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LOW INTEREST RATE
ENVIRONMENT
January 2010
The following Nationwide Building Society briefing details the impact of a low interest rate environment
on the financial services industry.
Background
The Bank of England base rate is now at the lowest level ever recorded in its more than 300 year history. Since
October 2008 the Bank of England has decreased the base rate from 5.0% to 0.5%, where it has remained since
March 2009.
This unprecedented level of interest rates is a policy response to the threat of deflation that has arisen out of the
financial crisis and the associated recession. Deflation is a highly undesirable outcome for highly indebted
economies, such as the UK, as it increases the real cost of servicing debts, resulting in disincentives to
investment and permanent losses in income and output.
In order to prevent a deflationary outcome, exceptionally loose monetary conditions are required, which the Bank
of England has implemented in the form of both low interest rates and the direct creation of new money via its
£200bn Asset Purchase Facility.
Low interest rates and new money creation aim to provide stimulus to the economy in a number of different ways,
as they:
1. Reduce debt-servicing costs, thereby increasing the money holdings of debtors from what they otherwise
would be and create stronger incentives for new investment;
2. Weaken the exchange rate, which increases the competitiveness of exports and the money holdings of
exporters;
3. Increase expectations of future inflation, creating incentives for consumers and businesses to spend spare
cash sooner rather than later.
Impacts of a low interest rate environment
Although low interest rates have provided a large stimulus to the economy, they have not been without major side
effects on deposit-taking institutions.
At a simplified level, the profit margin of lenders is essentially made up of two components. First, a margin is
earned by paying savings rates at a level somewhat below the base rate, generally 1.0-1.5 percentage points.
Second, a margin is earned by charging interest
6.0% Household savings rate vs base rate 300 on loans at a slight spread above base rate.
4.0% 200 The problem presented by a low interest rate
environment is that in practice, savings rates
2.0% 100 face a zero lower bound. Therefore, when the
0.0% 0 base rate is at 0.5%, deposit-takers cannot earn
the typical savings margin by paying interest on
-2.0% Spread (bps) (RHS) -100 savings 1.0-1.5 percentage points below the
Average Savings Rate (LHS)
-4.0% -200 base rate. This can be clearly seen in graph 1.
BoE Base Rate (LHS)
-6.0% -300
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Before the cut in base rate to 0.5%, savings
rates were consistently below the base rate –
they are now significantly above it. In effect,
Source: Bank of England lenders are making losses on the deposit side of
their business.
In order to maintain overall profitability, lenders must widen the margin on the asset side of their balance sheet
wherever possible, and this is one of the reasons why rates on new mortgage business have not been able to
come down by as much as the base rate.
In those cases where mortgage rates have been reduced in line with base rate, overall profit margins have
declined, putting pressure on capital positions.
Enquiries to: james.harborne@nationwide.co.uk, 020 7826 2103
hannah.sanders@nationwide.co.uk, 01793 657500
LOW INTEREST RATE
ENVIRONMENT
January 2010
Competition pressures Household savings balance growth (£bn)
The pressure on deposit margins has been
exacerbated further by exceptionally strong competition 50 Interest paid New receipts
for retail funds, within the context of a shrinking savings
40
market. This has significantly increased the marginal
cost of attracting and retaining deposits. 30
20
• Shrinking household savings balances
10
Growth in household savings balances has slowed
dramatically over the last year. In the first half of 2009, 0
balances grew by only £14bn, compared to £40bn in (Graph 2)
the first half of 2008 (graph 2). More importantly, -10
balance growth is currently being driven purely by H2 2007 H1 2008 H2 2008 H1 2009
capitalised interest. Excluding interest paid on the Source: Bank of England, Nationwide calculations
existing savings stock, household deposits actually saw
an outflow of £4bn during the first half of 2009.
The weakness of the household savings market reflects a number of factors, including higher household debt
repayments and a lower flow of money into deposit accounts from other asset markets, such as housing and
equities. Moreover, the dividend yield on the main equity markets is now above most savings rates and this has
led many households to shift savings from deposits into the equity markets. At the same time as the savings
market has shrunk, competition for funds has been fiercer than ever.
• Customer funding gap between loans and
deposits
This competition is a direct result of the funding gap
that exists between loans and deposits in the UK
banking system. The Bank of England has estimated
this gap at £800bn (graph 3).
Before the financial crisis, the gap could be filled by
inexpensive wholesale funding. However, since 2007
funding through the wholesale markets has not been
possible to any significant degree. In place of private
funding, the gap is now being financed by
government schemes such as the Bank of England’s
Special Liquidity Scheme (SLS) or the Credit
Guarantee Scheme (CGS). These schemes,
(Graph 3) however, are due to expire in 2010-12.
Before this happens, banks are under tremendous pressure to close their funding gaps as much as possible by
raising retail deposits. However, the growth in the household deposit market is nowhere near enough to close the
funding gap over the next several years.
• Competition for deposits
As a result, banks with large funding gaps are targeting the funds of competitors with particularly large retail
deposit books. Building societies have been especially exposed to this increase in competition, given that they
have always been financed to a much greater degree by retail savings. This could become more of an issue if
the proposals by the FSA in CP08/22 and CP09/17 could require banks to hold greater capital and liquidity as
part of improved liquidity regulations.
Enquiries to: james.harborne@nationwide.co.uk, 020 7826 2103
hannah.sanders@nationwide.co.uk, 01793 657500
