Treasurers have been struggling with negative interest rates in the euro zone for 4 years now. Especially short-term liquidity is no longer an attractive money market investment. Since 2016, the markets have repeatedly promised to raise interest rates, but so far, this has not materialized. The ECB recently dispelled the hope for a turnaround in interest rates in 2019, instead postponing it to 2020 at the earliest.¹ Moreover, these days, the IMF is tossing about the idea of decoupling electronic money from cash, and familiar buzzwords such as helicopter money are making the rounds. The signs therefore point more towards a worsening of the interest rate situation than towards a return to normal interest rates in the near future. In this article, we would like to shed some light on the background to this development and the potential implications for Treasury. 

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¹  https://www.tagesspiegel.de/wirtschaft/ezb-ratssitzung-mario-draghi-wird-als-nullzins-praesident-in-die-geschichte-eingehen/24078568.html

Since 2014, interest rates in the euro zone have been close to zero or even negative. Originally, the reason given by the ECB for the interest rate cut was to boost the economy and to encourage loans. The economy has improved consistently since the end of the financial crisis (also due to a favorable global economic situation) with peak levels reached in equities, real estate and other investments. Since the end of 2018, however, the global economic outlook has become somewhat gloomier. This is partly due to the trade and customs disputes between the USA and China, as well as the USA and Europe. Last but not least, Brexit has also become a major uncertainty factor for the markets and investors. For example, incoming orders from the manufacturing sector, which has shown a downward trend² since the end of 2017, underscore this bleak outlook. The driving force of the German economy, the automotive industry, has also recently reduced its sales forecasts and the industry is facing a critical year.³ A stagnating or weaker economy is not the moment for a significant interest rate hike. As already mentioned in the introduction, the ECB seems instead to be trying to consider other measures to stabilize and revive the economy. 

In a normal, positive interest rate environment, the central bank would lower interest rates even further, but this has become nearly impossible with interest rates already at zero or even negative. In July 2012, the head of the ECB, Mario Draghi, promised to do everything (at least within the ECB's mandate) to save the euro. It is in this context that we should assess the measures to stimulate economic demand currently under discussion. In addition to the option of helicopter money (i.e. the direct injection of central bank money into an economy), the IMF's idea to lower interest rates to well below zero is being discussed among experts.⁴ The IMF economists Agarwal and Krogstrup lead the way: 

"Many central banks have lowered key interest rates to zero during the global financial crisis to boost growth. Ten years later, interest rates remain low in most countries and while the global economy has recovered, future downturns are inevitable. In previous severe recessions, a three to six percentage point cut in key interest rates was required..."

This would mean a key interest rate of between minus three and minus six percent for the euro zone. Such a drastic negative interest rate on bank deposits would make cash holdings attractive and thus lead to a massive withdrawal of deposits. To prevent this, economists propose separating cash and bank deposits into two different currencies, which would make the holding of cash at least as unattractive as holding bank deposits. This would require an exchange rate between bank deposits and cash. If the bank money now bears a negative interest rate, the exchange rate from cash to bank money is devalued annually by the same ratio. The working paper by Signe Krogstrup and Katrin Assenmacher, "Decoupling Cash from Electronic Money”⁵ (in her role as the Head of the ECB's Department for Strategic Monetary Policy) shows that the ECB is not disinclined to entertain such ideas either. 

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²  https://www.destatis.de/DE/PresseService/Presse/Pressemitteilungen/2019/02/PD19_042_421.html

³ Zeit Artikel: https://www.zeit.de/news/2019-03/03/vw-chef-sieht-deutsche-autoindustrie-vor-kritischem-jahr-190303-99-218712

⁴ https://blogs.imf.org/2019/02/05/cashing-in-how-to-make-negative-interest-rates-work/

⁵ Monetary Policy with Negative Interest Rates: Decoupling Cash from Electronic Money

In the euro zone, the primary focus should be on commercial banks. Commercial banks are an essential cornerstone of the monetary system, as they are largely responsible for creating bank money through lending. In contrast, the share of central bank money in the overall money supply is only about 10-15%. However, this money and lending system is calibrated to a world with positive interest rates; the prevailing low-interest environment is increasingly exacerbating the banks' situation in terms of their profitability and risk-bearing capacity. 

Continuously declining profitability of banks

In its report on banks’ earnings situation, the German Central Bank (Deutsche Bundesbank) states:

"...The low level of interest rates caused by the expansionary monetary policy measures and the flat yield curve, as well as the negative interest rate on banks' surplus deposits with Eurosystem, which has been at -0.4% since 16 March 2016, in themselves reduced the net interest income of the banks... Major banks, the Landesbanken as well as mortgage banks have again reported a noticeable decline in net interest income despite shrinking balance sheet totals. As this drop could not be offset by other net income from operating activities, operating income in these banking groups fell markedly...". ⁶

In addition to commission income, a bank generates 70 - 80% of its income from interest margins. The loan margin, as an essential part of a bank's income, is being eroded due to the current interest rate situation on the one hand and the increased supply of loans on the other, with demand for loans not growing at the same rate. (On average, the margin for corporate loans in mid-2018 was 1.41%, the lowest level since the financial crisis of 2009)⁷. The average duration of loans has continued to grow steadily in recent years, as customers have secured favorable conditions for themselves over the long term. As a result, banks' loan books are filling up with long-term, low-margin business. The long duration means that banks have to commit themselves to "unfavorable conditions" for a correspondingly long term, thus taking longer to remove these unfavorable loans from the books. In 2018, demand for loans rose at an above-average rate compared with previous years.⁸ However, at least according to the experts at KfW Kreditanstalt, the reasons have less to do with an investment boom than with a potentially slackening economy and heightened uncertainty. Hence, companies could accumulate a financial cushion at low interest rates.⁹ According to the Bundesbank, the only uptick in the earnings was achieved through fees and the commission business. Net commission income includes, in particular, fees from checking and payment transactions, securities and custody business as well as remunerations for brokering activities in connection with credit, savings, home savings and insurance contracts. In view of limited growth rates, customers' price sensitivity and increasing competition in the payment and financing environment from innovative FinTechs, it is unclear how long banks will be able to rely on this segment.

The declining quality of banks' credit portfolios 

It should also be noted that the combination of the ECB's quantitative easing, low interest rates and intensified competition among banks has led to increasingly lenient lending conditions for corporate and housing loans over the past few years, as confirmed by relevant reports by the ECB and the German Bundesbank.¹⁰ Another aspect that should also be examined is to what degree banks' internal rating models (originally designed positive interest rates in mind) still reflect the actual creditworthiness and solvency of potential borrowers (e.g. indicators on the likelihood of interest payment and principal repayment capacity, overall profitability or debt repayment ratio), or whether these are not too optimistic. Ultimately, there is a risk that adverse selection will take place because of too favorable credit conditions, i.e. the demand for credit from customers with high creditworthiness and stable equity remains constant or even decreases, while the demand for credit from customers with poor creditworthiness increases. This scenario is confirmed, among other things, by the fact that the number of corporate insolvencies has almost halved between 2006 and 2018 and that the average insolvency ratio is below the long-term average in a normal interest rate environment. Thus the fewer insolvencies are not due to better management skills but to easier access to cash.¹¹ However, Euler Hermes expects the number of corporate insolvencies to increase by 6% in 2019 due to the weak economic outlook and the corresponding reduction in corporate profitability.¹²

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⁶ https://www.bundesbank.de/resource/blob/759806/73b1edc6d411dd1db2c079d26fb9c249/mL/2018-09-ertragslage-data.pdf

⁷ https://www.handelsblatt.com/finanzen/banken-versicherungen/firmenkredite-der-unheimliche-schuldenboom-der-deutschen-banken-beunruhigt-die-aufseher/23189882.html

⁸ https://de.statista.com/statistik/daten/studie/6798/umfrage/kredite-an-unternehmen-und-selbstaendige/

⁹ https://www.handelsblatt.com/finanzen/banken-versicherungen/kfw-kreditmarktausblick-das-kreditgeschaeft-boomt-doch-die-gruende-sind-unerfreulich/23140420.html?ticket=ST-1259745-JCv0uHMHxwfsp5docB6I-ap1

¹⁰ https://www.bundesbank.de/resource/blob/764574/523ab4f9da55154befcdd8cbb7ac0b0b/mL/2018-10-23-kreditgeschaeft-download.pdf

¹¹ https://de.statista.com/statistik/daten/studie/75215/umfrage/unternehmensinsolvenzen-in-deutschland-seit-2000/

¹² https://www.eulerhermes.de/content/dam/onemarketing/euh/eulerhermes_de/dokumente/euler-hermes-globaler-insolvenzausblick-2019.pdf

The shrinking margins are becoming increasingly apparent in the banks' income statements. As described above, margins have already disappeared completely or the old high-margin lending business is gradually being replaced by new low-margin business. Conversely, if the current situation in the interest rate market persists, this means that margins will shrink even faster. On the other hand, banks have so far had a rather rigid cost structure, which at some point may mean that income no longer covers costs. The consequence is the reduction of banks' equity base, thus lowering their risk-bearing capacity and ultimately their ability to grant loans. Reduced lending means a shrinking money supply and deflation for capital and consumer goods - exactly the scenario the ECB wants to prevent. 

If the central bank’s solution is to raise interest rates, the question concerning the credit portfolio is about the quality of the loans and how robust the borrowers’ cash flow is, i.e. whether they are capable of repaying these. The fact that, assuming unchanged low interest rates and a sluggish economy, leading credit insurers believe that corporate bankruptcies will increase by 6%, suggests that the portfolios are somewhat sensitive in this regard. If, on top of this, one considers the fact that overall economic default rates have fallen continuously since 2009 (from 2.17% to 1.44%)¹³, it may be assumed that over the past 8-10 years, there has been an accumulation of companies that might have had to file for insolvency under normal market conditions. At this point, we can only speculate about the numbers of affected companies and households. What remains questionable is the prosperity of these companies and their ability to make repayments if interest rates were to rise. In the event of a critical mass of non-performing loans, which in extreme cases would have to be written off, this becomes relevant for the banks. This would also lead to a reduction in equity capital, lower risk-bearing capacity, a credit crunch as well as a smaller money supply with an ensuing lower demand. 

It thus seems that neither an interest rate hike nor a further interest rate cut can offer a solution to the current situation. The IMF's proposed solution of introducing even more drastic negative interest rates would further accelerate banks' already eroding margins and, as a last resort, the ECB or the European governments would have to intervene in a similar fashion as they did in 2008/2009.

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¹³ https://www.creditreform-rating.de/pub/media/global/page_document/Ausfallraten_deutsche_Wirtschaft_2018.pdf

Treasurers should therefore probably expect interest rates in the euro zone to remain at the same level for the time being. Instead, the effects of negative interest rates and ECB policy should be analyzed and managed in view of one's own business model.

The search for profitable investment alternatives for excess liquidity

Once the operational business options to reduce possible excess liquidity are exhausted (e.g. by settling supplier invoices early), negative interest rates should be avoided in particular (or at least limited) for short to medium-term investments. For example in the case of classic money market instruments, time deposits with longer maturity periods can (still) provide a remedy to this quandary. In addition, there are alternative forms of investment such as credit-linked notes, where interest is charged based on the debtor's solvency and creditworthiness. FX term deposits can also be used to generate higher interest income, where the domestic currency is turned into the investment currency with a higher interest rate level for the term of the investment with a swap. Nevertheless, this last alternative must take into account possible effects due to the exchange rate at maturity in the investment currency.

Possible actions in the event of major frictions on the interest rate market and the ECB intensifying its intervention policy 

Should the scenarios described above materialize, i.e. interest rates falling significantly below zero or the commercial banking sector becoming more unstable, the following aspects will also require greater attention:

• Internal netting for in-house banks and cash pools: One advantage of an in-house bank for large corporations is that they can refinance themselves within the group at preferential interest rates and reduce their dependence on external financial institutions and thus lowering external costs. At the same time, excess liquidity can be invested at market conditions in a normal interest rate environment. By definition, an in-house bank is an intermediary that operates as risk-free as possible and should pass on any profits and costs to the corporation. In the age of negative interest rates, however, this also means passing on these external market conditions to the corporation, which could lead to conflicts between the in-house bank and the company and, ultimately, acceptance difficulties. Conversely, not passing on the external costs would inevitably lead to an accumulation of costs and risks within the in-house bank. This raises the question of how the bank is supposed to deal with these costs and risks and how intercompany interest rates and possible risk premiums and discounts (that are not in line with the market) are calculated and properly reported. 
• Liquidity reserves and hedging: The advantages of a strong cash reserve or a refinancing source independent of the commercial banks became apparent at the latest, namely with the 2008 financial crisis and the collapse of Lehman Brothers. The global lending business almost came to a standstill at that time and even banks did not lend money to each other. The result was a lack of liquidity and a credit crunch, which had a very negative impact on investments and orders placed by companies and the private sector. Large corporations in particular often dispose of their own banking companies. These banking companies not only offer an independent refinancing basis thanks to their deposit base, they are also generally closely intertwined with the parent company's value chain and safeguard the value creation process at various levels. 
• Companies that do not have the critical size to set up their own bank should make their own supply chain with associated suppliers as transparent as possible and ensure the local financial security along this chain. A significant strategic advantage may also be that a variable cost structure and a low overhead can soften the potential blow of lower sales and liquidity constraints.

In conclusion, it may be said that the situation on the interest rate market remains uncertain and that the European and global economic situation will play a major role for the outcome. A recession will hit sooner or later. However, the question is how intense this will be in view of the market gains made since 2008 and how flexibly the Treasury department can adjust and react to this market situation. For the treasurer, all of this means making use of the good times to create provisions for the future by implementing automation, optimizing processes, increasing transparency and other measures in order to have both the resources and instruments on hand when the crisis does occur.

Source: KPMG Corporate Treasury News, Edition 89, March 2019