BankThink

Low Rates Mean It's Time for Some Old-School Lending

"What fresh hell is this?" to quote the sharp-witted Dorothy Parker. American banking has coped with unprecedented troubles in the last couple of years and now face an interesting new twist — negative interest rates. The notion may disturb our very capitalistic core, but there is no need for panic...yet.

We have seen crazy interest rate curves in the past. We have certainly watched rates zig zag. However, we have never before seen depositors paying their banks to hold their money — until now.

Despite the recent U.S. government ratings downgrade by Standard & Poor's, treasury rates are at all time lows and the flight to safety has caused equities to fall twenty percent in the last month alone. With few choices of where to park funds, corporations are uncertain about what to do with their excess cash. As they study the situation, demand deposits continue to accumulate. With minimal growth in the economy, banks too are stymied, awash in excess cash.

Rather than turn customers away, banks — such as Bank of New York Mellon last week — have announced that they will be "paying" their customers negative interest on large deposits. Though this is new in the United States, it is hardly a new occurrence.

Japan faced the issue of negative inter-bank deposit rates as far back as 1998. As a banker in Japan during this period, I can attest to the fact that the Japanese business community, while unruffled by the peculiar economic turn, knew they were entering uncharted waters. Their stoic reaction to the negative rates, and what they foreshadowed, was in keeping with Japan's reserved business culture.

(Meanwhile the Japanese public shrugged and referred to the returns as tansu rates, the rough equivalent of "sock drawer" rates — signifying that one may as well stick the money in a drawer.)

But be clear, this glitch in interest rates is a call to arms. Bankers must act. Japan hesitated and sank into the morass for, what is locally called, the "lost decade." Here in the U.S., proprietary trading desks can no longer fuel bank profits thanks to the Volcker provision of the Dodd-Frank Act. Securitization was a cause of the crisis; it will not be the cure.

The solution is inescapable. American banks must start lending. They must dust off their credit manuals and relearn straightforward finance. The current low rate environment offers an opportunity to get back to the basics. Finding worthwhile borrowers in a slow economy won't be easy, but the banks that make the effort will be rewarded when the economy rebounds.

If negative rates are the harbinger of the type of stagflation that destroyed many of the top Japanese banks through the 1990s, then American bankers need to heed the lessons learned and prepare for a lingering low interest rate environment and a slow recovery. It's easy to forget that in 1988, the top 10 banks in the world ranked by deposits were all Japanese. Half those banks are no longer in existence, merged into oblivion.

Will American institutions be able to manage low, or even negative, interest rates while struggling to deal with the harsh realities of a stagnant economy and heightened regulatory environment, or will they follow the Japanese example and simply merge and cut costs?

Demand deposit rates in the past have often been low, and when compensating balances or bank fees have been taken into account, zero. So the fact that U.S. corporations are willing to pay for the convenience of maintaining demand deposits should hardly be surprising. We must face the difficult truth. Bank statements may contain distressing negative numbers for some time to come. Negative rates, in and of themselves, should not cause bankers to lose sleep — but what they may portend should be a wake-up call.

American banks will survive even this crazy anomaly of upside-down interest rates. There will be consolidation and belt-tightening, but in the end, if American banks will get back to the business of banking, they will find a way to deal with even this "fresh hell."

Try to think positive.

Richard Magrann-Wells is a senior vice president and the financial services consulting practice leader for Willis North America.

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