German municipalities may be unwittingly exposing themselves to huge monetary risks: The financial instruments they use are not geared up for the kind of negative interest rate environment that Europe is currently experiencing.
The German Association of Cities has warned local authorities that they may be exposed to “theoretically unlimited risk,” in a letter written in March and seen by Handelsblatt.
Ironically, the new risk actually stems from a cautious approach taken by many local communities. Many engaged in hedging deals in the past years to protect themselves from interest-rate fluctuations.
The trouble is that these are not really geared up to deal with the current monetary policy of the European Central Bank, which last year began pushing some interest rates in the 19-nation euro zone into negative territory for the first time in its history.
Ordinarily, German city and town treasurers benefit from a low interest-rate environment, because it reduces their borrowing costs. However, municipal governments often take out variable interest-rate loans and try to hedge against rising rates with swap transactions.
The problem is that banks now bill each other for negative interest rates in their deals with one another. Many swap transactions are based on these reference rates. The result is that the construct, intended as a safeguard, could turn into a cost trap for cities and towns.
German municipalities have about €52 billion ($59 billion) in credit on their books, and they are often hedged with swaps. In these arrangements, a bank lends money to a city, while another bank provides what is typically an insurance mechanism. The trouble is that this insurance may now turn into a major cost.