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The unsuspected consequences of negative interest rates

Perverse effects

Would negative interest rates not have perverse effects? If these interest rates (at least in Europe) remain negative for a long time, it will have indirect and collateral consequences that are often neglected or unsuspected. Let's look at some of the consequences. There are many others that we have certainly forgotten. Nevertheless, the first question to address is related to EU State Members: could they manage budget deficits without these low/negative rates? It is impossible to imagine. Indeed, their debts have increased too strongly since the 2008 crisis. State debt service requires interest rates low or even at zero to pay less interest despite the increase in the amounts borrowed and therefore the potential interest charges. This is an obvious paradox: lower rates should mean less debt and easier repayment and eventually it resulted in more debt... but with less interests to pay. Low rates encourage individuals and many others to borrow in order to invest in real estate,creating a kind of real estate bubble. What serves one can serve the other (or the others). The a priori positive effects of low rates seem to be underestimated. The long persistence and length that has struck Japan for so long is frightening, in my opinion, and drive us into a new paradigm, a new dimension and involves a whole new way of managing finance. There may have been a "before the negative rates" and an “after" as a kind of border between two economic worlds. These rates will have a long-term effect perhaps deeper than the global crisis of eleven years ago. Economic history may confirm it in a few years.

Who could have ever imagined negative rates?

Negative interest rates, who would have even imagined such a situation 5 years ago, in a declining rate environment. The situation we are facing these days is unique in the whole financial history and exceptional, although it could last for years. Time is now destroying value, conversely to what we all learnt at university. The cash asset class is the less productive. The objective is now, when you are long, to reduce as much as possible principal destruction and losses, and for those who are short to be ready to keep paying only margins (as benchmark rates are quasi all negative). Without flooring of rates for borrowers, banks would be in an even worse situation.

Cash-Pooling long position should be charged

Even if some banks are still giving zero on long positions on current accounts, they should stop one day or the other. Nevertheless, because of this temporary “generosity” and artificial situation, MNC’s GroupTreasurers grant a zero return on cash-pooling to their affiliates. It means a gift of the new “ESTR” rate (at least) plus margin. Under new Transfer Pricing (TP) rules, it is difficult to justify. And on the other hand, with less than zero percent on current accounts, affiliates would complain. Banks should charge client at the real cost or at least at cost (i.e. rate received from ECB for their deposits). Thus, banks make losses as the deposits to the ECB are charged at “ESTR” or equivalent term rates (i.e. at negative rates). Unbalanced situations always create problems and are not sustainable, and certainly not at such a high cost for banks. It is a form of dumping imposed by the market. Some banks are facing number of problems and see compliance charges increasing overtime at crazy levels. Basel IV is announced. It will certainly deteriorate even further the situation. By dumping everything or not pricing properly, a bank cannot remain profitable. With negative rates, their ALM management is also more complicate, even with mortgages and long-term loans, to partly offset.

Taking more risks to compensate current interest rates: bad or good idea?

Some Corporate Treasurers are tempted to make deposits to unrated or lower rated banks to try to get more return or less capital destruction. They will onboard more counterparty risks to simply improve returns. It sounds silly. The asset management strategy should be adapted in such an interest rate environment. However, it should not imply increasing credit risk taken. The strategy of taking risks by onboarding more volatility and investing in non-cash and cash equivalent assets or funds is possible, if properly framed and ring fenced. It requires dedicated tools, new investment policies and courage to change things. Why should CFO’s be simply resigned in front of the value destruction? Why not tempting a more dynamic asset management strategy? I do recommend it.

Quasi all loans are these days “floored”

All loan documentations have been floored. Borrowers cannot fully benefit from negative rates as rates are floored at zero. Conversely, term deposits arent’ and money market funds give negative returns. All intercompany loans and cash-poolings of an MNC should be mirrored with external financing and therefore “floored” too, to avoid mismatched funding structures. The net results generated by the Central Treasury could be tax inefficient. If such a case occurs, it reduces reasons for choosing a tax heaven. As recommended by OECD Transfer Pricing principles, intercompany funding methods should be applied consistently. Such current rates do not help being consistent.

Time destroys value, unusual financial principle never considered in finance manuals

Accepting negative return results in tolerating value destruction. Paying for lending money seems harsh but accepted by all. For Money Market Funds (MMF’s) and with the recent reform, it is impossible to maintain constant NAV or even the newly created so-called “LVNAV”. American constant NAV MMF’s were not build and set up for a negative rate environment. If they cancel shares to compensate negative rates, are they still really at “constant NAV”? There is a technical issue with the new LVNAV’s, which make them impossible to develop. Eventually, low rates also oblige fund managers to reduce at minimum their margins, impacting their own profitability. Dumping is not the answer to such rates.

Besides corporates, all stakeholders are also deeply hit

The banks are penalized by these negative rates, which cannot always be properly recharged to customers. A zero percent on an account has a huge cost and remain unsustainable in mid-run. No one would like to have weaker banks. The market capitalizations of some of them are so low that we can suppose a further bank consolidation. However, it doesn’t come because these banks are afraid by size and know size doesn’t solve all problems. Look at recent unsuccessful attempt to merge some of the German banks. To avoid systemic risks, the major banks must remain solid and robust. The ECB itself must continue being creative and innovate to maintain the whole economic system in place. Its strategies are complex and will remain dangerous and artificially hold the financial world. The systemic risk remains the main threat. The paradox of compliance rules reinforcement which has huge costs while banks or lots of them are weakening and suffering from these low rates and complicate ALM management. To reduce risks, we have adopted compliance regulations which now cost so much that they penalize P&L of banks, on top of the weight of negative interest rates. The combination of negative factors is weighting on results and alter solidity of many institutions. Even if treasurers would prefer not been charged with negative rates on current accounts and deposits, the floored rates for borrowing should be accompanied by unfloored rates for deposits, to compensate. If not, I guess times will become tough for bankers. Treasurers need strong(er) banks and couldn’t be pleased by such a difficult banking situation. We can also list other investors severely hit, like insurance companies or pension funds, both directly impacted by negative rates. On the other side, Private Equity Funds seem to grow fast, as alternative investments.

Tax and TP issues

As already mentioned, the TP rules, for cash-pooling for example, are complicate to be followed and respected. However, the consistency is needed and must be justified. There are risks of arguments with Inland Revenue in case of tax audit. The interests collected are taxed (in principle). Therefore, are interest losses (paid on deposits) deductible symmetrically? When rates are around zero (+/-), it is difficult to apply spreads/margins, which are often minimized. Being consistent over time has become complicate when rates felt down below zero percent. Nevertheless, there are good news. For example, the lower the rates, the lower the risk around interest deduction limitation (imposed by ATAD 1) will be.

Systems were adapted to manage negative rates

IT systems have been adapted to be able to treat such negative rates. It was one of the easiest measures, although not that easy as unexpected. Maybe it was the simplest adjustment to achieve. Recent new IBOR’s have also imposed adjustments of IT solutions.

Beside the systems, documentations have/had also to be amended to incorporate these newly negative rates and the “flooring” of rates (at zero or not), consequence imposed by lenders to avoid paying for lending (which remains a crazy paradox, when you think about it).

Notional Interest Deduction (NID) are impacted too

In Belgium where NID was invented, large MNC’s will not be able to deduct them from the taxable profits as the rate of this tax advantage will pass under zero percent in 2020 (i.e. – 0,092%). The tax authorities had thought about a ceiling and maximum threshold of 3,0 percent to limit deductions. However, they never thought about a negative rates situation and therefore they never considered a floor, for example at 0,5 percent. On top of that Belgian have limited the deduction to the new equity injected and not anymore to the whole equity.

With lots of countries reducing corporate tax rates, it reduces even further the advantage of such deduction. We can see that a tax advantage can become (temporarily) obsolete or limited. If because of economic reasons, Belgium loses its tax competitive advantage forwhat we can foresee as a long period of time, MNC’s could be tempted to move abroad.

The list is too long and consequences not all perceived and known

As we can see, we have just listed couple of potential consequences and impacts of negative rates. The worst should come from the possible longevity of this crazy and unusual situation. The impacts will be tough although gradual, deep although apparently beneficent and pernicious although anticipated by the markets. We will certainly address again this major issue for the global eco-system. I am convinced that despite some obvious virtues, negative rates aren’t sustainable or will have major insidious consequences we aren’t prepared for.

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