Low Growth, Low Interest Rates, And Financial Intermediation, APRIL 2017

Advanced economies have experienced a prolonged episode of low interest rates and low growth since the global financial crisis. From a longer-term perspective, real interest rates have been on a steady decline over the past three decades. Despite recent signs of an increase in long-term yields, particularly in the United States, the experience of Japan suggests that an imminent and permanent exit from a low-interest-rate environment need not be guaranteed. A combination of slow-moving structural factors, notably population aging and slower productivity growth common to many advanced economies, could conceivably generate a steady state of lower growth and lower nominal and real interest rates in these countries.

What would be the consequences for the financial sector of such a scenario? This chapter examines this question, abstracting from the role of monetary policy and from temporary effects. The chapter argues that the persistence of a prolonged low-interest-rate environment would present a considerable challenge to financial institutions. Over the long term, the scenario would entail significant changes to the business models of banks, insurers, and pension funds and the products offered by the financial sector. 

In such an environment, yield curves would likely flatten, lowering bank earnings and presenting long-lasting challenges for life insurers and defined-benefit pension funds. If bank deposit rates cannot drop (significantly) below zero, bank profits would be squeezed even further. Smaller, deposit-funded, and less diversified banks would be hurt most, which could increase the pressure to consolidate. As banks reach for yield at home and abroad, new financial stability challenges may arise in their home and host markets. These hypotheses are supported by the experience of Japanese banks.

Low growth and aging populations would likely lower credit demand by households and firms and increase household demand for liquid bank deposits and transaction services. Consequently, in this scenario, domestic banking in advanced economies may generally evolve toward provision of fee-based and utility services.

Pension arrangements and the products and business models of life insurers would also likely change significantly in the long term. In this scenario, defined-benefit pension plans provided by employers would tend to become less attractive relative to defined-contribution plans, which offer more portability. Rising longevity would likely boost the demand for health and long-term care insurance. Demand for guaranteed-return, long-term savings products offered by insurers could be expected to weaken, while that for passive index funds offered by asset management firms would likely grow.

Policies could help ease adjustment to such an environment. Prudential frameworks would need to provide incentives to ensure longer-term stability instead of falling prey to demands for deregulation to ease the short-term pain. For banks, policies should help facilitate smooth consolidation and exit of nonviable institutions, while limiting excessive increases in risk taking and ensuring that the too-big-to-fail problem does not worsen. Implementing economic solvency requirements that encourage life insurers to undertake necessary adjustments to their business models would be vital. Surveillance and regulation of asset management activities would become more important as this industry’s share in the financial sector grows. Full Report

All photography by Jared Chambers