Compression of interest rate margins for financial institutions can lead to several unintended consequences
The risks of unconventional monetary policy are beginning to be recognized.
In a speech last week, Bank of Japan governor Haruhiko Kuroda noted that a fall in nominal interest rates is eroding profits of financial institutions.
Compression of interest rate margins for financial institutions can lead to several unintended consequences. For instance, lower profits can reduce the ability of the banking system to absorb losses and could become a risk to financial stability. Besides, in order to maintain respectable margins, financial institutions may be taking excessive risk and avoiding their core lending business, which can affect capital allocation and growth prospects.
This misalignment of incentives in the financial sector could well become a source of instability. The problem is that if the risk actually materializes, unlike the 2008 financial crisis, systemically important central banks would not have the tools to deal with it. The best that they would be able to do is to pump more money into the system, which could worsen the situation.