Negative interest rates are now a real possibility to cope with in the aftermath of COVID-19 across developed markets.
In May Andrew Baily, governor of the Bank of England, confirmed negative rates were under “active review.” Already UK gilts are trading with negative yield, signaling markets are expecting UK rates to turn negative at some stage. In June, financial data provider Bloomberg Finance L.P. urged its users to switch the way they price US dollar interest rate options to prepare for the prospect of the Federal Reserve pushing rates below zero.
While the use of negative interest rate as monetary policy is not unusual these days—with precedence in the Eurozone, Japan and Switzerland—in my view few banks would consider it viable or acceptable to pass the negative rates onto retail customers (e.g., by “charging” an interest rate on deposit).
It is key that banks harness existing programs, particularly IBOR transition programs, to prepare for the looming prospect of negative rates.
This dilemma raises distinct challenges for banks’ strategy, operations and systems. Firstly, facing already squeezed profitability in a near-zero rate environment, banks need to consider carefully how best to identify and address the impact of further rate cuts across their product portfolio. The complexity would be exacerbated by rates entering the negative territory.
Secondly, banks need to be aware of the conduct implications of negative rates on their existing contracts when it comes to stated objectives, interest rate floors and caps.
Lastly, interest rates turning negative place banks’ operational and technology systems in uncharted waters when it comes to pricing and risk modeling. Preparing banks’ systems for the prospect of negative rates is the key message of a recent Dear CEO letter by the Bank of England Governor, and indeed the warning by Bloomberg too.
Be prepared and pragmatic
Firms should heed these warnings and mobilize efforts to identify impacted products, clients and the implications across front, middle and back office. But not at the cost of pragmatism when banks already face significant uncertainty and cost pressure after COVID-19. It is key that banks harness existing programs, particularly IBOR transition programs, to prepare the looming prospect of negative rates.
Checklists should include these steps:
- Identify products with direct interest rate exposure;
- Identify products with indirect interest rate sensitivity;
- Identify related contractual references and legal obligations;
- Confirm continuing suitability and appropriateness of products that may be impacted by negative interest rates;
- Identify IT and operational systems impacts;
- Identify associated sales and marketing materials;
- Plan and execute remediation work;
- Prepare for Supervisory meetings.
Leveraging IBOR transition programs Inter-Bank Offered Rates (IBOR) transition programs are already remediating financial products that reference certain interest rates by transitioning them to Alternative Reference Rates (ARRs), as mandated by the Financial Stability Board back in 2014. Much of the work already carried out by these programs can be leveraged to prepare for the prospect of negative rates.
Firstly, significant analysis can be leveraged in identifying products referencing interest rates, corresponding exposures and impacted clients/counterparties.
Secondly, as products are restructured to transition them from IBOR to backward-looking ARRs, new design features can be built in to capture or clarify the product objective and contractual treatment of negative interest rates.
Thirdly, implications of negative rates on front-, middle- and back-office systems and processes can be identified and tested as part of the new product launches referencing ARRs.
Finally, existing contracts with interest rate exposures are already being identified and remediated to facilitate the move to ARRs and mitigate risk associated with the transition. Banks should harness client outreach programs already in place to support these contractual changes and to facilitate any required client/counterparty communications as a result of product changes flowing from negative rates.
To effectively harness IBOR transition programs and to prepare for the prospect of negative rates, I suggest the following steps:
- Conduct an impact assessment to help you understand how negative rates affect your products, clients, systems and processes.
- Use proprietary tools leveraging Optical Character Recognition (OCR) and Artificial Intelligence (AI) to accelerate impact assessment.
- Perform a conduct risk assessment to help you evidence that client interests are prioritized.
- Identify synergies with other ongoing benchmark reform programs to reduce effort.
- Create a risk-based remediation program to mitigate and/or eliminate risks associated with negative rates.
To find out more on the topic, please contact the author.