some banks have taken their lead from the European Central Bank and set negative interest rates, and in Japan, where the central bank went negative in August, putting a cost on depositing cash.
Negative interest could lead banks to have to push up their IT costs as their systems may have limited scope for dealing with negative interest rates, further eroding their weak profitability as they adapt to cope with the revised reporting and accounting procedures, writes Amreeta Hosanee.
The change amounts to yet another chilly headwind eroding banks’ already weak profitability with no respite in sight. Many commentators are predicting a low or negative interest rate environment in Europe for another four or five years at least, possibly longer. The situation is the same in the bond market where the Financial Times recently reported that interest rates in Switzerland are negative on government bonds with up to at least 20 years on their maturity.
According to McKinsey, German banks earn some 70% of the revenues from shorter-term deposits and by making longer-term loans. So it’s no surprise that Commerzbank blamed negative rates as the chief reason for a €90m drop in its first quarter corporate and consumer banking revenues last year.
But the hit to the balance sheets doesn’t stop there. Negative interest rates means banks having to scramble to meet new reporting needs.
Bank software systems have been designed to run in a positive interest environment. Compliance, reports, accounting, balances, payment calculations are all set up accordingly. Today, they need a hasty reworking of their systems – a demand that banks without modern core platforms are finding tough and expensive to meet.
The list of functions a bank needs to change is long – from the ability to apply negative rates to ensuring that it applies the correct direction of receipt or payment message with negative interest amounts. In the same vein, banks need to ensure they don’t levy withholding taxes (gathered and paid by banks to the government on behalf of their customers on income earned) on deposits with negative rates.
Without a flexible core system, the bank must make these changes manually, a time consuming and expensive business, and one with many risks.
The pain doesn’t stop there. Negative interest rates change the way revenues and costs must be booked. According to the IFRS, the accounting standards body, negative interest revenue arises on an asset instead of a liability, so it cannot be booked as an interest expense. Similarly, the expense arising from a financial asset because of negative effective interest rates cannot be presented as interest revenue or expense, although the IFRS doesn’t offer a more appropriate way to account for it.
The beauty of a modern, flexible core platform is that all these changes can be made easily and quickly, because the system is configurable. New reports can be set up, accounting changes incorporated and tax situations assessed. Its powerful analytics can allow banks to refine loyalty schemes to identify customers likely to leave should they be charged interest on their deposits.
Many banks are concerned that they will lose customers if they pass on negative interest rates and so far have refrained, taking the hit to their own balance sheets. For those that can separate out those likely to quit from those that are likely to stay, there’s an opportunity to raise new revenues and avoid new costs.
This is critical. New loans are being priced at uneconomic rates, and the cost of holding bonds exceeds the yields generated. As one commentator recently warned: “This negative carry is set to worsen in the face of tighter liquidity rules in the near future.” As illustrated by Commerzbank, this is already having a stark effect on the bottom line.
With low or negative interest rates taking big bites out of revenues and profitability, banks need to do all they can to protect margins and embrace new revenue streams. It’s another good reason to look at modern core banking platforms.