From  Committee on the Global Financial System

The decade following the Great Financial Crisis (GFC) has been marked by historically low interest rates. An environment characterised by “low-for-long” interest rates may dampen the profitability and strength of financial firms and thus become a source of vulnerability for the financial system. In addition, low rates could change firms’ incentives to take risks, which could engender additional financial sector vulnerabilities.

This report identifies and provides evidence for the channels through which a “low-for-long” scenario might affect financial stability, focusing on the impact of low rates on banks and on insurance companies and private pension funds (ICPFs). For banks, low rates might reduce resilience by lowering profitability, and thus the ability of banks to replenish capital after a negative shock, and by encouraging risk-taking. For ICPFs, falling interest rates cause the present value of liabilities to rise more than that of assets, affecting solvency. In addition, the scope for claimholders to terminate life insurance contracts early can become a source of liquidity vulnerability for insurance companies if a period of low interest rates ends with a sudden snapback in rates.

The report finds that while banks should generally be able to cope with solvency challenges in a low-for-long scenario, ICPFs would do less well. Even though the Working Group identified only a relatively limited amount of additional risk-taking by banks and ICPFs in response to low rates, a low-for-long scenario could still engender material risks to financial stability. For example, even in the absence of greater risk-taking, a future snapback in interest rates could be challenging for financial institutions. Banks without sufficient capital buffers could face solvency issues, driven by both valuation and credit losses. ICPFs, instead, could face liquidity problems, driven either by additional collateral demands linked to losses on derivative positions or by spikes in early liquidations.

Source: BIS