IMF highlights risks of permanently low interest rates

According to IMF paper there has-been a long-term low interest rates in major economies which will make global financial stability difficult to attain.

Part of the International Monetary Fund’s twice-annual review of financial stability, the report follows moves by the US Federal Reserve to lift benchmark rates in the last two quarters after a period of extraordinary accommodation following the 2008 financial crisis.

Nevertheless, rates in the US remain historically low, while other major central banks still maintain ultra-low interest rates.

Persistently low interest rates “would present a considerable challenge to financial institutions,” requiring “significant” changes to business models, the paper said.

“In such an environment, yield curves would likely flatten, lowering bank earnings and presenting long-lasting challenges for life insurers and defined-benefit pension funds.”

Although the IMF paper did not predict a permanent shift to low rates, it said the implications of such an outcome must be considered. Low interest rates could become a feature of low growth in advanced economies with aging populations and stagnant productivity.

The example of Japan suggests “an imminent and permanent exit from a low-interest rate environment need not be guaranteed,” the paper said.

Perpetually low rates pose challenges for banks by cutting into profits that traditionally come from the gap generated by their ability to borrow money at low rates for short periods while lending for long periods at higher rates.

That condition could force smaller banks to merge with each other or larger banks that may be less stressed because of greater regional diversification.

Low interest rates would also pose difficulties to the insurance and pensions sectors, which could no longer rely on interest-rate-based returns to meet future liabilities and may be forced to raise additional capital, the paper said. They may also need to shift to different product lines as consumers live longer, demanding fewer savings products and more health insurance.

The paper urges policy makers to work to ensure long-term stability “instead of falling prey to demands for deregulation.”

Key policy changes could include not hindering consolidation among banks that need to merge, tightening requirements on insurers and pension funds to evaluate their assets and liabilities based on economic value, and stepping up oversight of passive index-linked funds that could attract more investors in a low-rate era, but are also more risky, the report said.

“Surveillance and regulation of asset management activities will become even more important if this industry’s share of the financial system continues to grow,” the report said.