When interest rates fall

The fact that local banks have so far not reacted to the cutting of the ECB main interest rate by 0.25% may have surprised many hard pressed mortgage borrowers and businesses that borrow money from banks. But this is not really surprising. There are of course good and not so good reasons behind the ‘let’s wait and see’ policy adopted by local banks.

An economist told maltastar.com: “Those who understand how the wheels of local banking move know that there is often a tacit agreement between banks to act in unison on issues that are of mutual interest to them. They will of course deny this statement vehemently but, believe me, this is how some important decisions are taken in this paradise of competition.”

A more respectable reason for waiting until local interest move in the direction signalled by the ECB is that while a drop in interest rates is good news for borrowers, it is bad news for depositors. In the current scenario of record low interest rates, depositors are often dangerously withdrawing their money from the relatively safer bank deposits to buy other investment products with a much higher risk profile. This is playing with fire - at least for those depositors who cannot afford to lose even 10 percent of their savings. It is also bad news for local banks that depend on locally raised deposits to finance their lending.

Banks have different options when interest rates fall – or at least they should have if the forces of competition are unshackled. A bank may pass on the full benefit of an interest rate drop to its borrowing customers, and wait to cut interest rate on deposits until it feels confident that depositors will not be scared away. However, such a strategy can only be sustained for a very short time as this constitutes an interest rate risk that can cause intensive damage to a bank’s profitability.

The ECB is running out of ammunition to tackle the economic slump in the eurozone. The talk on stimulating economic growth will only bear results when major economic and political decisions are taken to put the eurozone on a sounder basis. This may have to include financial and fiscal integration and the giving up of some sovereignty.

Interest rates are now so low that a drop of 0.25% may not have much effect on businesses, although admittedly it will ease pressure on households who have to pay their monthly mortgage rates. The current economic slump is being made even worse by banks that have become very risk averse and are unwilling to lend money to struggling businesses. The popular cliché that banks are very insistent on lending you an umbrella when it is sunny only to demand that you give it back to them when it starts raining has never been truer than in the current economic crisis.

In the current situation it is important that if interest rates are reduced, depositors should think twice before giving up on bank deposits to enter into high risk investments like junk bonds. Even if, after the Bank of Valletta Property Fund debacle, banks have become rather more responsible in advising customers on investment opportunities, one will do well to thank independent advice for a trusted and well informed person.

The same economist says: “People who cannot afford to lose any of their capital should shy away from promises of high returns because the relationship between risk and reward is very real.”