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UK banks ready for 'painful' negative interest rates; market has baked them in

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UK banks ready for 'painful' negative interest rates; market has baked them in

U.K. banks have already run the numbers on possible negative central bank interest rates and foresee big potential cuts to income, but economists wonder if they are the right solution anyway.

Britain's lenders are robust enough to cope with negative rates, which are already priced into the market, even as the Bank of England continues its review of the impact they might have in Britain, according to economists.

Currency rates already reflect the notion of negative rates, with one-year forward overnight indexed swaps below 0% since June this year, while the Sterling Overnight Index Average forwards are consistent with a BoE rate cut to minus 0.15%, said Dutch bank ING. The U.K. sold three-year debt at a negative yield for the first time in May this year.

"The markets have, to a certain extent, been pricing negative rates for a few months now, so it wouldn't come as a massive surprise to the banks if we do get them," said James Smith, an economist at ING. "The banks can cope with it. This is a bit of a success for the BoE; it's forward guidance — if markets know how you might react then that's doing some of the work for you so the banks are better able to cope."

He said that if the BoE were to introduce a negative rate — the bank rate currently stands at 0.1% — it would probably not go significantly below zero, perhaps minus 20 to 30 basis points compared with a deposit rate of minus 0.5% for the ECB and minus 0.75% for Switzerland.

That said, ING expects the BoE to veer away from lowering interest rates further next year, though it warns that this depends on a Brexit trade deal being announced and on the coronavirus crisis waning.

Howard Archer, chief economist for the EY ITEM Club, the forecasting group, has a similar view.

"I do think an expectation of negative rates has been baked into the market to some degree," he said. "But I'm not sure that monetary policy can do that much more to help the economy."

If a vaccine gets rolled out late this year or early next year, that will reduce the downside risk to the economy and alleviate the need for further stimulus, he said.

"Our forecast doesn't have negative interest rates; we think the economy will start to improve early next year," Archer said.

Bank preparedness

The BoE is carrying out a review of banks' readiness to cope with negative rates, although Governor Andrew Bailey told Parliament in October that there had been no discussions around introducing them immediately.

But he also warned that a return of COVID-19 would increase the chances of longer-term damage to the economy, meaning more drastic measures might be required.

ING's Smith, like Archer, points to a potential lack of consensus on negative rates on the BoE's monetary policy committee on the issue and noted that there were bigger issues on the horizon.

"In this economic environment are lower borrowing costs really the core problem? It would affect the exchange rate, but over the next year there are much bigger issues likely to affect this — related to Brexit. Bailey appears to think quantitative easing is a much better tool," he said.

Archer said he believes U.K. banks would not see their profitability impacted too badly, even though negative rates can weaken short-term debt markets.

"If the interest rates only went to minus 0.1% or minus 0.25%, I can't see that being a huge problem for U.K. banks," he said, since they are sufficiently robust now.

"A lot depends on how low you go and for how long. I certainly think in the U.K. if we did dip into negative rates, it would be pretty easy to get out of them — but the lower rates have gone in places and the longer they've stayed there, the trickier it is to get out of them."

Earlier this month the BoE opted for more quantitative easing rather than additional rate cuts and promised to pump an additional £150 billion into the financial system, adding to the £300 billion it has already completed this year.

Impact on interest income

However, major U.K. banks have already calculated the potential effects of negative rates on their net interest margin. Barclays PLC, for instance, revealed that a 25-basis-point fall in interest rates would see its net interest income fall by £500 million in the first year, though this was an illustrative scenario rather than a forecast. Its net interest income for the nine months to September 2020 was £6.3 billion.

The bank's CFO, Tushar Morzaria, said it would "definitely be painful" if negative rates are applied but cautioned that the exact application of the rates by the BoE, and whether there would be a tiering of rates, for instance, were unknown.

Barclays said negative rates would mean asset margins would become the focus of attention.

“But I do think once you've got virtually no lever left on the liability side, I think most lenders will look at the asset side margin very closely to try and manage their net interest margin,” said Morzaria on a call to discuss third-quarter results.

"It will have a different effect if short rates are negative and long rates are positive. It will have a different effect if short rates are negative and long rates are further negative, sort of downward sloping, deeply negative curve," said Morzaria.

He also said negative rates might be accompanied by further cheap bank borrowing availability from the BoE. He said Barclays' most popular savings account at present only paid 0.1% interest, so there was little room for repricing in the event negative rates are unveiled.

Barclays CEO Jes Staley said the consequences of a move into negative rates were far from clear but such a move would hardly be regarded as a sign of confidence in the wider economy.

Katie Murray, CFO of NatWest Group PLC, said a 25-basis-point fall in interest rates would have a £450 million impact in year three for the bank.

"So, it really becomes a question of making sure that you're absolutely looking after the core, and so I think some of the benefits that we've seen in the increased mortgage margins will help us," she said at a third-quarter results presentation.

Banks in other European countries which already have negative rates have sometimes passed these on to customers. From next year, Denmark's Danske Bank A/S will apply a negative interest rate of 0.6% to retail customer deposits above 250,000 kroner, equivalent to $40,000, down from 1.5 million kroner before.

As of Nov. 17, US$1 was equivalent to 6.28 Danish kroner.