Since the global financial crisis of 2007-2008, interest rates in many countries have reached historically low levels. Central Banks in some countries such as Sweden, Denmark, Japan and Switzerland, as well as the European Central Bank, have even resorted to negative or zero reference interest rates as a monetary policy tool, relying on the transmission mechanism of monetary policy to meet their policy objectives.
Negative or zero interest rates present challenges for financial institutions as they normally refer to the reference interest rates in their contracts. In particular, there may be issues with respect to accommodating a zero or negative reference rate on retail products such as mortgages, current accounts and/or savings accounts. Using a negative number as a reference rate may also present very severe operational challenges, requiring financial institutions to make certain changes to their internal systems and processes.
In the UK, where the reference interest rate (“Bank Rate”) remains a decision for the Monetary Policy Committee (MPC) of the Bank of England (BoE), the prospect of negative or zero interest rates has prompted the Prudential Regulation Authority (PRA) to take certain measures that would help ensure the operational readiness of the financial sector in the case of a zero or negative Bank Rate.
The BoE currently maintains the Bank Rate at 0.1% but it requires the financial sector to be prepared in order for a negative or zero Bank Rate to be effective as a policy tool in a way that does not adversely affect the safety and soundness of financial institutions. As per the minutes of the September 2020 meeting of the MPC, the PRA has already commenced a “structured engagement” on the operational considerations of a negative policy rate.
Cautioning that this structured engagement “should not be interpreted as a signal that the setting of a negative Bank Rate is imminent, or indeed in prospect at any time”, the PRA refrains from requiring firms to begin taking steps to ensure they are operationally ready to implement a negative Bank Rate. However, it sent a “Dear CEO letter” to certain financial institutions in October 2020, seeking information from firms with respect to time and cost expectations for the tactical and strategic solutions which would be required in the event of a zero or negative Bank Rate.
The letter included a set of structured survey questions designed to assess the sector’s operational readiness and the potential challenges that it may face, particularly in terms of technological implementation capabilities. The sector’s response to these questions presents important implications for the supervision of financial institutions in the UK and elsewhere.
A subsequent Dear CEO letter issued by the PRA in February 2021 cautions that preparatory work would be needed on tracker mortgages, where customer rates are directly determined by Bank Rate. However, the letter reveals that a zero Bank Rate would pose less of an operational challenge for the financial sector than a negative one, and would take less time to implement without material risks to firms’ safety and soundness.
The PRA believes that an implementation period of shorter than six months would attract increased operational risks and could adversely impact some firms’ safety and soundness and the PRA’s wider statutory objectives. Therefore, the letter cautions that the majority of financial institutions would be required to make certain changes to their internal systems and processes regardless of whether they implement a “strategic” or a “tactical” solution, to ensure that they are capable of adapting to a negative interest rate “at any point after six months”.
The letter suggests that wholesale businesses would have an easier time adapting a negative Bank Rate as they are generally newer and more bespoke. Substantive changes would need to be made to legacy retail systems, which are not currently capable of accepting and processing a negative number as a reference rate. A zero Bank Rate would not present any operational challenges for insurance firms as they do not refer to the Bank Rate in their contracts
The PRA suggests that tactical solutions may include “shorter-term fixes”, such as workarounds on the periphery of core systems or overrides in downstream systems and customer communications, whereas strategic solutions may include more permanent changes, involving material systems upgrades that feed through internal systems for managing the calculation of interest, customer communications, treasury, accounting, and risk models.
Strategic solutions to implementing a negative Bank Rate have been reported by many firms as having a significantly longer timeframe than tactical solutions. The letter reveals that shorter-term tactical solutions do not necessarily result in a negative rate on retail products such as mortgages and current or savings accounts, but their implementation could take up to six months to implement, while longer-term strategic solutions would take up to twelve to eighteen months.
For financial institutions, this could involve reprioritizing other important projects. Hence, the PRA’s intention for now is only to set out the timeframe for firms to develop “tactical solutions” to implement a negative Bank Rate and to engage with them on their development of such solutions to overcome potential operational implications in the context of its objectives, including promoting safety and soundness.
Regulators in other countries, where the announcement of a negative or zero interest rate is a strong possibility, should follow the PRA closely and take similar action to ensure that they have an accurate and comprehensive understanding of any potential issues and risks associated with the operational implementation of zero or negative reference rates.
Mete Feridun is the Chair of the Centre for Financial Regulation and Risk Management at the Eastern Mediterranean University