Extended Period of Low Interest Rates Can Rekindle Financial Risks

Unconventional central bank policies helped stabilize financial system

Financial risks may redevelop if banks don’t clean up their financial act

Appropriate policies can lessen emerging risks

In its latest Global Financial Stability Report, the IMF analyzes the effects of central bank policies on banks and financial stability since the global crisis. Central banks have taken bold policy actions that have reduced banking sector vulnerabilities and stabilized some markets, such as the interbank and mortgage securities markets. But the policies may have undesirable side-effects that could put financial stability at risk the longer they are in place.

The IMF said so far these risks are not showing up much in banks, but could be shifting to other parts of the financial sector, such as to so-called “shadow banks.” There is also some concern that the prolonged period of low interest rates is encouraging banks to roll over nonperforming loans rather than repairing their balance sheets.

“So far, so good, but if the time that central banks have provided through their unconventional policies is not used productively by financial institutions and their regulators, at some point we can expect another round of financial distress,” said Laura Kodres, chief of global stability analysis in the IMF’s Monetary and Capital Markets Department and the head of the team that produced the analysis.

Potential risks

Despite the positive short-run effects for banks, there are financial risks associated with these central bank policies, which are likely to increase the longer they are maintained, according to the IMF.

The analysis found some aspects of this unprecedented monetary policy may be delaying balance sheet repair in banks and could raise credit risk over the medium term. This would explain the increase in market perceptions of bank default risk in response to central bank policy announcements, the IMF said.

Risks may also be shifting to other parts of the financial system not examined in the report, such as shadow banks, pension funds and insurance companies—or to other countries. Monitoring these risks requires improved data collection by those responsible for monitoring system-wide risks on nonbank financial institutions, as well as intrusive oversight by financial supervisors.

The report cautions that some risks may materialize when central banks end the measures taken in the wake of the global crisis.

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