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Economic analysis 21 Nov 2016

Long live low interest rates in Europe?

One of the questions hanging over the European economy and more specifically, the financial sector, is if the ECB will maintain its current policy of low, or even negative, interest rates for an extended period of time. Moreover, after the warnings announced last Thursday by the Chair of the Federal Reserve, Janet Yellen, who predicted a hike of the interest rates “relatively soon” if the improvement in the labour market and the inflation continues.

Economists and experts differ over whether this policy is reaching its end, or is here to stay for a while. While the ECB decides if the low rates will remain or start to increase, banks are reflecting on how to face this new environment that is putting their profitability at risk. One key way is through digitization.

What is expected of the ECB?

On November 4th, ECB Vice President Vitor Constâncio defended the effectiveness of the low interest rates for deposits, and negative interest rates for the deposit facility, which Swiss and Swedish banks have also imposed. He feels it complements the bond buying program well. However, he said “the long term consequences of an environment with low, but positive inflation and negative rates would be too severe for the financial sector, savers and retirees.”

Constancio also recognizes that the “this policy was always intended to be temporary” as its possible positive effects can “diminish over time and run the risk of disappearing at some point.”

What are experts predicting?

Sonsoles Castillo, Financial Scenarios Chief Economist at BBVA Research, says that “Central banks in general, and the ECB in particular are not to blame for the low rates.” “Central banks have used the tools available to them to face a scenario of low growth and very low inflation. The real causes of the low rates are economic and largely structural,” she adds. In her opinion, “The margin for monetary policy is practically over. In fact, the cost of measures like the negative rates can surpass the benefits, so it is not recommended to focus too much on them. Other policies, especially supply and fiscal policies, have to complement or take over from monetary policy.”

It is therefore possible that the ECB will follow the trend of the central banks on the other side of the Atlantic, where the Federal Reserve may start to gradually raise rates, with an increase of 25 basis points after the U.S. elections, predicted BBVA Research in early November.

How does this policy affect banks?

Also from BBVA Research, Ana Rubio, Head Economist of the Financial Systems Unit, says that Spanish banks are recovering in terms of profitability, but that “the interest rates are affecting the sector.” She feels that: “A banking sector that is less profitable than the markets demand for an extended period of time is less resilient, and European authorities should address these challenges.”

Even Mario Draghi said last Friday in Frankfurt that this context of low interest rates is affecting the entire sector. Experts say that the most solvent banks with the cleanest balance sheets, like BBVA, will be better prepared to face this new environment. But banks’ strategy to ensure a profitable business is also important.

How can banks manage?

Every financial institution follows a path. For BBVA, the key lies in a profound transformation that affects the whole organization. As Global Executive Chairman Francisco González said in an article published on the website of The Singapore Summit, low interest rates are not the only major challenge facing financial institutions. There’s also the subdued global economic growth, very low, or even negative, inflation and greater regulation. For the Global Executive Chairman of BBVA, the solution is for the technological advances to bring about a radical transformation of the banking industry, leading to greater efficiency and better customer experiences.  Both are fundamental to survive in this new, much more demanding environment.

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