Banker's Digest

Banker's Digest


108.03台灣銀行家雜誌第111期 / By David Stinson

Three Ways to Handle a Crisis When Banks are Struggling with ProfitabilityThree Ways to Handle a Crisis When Banks are Struggling with Profitability
Net Interest Margin is to a bank as profit margin is to an ordinary business – say a supermarket. It reflects the difference in cost between goods bought and goods sold, or funds borrowed and lent. Some have thus blamed Taiwan’s especially low margins on a highly competitive banking sector which is too focused on cost performance, just as might be the case for a supermarket. In fact, while Taiwan has been hit especially bad, compressed spreads are a problem in countries around the world. Taiwan’s 10-year interest rate spread is 0.27%, which means that it would be difficult to imagine the spread being much higher even with better management. This is a trend all around the world. Economists measure the “natural rate of interest” – a level that is neither expansionary or contractionary. Although it is the outcome of a model, and not directly observed, measurements in the US show a decline of somewhere around 1-2% since the late 1990s; estimates in the EU have entered negative territory. Interest rates can be transmitted easily around the globe, so this issue is of direct concern to Taiwan. Since countries around the world are facing similar problems, it is worthwhile to take an international perspective. There are three general approaches, which could be (inexactly) associated with Europe, the US, and Asia. The EU has experimented with negative interest rates, while the US has preferred central bank balance sheet policies, and China has leaned heavily on fiscal policy. This isn’t to say that each of them isn’t controversial where they have been used. In fact, the use of such policies has defined political and economic fissures in each of those countries for the past decade or more. Although the situation in Taiwan is currently stable, it is not too early to start planning for a possible deterioration. Banks may not decide this debate, but these choices nevertheless concern the future of the industry.How Low Can You Go?In theory, the most straightforward solution to the deposit rate being too high is to simply lower it, even beyond zero. Logistically speaking, savers can’t keep all of their money in cash, and are willing to accept some degree of penalty for storage in a bank. The hope is that the banks will not accept the penalty, but rather loan the funds out (which would indirectly improve margins by increasing the amount of assets earning substantial interest). In 2017, US$ 9.5 trillion worth of global sovereign debt assets paid negative interest.The logic of this policy is the simplest, and it seems suitable for a small economy like Taiwan, because it acts directly on international capital (and therefore the exchange rate). It has strong limitations though. First, the lowest rate that has been tried is -0.75%, in Switzerland and Denmark. Much lower than that, savers will find some alternative way to store their money. The ideal case for negative rate policies is in a cashless economy, where the government can control holdings. Some countries have even discussed getting rid of the 500 euro note for this reason. For the present-day world, however, its application may be limited.In fact, despite the promise of a neutral policy, it has turned out that not all interest rates are affected equally. Banks have found it difficult to pass such low rates onto depositors (and in practical implementation, regulators have shielded ordinary depositors from the policy). Thus, the policy is not a solution at all to the problem of low profitability, but rather an extension of the problem. Furthermore, it is questionable whether this approach promotes lending at all. The policy functions as both an interest rate and a tax on cash savings, and taxes are known to be contractionary. The end result may simply be less lending.Many countries have found the effects of negative rates to be the opposite of those intended, with exchange rates eventually rising and interbank lending declining. Thus, while negative rates have some actual history of implementation, their applicability is limited, and the results have not even been entirely positive. For these reasons, American economists have generally been more skeptical of this type of policy.The role of the governmentAside from emergency measures to support the financial system in the very early stages, the most important US policy response to the aftermath of the 2008 financial crisis was quantitative easing. As with negative rates, this policy has proven controversial wherever it has been used, and it implies a strong separation of the central bank from the rest of the government. It is also not very applicable to Taiwan, which has relatively little debt in securitized form (although this will be discussed further below.) An extension of this policy which has not yet been implemented, yet has received some positive attention from a few key American policy makers, is known as “helicopter money.” (Former Chairman of the Federal Reserve Ben Bernanke earned the nickname “Helicopter Ben” for an early speech on the topic.) The idea originated from a memorable thought experiment by the economist Milton Friedman in which a helicopter flies over the country directly distributing cash newly printed by the central bank. This method works by directly stimulating consumer demand. Because it must eventually succeed in producing inflation, it pushes up long-term interest rate expectations, justifying lending by banks, rather than simply forcing it by penalizing cash deposits. Although this is a blunt instrument, and policy calibration would probably be difficult even with historical data, it works by stimulating the consumer class, a laudable goal for any economic policy. We may see experimentation with this tool if central banks fail to clear their balance sheets before the next crisis.The other alternative to either of these approaches is the use of fiscal policy to build up a country’s assets. Asian countries tend to be institutionally well-suited for this sort of approach, which requires quick-acting government spending to fill in the gap left by a private sector in crisis. China does not face the same problems as Taiwan in terms of long-term interest rate, but its actions in the 2008 crisis certainly make it a poster child for the use of debt for macroeconomic regulation. Japan has used all of the approaches discussed so far, but its debt level sets the world record, at about 200% of GDP. The extensive use of fiscal policy tends to blur the line between banks and the government, so while it may be better for the health of the sector than negative rates, it can also change its operating model. While helicopter money is also technically government spending, fiscal policy is typically used to improve a country’s assets like infrastructure. Its successful cases are usually when a country already needed improvement, regardless of the macroeconomic situation. The World Bank ranked Taiwan 23rd in infrastructure in 2018 – below countries such as Korea, China, and Japan, but also above Norway, Israel, and Malaysia. On paper, Taiwan’s public debt amounts to a very manageable 30% of GDP, but this figure conceals several problems. Reform of the generous public service pension system has been stalled for a long time, while other trends like housing affordability are not improving. The biggest problem with taking on large amounts of debt is the country’s demographics: Taiwan officially became an “aged” society in 2018, and will become “super-aged” by only 2026, with more than 20% of the population over 65. The National Development Council projects that the population could begin to decline in 2022. All in all, this is not a good environment for extreme fiscal policies like in China and Japan, although there is probably some room for moderate growth.Unintended consequencesA Financial System Report issued by the Bank of Japan in October addressed the question of low bank profitability in Japan, which is in a similar situation as Taiwan. It noted that banks which seem healthy may still be driven to increase their risk-taking. In the case of a tail-risk event, risks may propagate throughout the system in a manner non-linear to the original amount of risk. The report underscores how low profitability can make the banking system vulnerable to other threats.Efforts to rescue banks in the US and Europe have reshaped politics in those places. In Europe, fears of contagion arising from debt in countries like Greece, Italy, and Spain morphed into debates about the role of marginal countries in the EU, ultimately contributing to some of the sentiments behind Brexit. In the US, the Democratic party has found it difficult to shake off an unintended pro-corporate image a decade after its intervention in the 2008 crisis. The lesson in each of these cases is that short-term decisions can define trends over a generation. Low bank profitability is at once a problem for the banks themselves, and for the Taiwanese economy as a whole, and a possible sign of things to come. Not all of these developments necessarily apply directly to Taiwan, but neither are its banking troubles unique. Furthermore, since interest rates are by nature international, Taiwan may find in a crisis situation that the exchange rate targeting it has used in the past may no longer be workable – every country in a similar situation would be going after the same scarce reserve assets.No options are good in a downturn when rates were low to begin with, but it is clear that asking questions like these ahead of time is crucial. The alternatives apparently involve continued profitability problems for banks, their loss of independence, or else the use of untested policies.


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