Negative interest rates threaten Europe’s financial stability
Negative interest rates erode the profitability of the banking sector and pose a threat to financial stability. In exchange, they offer an economic stimulus that is mild at best and that has actually been seen to backfire in some regions. The world economy is once again navigating in uncharted waters. Watch out for the reefs.
Central bankers are at it again. After having taken policy rates precipitously to zero following the global financial crisis of 2008 and experimented with the new instruments of quantitative easing and forward guidance, they are back in the lab. The new gadget is called negative interest rate policy, and it is emitting a distressing tick.
The first major central bank to take rates negative was the ECB. It lowered its deposit rate to -0.10% in June 2014, before doubling down – quite literally – the following September. Then came the Danmarks Nationalbank and the Swiss National Bank, followed by the Swedish Riksbank in February 2015. The last entry into the club was by the Bank of Japan in January 2016. The latest of these moves, on March 10th, saw the ECB cut its deposit rate by 10 basis points, bringing it to a historical low of -0.4%.
Source: BIS Quarterly Review, March 2016
Why it took so long to implement negative interest rates
Raising or lowering the policy rate is just about the plainest item on a central bank’s menu. In normal times, it is the bread and butter of monetary policy. Why, then, are negative rates being considered by some as the most dangerous experiment in monetary policy to be undertaken in decades?
For a long time economists believed that nominal interest rates could never go below zero, or at the very least should not, given the inherent uncertainty of venturing into such strange and unfamiliar territory.
There are very good reasons to think that. A negative nominal rate on a loan means the lender is effectively paying the borrower. Such a situation has long been the case in real terms. With nominal rates near zero, any positive rate of inflation means that the real return on a loan is negative. However, inflation is hard to evade.
Negative nominal rates, however, are much easier to avoid. Simply holding cash offers a nominal return of 0%. Therefore, it was thought market rates would not go below zero, and hence a negative policy rate would not provide further monetary stimulus.
How have negative rates been implemented?
In practice, negative policy rates mean that banks pay to keep their reserves at the central bank overnight, or equivalently lend them to other banks at a loss. This fee is usually levied only on reserves above a certain amount – sometimes called excess reserves – to avoid penalizing banks for holding a reasonable amount of reserves.
Imposing a negative rate on excess reserves is feasible because to avoid paying the penalty, banks would need to withdraw these excess reserves from the central bank in the form of cash. As long as rates remain only moderately negative, the storage, security, insurance, and inconvenience costs involved outweigh the benefits, and a stampede for physical currency remains unlikely.
Business as usual: Why they are the same as regular rates
The BIS reports that some money market rates have gone negative as a result of the negative policy rates. Commercial banks have thus began lending at a negative nominal yield to short-term corporate borrowers. It would seem that negative policy rates are having the intended effect.
Some sovereign bonds are also trading at negative yields. This, at first glance, is puzzling. The investors buying these bonds are not subject to negative central bank deposit rates, and so should shy away from such assets. Some investment funds, however, are institutionally required to hold sovereign debt, therefore setting a floor on the demand for sovereign bonds irrespective of their yield. Others may still consider a negative-yield asset profitable if interest rates or the exchange rate are expected to move favorably.
Source: BIS Quarterly Review, March 2016
Additionally, when it comes to currency depreciation, negative yields work no differently than their positive counterparts. A fall in interest rates weakens a currency because investors in search of specific returns are forced to park their capital elsewhere. This is just as true when rates go negative. That is why Switzerland, a common destination for capital fleeing Eurozone volatility, and Denmark, whose currency is pegged to the Euro, have chosen to follow the ECB into negative territory.
Why they are different from regular rates
Negative rates, however, differ in at least one important dimension from positive rates. It is difficult – perhaps impossible – for banks to pass them on to retail depositors.
A good measure of bank profitability is the net interest margin (NIM) – the difference between the average yield banks receive on their assets and the average rate they pay on liabilities. An important component of the latter is the interest rate paid on retail deposits.
When rates turn negative, NIMs get squeezed because asset yields fall but the rate on deposit liabilities cannot be made to follow. With roughly 50% of Eurozone banking profits coming from net interest income, this is a significant side-effect. Partly as a result of this fall in profitability, bank stocks have been consistently underperforming their domestic markets since the introduction of negative rates.
Banks are unwilling to impose negative rates on depositors because they fear doing so would trigger a run on their deposits. In general, the elasticity of deposits to the rate they are paid is relatively low; few retail depositors switch banks in their deposit rate is cut. Many fear, however, that this elasticity would jump if deposits were brought below zero. Negative rates have a psychological bite that positive rates do not.
The situation is further complicated by the fact that its strategic structure can be conceived as a sort of prisoner’s dilemma. If no banks paid negative interest rates to depositors, it would be in no individual bank’s interest to be the first to do so. If, instead, every bank was paying negative rates to depositors, it would be in every bank’s advantage to be the first to stop doing so.
Some experiments are underway that should help clarify whether there is cause for these concerns. A small Swiss bank, Alternative Bank Schweiz (ABS), started imposing negative rates on individual depositors in January 2016. Some large banks, including Credit Suisse and UBS, have begun doing the same for larger institutional clients.
If banks remain unable to pass on the operational costs entailed by negative rates, this loss in profitability is likely to have perverse side effects. Some banks in Switzerland have responded to negative rates by increasing interest rates on mortgages.
To similar effect, eroded profitability increases the cost of equity for banks. Meanwhile, institutional requirements force banks to hold capital for every new asset they load onto their balance sheet. While the cost of debt should follow the policy rate, negative rates could end up raising the average cost of issuing a new loan if the cost of equity increases sufficiently. This would, perversely, make banks less willing to extend additional loans.
Banks may also take undue risk in search of the higher yields they now need to stay profitable. Banks are being bled slowly by negative rates. This could push some to act in desperation. Letting this go on for too long would be inviting a repeat of 2008.
The new lower bound
As long as cash exists as an alternative to deposits, there will be a lower bound on nominal interest rates. Therefore, to get rid of the lower bound, some have suggested getting rid of cash completely.
Wherever it lies, the true lower bound is likely to be flexible. Important fixed costs must be paid before a bank can withdraw large amounts of reserves. Banks first have to acquire and adapt large facilities in which to store the physical currency. As long as rates are expected to turn positive quickly enough, they may shy from these investments. Once the fixed costs are spent, however, banks are likely to tolerate much less negativity in interest rates. Thus, pushing rates too low for too long could make the lower bound move up.
Looking forward
Negative rates have crossed the Sea of Japan but they are not about to cross the Atlantic. The likely trajectory for the Fed Funds rate points up, not down, although adverse developments in China or Europe could belie that. Still, the Fed has demonstrated openness to the idea. Its 2016 stress tests for banks will include scenarios where short-term treasury yields turn negative.
It is unlikely that calls to get rid of cash or tax it heavily will be heeded in the near future. The uncertain benefits of such a move would be too difficult to convey to a recalcitrant public.
If that is the case, however, central bankers will need to start bringing rates back in the black soon. Banks can only be bled so much before they start jerking on the operating table. In an already fraught global financial system, that would be to the detriment of all.
