Low interest rates: a mixed blessing?

This is the short version, the full article can be found here.

As a result of the European Central Bank’s (ECB) policy, we find ourselves in an unprecedented long period of low interest rates. What has been the impact on our economy? Which kind of risks are involved? Can this situation continue for much longer? These are the questions, together with many others, we have asked to four experts: Edward Roosens, Chief Economist and Executive Manager for the Federation of Enterprises in Belgium (FEB), Koen De Loose, Partner at KPMG Advisory, Leonardo Iania, Associate Professor at the UCLouvain and Geert Gielens, Chief Economist of Belfius.

Gentlemen, what is your opinion on the low interest rate policy of the ECB? Has it turned out to be the right choice? 

Koen De Loose (KDL): I think it was the only choice the ECB had. In my opinion, the decision has prevented a second banking crisis. I cannot imagine what would have happened in Italy for example, if the interest rates had remained high. There is zero evidence, but I feel the situation in Italy may be one of the causes of the measures the ECB has taken.

Leonardo Iania (LI): There is a clear distinction between two periods since 2010: first, we witnessed the outbreak of the European bonds crisis and the rather unconventional reaction from the ECB. Then, the crisis became less severe, but this period was marked by weak economic growth and low inflation. Those were very complicated times and even the danger of seeing the euro going bankrupt was real. The ECB has been doing well, also considering the fact that it had to face an unprecedented situation and it was called to solve problems well beyond the boundaries its mandate, i.e. keeping prices under control. The ECB has succeeded in preventing the euro from disappearing.  

Geert Gielens (GG): I am somewhat more sceptical about this. Especially when it comes to quantitative easing (a central bank creates money by buying bonds, Ed.). The ECB should have introduced this measure at the time when the euro crisis erupted. In 2015 this decision was already overdue, interest rates were very low already. I admit that the number of options was limited. Several governments were cutting public spending quite significantly and as a result of this the economy virtually came to a standstill. The massive amount of money which became available, however was perceived as a positive message and helped to restore confidence to some extent. Then the ECB started to exaggerate, especially last year. Nobody benefits from very negative interest rates. The same goes for large-scale buying in of bonds, since banks are just sitting on a pile of surplus money. At the end of each day, 75% of newly created liquidity returns to the ECB safes.

The divergence between the inflation rates in the euro area is also increasing. In Belgium, the inflation rate is rather high and interest rates are low. How long can this situation last?

Edward Roosens (ER): In Belgium, the inflation rate is 2.7% (January 2017, Ed.), However, core inflation stands at 1.5% versus 1.1% in the European Union. So, the difference is not enormous. Despite this relative difference, we still have to be careful in Belgium. There are many reasons for this 2.7% figure such as for instance the government measures in the field of energy prices, investments in renewable energy, and also a lack of efficiency caused by local distribution monopolies.

Should the authorities seize this opportunity and invest more?

GG: They should, but should they invest more or invest differently? The first in my opinion. The part of the budgetary resources used for developing the infrastructure for instance should be higher. But then again, the big question is: what exactly is a real investment? Building more hospitals or retirement homes? This is also considered as an investment, but in fact there is very little economic value in it.

ER: The question is to find a proper definition for a net investment in productive infrastructure. The FEB takes only three domains into account, i.e. mobility, energy and digitalisation, for they hold the best chances for growth.

How do you expect interest rates to evolve?

GG: You mean, are we going to head back to the historical average, let’s say 5% between 1990 and 2010? I don’t think so. Maybe 2.5%, perhaps also 3%. But more than that? No.

What are the risks of those low interest rates? Should we fear a bubble?

LI: Let us take a look at a very straightforward example: the yield of your investment in government paper is almost nihil. If you want to increase income, you have to take more risks.

ER: I think there is little danger of being confronted with a massive number of speculative bubbles. In my opinion, banks are the biggest victims of the low interest rates, for they see their margins disappear into thin air.

And what about the Belgian households and companies?

ER: For some people refinancing their loan has proved to be more profitable than all of the tax incentives granted by the government over the past few years (laughs). The positive impact on repayment should not be underestimated.

GG: One must not forget those who have made a deposit at their bank and whose yield has now become far less. Twenty years ago, savers earned about 1,000 EUR of interest each year. Nowadays, they earn 15 EUR of interest and are charged 20 EUR of fees (laughs).

ER: Companies will see this differently. They certainly do not keep a close watch on interest rates so as to be ready to invest whenever a particular limited can no longer be held. After 2008, the credit channel was no longer operational, banks were in dire straits and corporate lending in combination with cleaning up balance sheets was not easy at all. This has changed. A couple of years ago, companies began actively looking again for new projects that are worth investing in. Moreover, all of the conditions for lending have become less stringent. Interest rate levels for risky projects have been dropping slowly and have reached a 2.5 or 3.5% figure over a period of ten years.

Do the low interest rates also impact the banks’ traditional business model?

GG: I am sure this model will change. We make huge investments in all aspects of digitalisation. Everyone is looking for new sources of income. One of the opportunities lies in selling apps to small foreign banks which lack the expertise or resources needed to develop their own app. This is slightly easier for big banks, because their burden of costs is slightly smaller and because they can gain more advantage from data and information. However, scale is not everything …

KDL: Much depends on your objectives, on the return on equity one hopes to achieve. Belgian banks no longer have the possibility to rely on interest margins to the same extent as they did in the past. Consequently, they have to take initiatives and one of these could be a further development of their fee business. Another possibility is cost cutting, for the cost burden is still far too heavy in Belgium. And maybe banks should also take bigger risks.

GG: There is something contradictory about the European rules. On the one hand, interest rates should be very low, and on the other hand, the banking sector should be very solid and profitable. You cannot have both.

LI: The market situation is rather challenging for banks, for there is not only the problem of low interest rates but also the competition from all kinds of fintech companies. Personally, I think banks should think about the essence of their core business. Digitalisation may be a useful instrument for this kind of reflection and may also be to the advantage of customers thanks to the provision of services which are more custom-made.

GG: Now, we are talking about fintech as if it were a threat to the banking sector, but this may also be an opportunity. If banks fully embrace digitalisation, they will be able to retain their customers’ loyalty.

KDL: Banks are investing 1% of turnover in R&D, tech companies invest 20 times as much. We have looked into this matter and asked ourselves what will banking look like in 2030? The Invisible Bank is one of the possibilities. In this scenario, fintech companies take care of the front-end activities, because they are far better at it than the banks we have today. And then there is the back end, which will be some kind of generic ‘factory’, a basic operational unit which will also be responsible for risk management, something which banks are also good at. And that will be all: banks could become invisible in the future.

That is only one of many possibilities, but will it turn out to be the first choice?

KDL: One thing is for sure: the pace at which banks are re-inventing themselves is much too low. And we are only at the beginning of the transformation. If things do not change, banks will be lagging far behind tech companies, which are moving ahead much faster and are more customer-oriented.

ER: I believe risk management will remain important for the banking sector. A big part can be digitally prepared thanks to artificial intelligence, but personal contact remains an important aspect.

KDL: Sure, but one should not overestimate this aspect. We have carried out a study on customer experience based on a comparison between customers who were served by bank staff and customers who fully relied on digital banking. The level of customer satisfaction was higher in the second group!

The Belgian banking community is characterised by a large variety of banks making proximity one of their assets…

KDL: I think the future in the first place belongs to big retail banks having the resources needed for investment and small specialist niche players. Some of those are making considerable profit and will continue to do so. Mid-range banks, which fall somewhere in between, are threatened.

LI: The banking sector has the advantage of having a massive amount of data at its disposal and, when it comes to offering custom-made services, this gives it the edge over all those small fintech companies.

KDL: All this can change quickly though. Just look at the new PSD II (Payment Service Directive)-rules, which impose on banks the obligation to share their data with third parties, with the customer’s consent of course.

What does this mean for customers?

GG: The major advantage will be the access to a much broader range of services and more transparency as for the functioning of the market and competition, which, in its turn, will be beneficial for competitiveness.

ER: The biggest improvement will be in the field of mobility. I hope there will be a vast number of new startups and scale-ups ready to respond to the customers’ needs. It is far from easy to develop a standard method for a perfect understanding of what customers really need and want…

KDL: In the future, banks which are customer-centred to the highest degree, will be the most successful. Those banks will abandon an approach purely based on products and try to make optimal use of the data at their disposal. Personally, I think Belgium is lagging behind in this respect. British banks are making so much more out of artificial intelligence, robotics and blockchain technology … They are two or three steps ahead of us.

Something else now: what about Brussels? Fintech platforms such as B-Hive are put forward as one of our assets at the international level. What can be done to go further ahead?

ER: A couple of years ago, most people saw Brussels as the capital of the EU. Now, it is perceived as a city where various levels of authority are in conflict, where the infrastructure tends to be unreliable, where investments are hard to make, where chaos and traffic jams are widespread… Something must be done about this as soon as possible. We are in the post-Brexit era now. Ten years ago, every London-based financial institution would have thought about setting up business in Brussels. Now, there is no interest… I mean, no interest at all. Quite tragic, isn’t it?

LI: Initiatives in the field of payment systems should be given more government support. With companies such as SWIFT and Euroclear already being established in Belgium, it would be a terrible setback to see Paris or Frankfurt taking the lead in this respect.

GG: This may be a classic example of the winner takes it all, provided you know how to get to grips with this kind of technology. That is what we should be aiming at. Our payment institutions have a proven track record. Moreover, we have a highly qualified population. But I admit, Brussels has no vibe. The government should play a more active role in creating a favourable environment for fintech companies and in developing a network.