Switzerland is one of a handful of countries with negative interest rates. In other words, depositors are charged for keeping money in an account above and beyond any simple handling fee and the penalty is designed, to some extent, to weaken the Swiss franc, so the central bank hopes. The consequences are far-reaching.

Swiss retail banks are being hit hard by the Alpine state’s negative real interest rates and non-bank players are likely to grab more market share in areas such as mortgages, says a report by EY (aka Ernst & Young) that also carries relevance for wealth managers.

Interest margins of Swiss retail banks fell from 2007 – the start of the low interest rate environment – to 2014. The median margin (the point at which half of the banks report higher margins and the other half lower) shrank during this period from 161 to 119 basis points, EY said. The decline was concentrated in deposit margins - the difference between the client interest rate and the market interest rate for client deposits. At the end of 2014, this was nearly zero at most banks, with these banks consequently unable to earn income on new deposits to cover their operating costs.

Negative rates are hurting banks, EY said in a study on the matter. It noted (see below) that only Denmark is suffering from a similar negative rate problem.

"Swiss retail banks haven't earned sustainable income from savings deposits since the end of 2014 – savings deposits have only been attractive for refinancing loans and mortgages," Dr Peppi Schnieper, partner and head of strategic consulting at EY Financial Services, said.

Non-bank organisations such as insurance and pension funds are likely to play a stronger role in the mortgage market going forward, EY said. 

Switzerland’s negative real interest rate environment has been a feature for some time. At present, the interest rate on sight deposits is at minus 0.75 per cent, and the target range for the three-month Libor unchanged at between minus 1.25 per cent and minus 0.25 per cent (source: SNB monetary policy statement, September, 2015). The Swiss National Bank has defended the policy as a way to weaken the Swiss franc, which has been boosted by its status as a safe haven currency. In January this year, the SNB stunned markets by abandoning its Swiss franc cap against the euro of 1.2, a move that is said to have wiped out several hedge funds; the surge in the franc also has hit earnings of major Swiss banks such as UBS and Credit Suisse that earn the bulk of their revenues overseas.

EY said that the adverse impact of negative interest rates is now “almost exclusively” affecting credit clients – and mortgage clients in particular. 

The report said conditions for the deposits of private individuals and smaller corporate clients are still slightly positive in nominal terms. As of 30 September 2015, the typical retail bank had a negative margin (difference between the client interest rate and the market interest rate) on new deposits of approximately 50 to 80 basis points. This negative margin is being fully passed on to borrowers, mortgage borrowers in particular. Thus, the typical margin for mortgage loans from 1 January to 30 September 2015 rose by about the same number of basis points, it said.

"Both credit conditions and savings rates have been decoupled from the market interest rate. Loans are now too expensive, while the rate of interest on savings is too high. Borrowers are subsidising savers," Dr Roger Stettler, retail banking expert at EY, said.

Wealth managers are feeling the pain of this interest rate environment, said Roger Stettler, retail banking expert at EY. “Savings rates have been decoupled from the market interest rate since banks are unable to pass negative interest rate on to clients on a broad basis. This led to significantly negative interest margins on saving products. Retail banks compensated this negative margin by increasing their lending margins. Private banks which are concentrated on the wealth management business and normally have limited loan books cannot profit from this cross-subsidisation and therefore suffer a loss of profitability. Private banks need to adjust by various measurements, including an increase in lending activities, in order to protect their profitability," he told this publication in an email.

Denmark
EY said Denmark is currently the only country aside from Switzerland that is affected by significantly negative interest rates on the money and capital markets. Here, too, there has been a sharp increase in margins in credit business, it said.

“Unlike in Switzerland, retail banks in Denmark have focused much more heavily on corporate clients and consumer loans, and not on mortgages. As a result, in Denmark commercial and corporate clients, in particular, have also been bearing the consequences of negative interest rates,” it said.

One effect of the environment is that the capital market, in the form of bonds and mortgage bonds, is now a much cheaper source of funding for Swiss banks than deposits, EY said. It gave the example of how the 0.1 per cent average risk premium compared to swaps of new mortgage bond issues during the period from May to July 2015 was in line with standard values before the start of negative interest rates. Such issues typically have a long maturity of well over ten years.

Issuance activity is now only limited by the small size of the Swiss bond market. If the Swiss bond market were larger, banks would rely much more heavily on bonds for funding than they do now, it said.

The much higher margins at present in mortgage businesses in Switzerland are leading to increased activity by non-banks in this market. Insurance companies and pension funds are particularly worth noting in this respect, as their share in the mortgage market has declined in recent years and is now less than 5 per cent combined.

Last year, a proposal to force the SNB to hold at least 20 per cent of its reserves in gold – a move that would have necessitated a sale of euros – was defeated, but the fact such a vote was held at all shows how controversial the central bank’s monetary policy has been. 

At a recent seminar in London, this publication was told that negative real interest rates, imposing an additional cost on the simple ability to hold cash accounts, could encourage people to hold physical cash in notes or gold in their own storage rather than risk losing out by depositing money in a bank, creating a two-tier market between physical and “electronic” cash. 

"Negative interest on bank deposits give people an incentive to withdraw and take out paper bank notes. This starves the banking system of capital, and establishes a spread between paper and electronic currency," Keith Weiner, CEO of Monetary Metals, a US-based business, told this publication. 

The curse of being a loved currency
The country has had to deal with the “curse” of its safe-haven currency status before. As recounted by Julius Baer, the private bank, this summer, policymakers have seen a series of episodes. 

“Between 1970 and 1978, the [Swiss franc] appreciated 54 per cent in real terms against the major currencies, in particular against the US dollar, which forced the SNB to perform substantial foreign exchange interventions, lower the discount rate to 1 per cent and even prohibit foreigners to invest in Swiss assets (i.e. capital controls). Nevertheless, the franc appreciated further, leading the SNB to eventually introduce its first currency floor for the DEM/CHF [Deutschemark/Swiss franc] exchange rate at 0.80 on 1 October 1978. When the European currency system dissolved in 1992, the central bank became active on the foreign exchange market again to offset appreciation pressure on the Swiss franc. Similarly, the SNB intervened significantly after 2009, until the currency floor versus the euro at 1.20 was introduced on 6 September 2011,” Julius Baer economists wrote.

Julius Baer said that it envisages two alternatives to alleviate the harmful policy impacts of a strong currency: an investment vehicle which manages the accumulated SNB foreign exchange reserves (such as in Singapore) and a policy change which focuses on the trade-weighted Swiss franc exchange rate.