What is the Current Banking Model?

If we go back into time, we see that the banking system is based on a central banking model – This central (typically government) run bank determines the prevailing rate that the other domestic or commercial banks within a country can borrow for.

Interest is the charge for the privilege of borrowing money, typically expressed as annual percentage rate (APR).

https://www.investopedia.com/terms/i/interest.asp

Where are we today?

As the headline states, due to the global shutdown and isolation, we are now approaching another unknown frontier – With the markets in turmoil – See our post here, the next step into the unknown appears to be the development of zero percent (0%) interest rates.

Therefore, as the interest rate approaches zero, we see that banks are basically borrowing for “free” from the central bank – This can be good for consumer borrowers if these banks pass along the “savings” or not if they keep rates at current levels.

What we are seeing across the world right now is governments are stimulating the economy by slashing their interest rates.

BANK OF CANADA 🍁 rate is now 0.25%

UNITED STATES FEDERAL RESERVE rate is now 0.00%

Additionally, we appear to be headed into an environment of negative interest rates on the horizon. So let’s review what exactly that means?

Negative Interest Rates – Is this Reality Soon?

As we mentioned above, interest is the amount paid to lenders by borrowers is income in the form of interest payments – So what happens now that central banks are at approximately zero?

The next step available in the central bankers platform is potentially taking the interest rates into negative territory.

A negative interest rate means that the central bank (and perhaps private banks) will charge negative interest. Instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank. This is intended to incentive banks to lend money more freely and businesses and individuals to invest, lend, and spend money rather than pay a fee to keep it safe. This happens during a negative interest rate environment.

Well, an interesting development that has already happened in Europe is negative interest rates – See the chart below based on pre-virus conditions vs current crisis conditions.

Exhibit 2: Euro-area 10-year Gov’t. Bond Yields, Pre-Virus vs Current

10-Year Govt. Bond Yield	Italy	Germany	France	Spain
Yield Pre-Virus	0.97%	-0.48%	-0.24%	0.21%
Yield – Current	1.57%	-0.27%	0.21%	0.87%

(Okada) Dates: Pre-Virus: 2.24.2020, Current: 3.24.2020

How Will These Banking Changes Affect Individuals?

If we see the current conditions are changing, do we expect that savings rates will approach zero or mortgage rates approach zero?

Case 1 – Mortgage rates

It appears that Mortgage rates in Canada are following the central bank and cutting rates slightly on home mortgages.

Banks Lowering Borrowing Costs?

(Bloomberg) — Royal Bank of Canada cut its prime rate by 50 basis points, matching Bank of Canada’s latest emergency rate cut.

Canada’s largest lender by assets reduced the key rate to 2.45% from 2.95%, the Toronto-based bank said Friday in a statement. Canada’s central bank unexpectedly cut its overnight lending rate by another half a percentage point to 0.25% on Friday, its third move this month amid efforts to shield the economy from the Covid-19 fallout. The prime rate influences borrowing rates for variable mortgages and credit lines. Bank of Nova Scotia also reduced its prime lending rate a half-point to 2.45%.

https://ca.finance.yahoo.com/news/rbc-pares-prime-rate-matching-225917445.html

Or Banks Raising Borrowing Costs?

Some Internet users have reported that certain banks are actually raising their mortgage rates in anticipation of a “liquidity” issue forming – more payouts requiring more cash incoming to the bank.

Will either of these cases prevail in the long term – We will have to wait and see as things continue to develop within the response to the economic situation?

Case 2 – Saving rates

The other scenario to visit is the current savings rate for individuals requiring interests paid on their savings accounts or interest bearing investments – What is happening here?

We can see despite all the central banking institutions dropping the central rates to zero, the prevailing interest rate for savers is still a healthy 2%+ – Will it continue to remain at this level, drop or rise? We will continue to monitor this situation as well.

Conclusion

It’s a very uncertain time, causing financial markets, banks and individuals a lot of stress. Therefore, it is probably the best time in recent history to focus on exactly what your personal situation is.

DEBT – If you have debt and can use this market opportunity to refinance this debt into a lower rate, RUN don’t walk and do so immediately – This will help you in the short term with smaller payments and as the economic situation improves, you can increase your payments and eliminate debt faster.

MORTGAGE – If you are looking at borrowing money to buy a house, it may make sense to wait a couple more months to see exactly where interest rates land – However, if you have a strong downpayment ready and financing is secured, it may make sense to purchase now.

SAVING / INVESTING – If you have substantial income bearing savings in the banking sector, what should you do – If you have a longer time-frame horizon with locked in GIC rates above today’s rates, probably best to leave this money alone for the time being. If you have renewal pending in the next few weeks or months, its time to look into options – Guarantee your returns through another GIC or savings account renewal or look into tucking some of this money back into the stock market through ETF investments that currently offer significant discount pricing – See our other posting about a Market Shock Absorber when investing.

Every situation is unique and you need to do what is best for your situation. Overall, stay healthy (both mentally and physically) and take care of yourself out there.

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