- Amid the talks of negative interest rate in the country BoE has asked banks to check how prepared they are for an entirely new system
- The Financial sector might have to undergo structural changes which would come at an additional cost
- Negative interest rates do not guarantee inflation and growth and a delicate balance between monetary and fiscal policy might help the UK to climb out of recession
United Kingdom’s apex bank, the Bank of England (BoE) has been leaving no stone unturned to resurrect nation’s economy. The bank had already pushed interest rates near zero during the peak of unprecedented crisis. The Bank of England has written to banks to check if they are prepared for an entirely new system, i.e., adoption of negative interest rates in the economy.
The apex authority has sought clarifications from the banking sector as in what changes they need to make in the banking landscape if the interest rates were pushed into negative territory.
Just like many other tools deployed by the central bank, interest rates are planned by the apex authority to control the flow of credit in an economy. To make negative interest rates more effective, the financial sector might need to undergo some structural changes to ensure the safety of the sector.
The idea behind seeking an opinion from banks on the adoption of negative interest rates is to understand whether there were any roadblocks or technological challenges involved in the transition to a new financial system.
Monetary policy and the accountability of central banks
Central banks control the interest rates in an economy through monetary policies. Central banks control the flow of money in an economy, as when an economy is doing well, people like to spend money on leisure activities unlike in recessionary cycles where people like to hoard more cash.
Traditionally, economies are driven by credit and interest rates. Interest rates are the percentage of the loan that the borrower pays to the bank as a fee for borrowing money from them. Interest rates also refer to the rate that the consumers receive for saving the money in the form of deposits with the bank or a financial institution. Though, these two rates probably will not equal one another. A normal interest rate will cost people for borrowing and reward people for saving.
Negative interest rates
The earliest form of banking simply involved people paying vault owners to keep their gold safe. This is the simplest example of negative interest rates back then. The main central banks across the world have slashed interest rates more often, and some of them have even strayed into negative territory.
The whole idea of negative interest rates is to push commercial banks into lending money to businesses and consumers in order to get money flowing in the economy. This has been essential since the financial crisis of 2008.
Central banks hold money for commercial banks. Now, if central banks cut their interest rates below zero, they can charge commercial banks interest on the money they are holding to protect their profits. The commercial banks have been encouraged to cut their own interest rates, and that means it costs less to borrow and more to save. Theoretically, they should spend more in the economy, which pushes up inflation.
Some of Europe’s central banks, Bank of Japan and the central bank of Denmark were among the first to venture below zero interest rates. There is no room for movement to accommodate further fluctuations when the interest rates are below zero. Most of the nations who adopted this unconventional interest rate regime could not meet their inflation targets, and nor witnessed any improvement in economic growth.
What would negative interest rates mean for banks?
Depositors would need to pay charges for keeping their money safe with the banks, and lenders would receive an incentive from banks to take more credit. In addition, commercial banks have to pay some money to the central bank for keeping their reserves safe.
All the existing loan contracts have been priced through an existing regime where borrowers are supposed to make interest payments. All the contracts, both new and existing, would need a revision of terms, which could translate to structural changes and eventually additional costs.
The banks had been under the pump during the peak of unprecedented crisis as they have facilitated billions of pounds in loans backed by the government. They have also made provisions in anticipation of losses.
The additional cost of making these structural changes would be on top of the cost incurred in making a transition to a new contract pricing mechanism known as SONIA from LIBOR, existing contract pricing system.
The problem that we have with the novel coronavirus is not just a weakness in demand, but it is also a big supply shock to the economy. Monetary policy cannot really do much about that. Its probably something like fiscal policy that can help more with.
Negative interest rates might signal the consumers that the economy is in really bad shape, and therefore, they will reduce spending and might even hoard cash. According to market experts, the main challenge in the UK is to resurrect the economy from the supply side. The lockdown has severely affected the economic activities, and the rising number of coronavirus infections would only exacerbate the situation further. This is not something which monetary policy could address. Although, there might be some kind of improvement, there is surely more scope for fiscal policy to provide some degree of stimulus to consumers with perhaps a cut in VAT or some specific incentives to get consumers out and to spend again.