Why are the interest rates so low?

The work, forthcoming in the Journal of Financial Economics, demonstrates that prudential regulation causes a decline in interest rates by increasing the lending supply and decreasing the borrowing demand in the money market. These regulations create unintended consequences within the new regulatory framework, which involves clearing houses and banks. These policies also bring with them important consequences for our society-at-large, policy makers, financial authorities and even central banks.

In all likelihood, the current pandemic crisis with the consequent economic problems and tensions in the financial markets will exacerbate the mechanism discovered in this study and create additional dispersion and downward pressure on interest rates. Angelo Ranaldo answered six questions on the subject.

Why are interest rate so low?

The obvious answer to this question is because of monetary policy whether it is conventional or unconventional such as Quantitative Easing programmes. The study shows that in addition to this, it is the financial stability policy that lowers interest rates. These polices were enacted to ensure that the turmoil that engulfed the world economy and global financial system in late 2008 were to be avoided in the future. Obviously, the consequences that this policy has on interest rates were not the intention of the central banks and legislators who designed policies, such as EMIR and Basel III.

 
How does the new regulatory framework put downward pressure on interest rates?

To use a metaphor, these new regulations have put elephants in the crystal room in the sense that it has created huge new players in the money market. This has had a significant impact on interest rates, which has maintained pressure on keeping them at historical lows.  

This gets complicated, but it goes like this… The new regulation requires that the clearing houses (CCPs) do not keep more than 5% of all the cash accumulated by (initial) margins in an unsecured way.

The only efficient, practical and economical way to meet the law's requirement for CCPs is to lend with a repurchase agreement (repo) contract. The repo allows the CCP to lend cash at short maturities (“overnight” up to one week, typically) and at the same time to purchase the (collateral) assets. Notice that to fulfil the legislation, CCPs typically buy very safe assets such as German government bonds. By doing this, CCPs decrease interest rates of the most secured repos and create a wider dispersion between repos secured by Euro area core and periphery countries.

 
Are we talking about a lot of money?

Yes! If you consider the top 10 European Market Infrastructure Regulation (EMIR) initial margin requests, about 100 billion Euros need to be secured in “reverse repos” every single day.

 
Why don't the banks take advantage of this?

In fact, banks could borrow from CCPs at advantageous rates. However, the Basel III leverage ratio disincentives banks to borrow in the repo market because this “expands” their balance sheet.  So not only does the CCPs’ supply of cash increase, but the demand of cash also decreases. Both the oversupply and the lack of demand has an effect on decreasing interest rates.

 
Why should we care about these effects?

We should care about the effects that financial stability policy has on interest rates for four primary reasons:

• Policy makers are not aware of this phenomenon.
• While new prudential policies strengthen financial stability, regulations, such as the Basel III leverage ratio, have created unintended effects, such as disincentivising repo intermediation, inducing collateral scarcity and window-dressing at the end of reporting periods.
• The new regulatory framework has made central clearing mandatory for a large number of interest rate swaps and credit default swaps (CDS), thus making CCPs large actors in financial markets. As said before, CCPs have become big elephants that becomes even bigger in “bad” times, such as the pandemic crisis. Why? Because exactly during those periods, CCPs requires larger margins (pro-cyclicality) and flood the money market with a larger amount of cash.  Understanding these issues is crucial for phasing-in and redesigning the regulatory framework aiming at reaching the desired level of market efficiency and financial stability.
• The new regulation creates a larger dispersion in short-term rates, which makes the transmission of the monetary policy more difficult.

Any final thoughts?

Sometimes one policy collides with another creating unintended consequences. This study sheds light on this phenomenon that affects the interest rates, which are crucial for monetary policy, to define benchmark rates, and that determine the many asset prices. The paper entitled Regulatory Effects on Short-Term Interest Rates is forthcoming in the Journal of Financial Economics.

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