I would like to start by saying that lower interest rates reflect a long-term pattern that has been taking place for longer than one might think. We relate lower interest rates to global financial crises, but, the left-hand chart of Figure 1 shows that global interest rates have been declining for many years and decades. This trend is, perhaps, related to fundamental factors. There are two prevailing views. According to the first view, structural factors have pushed interest rates to record low levels. These structural factors include demographics and longer life expectancy. This affects their propensity to save and invest. In addition, there are, for example, developments related to China, becoming much more important in the world economy and much more financially integrated.
On the other hand, there are others who think that lower interest rates are a cyclical phenomenon, in which lower interest rates are a reaction to the high leverage levels, which contributed to the global financial crisis. According to this view, lower interest rates are necessary to facilitate the deleveraging process, thereby they are expected to return to normal, in the future, when the deleveraging process will have been completed.
Since there is no conclusive answer, yet, it is better to prepare for both scenarios. Obviously, for the financial system and financial stability, it matters whether low interest rates are here for long, or they are going to return to more normal levels.
The right hand chart of Figure 1 shows that there is an investors’ preference for longer portfolio in parallel to the decline of the government debt yields in the Japan, UK, and US.
This shows that there is a high propensity to save and invest in safer assets. Table 1 summarizes the implications of the low interest rates environment for financial stability. The first impact is obviously on banks’ profitability. As long as the interest rates go down, especially if intermediation spreads narrow, the net interest income declines. But, on the other hand, lower interest rates could also help borrowers’ debt servicing capabilities and lower default probability. The net effect is difficult to predict, as it depends whether the net interest income effect or the NPLs effect prevails.
How low interest rates affect financial stability
How low interest rates affect financial stability
| Profitability | Net interest Income: Lower Net Interest Margins (more sensitive for those with higher weights of deposits in liabilities; inflexible cost structure) | Net interest Income: Insurance/Pension Funds: Guaranteed return / defined benefits (more sensitive for Life insurance companies) | Reducing debt servicing costs, hence improving profitability/viability for existing borrowers; possible lower incomes for savers. | Increasing duration, possibly higher asset (financial and real asset) prices; |
| Possible mitigation | Search for yields; Increasing fee-generating products/services; further cost cutting | Moving toward interest rate-linked products | ||
| Risk Taking | Possibly higher investment/assets risk; | Similar to banks | More exposed to market risk; | Higher concentration on investment assets; |
| funding structure risk; | Increasing leverage for new borrowers (debt-to-income, debt-to-capital could deteriorate quickly) | more interconnected system’ | ||
| risks to viability. | possibly higher systemic risk | |||
| Structural changes | Lower profitability (expectation) could induce efforts to divest/consolidate | Newcomers, with more competitive cost structure could join in. | More interest to raise finance directly in the market | Move toward a more market-based system |
| Challenges far regulators | How to balance/prioritize between higher capital needs, with lower profitability and {possibly) lower financial intermediation? | Is there a need and how to adjust the supervisory perimeter? | How to effectively reach households/firms and alert about risks? How to ensure sufficient transparency on prices of financial services? How to meet the need to collect better data from the real sector? | How to improve rules, procedures, inter-institutional coordination to accommodate for possibly increasing systemic risk? |
| How to ensure orderly exits and valid new-entrants in the market? | What about possible (unregulated and) unfair competition? |
How low interest rates affect financial stability
| Profitability | Net interest Income: Lower Net Interest Margins (more sensitive for those with higher weights of deposits in liabilities; inflexible cost structure) | Net interest Income: Insurance/Pension Funds: Guaranteed return / defined benefits (more sensitive for Life insurance companies) | Reducing debt servicing costs, hence improving profitability/viability for existing borrowers; possible lower incomes for savers. | Increasing duration, possibly higher asset (financial and real asset) prices; |
| Possible mitigation | Search for yields; Increasing fee-generating products/services; further cost cutting | Moving toward interest rate-linked products | ||
| Risk Taking | Possibly higher investment/assets risk; | Similar to banks | More exposed to market risk; | Higher concentration on investment assets; |
| funding structure risk; | Increasing leverage for new borrowers (debt-to-income, debt-to-capital could deteriorate quickly) | more interconnected system’ | ||
| risks to viability. | possibly higher systemic risk | |||
| Structural changes | Lower profitability (expectation) could induce efforts to divest/consolidate | Newcomers, with more competitive cost structure could join in. | More interest to raise finance directly in the market | Move toward a more market-based system |
| Challenges far regulators | How to balance/prioritize between higher capital needs, with lower profitability and {possibly) lower financial intermediation? | Is there a need and how to adjust the supervisory perimeter? | How to effectively reach households/firms and alert about risks? How to ensure sufficient transparency on prices of financial services? How to meet the need to collect better data from the real sector? | How to improve rules, procedures, inter-institutional coordination to accommodate for possibly increasing systemic risk? |
| How to ensure orderly exits and valid new-entrants in the market? | What about possible (unregulated and) unfair competition? |
Obviously, the effect also depends on the composition of banks’ liabilities. Given the zero lower bound on deposits’ remuneration, the net interest income effect may prevail for banks relying to a greater extent on customers’ deposits as opposed to wholesale funding.
Other financial institutions may also find it difficult to cope with lower interest rates. Some of these institutions provide guaranteed return or defined benefits, for example, insurances or pension funds, and, if returns on assets decline, they have difficulties honoring their liabilities. This is especially true for life insurance companies.
Regarding private non-financial entities, the lower interest rates are to some extent positive, because they reduce the debt servicing costs, and hence improve the profitability and viability of existing borrowers. On the other hand, they also provide lower income for savers.
Regarding the risk-taking behavior, in markets with lower interest rates, lower returns could encourage taking longer duration positions and, possibly, underpin higher financial and real asset prices. Banks may compensate the lower yields on their financial assets with longer duration and may expand their fee-generating services. Obviously, they could also cut costs, up to a certain point. This low-interest environment, therefore, encourages banks to compensate lower yields and lower margins with greater volumes and riskier investments. Banks are also exposed to a funding structure risk, which relates to the structure of their liabilities, short-term, longer term, and how stable it is and, again, if the profitability is a problem, this could also translate into risk shifting.
Non-bank financial institutions are exposed to the same risks of banks. Private non-financial entities could be more exposed to market risk, and also, for new borrowers, there could be a risk of higher leverage as measured by the debt-to-income or debt-to-capital levels.
In financial markets, there could be higher concentration on investment assets, meaning, for example, government debt, and a more interconnected system because there is a larger concentration so that systemic risk may increase. There might also be structural changes because of low interest rates. This could relate with low profitability or expectations of lower future profitability. This could induce efforts to divest or consolidate, and also there might be competition from newcomers to the market, which could have structural advantages and challenge the existing players. There could be more interest from private non-financial firms to raise finance directly in the market, especially if there are greater bank lending constraints. Therefore, there could be a move toward a more market-based financial system.
All this could provide challenges for regulators. These are some of the challenges that I included in Table 1. For example, for banks, the challenge is how to balance or how to prioritize the higher capital needs with lower profitability in a context in which it is desirable for them to continue financial intermediation. The challenge is also how to manage a market restructuring process to ensure an orderly exit of banks willing to divest and the smooth entry of newcomers. There is also the question of supervisory perimeter. These newcomers could be unregulated, so that they need to be regulated. The balance has to be found there as well, and competition is also an issue that could come up.
About private non-financial entities, companies could find the situation very accommodative, they could increase leverage, and there should be an effort to make them aware of the risks incurred. Banks may compensate lower interest income with higher commissions income from fee-generating services. The terms of these services are not always transparent to the customers. This may require better bank data-collection capabilities from regulators to monitor these policies.
In terms of a possible increase in systemic risks, this is a question that calls for better coordination among regulators in any particular country.
If we now turn our attention to Albania, we see that interest rates in Albania have been declining. Figure 2 shows interbank interest rates, the policy rate of the central bank, which has declined since 2012, and its transmission to the government bond yields in the primary market, which have also declined for all maturities.
Chart 3 of Figure 2 shows the lek lending rates for different types of loans. They have reflected the monetary policy accommodation of the central bank. Chart 4 shows the difference between lek lending rates and lek deposits rates. The blue line shows a narrowing intermediation spread, while there is a more stable difference between lek lending rate and T-bill rate.
Regarding the profitability of the Albanian banking sector, so far, the sector has been profitable during all these years and the operating income has remained broadly stable. Banks have been able to compensate, to some extent, their lower net interest income with lower operating expenses. Chart 3 in figure 3 shows that the blue column is decreasing in terms of weight to risk weighted assets, so does the green column, which narrows as well. This means that, so far, banks have been able to reduce operating expenses to keep their cost-to-income ratio steady. This doesn’t include provisions. Provisions are the purple column, which also has an impact on the net financial results. In conclusion, banks, so far, have been able to accommodate the lower net interest income with lower operating costs and lower provisions.
In the meantime, the sector has remained well capitalized, with a capital adequacy ratio of 15.7 percent. The minimum is 12 percent. Figure 4 is an effort to distinguish between the nine subsidiaries of EU-headquartered banks operating in Albania, four subsidiaries of non-EU banks, and the three Albanian banks.
Figure 4 shows that the subsidiaries of non-EU banks experience the sharpest decline in the net interest income in terms of risk-weighted assets, but graph 3 of Figure 4 also shows that in addition, these banks have also been more successful in containing their operating costs as a share of risk-weighted assets.
In terms of risk-taking, one of the purposes of the low-interest rate environment is to encourage extra risk-taking in a context of heightened risk aversion. The problem could be if the low interest rate enviroment persists for too long as it could induce excessive risk-taking. This could take place in several ways: the build-up of leverage; the search of yield, both for banks and for investors; unsustainable higher asset prices, both financial and real estate assets; and also a misallocation of capital and the ability of banks to continue maturity transformation.
The sensitivity for banks could be higher given the possible changes in the funding structure and also changes in currency composition of the balance sheet and the rising exposure to market risks. For example, figure 5 shows what we see in terms of leverage of the banking sector in Albania. Leverage is relatively stable.
Chart 1 of Figure 5 shows the ratio of total assets to shareholders’ equity. If we look at the composition of assets, we can notice, for example, that there is an increase in the weight of transactions in securities and also in treasury and interbank transactions. Chart 3 shows that the duration of the so-called risk-free government securities portfolio has also increased for the entire system. It has gone from 1.3 years to around 1.8 years. The largest increase is noticeable for EU banks and for Albanian banks.
Figure 6 focuses on households and non-financial firms. We get this data from the survey that we conduct every six months with households and non-financial firms to understand their debt burden. Chart 1 of Figure 6 shows that the weight of indebted households has not changed since 2010.
If we also notice the distribution of monthly debt payments to income ratio, it shows that the debt servicing costs have increased as a proportion of monthly income. The proportion of households with debt servicing costs to income between 31 percent and 50 percent has increased from 9.2 percent to around 27.3 percent.
In terms of non-financial firms’ indebtedness, the ratio of indebted firms has steadily declined since the first semester of 2014. This may reflect, for example, the banking sector lending constrains on non-financial firms, but it could also reflect the improvement of the non-financial firms’ liquidity position, so that they can fulfill their financing needs with their own resources. Chart 4 shows the distribution of debt payment to revenues for non-financial firms. There is also an increase here, but it is minimal.
Figure 7 looks at the duration of the portfolio of financial assets of households and non-financial firms. There is a slight increase from 1.46 to 1.53 for households, while the duration for non-financial firms has remained stable over time.
But if we look at households’ deposits with the banking sector, we notice an increase in their deposits with a maturity over two years to compensate for lower deposit rates with the higher yield pickup provided by longer-dated deposits.
Chart 4 of Figure 7 shows the overall investment portfolio composition of households. We notice an increase of their investments in government securities.
In terms of asset prices, lower interest rates have been reflected in lower government bond yields and corresponding higher prices, as evidenced in chart 1 of Figure 8. However, chart 2 shows that the declining yields have coincided with lower government borrowing in the past two years so that rising prices also reflect the lower government financing needs.
In terms of real assets, the results of two Bank of Albania’s surveys show that the real estate prices have remained at the end of 2016 broadly at the same level recorded at the beginning of 2013.
In terms of maturity transformation, as shown in Figure 9, growth in banks’ deposits has funded mostly investments in securities and treasury operations, especially with non-residents. The deposit structure shows, as evidenced in chart 3 of Figure 9, a decline in the weight of time deposits and the rising weights of current accounts and saving accounts.
Despite these changes, the weighted average maturity of banks’ assets and liabilities has not significantly changed, as evidenced in Figure 10. The loan-to-deposit ratio has marginally increased, but remains at very low levels compared to other countries in the region and EU banks.
Chart 3 of Figure 10 shows the change in risk-weighted assets and in the risk-free government debt assets. It displays an increase in risk-weighted assets, which might be interpreted as a pursuit of higher returns via extra risk-taking. This is also confirmed by chart 4.
Figure 11 breaks down the changes in risk-weighted assets between EU banks, non-EU banks, and Albanian banks. Chart 1 shows that risk-weighted assets of subsidiaries of EU banks have been mostly stable. Therefore, the increase in the banking sectors risk-weighted assets can be almost exclusively attributed to Albanian banks and to subsidiaries of non-EU banks.
In terms of asset quality, one might expect that banks would use the benign interest rate environment to improve asset quality and restructure existing, impaired loans. Figure 12 shows that there has been an improvement in the NPL ratio for both foreign currency and domestic currency loans. However, such improvement largely reflects approximately 40 billion lek of non-performing loans written off in the past two years, while it is still unclear whether the lower NPL ratio also reflects an effective improvement in the quality of the lending portfolio.
As it was mentioned in the previous session, low interest rates have also had effects on the currency composition of the banks’ balance sheet. Chart 1 of Figure 13 evidences that deposit growth is almost exclusively driven by foreign currency deposits, whereas chart 2 shows that lending mostly happens in domestic currency, while it is contracting in foreign currency.
Banks: changes in currency composition of the balance sheet
Banks: changes in currency composition of the balance sheet
Banks: changes in currency composition of the balance sheet
This has changed the loan-to-deposit ratio in lek and in foreign currency. The loan-to-deposit ratio in lek has risen from 22.3 percent 10 years ago to around 45 percent. In terms of loans and deposits in foreign currency, foreign currency loans now stand at 58.6 percent of total loans, foreign currency deposits have increased to around 53 percent of total deposits.
This brings us to the issue of unhedged foreign currency credit. Figure 14 shows that since the end of 2014, unhedged loans have been declining with a stabilization observed in 2016. However, the recent growth of foreign currency deposits could fuel foreign currency lending, which would be worrisome. Figure 14 shows the composition of foreign currency unhedged loans between different segments. Around three-quarters of unhedged loans are placed with non-financial firms, which may be better equipped than households to withstand exchange rate fluctuations.
Increasing foreign currency deposits with stable foreign currency lending has challenged the banks to find suitable foreign currency investment opportunities. One of them has been increasing placements with non-residents. Figure 15 shows that claims on non-residents have increased to around 27 percent of total assets, while liabilities toward non-residents have remained very limited. If we look at the geographical distribution of placements, claims on non-residents are mainly deposits placed with non-resident financial institutions. Placements with the euro area have declined, while placements with non-EU countries have increased. This may reflect the pursuit of higher returns in a low-interest rate environment, but it remains a concentrated phenomenon. The higher placements with non-EU residents reflect the policies of just a couple of banks.
In terms of portfolio investment in foreign currency, we see that the weight of euro investments has marginally increased at the expense of the US dollar, whereas other currencies have remained relatively stable.
A low interest rate environment could also bring other structural changes. In the banking sector, we have not yet noticed any increase in the non-interest income generated by fees and commissions. They are relatively stable, which means that banks, in general, are not very active in this regard. Pressure on profitability has been felt in our banks, but, so far, they have withstood it well and have attempted to streamline their operations and increase efficiency levels.
However, profitability concerns could be accentuated in the near future, which, together with the new regulatory landscape in the EU, may exert pressures on EU banks with local subsidiaries to divest or to consolidate. Therefore, we need to remain vigilant, and banks should be prepared for different scenarios, both a scenario in which interest rates will continue for longer to remain low, but, especially, for a scenario in which interest rates will rise because this will expose their balance sheets to market risks.
In non-bank financial institutions and in financial markets, we see increasing evidence of market-based financing needs to diversify financing sources away from pure bank-based financing. In the past 18 months, non-financial firms have issued some short-term debt. A private stock exchange is also being established.
These developments provide challenges for regulators and for the financial industry. Therefore, in conclusion, we have a very low interest rate environment, but we don’t really know whether this is going to continue for longer or is going to reverse soon. So far, in this environment, the Albanian banking sector has managed to offset lower net interest income with lower costs, so the profitability has been relatively stable. The liabilities of banks are changing both in terms of maturity structure and in terms of currency composition. This is having some impact on their ability to intermediate and on euroization levels. Banks are increasing their portfolio investment toward longer-dated securities, while at the same time, the loans’ quality and the NPLs ratio remain problems.
Households and non-financial firms are not increasing their leverage to any concerning level, but they are looking for higher returns on their asset side. Asset prices are relatively stable. Banks are still focused on their core activity. In terms of the rest of the market, there is an increasing preference for more market-based financing, though the trend is just at the beginning. This raises several challenges for the regulators that could be handled with better communication with the industry, especially better information collection and sharing capabilities. Finally, we have to maintain a risk-focused approach for all these developments.
