The Swiss and negative rates: how is the experiment going?

Swiss residential mortgage rates actually rose after the Frankenschock, before falling again Keystone

The Swiss still refer to the day of the “Frankenschock”. On January 15 last year, their stable economic lives were shattered by news the Swiss National Bank (SNB) had abandoned its cap on the super-strong franc’s value against the weak euro.

To deter investor inflows, the central bank instead pushed its main policy interest rate even deeper into negative territory – to minus 0.75%.

But if the Swiss feared the sky over the Alps would be brought down by upside-down interest rates, dysfunctional banks and a soaring currency, they were wrong.

Almost two years later, the affluent Alpine state’s financial system still functions despite the most negative interest rates in the world; markets clear; savings are kept in bank accounts rather than under mattresses; dark-suited bankers still manage to dodge the trams rattling across Zurich’s Paradeplatz as they go about their business.

Indeed, Swiss banks’ profits are perky. The Swiss Bankers Association last week reported their net income rose 5% last year to CHF64.6 billion ($66.5 billion) – the highest since before the 2008 global financial crisis. Remarkably, for the first time in a decade, net income from interest-earning lending businesses overtook commission-based and service activities as the most important driver of profits.

So is Switzerland an example of how negative interest rates can work? Does it offer lessons for other financial markets, including the UK, where official interest rates may yet “go negative”? The answer to both is “yes” – but maybe only in the short term.

Secrets of success

The SNB – which holds its latest monetary policy meeting on Thursday – can claim its policies have succeeded. After the immediate “Frankenschock”, the currency weakened and has remained within acceptable ranges, although the central bank has also intervened heavily in foreign exchange markets.

Controlling the franc was the SNB’s main objective – not providing an economic stimulus as is the case at other central banks. In Switzerland, there was no need: although annual inflation remains negative, the Frankenschock did not tip the country into recession last year. In the second quarter of this year, gross domestic product expanded by 0.65 – the fastest pace since late 2014.

What is more, Switzerland shows the financial system can adapt to a world below zero. Swiss banks knew imposing negative interest rates on ordinary retail customers would risk a disastrous bank run. So they looked elsewhere to compensate for the cost of providing deposit accounts – namely, the mortgage market.

Expanding mortgage loan books, increased margins on lending businesses, as well as lower re-financing costs, explain why Swiss banks remain so profitable.

But the “success” of negative interest rates in Switzerland has depended on local factors – most obviously a buoyant-yet-disciplined mortgage market. There is no talk here of “negative mortgages” – whereby banks would pay homeowners.

Swiss residential mortgage rates actually rose after the Frankenschock, before falling again. UK banks would be pilloried if they reacted to aggressive action by the Bank of England by hiking borrowing costs for home owners.

Fragile equilibrium

Moreover, the equilibrium is fragile. If the SNB pushed interest rates further into negative territory, it could quickly become unstable, especially if the mortgage market spluttered. Foreign competitors could attack the relatively juicy margins in the domestic bank market, and Swiss banks might be forced to impose charges on retail customers. Inquiries from Swiss companies about insuring cash held in safe deposits rather than in bank accounts have increased significantly, Zurich Insurance reports.

Even if the equilibrium is maintained, Switzerland has not found a way of avoiding the pernicious long-term effects of exceptionally low interest rates on the pensions and insurance industry, which worry investors worldwide.

Rather, the public debate about the creeping distortions created by negative rates grows louder. The commentary in Swiss media is about whether it really would be more damaging to the Swiss economy if the SNB returned to positive official interest rates. Worries remain that negative rates could yet cause the sky to fall in.

Copyright The Financial Times Limited 2016