The world has been keeping a close watch on all the markets in which their central banks have adopted negative rates, and there is some debate about their effectiveness. Most do agree, however, that negative rates create significant systemic risk for their markets, although Oxford Economics strategists see greater risk for Eurozone banks than for Japanese or U.S. banks.

Bank profits called into question under NIRP

Bronka Rzepkowski, Ph.D., said in a March 14 report titled “Negative rates, banks and systemic risk” that they have developed a “market-based systemic risk indicator (SRI), based on Credit Default Swaps (CDS) spreads.” She added that their indicator suggests that the risk of negative interest rate policies affecting individual banks in the U.S., Japan, and most parts of the global “remains contained.”

systemic risk 1

However, she says the risk of negative rates impacting banks in the Eurozone has increased since the beginning of the year, although it has declined slightly since the middle of last month.

Systemic risks from negative rates can only increase

Rzepkowski said that it really doesn’t matter whether banks pass on the costs associated with negative rates to their customers. Either way, she sees the risks to their financial stability as increasing, at least for the “medium term.” For example, if banks do pass on the costs, customers may withdraw their deposits and hoard their cash instead.

And if banks attempt to maintain their margins, they might need to take on riskier loan portfolios.

systemic risk 3

If they don’t do anything, their net interest margins will erode, she said, and even if banks can raise rates for some “lender risk-profiles,” the plan could “derail an already tepid recovery in credit growth.” She adds though that the Eurozone might be able to avoid this last possibility through targeted longer-term refinancing operations 2.0.

Japanese bank stock correction overdone

The Oxford Economics strategist thinks that the correction in bank stocks in Japan is overdone because she thinks the systemic risk there is low right now. Also Japanese banks currently have a low level of non-performing loans and benefit from a multi-tier system of interest rates, which means just 4% of Bank of Japan deposits are subject to negative rates.

systemic risk 4

She also cited “substantial capital gains on government bond holdings from the downward shift in the yield curve following the NIRP announcement,” adding that capital gains will likely increase if the Japanese central bank moves rates further into negative territory. This would give bank earnings a boost, at least for now, she clarified.

Why the Eurozone has the most systemic risk

She explains several reasons why Eurozone banks face more of a systemic risk from negative rates than banks in other areas. For example, the U.S. forced banks to restructure and clean up their balance sheets more quickly than the Eurozone did, she noted, as banks had to start recognizing their losses and selling off their distressed loan portfolios.

In January, Italian and Spanish banks’ climbing credit default swaps drove Oxford Economics’ systemic risk indicator sharply higher. Rzepkowski reported that it didn’t reach the levels seen during the Eurozone crisis and has since abated slightly, although she adds that it still high compared to the historical average for the Eurozone. She said this suggests that the concerns haven’t totally cleared out, especially in “the periphery.”

She noted confirmation in the Eurostoxx Bank Index’s “still high level of implied volatility.”

systemic risk 2

“That said, the risk of a crash in bank equities, as reflected in the price of out-of-the-money (OTM) options, has been receding, reflecting declining risks associated with large write-offs and associated capital dilutions,” she added.

Eurozone’s NIRP “the most restrictive”

Of course both Japan and the Eurozone have negative interest rate policies in place, but one reason Rzepkowski sees a much greater systemic risk for the Eurozone rather than Japan deals with the implementation of those policies. As mentioned above, just 4% of Japanese bank accounts are subject to negative rates. However, the European central bank’s NIRP makes all excess reserves or 85% of current accounts subject to the -0.4% rate. In Switzerland, 40% of accounts are subject to the central bank’s negative rates.

But negative rates aren’t the only big factor contributing to the Eurozone’s heightened systemic risk right now, she said. The other is the EU Bank Recovery and Resolution Directive,” which went into effect on Jan. 1. She predicts that it will have “a number of detrimental impacts on European banks.” She believes that the new policy has caused rising uncertainties, trigging “a pernicious dynamic between banks’ share prices and the price of bail-in instruments during the sell-off seen earlier this year.”

“At the heart of the feedback loop were contingent convertible instruments (cocos) issued by banks, instruments which can be converted into equities to ensure banks remain adequately capitalised if a pre-agreed trigger is crossed,” she explained. “The new regulation, with the aim at sparing depositors in the event of a bankruptcy, forces banks to issue more cocos.”

This policy seems to have created a sort of domino effect as the uncertainty caused by it caused bank stocks to plummet, which then upped the likelihood of those cocos being converted into stock, she said, which would pressure banks’ subordinated debt spreads. This raises the likelihood that bank investors will see their investments being diluted, which in turn sent Eurozone bank stocks into a nosedive.