As Prospect for Negative Interest Rates Grow, Israel’s Banks Face Big Challenges

Will savers have to pay to maintain deposits, investors to hold bonds?

Reuters

Israel’s bankers say they are not ready for the possibility that the Bank of Israel will lower interest rates below zero, a development that could end up with depositors having to pay to keep money in the bank.

The Bank of Israel’s base rate is already at a record low 0.1%, and with many central banks in Europe putting their interest rates into negative territory, including the European Central Bank, Governor Karnit Flug may have no choice to match them or risk an appreciating shekels and its damage to the economy.

“You see what’s happening around the world and realize that the odds of negative interest rates in Israel are not zero anymore,” an executive at one of Israel’s big five banks told TheMarker.

“No [commercial] bank is prepared for this. It requires operations preparations and decisions about what to do in such a scenario, whether we’ll absorb negative interest rates or pass them on to depositors,” said the banker, who asked not to be named. “We started discussions on the matter a few weeks ago to ensure we’re ready and that we’ll know how to act.”

Bankers said that while no policy had been determined, Israeli lenders would probably follow the same policy as their European counterparts – refrain from collecting interest on consumer deposits but collect them on business accounts.

Bankers said they were worried that if they tried to collect interest on consumer accounts, it could set off an interest rate war over the approximately 148 billion shekels ($37.8 billion) in ordinary savings accounts as other banks exploited the anger to lure clients away from rivals.

Those deposits are especially profitable as the banks pay nearly zero interest these days.

“European banks have told about the problems they’ve encountered on an operating level. How do you collect negative interest? If you collect negative interest on deposits and don’t do it on ordinary savings, it creates arbitrage,” said one senior banker. “In Israel it you were to collect interest rate savings accounts, you need to change the fee structure of the bank, and that requires Bank of Israel approval.”

The problem could extend to the fixed-income market, where the government’s Gilon bond, whose yield is linked to interest on Bank of Israel short-term notes (makams). “If the coupon on a Gilon is negative, will the Bank of Israel charge interest to a client holding Gilons?” asked a banker. “We assume no.”

Israeli bankers warn that trying to instruct their computer networks to recognize interest rates may cause the same kind of bugs that experts feared as the world moved to the year 2000, albeit on a smaller scale.

Bankers say systems are designed on the assumption that interest rates are positive. It’s not that they will crash in the events rates go negative, but it increases the chance of all kinds of distortions and errors.

“We’ve had discussions recently with executives at European banks who have already adjusted to negative interest rates in order to learn the impact,” said one Israeli banker, who asked not to be identified. “I understand that they also had to cope with glitches and error because their information systems weren’t prepared. We can’t really solve the problem in advance but we need to prepare.”

Dismal U.S. jobs

Although the Bank of Israel refrained from acting on the interest rate last month, a dismal U.S. jobs report over the weekend had led many economist to say the odds are increasing that the bank will soon lower interest rates to below zero.

The latest jobs data have caused investors to pare bets that the U.S. Federal Reserve would hike interest rates anytime soon. Employers added just 126,000 jobs in March, a little over half the number forecast by a Reuters poll of economists. If that reflects sputtering economic growth in the United States, the Federal Reserve is unlikely to raise its super-low base rate anytime soon.

“The new data create a problematic situation for the Bank of Israel because suddenly it is finding itself again in the position of ‘defending’ the shekel to prevent it from strengthening,” said Idan Azoulay of Epsilon Investment House in a report Monday.

“We believe the chances of an additional rate cut or other monetary actions like buying bonds have risen a lot,” he said.

The ECB first let its base lending rate go into minus last June, and in September cut it again to minus 0.2%, a move aimed at encouraging banks to lend and spur economic growth rather than hold deposits. Other European banks followed suit. Switzerland’s base rate today is minus 0.75%, Denmark’s minus 0.2% and Sweden’s minus 0. 1%.

On Monday the Bank of Israel released the minutes of its last rate-setting meeting at the end of March, which showed members of the Monetary Committee were concerned about entering uncharted waters with below-zero interest rates.

The committee expressed the view that conditions didn’t yet demand lower interest rates, but it also warned of “the risks deriving from the asset markets, including the corporate bond and housing markets,” in other words creating an asset bubble.

With reporting by Dror Reich