Low rates, silly banks and the next bubble
(James Saft is a Reuters columnist. The opinions expressed are his own)
So it is official, if not a surprise: keep interest rates low enough for long enough and banks will behave in very silly ways.
That makes one more reason to expect further bubbles as part of the cost of recovering from the last one, which was in turn part of the cost of repairing the damage done by the bubble before that.
Keep interest rates low for 10 consecutive quarters and, hey presto, the expected rate of defaults experienced by banks rises by 3.3 percent, according to a study of 600 banks in Europe and the United States by Leonardo Gambacorta of the International Bank of Settlements. For study click here.
Even worse, as we have seen, is that the spike in defaults happens suddenly and, if you only look at defaults in the recent past, out of a clear blue sky.
Of course, lots of people were screaming blue murder about the housing bubble before the banking crisis hit, but on the measure that banks pay most attention to — default rates — there was precious little evidence of impending losses.
All of which is to say that we run a considerable risk of future bubbles and repeated banking crises unless one of two things happens, and preferably both: risk taking by banks is reined in by higher rates or tighter regulation. Neither seems particularly likely, at least in the current cycle.
“Monetary policy is not fully neutral from a financial stability perspective,” Gambacorta wrote.
“It is important that monetary authorities learn how to factor in the effect of their policies on risk taking, and that prudential authorities be especially vigilant during periods of unusually low interest rates, particularly if they are accompanied by other signs of risk taking, such as rapid credit and asset price increases,” he added.
The signals are mixed. Interest rates are very low and will stay very low for a very long time, at least to judge by comments from central bankers. There has been a rapid increase in credit available through financial markets, but this is from a very low base and certainly is not the case for consumers and small businesses. As for asset markets, they too have in many cases rebounded strongly after bottoming in March. Some, such as emerging markets and gold, are giving out the kinds of signs associated with bubble, but the big asset that serves so often as housing, real estate, is only showing shallow signs of respiration.
MORE PROBLEMS THAN TOOLS
Low rates feed through to lax lending and higher default rates in a variety of ways. First is the good old drive for yield. As rates fall the benchmarks for many actors in the financial system don’t ratchet down in tandem. Some of that is simply an illusion, investors and lenders don’t adjust to a low interest rate environment and simply up their risks in order to keep nominal returns at the level they are used to and think they deserve. This feeds through naturally to lending rates and encourages riskier credits to take on more leverage. It also flatters returns on both sides of the lending equation, so long as credit remains loose and asset prices play along. So if the value of the collateral is rising, lenders are willing to advance more against it. Volatility also tends to fall in rising asset markets, which affects the way risk is perceived and measured, by bankers and regulators alike.
Again unsurprisingly, banks that showed a faster rate of growth tended to turn out to have made riskier loans, while there was a weaker but positive relationship between being active in securitization and risky lending.
Now U.S. Federal Reserve Chairman Ben Bernanke has said he doesn’t rule out using monetary policy to unwind bubbles, but believes regulation is a better bet. This is certainly a step forward, but there are pretty good reasons to think neither will be used, or at least used effectively. First off, monetary policy; unemployment, housing and banking are three big reasons the Fed will find it hard to pull the trigger on rate rises, even when other indicators turn red. Even after last week’s surprisingly good jobs figures, the United States is still looking at 10 percent unemployment, a social and economic tragedy and a political live hand grenade.
Banks too are not out of the woods, especially if real estate begins again to fade. The extension of tax credits will help but mortgage rates will be under upward pressure as Fed purchases of mortgage debt slow and eventually stop next year.
So if we must live with low rates, this then leaves us with regulation as a defense against excessive risk-taking during times of low rates.
That is a heavy weight hanging by a slender thread.
(Editing by James Dalgleish)
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)