- Financial institutions are obliged to pay interest for storing the reserves, with the central bank under a negative interest rate policy.
- Policymakers in Denmark, Switzerland, Sweden, Japan and in the eurozone have allowed negative interest rates to drop below 0%.
- The US Federal Reserve has cut rates to just above 0 but has steered clear of negative rates, while Bank of England reduced its rates to record low of 0.1% in March.
- Negative interest rates can have both unfavourable and beneficial effects on the profitability of banks.
How would you feel if banks charged you for storing money with them, reversing the trend of earning interest income from the deposits made?
Negative interest rates have gained popularity, as COVID-19 pandemic has ravaged the global economy, pushing it into the worst economic slump since the Great Depression (1929-1939).
Central banks are responsible for maintaining financial stability and using the tool of interest rates to keep inflation in check and boost the economy as per the requirement.
The base rate, which is determined by the central bank decides how much it can charge financial institutions for borrowing or depositing money. This, in turn, influences other interest rates in the broader economy such as those on loans, deposits and even bond prices. Interest rates are one of the tools applied by central banks to accomplish economic targets, for example- low unemployment, stable inflation, and balanced growth.
Reducing a policy rate, usually ends up cutting down loan and deposit rates, which also allow companies and people to make investments and spend more, thus helping the economy to expand.
Negative interest rates would have the same impact, ideally. Several economists say that when commercial banks have to pay to deposit money with the central bank, in its place of earning interest on them, they must be urged to loan out that money. While others say that negative interest rates work with uncertainty.
Negative interest rates enfeeble a country’s currency, which makes exports affordable, fuels overseas demand and thus, supporting economic growth. They cause more businesses and commerce to happen, discourage savings and encourage spending to lift up demand.
Countries who have tried negative rates
The concept of negative interest rates first came into light after the global financial crisis of 2008. It was considered as a way to encourage growth and lift up businesses when the global economy was in recession. Many central banks reduced their interest rates close to 0.
A handful of nations like Denmark, Japan, Sweden, Switzerland, and others in the eurozone, have tried negative interest rates. Sweden was the primary country to test negative rates in 2009 by reducing its rate to -0.25% followed by European central bank in 2014 and further by Japan in early 2016, both lowering its deposit rates to -0.1%. Moreover, Switzerland also cut its rates by -0.75% in 2015.
Since coronavirus outbreak, Bank of England has cut its bank rate to a record low of 0.1% in March to uplift the economy, while the US Federal Reserve dropped its interest rates to 0 in an emergency move, introducing a fresh round of quantitative easing.
The US President Donald Trump had called negative rates a gift, which pushed many people into believing that the rates would be a lift for the US economy. However, Fed Chairman Jerome Powell, when asked about the possibility of adopting negative rates by Fed, denied taking such a step stating that negative rates were not a suitable tool for the US economy.
Pros and cons of negative rates on bank profits
The effectiveness of negative interest rates has largely remained mixed. Some research reports suggest that negative rates did not do any good to European economies, as well as Japan and even lowered profitability of banks. Such an event occurred due to unwillingness of banks in lowering deposit rates below 0 as it would lower their funding.
However, profits deteriorated as banks earned less on loans by not charging depositors. At the same time, other reports have found that banks in an attempt to boost profits, concentrated their lending to riskier companies and hence grew chances of economic crunch.
Further, negative rates generate a challenging environment for other parts of the financial system, like the pension and insurance sectors, which extend nominal returns and minimum income guarantees in the future. With negative rates, such commitments come under risk as there is not sufficient yield generation.
However, as per ECB (European Central Bank) bulletin published in May, banks can also benefit from negative rates as a better macroeconomic environment can push a bank’s business volume and can lift the value of securities held by the bank. Further, the creditworthiness of borrowers can be lifted by improved outlook and lower rates, thus lowering extra costs for banks.
By charging lenders to pay for storing money with the central bank can coerce lenders into lending more. Lenders would gain interest by lending funds rather than be charged for keeping their money.
Further, consumers and businesses tend to save money at the time of downturn and wait for the economy to improve. Negative interest rate policy can force them to rather spend than give away money to hold deposit in a bank and hence, boosts spending and avoid any deflationary scenario.