12th Financial Risks International Forum Low Interest Rate Environment, 18 – 19 March 2019, Paris

Financial Sectors Risks in a low Interest Rate Environment

Guest Speaker: John FELL, Deputy Director General, European Central Bank

Three main arguments can be identified

  • According to John Fell the constant low interest rate environment is not necessarily a consequence of the Central Bank’s politics but a consequence of market tendencies since mid-1980;
  • Shift from funds with defined benefit pension fund schemes to defined contribution, consequences being to transfer risks on the households;
  • The low interest rates are negatively impacting the profitability of commercial banks which have to increase their own and permanent capital as directed by the Basel III Committee on prudential rules and searching for profitable involvements. The consequence of the Basel III requirements for the construction industry is that the appetite of commercial to finance Greenfield period of construction is declining.

Investment Challenges and Opportunities in a Low Interest Rate Environment

Nathalie PISTRE, Deputy Head of Fixed Income Head of the Quantitative Research and Analysis, Ostrum Asset Management

Alternative Asset class

Equities and bonds represent the traditional assets, but in low interest rate environment bond yields are equally low. This means that investors are looking for other ways to offset equities that offer a higher return than bonds. Alternative asset classes include among others commodities, real estate, collectibles, foreign currency, insurance products, derivatives, venture capital, hedge funds, private equity, and distressed securities.

Main arguments concerning the construction industry

Infrastructure is now considered to be an alternative asset class. However, the expected high Internal Rates of Return requirements (IRR) are not compatible with most of the infrastructure projects (transportation, water, energy, ICT). These projects won’t meet the Private Equity’s requirement of profitability often close to 20%. Fundraising remains more important than investment (dry power). They explain the reinforced search for yield to remunerate funds waiting for investment.

How are Institutional Investors reacting to Low Interest Rates?

Marie BRIERE, Chairwoman of the Scientific Committee, Amundi, PSL Paris-Dauphine University and Free University of Brussels

The decline in long-term interest rates is a trend which can be observed since mid-1980. The steady decline in inflation rates as well as monetary policies by Central Banks such as Quantitative Easing is enhancing this trend. According to the Deutsche Bank, today 17% of all bonds issued come with negative rates.

As a consequence, institutional investors are opting for riskier and less liquid assets, thus increasing prices and squeezing their expected returns. The traditional assets, namely equities and bonds are being supplemented by alternative asset classes: Real Estate and private equity have benefitted.

In the balance sheet of insurance companies and pension funds, the already invested assets are performing less well. As mentioned above, pension funds balance sheets have deteriorated mainly because of low interest rates, as well as from the increasing life expectancy of beneficiaries. Insurance companies and pension funds react by reducing the guarantees offered with a transfer of risks to individuals. This share of risk can be quite effective and even attractive for individuals. The consequence is a reallocation of risks towards individuals.

In sum, risk of contagion in the current environment is higher due to the involvement of new partners which were not in relation before.  

Main conclusions for CICA

The current financial environment is not favorable to the pure private financing of infrastructure projects for mainly three reasons

  1. The low interest rate environment as well as the Basel III reforms requiring a rise in permanent capital of the commercial banks  is negatively impacting the profitability of banks and thus their appetite to finance the greenfield period of construction;
  2. The low interest rate environment forces institutional investors such as insurers and pension funds to search for greater yield leading to a high Internal Rate of Requirement (IRR). However, most of the infrastructure projects won’t meet the Private Equity’s requirement of profitability often close to 20%;
  3. Theoretically, the low interest rates were meant to provide States the ability to borrow money for investment projects. However, the debt level of public institutions is that high that investments are not carried out. Even if infrastructure projects demonstrate their usefulness having no or if not a positive impact on State budgets (cf. IMF), public investment becomes a budgetary adjustment variable rather than an investment triggering the development of a country.