RDP 2022-08: The Consequences of Low Interest Rates for the Australian Banking Sector 1. Introduction

Banks are complex. People tend to think of them as sources of credit and repositories for their savings. But banks also hold debt securities and reserves at central banks, borrow in wholesale funding markets, provision for losses on their assets, and must meet regulatory requirements. So there are many channels through which low interest rates could affect how banks operate.

In this paper, I'll examine the vast international literature that explores the consequences of low interest rates for various banking sectors. Because there are multiple channels through which these consequences might arise, and because some of these channels might operate differently in Australia, I'll structure my discussion around the various components of Australian banks' balance sheets.

Australia's major banks – accounting for more than three-quarters of bank loans in Australia – maintained a fairly stable spread between their lending rates and their costs of debt (including deposits) funding as the cash rate fell towards zero. Compression of these spreads is one of the key mechanisms highlighted in the literature that can adversely affect bank profitability at low rates, and results from competition with lenders less reliant on deposit funding and the tendency for the yield curve to flatten as rates approach zero.^[1] Therefore, the lack of spread compression evidence in Australia suggests Australian banks' profitability has likely not declined as much as the international literature would predict.^[2]

Low rates can still affect profitability even when spreads remain constant. Banks' net interest margins (NIMs) – the difference between their interest income and interest expenses (as a share of assets) – will fall with interest rates if spreads remain constant. This occurs because some of banks' assets are funded by equity. So as the returns on these assets fall, so does the return on this equity (all else equal). Australian banks are affected by this part of the profitability channel just as the international literature predicts.

The combination of stable spreads and a deposit lower bound would result in monetary policy pass-through becoming more muted at low interest rates. The apparent stability of spreads in Australia therefore suggests the pass-through of monetary policy to lending rates may have been more muted than what would be predicted by the literature. Previous estimates suggest that if the cash rate were to fall 25 basis points from zero per cent, the deposit lower bound would cause only 20 basis points of this to feed through to lending rates (Brassil, Major and Rickards 2022).

But ‘lower than predicted’ pass-through does not necessarily mean pass-through in a low-rate environment is lower overall. If the economy is in the midst of a banking crisis, monetary policy pass-through temporarily becomes higher than normal.^[3] To the extent that banking crises become more frequent in a low-rate world (due to increased risk-taking, for example), this suggests that pass-through will more frequently be amplified.

Outside of banking crises, however, pass-through tends to be lower at low rates. This raises a key question for central banks. Does lower pass-through mean they should move policy rates by more or less? If the central bank is solely focused on achieving its current inflation and unemployment objectives, the answer is surely more. But if the central bank has other considerations, such as financial stability, then the answer is not as clear.

There is, however, a situation in which the answer is a clear ‘the central bank should do no more’, and that is if the economy has reached its ‘reversal rate’. The reversal rate is the point at which any further reduction in the central bank's policy rate will cause banks to increase their lending rates, such that policy rate reductions become counterproductive. Such a rate was famously theorised by Brunnermeier and Koby (2018). But with scant evidence of this rate actually being reached in any jurisdiction, and the theoretical existence of this rate being highly model dependent, there remains considerable uncertainty about both the level of the rate and its determinants (if it exists at all).

With the new banking sector addition to MARTIN (Brassil et al 2022) – henceforth, BA-MARTIN – it is possible to investigate whether a reversal rate can exist in Australia, and if it can, what determines its existence. BA-MARTIN is more detailed than the highly stylised model of Brunnermeier and Koby (2018), thereby enabling exploration of both the reversal rate theorised by Brunnermeier and Koby and additional channels that might lead to a reversal rate.

The Brunnermeier and Koby (2018) reversal rate does not currently exist in Australia. This is because, unlike banks in some other jurisdictions, Australian banks tend to have more liabilities that follow wholesale market interest rates than they hold as assets (e.g. debt securities and reserves).^[4] Holding lending rates constant following a cash rate reduction would therefore prevent any NIM reduction and would prevent any change to credit demand; if zero pass-through is enough to prevent capital ratio deterioration, there can be no Brunnermeier and Koby reversal rate.

However, this wholesale market funding opens another potential reversal rate channel not explored by Brunnermeier and Koby (2018); the possibility that banks' creditors may deem banks' responses to further capital deteriorations as insufficient, and as a result require additional compensation to provide continued funding (i.e. a risk premium increase). If this risk premium increase offsets the cash rate reduction by a sufficient amount, lending rates would increase. While this is theoretically possible in Australia, I show that it would require an extreme and highly unlikely scenario in which banks remain below their target capital ratio for an extended period of time, they remain excluded from external equity markets for this entire period, and there is no regulatory/government policy response that alleviates the problem despite the effect such a scenario would be having on the Australian economy.

In the remainder of this paper, Section 2 briefly sets the scene by explaining what is typically meant by the ‘low interest rate environment’. Section 3 will explore the literature through the lens of banks' balance sheets. Given all the ways the Australian banking system differs from some of the major international systems, Section 4 will explain what the Australian banking system's features mean for the pass-through of monetary policy at low rates, and provide some quantitative estimates. Section 5 will then investigate the reversal rate in Australia. Section 6 will conclude by discussing some policy implications and avenues for future research.

Footnotes

Retail deposit interest rates have a lower bound around zero, due to the possibility of holding physical currency instead. [1]

On the other hand, Australian banks do not benefit from the transitional profitability boost predicted by the literature. This is because most loans in Australia are variable rate, and Australian banks tend to hedge any residual interest rate risk. [2]

This occurs because more expansionary monetary policy lowers banks' loan losses (both by reducing the frequency of default and the loss given default), thereby improving banks' profitability and, in turn, moderating any credit supply reduction implemented by the banks. While the effect of policy on loan losses is not unique to crises, banks are assumed to reduce credit supply only when their capital falls below desired levels (Brassil et al 2022; Garvin et al 2022). This amplified pass-through is only temporary because losses return to more normal levels once the economy stabilises. [3]

In general, the recent increase in reserve holdings associated with the RBA's unconventional policies has not altered this fact. [4]