The level of interest rates is of major importance to financial market participants, including banks. In a context where interest rates remain low for a long period of time (in one scenario over a ten-year horizon), the impact on the EU banking sector could be quite significant. In particular, the following vulnerabilities have been identified, and have the potential to trigger structural changes. Resilience. The resilience of the EU banking sector may weaken under the "low for long" scenario if the negative impact on bank profitability of reduced net interest income outweighs the potential positive impact on credit risk due, for example, to reduced impairments. A low interest rate environment implies lower net interest margins because it is difficult to set negative deposit rates for bank customers (which could be required to maintain net interest margins, recovering the cost of equity in a period of low asset returns). At the same time, other components of bank profitability may benefit from low interest rates in the short term given, for example, increased trading activity due to rising asset prices and a reduction in impaired loans. On balance, over the longer term, negative effects are expected to outweigh positive effects if subdued real economic growth persists. Nevertheless, this outcome is highly uncertain. Pressures on bank profitability could lead to increased risk-taking and lower asset quality to compensate for the reduced interest income. In terms of capital, using retained earnings to boost nominal capital may not be enough to meet new regulatory requirements (capital buffers and MREL/TLAC being the most prominent of these) and banks may be forced to deleverage if investors' appetites for banks' equity are not sufficiently large. This could be the case if investors' expectations of banks' return on equity are adjusting too slowly to the new equilibrium. A negative feedback loop among low profitability, depressed new lending and real economic growth could persist in the "low for long" scenario. Credit cycle. Low interest rates should be conducive to an increase in loan volumes by fostering loan creation, as long as credit demand is not suppressed by expectations of low growth. However, lower credit standards may be incentivised, reducing asset quality in the long run. The relative uncertainty over which scenario will prevail ("low for long" or "back to normal") may encourage banks to indulge in an excessive relaxation of credit standards and/or widespread forbearance. In that case excessive forbearance and relaxed credit expansion would have a negative effect on the quality of banks' asset growth. It is also possible that there would be shifts within banks' loan portfolios towards more profitable or less capital-costly loans. Additionally, banks' probable increased risk tolerance (search for yield) could expose them to significant losses in the future, which may be triggered, amongst other factors, by a return to higher interest rates due to higher credit risk rather than a solid economic recovery.
