Technical documentation Section E : the impact of low interest rates on ongoing structural changes from horizontal, cross-country and EU-wide perspectives, November 2016

Interest rate trends, particularly when they interact with structural vulnerabilities, may have significant systemic consequences for financial stability. The "low for long" scenario poses significant challenges because, in the long run, it is likely to challenge the profitability of most types of financial institutions, giving rise to a search for yield. Adverse financial stability consequences may also arise from an unexpected increase in interest rates after a long period of low interest rates. It is not possible to hedge against the structural changes that produce a scenario of a prolonged period of low interest rates but there are inherent risks that have to be borne. In some instances it may be optimal from a financial stability perspective to shift risks to non-financial agents (firms and households) or to the government. In contrast, a shift of risk to less-regulated agents (regulatory arbitrage) may raise risk even further. In the EU, firms and households are financed predominantly through banks which, as a consequence, play an important role in the transmission of risks emerging in the low interest rate environment. Life insurance companies play an important role in retirement saving in many countries, and both types of institutions have come under pressure as their profitability has been squeezed in the low interest rate environment. Reduced profit margins are incentives to increase risk-taking in large parts of the financial system, affecting the pricing of risk in the economy. At the same time, the role of the shadow banking sector has increased over time, although with significant heterogeneities across EU countries. This trend could be amplified in the "low for long" scenario. For example, there is likely to be a growing reallocation of activities to less-regulated sectors in a search for yield, which potentially raises financial stability risks. As a consequence of the shift towards market-based financing, market liquidity risks may become more significant as more financing activities are conducted through markets, reducing the diversity of the financial system. Contagion effects through fire sales may therefore increase in importance. Although developments in the regulatory environment in recent years have enhanced the resilience of the EU financial system overall, some features may, in certain sectors, also increase the vulnerabilities associated with a low interest rate environment.