In the British comedy series Little Britain there’s a skit with an insufferable banker who answers every customer question with ‘Computer says no’but not before she has a flashy passive-aggressive tap on her keyboard.
It’s not even that far from reality. Banks work with models and software that have their limitations. A good example of this dates back to early 2014, when the European Central Bank (ECB) devised the plan to introduce a negative deposit rate and thus make banks pay for the privilege of keeping money in Frankfurt. The idea behind this was that these banks would rather lend the money and thus stimulate the economy.
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But central banks were forced to pause. The computer systems of several large banks were found not to accept a negative number for the deposit rate because it had never occurred to the programmers that it might be necessary. Computer said no. The banks were given extra time to rectify the problem, after which the negative deposit rate was introduced after all.
This means that the banks’ models do not take all possibilities into account. At least at the moment with too few options, Luis de Guindos and Andrea Enria state in a blog post. Bankers will have read it with red ears because De Guindos is vice-president of the ECB and Enria is head of banking supervision.
‘Are the banks ready to face rising interest rates?’ reads the title of their contribution. The ECB has already raised interest rates from -0.5 percent to 2 percent this year, and it’s not over yet. In addition, inflation in the eurozone is too high. In November, it was 10.1 percent, which is five times the central bank’s target.
The title of that blog post might surprise the unsuspecting reader. Higher interest rates are good for the banks, right? They attract short-term savings deposits and convert them into long-term loans to households, businesses and governments. In other words, they make themselves illiquid in order to make the economy liquid.
Banks earn a margin on this service, which is the difference between long and short interest rates. If the income from loans increases more than the interest they have to pay on the deposits, it is good for the bottom line of their income statement.
With rising interest rates, the interest margin can grow. Bank of America economist Alastair Ryan expects banks’ interest income in Europe to be more than a quarter higher in the third quarter of 2023 than in the same period this year.
De Guindo and Enria’s warning is at risk of more bad loans. When the economy goes down, the chance that customers will not be able to pay their loans in full increases (something that DNB chairman Klaas Knot also warned about in October). Especially when it comes to loans with variable (read: rising) interest rates. The banks must ensure this.
Changed consumer behavior
Still, all things considered, central bankers see little cause for concern. Even with the extreme scenarios the ECB unleashed for the future (including the annoying combination of high short-term interest rates and low long-term interest rates), the banks appear to be sufficiently robust.
Nevertheless, De Guindos and Enria still open a can of criticism. In fact, the ECB also examined how banks manage the risks associated with interest rate differentials to determine whether they are prepared for sudden changes. What did it reveal? That banks’ models are geared to an environment with low interest rates, which means that they take too little account of consumers’ changed behavior when, for example, interest rates rise.
I’m sure that’s a fair criticism, but a little self-criticism wouldn’t have gone amiss. For a decade, the ECB did everything it could to pull down interest rates in the eurozone, promising they would remain low until the hoped-for monetary depreciation was achieved (this was another time when inflation remained stubbornly below target). So is it so strange that the banking models are calibrated accordingly?