How do low interest rates affect financial institutions and stability?

Global financial markets have witnessed a secular decline in interest rates since the the mid-1990s. This development was initially largely driven by the effects of globalization on production and increased trade, resulting in lower inflationary forces, especially in developed economies. In the wake of the financial crisis in 2008, this development was exacerbated by material interest rate reductions and additional emergency actions taken by various central banks to stabilize markets. The following public bail-out programs for the banking sector led to a government debt crisis that was particularly pronounced in weaker parts of the Eurozone, with the resulting flight to quality further depressing rate levels, especially for high quality issuers. Since then, market participants have experienced a steady decline in interest rates driven by the ECB’s extraordinary quantitative easing program. This development culminated in unprecedented low rate levels in late 2016, which even turned negative for high quality benchmark bonds like the 10-year German Bunds, as illustrated by Figure 1. The development is even more disconcerting in view of the fact that over 70 percent of total outstanding German public debt now provides negative returns. For the Eurozone as a whole, just over 50 percent of sovereign debt is traded at negative yields. This proportion rises to nearly 95 percent for short-term debt with a maturity of two years or less. While at the time of writing this article rates have slightly increased due to inflationary expectations triggered by the new US administration, overall interest rates remain at an extremely depressed level.