Misbehavioral Finance

Credit: McMillan

Question:  Why would a captain purposefully capsize her ship?

Answer:  Because the ship she is commanding was floating right-side-up in an upside-down world.


I've been keeping an eye on what is happening to the German Sparkassen to see how they are reacting to the Eurozone's (and particularly Germany's) negative nominal interest rate environment.  I would like to know what we, in the United States, can learn about the street-level structural business impact of the negative nominal interest rate environment on the community banking model.

The German Sparkassen can be viewed as a rough analog to community banks in the United States.  They are a network of 409 local savings banks that offer a full menu of banking services to individual persons and small-to-medium size businesses.  The major difference is the ownership structure, as Sparkassen are public-sector municipal banks and are not privately-owned.  They, however, compete with the retail operations of the large private banks in Germany.

Negative Interest Rate Policy (NIRP)

In the U.S., at the present time, we are fortunate to be only observers of the negative nominal interest rate banking phenomenon.  We have ring-side seats to the most dangerous monetary policy experiment in the history of modern finance.

NIRP is misbehavioral finance in action, plain and simple.  It can be likened to the Rosemary's Baby of monetary policy.  This experiment involves the corrupting, by mainly the European and Japanese central banks, of a core economic concept of what constitutes "money" in our society - money as a fundamental store of value.

When you have to pay someone to accept your money (that exists in the form of bookkeeping entries), then your money (that exists in the form of bookkeeping entries) does not have a stable value, it instead becomes a eroding asset which loses purchasing ability every day.

Money in the form of physical banknotes might seem to escape the corrosive centripetal force of NIRP, but the cost of storing, protecting, and insuring physical banknotes is itself a form of negative interest rate.  So people and companies in NIRP economies need to compare one cost to the other when making decisions about their money.

But all sorts of twisted, counter-intuitive behaviors occur in this NIRP environment.  For example, it has long been a basic tenet of finance that you try to defer paying your taxes for as long as it is allowable.  In the upside-down world of NIRP, it is better to prepay as many expenses as possible, including your taxes.

Governments, have traditionally had to pay interest for the privilege of borrowing when they spend more money than they take in from taxes and fees.  In the doppelgänger world of negative nominal interest rates, the marketplace pays governments to borrow more!  In fact in the first quarter of 2016, the German government made over a billion euro issuing negative rate debt.

Buying bank cashier's checks or bank drafts have been mentioned in the internet chatter as a way to avoid negative rates while avoiding the costs (and dangers) of bulk cash storage.  Is this the kind of unhealthy game-playing behavior we want to encourage?

What other kinds of weird behavioral finance distortions, yet to be appreciated, is NIRP giving birth to?

How NIRP is Affecting the Sparkassen

Nevertheless, my histrionics and prejudices aside, observing and learning how NIRP is affecting the Sparkassen could be instructive should the Federal Reserve ever be dragged toward negative nominal interest rates by the arsonous behavior of the central banks practicing NIRP or, even by the next recession in the United States.

In the United States, the banking system has occasional bouts with dealing with negative real interest rates.  That is, the nominal rate of interest less the rate of inflation.  Negative real interest rates are invisible, however, to retail bank customers because their nominal rates of interest (the interest rates they see printed on their bank statements) have, so far, always been positive interest rates.

Generally, banking is all about the spread, the margin; the difference between what a bank pays and what the bank receives.  In a normal, positive interest rate world, the bank pays for deposits and charges for making loans.  In the upside-down world of pure negative interest rates, the bank pays for loans and charges for deposits.  In the bizarre twilight zone that exists between those two states of being, banks would have negative deposit interest rates and positive loan rates - effectively taking in income from both sides of their balance sheet to make their margin.

The book-trained economists running the central banks that have signed up to NIRP blithely assume that their banks are as flexible as an Indian Yogi and can contort themselves into any form of pretzel to maintain their interest margins.

The Sparkassen are showing us a collision between the economist's academic theory and the customer's reality.  In the impure, real world we live in, the victim in the middle, becomes the bank and that raises further questions about whether NIRP also undermines systemic financial stability.

If a community bank levies an interest charge on its depositors (or attempts to cloak its intentions in the form of  "administrative" charges) that bank risks losing its key funding source and lifeblood.

On the other hand, attempt to raise the rates on loans and the bank risks being noncompetitive in the market.  So interest margins collapse and the viability of the traditional community banking business model comes into question.

In August, after finding its interest margin squeeze no longer tolerable, a tipping point may have been reached.  One community bank in Germany began charging retail customers for depositing money in the bank.  It would not, probably could not, shelter its customers from the European Central Bank's dysmorphic monetary policy and still stay in business.

Wolfgang Münchau, in the Financial Times (subscription required), summed up the conundrum:

"Of the German banks, the Sparkassen and the mutual savings banks are most affected. They are classic savings and loans outlets in that they lend locally and fund themselves through savings. Credit demand is more or less fixed. So when savings exceed loans, as they now do in Germany, the banks deposit their surplus with the ECB at negative rates — known as “penalty rates” in Germany. They cannot offset the losses by cutting interest rates on savings accounts because of the zero lower bound. Savers would switch from accounts to cash in safe deposit boxes."

Following on that thought, a related Financial Times article gives an example:

"In Dillingen an der Donau, a small town in rural Bavaria, the local Sparkasse savings bank is providing an unusual service. For customers who live a long way from a branch, it is giving out free bus tickets. And for those who cannot get to the bank at all — the old or sick, for example — it offers to send a member of staff directly to their homes to deliver small sums of cash.

The Sparkasse came up with the idea to compensate for the fact that it was closing several branches as revenues dwindled due to interest rates being at a record low and customers visiting less frequently. “If your revenues are shrinking, then you have to do something about your costs,” says an official at the bank. “You have to economise.”

The pressure on Germany’s army of savings banks is just one example of the increasing strains on the country’s financial system caused by the ultra-loose monetary policy of the Frankfurt-based European Central Bank.

In a bid to jolt the eurozone’s lacklustre economy back to life, the central bank has, over the past five years, slashed interest rates to record lows and even pushed its deposit rate into negative territory. On top of this, it has launched a €1.7tn asset purchase programme, which has driven down bond yields across the continent."

In it's 2015 Annual Report, BaFin, the German Financial Services Regulator said this about the Sparkassen:

"Most banks currently have sufficient capital to survive this period of low interest rates.  But earnings will deteriorate significantly if ­interest rates remain at these low levels – despite the positive economic conditions.  Even a rise in interest rates would not solve the problems immediately.  Banks that have focused heavily on maturity transformation, i.e. accepting short-term cash deposits and turning them into long-term loans, would only feel the effects after a considerable time lag.  A sudden sharp rise in interest rates would even exacerbate their situation.

BaFin looks across the board at what the institutions under its direct supervision are doing to counteract these problems.  Are they cutting costs?  Are they interrogating their business models and thinking of ways to expand their non-interest-bearing business?  Are banks offering their services on adequate terms and conditions?  It is also important to find out whether they strengthen their capital in a timely manner.  There are no one-size-fits-all solutions.

One thing is certain, however: it would be irresponsible to wait and do nothing, because there can be no reliable predictions as to how long the low interest rates will persist."

Accelerated Financial Darwinism

Add the post-financial crisis layering-on of increasing regulatory compliance costs, and the community bank model in Germany is under immediate existential threat.  For the Sparkassen, evolution must become revolution.

NIRP, new compliance requirements, as well as growing customer preferences for distance-banking services for routine transactions, are forcing the Sparkassen (like the captain at the beginning of this blog post) to have to flip their existing community banking model upside-down.

Instead of overlaying distance-banking technology services over an existing brick-and-mortar network (as is also the present community banking structure paradigm in the U.S.), the German community banks need to immediately consider a lower-overhead and smaller brick and mortar network that is sits on top of more cost-efficient technology-driven distribution channels.

These necessary strategic structural changes in the model of community banking in Germany should be a wake-up call for community banks in the U.S.  We, in the United States, have had the luxury of moving in an evolutionary fashion, with most community banks surfing the slow changes in their customer demographics at the pace of a leisurely stroll.

In the end, the pressures of a "Big Flip" in Germany means either extinction of a treasured form of banking, making the Sparkassen a quaint footnote in the history of banking in Germany or, alternatively, we will see its rebirth and revival.

I'm hoping for the latter.   As we are finding out in the financial press this week, relying on the German banking giants, Deutsche Bank and Commerzbank, is not a wonderful alternative.