- William R. White – Chairman of the Economic and Development Review Committee, OECD
- Gabriel Bernardino – Chairman, EIOPA
- Ingo Fender – Head of Financial Systems and Regulation, BIS
- Peter Praet – Member of the Executive Board, ECB
- Cora van Nieuwenhuizen – MEP, ECON Committee, European Parliament
- Jesper Berg – Member of the Executive Board, Nykredit Bank
- Jérôme Haegeli – Head Investment Strategy, Swiss Reinsurance Company Ltd
- Xavier Larnaudie-Eiffel – Deputy General Manager, CNP Assurances
Understanding low interest rates
Central bank policies should be interpreted as a response to economic malaise and disinflationary pressures, which the central bank aims to forestall. According to a public decision maker, the low interest rate environment is in part a secular phenomenon. But cyclical forces also lead to fluctuations around secular trends, especially when driven by the financial cycle, and such forces are still at play in the euro area today.
Real interest rates in the long run reflect the potential growth rate. This in turn reflects productivity and population growth and savings behaviour. The growth rate of total factor productivity (TFP) has been slowing in the euro area for decades. Population growth has also declined from about 0.7% in the early 1970s to around 0.3% in recent years. This has been mirrored in the long-term decline of real interest rates.
Cyclical factors, “the circular trend”, are also weighing on real interest rates. They are more directly linked with the global financial crisis. Notably, the euro area is still working its way through a “balance sheet recession” where a situation of severe debt overhang sets the conditions for a sharp downturn, which in turn creates the need for substantial deleveraging and prolongs the length of the slump. This is the product of a pre-crisis period where, misreading the signs of declining productivity growth, firms, households and, in some cases, governments, accumulated excessive debt on the basis of overly optimistic real income expectations. The result has been excess savings in the post-crisis period caused by the need for all three sectors to repair their balance sheets. Moreover, over-indebted firms and households in some countries have been confronted with higher credit premia, further depressing investment. Investment indeed remains well below pre-crisis levels.
On the cyclical side, monetary policy has played, and will continue to play, an important role in responding to demand weakness and the disinflationary pressures it creates. With fiscal policy largely unavailable due to fragile public finances, this has required a determined monetary policy stance to provide countercyclical stabilisation.
The negative impact of the crisis has been stronger for the euro area than for other jurisdictions due to institutional and structural weaknesses at both national and euro area levels (e.g. absence of an integrated euro area banking system, lack of formal macroeconomic risk sharing mechanisms).
The same speaker stated that the normalisation of interest rates depends notably on progress on three fronts: the implementation of structural reforms to boost the euro area's long term growth prospects; the acceleration of the repair of the balance sheets of the private sector within the euro area (e.g. reduction of non-performing exposures in banks' balance sheets); and the reforms addressing the institutional incompleteness of the monetary union.
The transmission channels hinder the expected benefits of loose monetary policies in the current over indebtedness environment
The credit channel is supposed to support the economy by suppressing saving, and pushing borrowing and spending. But this process is impeded in an EU environment where debt levels are already pretty elevated and loose monetary policies would exacerbate this debt issue.
The asset valuation channel can boost asset prices but generates short term exuberance and the potential for future price declines. The portfolio balance channel can lead to a mispricing of the Eurozone's sovereign risks. In their search for yield, investors also reach for duration. They are piling up risks by investing in long-dated securities at very low yields. As a result an eventual normalisation of long-term yields would inflict significant and widespread losses on investors.
This lens suggests that, rather than just reflecting the current economic weakness, low rates may in part have contributed to that weakness by fuelling costly financial booms and busts. The result is too much debt, too little growth and excessively low interest rates. In short low rates beget lower rates.
In addition, very low interest rates will discourage people from saving. Another risk would be a massive, brutal rise in longer term interest rates arising from either endogenous market forces or in response to moves to tighten monetary policy after such a long period of relative ease.
Financial repression: the unintended consequences
Today's low interest rate environment is not only driven by macroeconomic factors, but foremost by policy actions that help governments deal with their high sovereign debt burden. These policies, called “financial repression” reflect the attempt by governments to direct funds to themselves that would otherwise go elsewhere.
Such policies can have unintended consequences. The impact of financial repression on markets is undisputable according to a leader of the industry. The impact of foregone interest income for households and long-term investors has become substantial: in the US alone, savers have lost about USD 470 bn in interest rate income (net) since the financial crisis (2008-2013). Over the same period, EU and US insurers have lost around USD 400 bn in yield income. This currently corresponds to an annual "tax" of roughly 0.8% of total financial assets on average, lowering long-term investors' capacity to channel funds to the real economy.
S&P estimates that in 2014 alone European defined benefit pension funds' liabilities increased by 11-18%, equivalent to EUR 58-92 bn. Hence financial repression also means future generations will have to shoulder the long-term costs. At present the need to increase savings to compensate for low interest rates has weakened consumption growth. This hinders economic recovery and adds to “the search for yield”.
Keeping interest rates artificially low through official intervention hampers the ability of long-term investors to deploy risk capital into the real economy. It has broken the financial market intermediation channel by crowding out viable private markets, lowering the funds available from long-term investors to be used for the real economy. Investments in infrastructure could repair this damage and address weak economic growth provided a tradable infrastructure asset class is created.
The low interest rate environment is a major threat to the business of EU life insurers pension funds and banks.
These problems for EU life insurers become even more pronounced where guaranteed rates of returns have been offered to policy-holders. Some mid-sized life insurers with guaranteed returns and long-dated liabilities that are not matched by similarly long-dated assets are indeed facing a particularly high and rising risk of failure.
The EIOPA EU-wide stress test (November 2014) provided EU supervisors with an updated picture of the vulnerabilities of the insurance sector. Supervisors must continue to monitor the situation very closely and challenge the industry on the sustainability of their business models. In such a context, it is essential that firms should use the time given under Solvency II transitional measures to take the necessary steps to restructure their business models.
A consolidation of the mid-sized segment of the EU insurance market will probably take place under the pressure of the monetary environment. In addition, a common recovery and resolution framework is needed for the EU insurance industry because the situation is completely fragmented across member states.
Financial market conditions, added to demographic changes, have also put a heavy strain on pension funds. Lasting low interest rates depress both investment returns and discount rates. Lower discount rates, in turn, raise the present value of funds' liabilities more sharply than that of their assets, which are typically of much shorter duration. This widens pension fund deficits and may ultimately affect the economy at large.
Finally, a prolonged lasting environment of zero rates also saps banks' interest margins and returns from maturity transformation, potentially weakening bank balance sheets, the capacity to generate capital internally, and in turn the supply of credit.
SummaryA speaker opened the session with an invitation to evaluate the trade-offs that the ECB is facing in conducting its monetary policy. The basic nature of the trade-off is very simple: it is a question of what the short run intended effects are and what are the longer run unintended effects. In case anybody thinks this is a new and novel way to look at this subject, the speaker referred to two quotes from two of the world's most famous economists. John Maynard Keynes said "this long run is a misleading guide to current affairs: in the long run we are all dead". However, Ludwig Von Mises took a very different view. He said that "no very deep knowledge of economics is usually needed to grasp the immediate effects of a measure but the task of economics is to foretell the remoter effects, with a view to avoiding even bigger errors".
1. Will monetary policy work in stimulating sustainable growth in Europe?
Understanding low interest rates
A public decision maker gave his views on the underlying drivers explaining why interest rates are so low. Central bank policies should not be interpreted as a cause of low interest rates but rather as a consequence of economic malaise and disinflationary pressures, which the central bank aims to forestall. According to him, the low interest rate environment is in part a secular phenomenon. But cyclical forces also lead to fluctuations around secular trends, especially when driven by the financial cycle. Such forces are still at play in the euro area today.
First, the speaker pointed out that the interest rates environment should not be viewed merely as a consequence of the central banks' reaction to the global financial crisis. He suggested looking at the secular trend since 1980, when long-term rates started to fall from above 10% to almost zero now.
To understand this point, it is useful to decompose long-term nominal yields into four components: expected inflation over the term of the asset; the expected path of short-term real rates; the inflation risk premium and real term premium, which together represent the compensation required by investors for holding long-term bonds as opposed to rolling over short-term securities. All these components have contributed to the very low long term rates we observe today.
From a long-term perspective, nominal yields on long-term bonds have been on a declining trend in all major advanced economies since the 1980s. Improvements in monetary frameworks have played a role in this: the commitment to low and stable inflation, and the adoption of explicitly quantified price stability objectives (or targets), have brought down long-term inflation expectations and compressed inflation premia, both of which have contributed to lower nominal yields. The speaker referred to the Volcker experience. Before October 1979, US monetary policy was insufficiently tight in fighting inflation. When Paul Volcker became the chair of the FED, he said that "I will do whatever it takes and inflation is going to come down". And he did. Long-term inflation expectations went down and stabilised at close to 2%. It took some time but the reduction was remarkable. This is one part of the secular trend of nominal rates.
Then the panellist explained that real interest rates in the long run pertain to productivity and population growth and savings behaviour. He underlined that the low growth and low interest rate environment we see in the euro area today are in part a secular phenomenon. The growth rate of total factor productivity (TFP) has been slowing in the euro area for decades. Population growth has also declined from about 0.7% in the early 1970s to around 0.3% in recent years. This has been mirrored in the long-term decline of real interest rates, as lower TFP and population growth imply a lower demand for investment and for loanable funds.
There is no guarantee that the nominal rates will go back to where they were before if productivity doesn't start to go up again. It is a long-term problem. The productivity story is key. It is for national policy makers to address the secular and institutional factors that are preventing a stronger and more sustained recovery. EU countries must implement structural reforms (product market reforms, labour market reforms) that help reverse resource misallocation and thereby increase TFP and employment. Efforts are now well underway but, the longer they take, the greater the hurdles that all policy makers will have to overcome.
On top of these secular forces leading to lower rates, there are also cyclical factors weighing on real interest rates. These are more directly linked to the global financial crisis. Notably, the euro area is still working its way through a "balance sheet recession" where a situation of severe debt overhang set the conditions for a sharp downturn. This in turn created the need for substantial deleveraging which has prolonged the length of the slump. This is the end product of a pre-crisis period where, misreading the signs of declining productivity growth, firms, households and in some cases governments accumulated excessive debt on the basis of overly optimistic real income expectations.
The result has been excess savings in the post-crisis period caused by the need for all three sectors to repair their balance sheets. Moreover, over-indebted firms and households in some countries have been confronted with higher credit premia, further depressing investment. Indeed, investment remains well below pre-crisis levels.
The same speaker added that, since this is a balance sheet recession, the question of how the financial sector adjusts to it remains a central issue to be addressed. The adjustment to the crisis has been too slow in the euro area. Non-Performing Loans (NPL) at banks are still too high in some Member States.
Again according to this speaker, the negative impact of the crisis has been stronger for the euro area than for other jurisdictions. The reason for this is that certain features of the euro area have made working through a debt crisis harder and more protracted; namely, institutional and structural weaknesses at both national and euro area levels.
The absence of an integrated euro area banking system is one such weakness. The Great Moderation – and a euro-specific misrepresentation of the type of risk that investors were exposed to when accepting to finance imbalances in other member states of the monetary union – had encouraged a formidable expansion in cross-border banking activities prior to the crisis. Yet despite an illusion of integration, the euro area still effectively consisted of multiple juxtaposed national banking systems. Large savings and investment gaps within the monetary union were therefore financed mainly through short-term banking debt, creating latent vulnerability to a "sudden stop".
When the cycle turned, there was little scope for risks to be reallocated across the union – also due to the lack of formal macroeconomic risk-sharing mechanisms in the architecture of our Treaty institutions. Worse, as banks in some of the most vulnerable countries remained heavily exposed to their own sovereigns, the banking sector in fact amplified the crisis via the "diabolical loop" between banks and sovereigns. In these ways, the incomplete structure of the euro area banking sector interacted with the incomplete construction of our institutions to aggravate financial fragmentation and credit constraints. This clearly magnified the impact of balance sheet adjustment on the economy.
The role of monetary policy
On the cyclical side, monetary policy has played, and will continue to play, an important role in responding to demand weakness and the disinflationary pressures it creates. With fiscal policy largely unavailable due to fragile public finances, this has required a determined monetary policy stance to provide countercyclical stabilisation. In recent years, when the need for stabilisation was most urgent, interest rates were already very low. This is why the implementation of this stance has implied unconventional measures since short-term nominal rates ran into the effective lower bound of zero.
The speaker stressed that, when rates are zero, the central banks still have other tools. However, the literature is very uncertain as to whether and how they might work and what the long-term consequences might be. So there is a gap in the knowledge and research, the speaker noted. In addition, there is monetary union in Europe but no federal state. When there are asymmetries, with some countries facing deeper crises than others, then there is no predetermined mechanism for redistribution or cross border support. When an individual country has no room for expansionary fiscal policy, monetary policy has to take the burden but it affects the whole zone not just individual countries in need. There is a need to think very creatively about the transmission of monetary policy because it is an instrument for all. Rates can be cut but then there is a need to think about things like the credit crunch in some countries compared with others.
So when are interest rates likely to go up?
On the inflation premium, central banks will do whatever it takes to keep inflation expectations close to 2%. On the real rate, the implementation of structural reforms is the key. Regarding the risk premium, the flaws of monetary union have to be addressed, which is not simple. In sum, progress on three fronts would accelerate the normalisation of interest rates away from low levels: the first is boosting the euro area's long term growth prospects by implementing structural reforms; the second part is accelerating the repair of the balance sheets of the private sector within the euro area (e.g. reduction of non-performing exposures in banks' balance sheets); the third part is addressing the institutional incompleteness of the European Monetary Union.
Lasting low interest rates: more harm than good
Quoting Milton Friedman, "only when clear and present danger lurks should monetary policy really hammer things", a leader of the industry agreed that a real danger of economic collapse was present in 2008 and 2009. There was therefore a clear need for sharply lower interest rates and going all out on supplying liquidity. The money markets had become dysfunctional and there was a disruption of the link between the short end of the money market, the yield curve and the credit curve.
But according to this representative of the private sector, in present circumstances where money markets are functioning well (in the sense that liquidity is being exchanged and enough liquidity has been supplied), it is questionable whether monetary policy should be still so aggressive.
Furthermore, it seems that the links are not always understood between the short end of the yield curve and the credit curve; markets have taken over directing these things and the chances to influence them by monetary policy actions are more limited than they were in the past.
Moreover, the speaker was extremely sceptical about the efficiency of loose monetary policies on the real economy. In addition, over time, he felt such policies negatively affect the business models of banks, fuel market volatility, make markets more fragile and add to the imbalances that caused the global crisis in the first place.
The transmission channel hinder the expected benefits of loose monetary policies in the current environment of over indebtedness
Considering transmission channels (credit channel, asset valuation channel, portfolio channel, international channel), a public decision maker highlighted some negative side effects of current accommodative monetary policies. He considered the main transmission channels and gave some of examples.
The credit channel effectively tends to suppress saving, pushes up borrowing and spending and thereby supports the economy. But that process is going to be impeded in an environment where debt levels are already quite elevated as they have been rising for some time. What monetary policies are doing at the moment will add to these debt levels, the speaker said. In the euro zone, euro-denominated outstanding debt, which is basically domestic, is around USD 30 tn or EUR 27-28 tn. That is already a great deal, and it has doubled over the last 10-15 years. That level has to be worked down at some point in the future.
The asset valuation channel works through lower discount rates which help to inflate asset prices, collateral values, lending, borrowing and spending. But, according to the panellist, it is also going to feed into debt levels. The hope is that once GDP picks up, those increased debt levels will be more easily serviced, but to what extent this will be the case in practice is an open question.
The third channel is the portfolio balance and risk-taking one. The idea is that the central bank goes into the market directly via asset purchases, leading to the compression of sovereign and credit spreads. In the case of insurers, it is basically about dynamic hedging of the liability side. The other effect might be to push investors along the credit curve into more risk-taking in general. The objective is to get real risk-taking and investment going up in consequence. However, the unintended consequence might be more financial risk taking, a possible mispricing of the euro and leverage with possible adjustment effects going forward.
Lastly, there is the international channel. The key point here is that, at least in the US case, there are indications of strong spill over effects, according to the speaker. International credit (credit to non-residents) has been strongly rising over the last couple of years. Current levels are to the tune of USD 9 tn. They are basically spill-overs from US monetary policy that feed credit booms elsewhere. The numbers are much lower for euro-denominated credit to non-residents, but the growth rates, according to BIS data, are quite high, something like 15% year on year. Now, this basically is going to weigh on corporate profitability and to feed into interest rate exposures.
The panellist added that, if one can believe that central banks were successful in compressing term premia, then the compensation for uncertainty about interest rates has already been priced into bond markets. If this so, then it is not far-fetched to believe that any credible change in the monetary policy stance of a major central bank could lead to a dynamic repricing of the term premium. In turn, this would translate into a dynamic repricing at the long end of the yield curve and therefore a materialisation of the interest-rate risk that has been building up for quite a number of years.
For central banks, what this means is that it will be very tough to time an exit correctly. A central bank doesn't want to exit too early because that might abort the recovery. However, it does not want to exit too late because that is going to add to interest-rate risk. If, somehow, a central bank must manage the transition gradually from one yield level to the other, forward guidance might play a helpful role. Even given this possibility, the speaker suggested that the panellists must brace themselves for increased interest-rate volatility going forward.
This lens suggests that, rather than just reflecting the current economic weakness, low rates may in part have contributed to the weakness by fuelling costly financial booms and busts. The result is too much debt, too little growth and excessively low interest rates. In short low rates beget lower rates.
Monetary policy is not the solution for all of the problems.
Another speaker stated that Unconventional Monetary Policy has to be combined in a holy trinity with fiscal policy and structural reforms. Quantitative Easing (QE) can pump up the economy, but in the long run it gets the economy nowhere because stopping QE makes its health deteriorate if there is no focus on structural reforms. And productivity is not growing in the way it should in most EU member states.
According to this panellist, many countries are still thinking with a centuries-old mindset based on the assumption that people work their whole life in the same job. The change has to be made from a job for life to a life full of jobs because that is where our economies are going. Hence there is a need for much more flexibility. Unless that problem is tackled, QE will only be like bodybuilders' steroids: difficult to quit because they are addictive.
An industry representative added that one of the effects, perhaps intended, of these very low interest rates is that this will discourage people from saving. This has both good (more consumption) and bad (more debt) implications. He also stressed that the issue is, not only if interest rates are kept too low for too long, but also what happens if a policy move is made too quickly. In this latter case, the associated risk would be a massive, brutal rise in interest rates with a non-mitigated market move.
Another panellist underlined that the two questions in relation to interest rates are: how long will they remain low? And even more importantly, how quickly will they go up? Since the answers could have nightmare implications for insurance companies and pension funds, should they choose new business models based on false assumptions, central banks should give as clear guidance as they possibly can.
3. Unintended consequences of unconventional monetary policies outside the financial sector
A panellist reminded the audience that when the crisis hit, the analytical models in common use were totally useless. In spring 2008, the IMF and the OECD for example were predicting real growth in the advanced market economies of 3.7% in 2009. The result was minus 3.6%, which was the biggest forecasting error in history. If the models are that far out, then we must accept logically that we do not know enough about how the system works to be able to say there will be no unintended consequences of policies as radical as the policies that all central banks have been following. These have been the subject of deep deliberation by many people in the past: Wicksell warned about inflation; Hayek warned about "malinvestments" (misallocations) and the nightmare of not having an international monetary system; H. Minsky said stability breeds instability; R. Koo spoke of balance sheet recession; and the BIS was and is worried about just about everything.
One of the questions asked by this speaker, noting that the ECB has come into this much more reluctantly than their colleagues at the Fed, is where all of this might end in terms of unexpected consequences?
Foreign exchange markets behave according to market fundamentals
Regarding the international monetary system, a speaker stated that one of the reasons why there has been a secular decline of interest rates has been the international demand for safe assets. In the pre-crisis years, there was huge demand for a safe asset by both corporates and the asset management business. However, there were not many safe assets because risks were increasing and debt ratios were rising. So the financial industry set to work to create assets that looked safe, in the form of structured products that tended to be rated triple A. Demand was very big in the world and the previous disequilibrium (with demand greater than supply) seemed to end. The Chinese bought US T-bonds and other demanders bought structured triple-As, but then the latter market collapsed. Arguably, this whole process, and the associated global current account imbalances, would have been mitigated had there been some discipline imposed by the existence of an International Monetary System. Such a system would ensure that national policies were to some degree formulated with a view to ensuring the stability of the global economic and financial system as a whole.
As for the question of "currency wars", there has been a downward adjustment of the euro since the introduction of the QE program. How much currencies should go up or down is always debatable. The movements of the euro to date are relatively in line with fundamentals. More recently, there has been a strong appreciation in the effective exchange rate of the euro. The ECB is monitoring carefully the impact of this appreciation of the euro on inflation and growth.
Good and bad deflation
Another speaker stated that it is important to note that one of the big international factors that led to monetary policy being so easy, and for such a long period of time, has been the total failure to incorporate supply side shocks coming out of China and elsewhere. He observed that the whole inflation-targeting approach is premised on the problem being demand shocks. If, rather, supply shocks are behind an observed deflation, this is a "good" deflation and not a "bad" one. At the least, such a "good" deflation is not one that justifies all of the risks that are currently being taken.
Misallocation of real resources
A speaker stated that in a low interest-rate environment, marginal companies can easily survive, because banks do not know if the company is insolvent. There is much evidence from Japan and elsewhere that, if these marginal and zombie companies don't disappear, they will basically eat out the heart of productivity from other companies that could survive if they did not have to face this competition. What can one say more specifically about Europe? More and earlier resolution of both companies and banks is needed.
Is this another expected consequence to worry about? A panellist answered that misallocation of resources in a low interest-rate environment exposes such companies to grave risks should interest rates eventually rise. There have been many such mistaken investments in the recent past. Regarding interest rates, people who go into debt sometimes think 5% is low, particularly if the rate has fallen from 10%. It is very often the case, when nominal rates go down from whatever level, that there is a positive cash flow because the first instalment of debt service is much lower than it was. However, this masks the fact that the rate of interest in real terms might actually have gone up.
It is true that, in the present context of very low rates, the cost of carry for Non-Performing Loans (NPL) is also very low. Banks are then tempted to "evergreen" the bad loan in the hope that things will turn around when the economy picks up. The size of the NPL problem and the poor institutions in Europe, compared to the US, make this problem more lasting and more endemic. The resolution authorities for non-financial corporations (NFCs) are, in general, poor in Europe. They are very different across countries and this is one of the main reasons for this misallocation of resources. Many European countries have been addressing this issue and some are really changing their banking institutions.
Another speaker stated that it is obvious that the real misallocation of resources in Europe was not within sectors, like corporates or households. The real misallocation was between countries, with all the financing flowing from the centre of the monetary union to the peripheral countries. These flows were based on the assumption you could not have a problem with current account imbalances in a currency union. That was a mistaken belief.
4. Specific problems arising in financial institutions (insurance companies, pension funds, banks and others) and possible solutions
Financial repression: the unintended consequences
Today's low interest rate environment is not only driven by macroeconomic factors, but also by policy actions designed to help governments deal with the high burden of their sovereign debt. These policies, often describes as "financial repression", have unintended consequences. Financial repression is effectively an attempt by governments to direct funds to themselves that would otherwise go elsewhere.
The impact of financial repression on markets is undisputable. Indeed, the impact of foregone interest income for households and long-term investors has become substantial. In the US alone, savers have lost about USD 470 bn in interest rate income (net) since the financial crisis began (2008-2013). Over the same period, EU and US insurers have lost around USD 400 bn in yield income. This currently corresponds to an annual "tax" of roughly 0.8% of total financial assets on average, lowering the long-term investors' capacity to channel funds to the real economy.
Similarly the discount rates of pension plans have declined substantially. The effect on a 50-year-old person, who wishes to receive an annuity of €3,000 per month for the next 30 years, is that they would have to save a great deal more. Without doing so, he or she will suffer a decrease in the annuity from the desired level of €3,000 to an actual annuity payment of €1,800 in Switzerland and Germany.
So, in the short term, the plight of pension funds is just the most visible reminder of the need to save more for retirement, which can weaken aggregate demand. Over a longer horizon, negative rates, whether in inflation-adjusted or in nominal terms, are hardly conducive to rational investment decisions and hence sustained growth.
S&P estimates that in 2014 alone the liabilities of European defined benefit pension funds increased by 11-18%, equivalent to EUR 58-92 bn. Hence, financial repression also means future generation will have to shoulder the long-term costs. At present the need to increase savings to compensate for low interest rates has weakened consumption growth. This hinders economic recovery and adds to the "search for yield".
Keeping interest rates artificially low through official intervention hampers the ability of long-term investors to deploy risk capital into the real economy. It has broken the financial market intermediation channel by crowding out viable private markets, lowering the funds available from long-term investors to be used for the real economy. Investments in infrastructure will be hurt, affecting in turn both short term aggregate demand and also longer term potential growth.
Central banks face a trade-off between supporting economic recovery and contributing to the further potential build-up of financial and economic imbalances. However, lower yields and distorted private market signals serve as a disincentive for governments to tackle pressing public policy challenges and thus to advance the structural reform agenda.
Today's environment already provides a great window of opportunity, particularly in the area of infrastructure investments. However, we also need a tradable debt asset class for infrastructure investment so we don't have to rely solely on the public sector for investments. Instead, the public policy environment should promote a well-functioning private market for infrastructure debt. In the same vein, suppressing regulatory disincentives to invest in standardized and transparent securitized products should be a key priority.
The low interest rate environment is a big threat for the business of EU life insurers and pension funds
A regulator detailed the consequences of lasting low interest rates for insurance and pensions. They are clear and already visible, and should be also recognised, by the monetary authorities. There are basically four main consequences, according to this speaker.
The first one is the search for yield, the second one is lower profitability. The third has to do with structural consequences; namely, different business models and the capacity to deal with the change that is needed. Finally low rates could become a threat to solvency.
The search for yield. A report was published in the UK after the introduction of QE which showed how the insurance and the pension sectors have been rebalancing their portfolios. They sold gilts and they bought corporate bonds and that had a good effect. That is something that also needs to be understood within the euro area. The search for yield is not always bad if it is an economic, rational decision by companies. However, what is needed from the institutions is that they try to mitigate the risks entailed. There are two main risks. One is that companies would increase their risk profile well beyond their risk-bearing capabilities. The second is they would enter into types of assets that the institution doesn't know how to manage. Are the institutions mitigating these risks? If not, insolvency might be the result where there is no reflection in terms of the capital requirements or on the riskiness of investments made compared with what lies ahead. In Solvency II, of course, this mitigation element will be there. According to the speaker, mitigation is a capital requirement. To be sustainable, the search for yield necessitates more capital.
The second element is risk management needs. All the requirements introduced in Solvency II have, of course, already been embedded in the day-to-day life of companies. The aim is to ensure that they only invest in assets that can be assessed and managed properly in terms of risks. This risk-mitigating element is rightly there in place. Is it going to work?
The speaker recommended being cautious on what is being done in the calibration work on infrastructure investment by insurers, particularly to avoid an asset bubble in this area. He said that asset risk calibration in Solvency II should not be used to privilege or incentive any specific asset class. If the regime creates incentives that are not properly aligned with risks, we will see the emergence of price distortions and vulnerabilities. So there must be a little bit of caution on this. Nobody wants to create bubbles. There has to be a proper risk-reward mechanism in there so that the insurance industry and the pension funds industry can be counted on to really carry out proper risk-reward analysis.
Regarding, profitability, the insurance sector never had the excesses of the banking industry such as returns on equity of 20%, 30% on a stable basis. So, while there is a challenge for maintaining profitability, that is something that will be easier to keep under control.
As to the third point, the business models, the speaker reminded the audience that this problem is even more pronounced where guaranteed rates of returns have been offered to policy-holders. Some mid-sized life insurers with guaranteed returns, and long-dated liabilities that are not matched by similarly long-dated assets, are indeed facing a particularly high (and rising) risk of failure. The EIOPA EU-wide stress test (November 2014) provided EU supervisors with an updated picture of the vulnerabilities of the insurance sector.
There are a number of solutions provided by the Solvency II framework which should contribute to solving this problem. Nevertheless, the insurance sector in Europe doesn't seem to be taking advantage of what has been done with the matching adjustment for instance. This workable tool is only used in two or three countries although it is advantageous from a capital perspective. So innovation in the products provided is a priority as well as pension plans forward looking plans to implement new product strategies. The Solvency 2 regime will be more transparent. There are transitional mechanisms in this framework to avoid disruptions and to ensure a soft landing. But like the ECB, which provides liquidity but asks the member states to make structural reforms, insurance supervisors are challenging unsustainable business models in the insurance industry.
In other words it is essential that firms should use the time given by the Solvency II transitional measures to take the necessary steps to restructure their business models. If current business models are unsustainable, there need to be solutions. Supervisors must continue to monitor the situation very closely and challenge the industry on the sustainability of their business models.
Moreover, the speaker emphasized that a better recovery and resolution framework is needed for the EU insurance in Europe. Indeed the situation is completely fragmented according to member states. This is something that will not result in a positive outcome if there are really adverse developments. Insurers need to address issues that are difficult, such as restructuring the liabilities of policyholders and having some kind of billing element, as in the banking sector. It is fundamental that insurance companies really deliver on their commitments. In Japan, this did happen at one point in time. On a relatively positive note, while the challenges are there, some mitigating tools are already in place and there are some others that could be introduced.
A representative of the public sector asked if there are lessons that can be learned from the Japanese experience in the 1990s, as the situation then was rather similar to the current one in Europe. Japanese insurers had sold products with high guaranteed interest rates and then had to live in a low interest rate environment. This brought forward two issues; the sustainability of their business models and the problem of resolution regimes (7 midsize life insurers went bankrupt in Japan between 1997 and 2001). According to this speaker, a consolidation in the mid-sized segment of the EU insurance market should probably take place under the pressure of the monetary environment.
Preserving a level playing field between life insurers and pension funds
A leader of the industry stated that the problem of the insurance industry is to adapt but to remain secure. It needs to preserve the confidence people currently have in it. Since the last Eurofi event, six months ago, much has been already achieved by the regulators as well as by the industry. Insurers are adapting their business models in a determined way but it takes time.
In order to mitigate the effects over time of lasting low interest rates, there must be a soft implementation of new rules and a preservation of a level playing field between life insurers and pension funds. Pension funds are very long-term schemes for retirements and should be regulated according to the Solvency II framework from next year on.
Citizens worry about the future of their pensions
A public sector decision maker pointed out that many people have worries now about their future, even about their pensions. They read in the newspapers that the premiums they will have to pay will rise or otherwise their pensions will be cut. It is very important to realise that in a few years' time, at least in the Netherlands, and eastwards in Europe, the majority of people will be over 50. This will have consequences for politics too, because the majority of voters will be over 50. In such a context, it is necessary for the industry to create more flexibility in their business models. There has also to be more flexibility in the regulatory field, and that is not just something like giving some leeway or more time for recovering solvency. There should be a proper discussion, with the wide variety of people involved, to find solutions so that people can be more confident about their pensions and also benefit from more choice in the retirement products offered.
For every solution there is another problem
A speaker stated that for every solution, there seems to be another problem. He gave the example of the suggested change in business models. If part of the change in the business model for insurance companies is simply to throw the risk back on to the consumer, this seemed to him to be the very opposite of what insurance, the pooling of risks, was originally supposed to provide.
The second issue is that a change in the business model, prompted by low interest rates, will take time. What if, in the interim, interest rates go back up again. Will a reversal of the business model also be needed?
Banks are also facing up to difficulties in a low interest rate environment
A panellist stressed that in a lasting environment of zero rates, the banking sector is unlikely to be spared. Such low rates squeeze banks' interest margins and the returns from maturity transformation. This could potentially weaken balance sheets and the supply of credit. In fact, the banking industry will have relatively greater difficulties in adapting because insurance sectors at least have the possibility to go from guaranteed and defined benefit products to market-related products. If banking moves to the market-based model, it will be faced with another difficulty that the insurance sector does not have: the risk of deposit "runs".
Moreover, there is a great risk that banking will turn to more market-based funding because it tends to be cheaper than deposit funding. If that happens, this would expose them to the vagaries of the capital markets. It would require in particular much tighter liquidity management or a greater trust by the market in the quality of their loan book. That trust in turn might depend on the quality of the loan book actually being significantly increased.
Will ultra-easy monetary policy work to stimulate aggregate demand? Whether yes or no, there are other problems that really have to be faced by governments. They have relied for far too long on the central banks to resolve a solvency problem that they are inherently incapable of solving.
On the unexpected consequences, the first point to note is the one major reason why monetary policy might not work. One of the unexpected consequences is a build-up of debt that in the end prevents monetary policy from working.
On other unexpected consequences, in particular "currency wars", more attention needs to be paid to international linkages, both real and financial. On the misallocation of real resources, zombie banks and zombie companies are a problem but resolution is a task for governments. On the financial markets, everyone is worried about boom and bust.
On the unexpected consequences for financial institutions, are the insurance companies and pension funds seeing problems? The answer is yes. Do they see ways to mitigate them? The answer is yes. Are the banks facing a problem? Again, the answer is yes. Sadly, there was no time in this session to identify possible means of mitigating these banking problems.
By W. R. White - Chairman of the Economic and Development Review Committee, Organisation for Economic Co-operation and Development (OECD)
By J. Haegeli – Head Investment Strategy, Swiss Reinsurance Company Ltd
By J. Berg - Member of the Executive Board, Nykredit Bank
By C. van Nieuwenhuizen - MEP, Committee on Economic and Financial Affairs, European Parliament.
By X. Larnaudie-Eiffel - Deputy General Manager, CNP Assurances
By G. Bernardino – Chairman, European Insurance and Occupational Pensions Authority (EIOPA)