(Bloomberg) -- As policy makers globally prepare to cut borrowing costs again, banks around the world are feeling the heat.
Rock-bottom interest rates can help stoke growth, but they also put the squeeze on lending margins. Big U.S. banks including JPMorgan Chase & Co. and Citigroup Inc., which reported second-quarter earnings last week, are already seeing the revenue impact of declining interest rates -- even before the Federal Reserve delivers a cut expected at the end of the month.
Their European and Japanese peers, which release their results in the next three weeks, are likely to struggle with the same issue. And they’ll be starting from a weaker position, as their central banks have cut deeper -- to negative benchmark rates -- and stuck to that policy even after the Fed reversed course and temporarily raised rates in the U.S.
“Low rates have hurt bank profitability in most developed markets for years now, and the pain doesn’t seem to be coming to an end any time soon,” said Jan Schildbach, head of research for banking and financial markets at Deutsche Bank AG in Frankfurt.
The rise of unorthodox monetary policies has upended the model of traditional banking that held for decades -- one epitomized by the old American joke that commercial bankers borrowed money at 3%, lent it out at 6% and were on the golf course by 3 p.m. In Europe, the squeeze from negative rates prompted drastic makeovers at some of the region’s biggest firms. Japanese lenders have been driven beyond their borders in search of growth.
Lower interest rates theoretically help banks too, by increasing demand for loans. That means the potential harm to net interest income -- the difference between what banks collect from borrowers and what they pay depositors -- would be countered by rising loan volume.
But it hasn’t always worked that way. Low rates sometimes haven’t provided enough of an impetus to rekindle demand. At other times, the uptick didn’t appear for several quarters -- or years -- while banks began suffering immediately.
“In Europe, further accommodative policies will be more painful for the banks,” Schildbach said. “In the U.S., it will slow down revenue and profit growth.”
The European Central Bank went negative in 2014, beginning to charge banks for the excess reserves they hold there. The Bank of Japan followed suit in 2016.
Those cuts brought down long-term borrowing costs, squeezing banks’ margins. When short-term interest rates are negative, banks have a hard time passing that on to customers because many of them -- households and small businesses, especially -- would simply pull their money out of the banking system rather than pay a lender to hold onto it.
On the other hand, as long-term interest rates drop due to negative short-term rates, what banks can charge borrowers for mortgages, corporate loans or other debt declines too. Thus the net interest margin, the spread between the lending rate and borrowing cost, keeps shrinking.
Quantitative easing -- when a central bank aggressively purchases government bonds -- also brings down long-term rates, which is what most lending by banks is based on. Even though the European Central Bank went negative before the Bank of Japan, Japanese banks’ spreads are tighter than European peers’ because of the longer history of rock-bottom rates and central bank easing in the Asian country.
UBS Group AG Chief Executive Officer Sergio Ermotti -- whose company, which leans more heavily on wealth management than lending compared with many of its rivals, posted its best quarterly earnings in almost a decade on Tuesday -- sounded the alarm on fresh monetary easing.
“I’d be very, very careful about growing further the balance sheet of central banks,” he said in a Bloomberg Television interview Tuesday, ahead of the European Central Bank’s policy decision this week. “We are at a risk of creating an asset bubble.”
The negative rates by the BOJ, the ECB and several other western central banks have pushed the yields of many government bonds and even some corporate debt to negative territory as well. In other words, investors have been paying borrowers to hold their money rather than collecting interest from them. There’s now $13 trillion of such debt around the world, most of it in the euro region and Japan.
That means that, in addition to the several billion dollars European banks pay the ECB for their excess reserves, many lose money on the government bonds they have to hold to comply with global liquidity requirements, given that German bunds and French and Dutch debt have had negative returns for years. The liquidity rules require the biggest lenders to have enough easy-to-sell assets -- either popular government bonds, or reserves at the central bank -- to deal with short-term funding demands if financial panic ensues.
A consistent improvement in loan quality alleviated some of interest-margin squeeze for Japanese banks. But that trend has probably run its course and is about to reverse, according to Keefe, Bruyette & Woods analyst David Threadgold. When loans start souring more often, banks’ narrow profit margins will be wiped out fast.
“Even after 20 years of near-zero rates, Japan is now about to find the true cost of low rates,” said Threadgold, who’s based in Tokyo and has been following the nation’s financial firms for more than three decades. “With such low spreads, you can barely get by in a very benign credit environment. It will be almost impossible, for many smaller firms especially, in a deteriorating environment.”
Steady rate increases by the Fed since 2015 boosted the net interest margins of U.S. lenders as they increased their lending rates more than what they paid depositors. That came under pressure in the second quarter as the gap between short-term and long-term rates narrowed, the latter falling on Fed-cut expectations.
If and when the cuts materialize, the difference between the two rates -- or yield curve -- could normalize and help the margins of big banks stabilize, according to RBC Capital Markets analyst Gerard Cassidy.
“Assuming Fed actually cuts the rates and the yield curve steepens, the pressure on net interest income growth will come down,” he said. “So second quarter might have been the worst point in the net interest margin.”
European banks, which last year managed to eke out their best profits since the financial crisis, won’t be so lucky. For the 20 biggest firms in the region, that wasn’t from higher revenue but rather ruthless cost-cutting and declining bad-loan provisions, according to Deutsche Bank research.
While the aggressive monetary policy has boosted some corporate lending, European banks’ loan growth has trailed that of U.S. rivals and done little for the bottom line.
In Japan, while the central bank may not make further cuts, the nation’s banks are nevertheless poised to be hurt by narrowing margins in the U.S. and Europe after years of overseas expansion. The average share of foreign loans in the portfolios of the top three Japanese mega-banks is about 35%, according to company filings. Lower yields on foreign bonds, meanwhile, will shrink returns on securities holdings, with some analysts saying that even U.S. Treasuries may yield negative returns in a few years.
“If the rest of the world looks more like Japan in coming years,” Threadgold said, “then as a Japanese bank you’ve diversified out of the frying pan into the fire.”
(Updates with UBS CEO’s comments in third, fourth paragraphs under Shrinking Margin subheadline.)
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