Seven reasons why negative deposit rates are a bad idea

There’s a lot of jawboning by central bank officials in the U.S. and Europe about negative deposit rates. According to media reports, the Federal Reserve and the European Central Bank (ECB) are both contemplating introducing negative deposit rates on the excess reserves that commercial banks hold with them (the central banks).

First, let’s get some facts straight.

A portion of total deposits is required to be held as reserves with the central bank by law. The business of negative interest rates refers to the interest rate imposed on excess reserves, funds that do not have to be maintained as statutory reserves.

The Federal Reserve currently pays 0.25% on these excess reserves to commercial banks, while the ECB doesn’t pay anything on those reserves.

Central banks are mulling the idea of a negative interest (in essence, asking banks to pay for their deposits) on these excess reserves in a bid to encourage banks to lend to the real economy instead of just stashing money away as central bank reserves.

Here’s another fact: negative interest rates, both nominal and real (adjusted for inflation), are not a novel phenomenon.

As a 2013 research report by the Federal Reserve Bank of St. Louis (one of the 12 branches of the Federal Reserve) notes, negative nominal and real yields are not unusual during times of uncertainty and often reflect investors’ flight to safety.

“The existence of negative yields, however, provides no support for the argument that central banks should consider negative policy rates as a monetary policy tool,” it adds.

Will the move (a negative deposit rate for banks) affect ordinary consumers? A Financial Times report freaked everyone out after it quoted anonymous bank officials who warned that they might charge ordinary depositors for their deposits if they (banks) were asked to do the same for their reserves at the central bank.

To be honest, there are several holes in the narrative depicted above. On the face of it, charging negative interest rates seems like one of those novel ideas that central banks are willing to try out among many to see what eventually sticks.

Here’s why it’s not likely to work.

One, there is little evidence to support the idea that negative interest rates will prod banks into lending more. Even at record low rates on both sides of the Atlantic, appetite for credit has stagnated. Clearly, interest rates are not the problem.

Two, even if a negative deposit rate prods commercial banks to lend, it offers no incentive for businesses and consumers to borrow. Borrowing for consumption or investment depends on a stable business/employment outlook. At the moment, nothing is stable, so it’s unlikely that lending activity will increase just because banks get punished for holding excess reserves.

Three, in the aftermath of the 2008 global financial crisis, regulations on bank capital and reserves have tightened.  As a result, banks aren’t willing to lend willy-nilly. Money withdrawn from central bank reserves will most likely end up in ‘safe haven’ securities, like U.S. Treasuries, as this excellent report notes.

Four, negative rates could hurt banks more than anyone else. Retail depositors will withdraw their deposits if they’re charged for them by banks. Banks will, therefore, be wary of imposing any charges on consumer deposits.

If they can’t pass on the cost of negative interest rates to consumers, then they may be forced to raise lending rates to protect margins, a Wall Street Journal report notes. That defeats the purpose if they’re trying to increase lending, doesn’t it?

Five, in the unlikely event that banks charge depositors, the financial system, will in effect, penalise savers. Yet, both the eurozone and the U.S. have a growing share of ageing populations, who need to save for their future.

The younger working age population also needs to hold on to savings because the unemployment rate on both sides of the pond remains quite high. Forcing people to spend instead of saving under such circumstances is not just bad economics, it’s irresponsible.

Six, there’s a good chance that more money could be pumped into equity markets, as depositors (banks or ordinary consumers) seek riskier, high-yielding assets to reduce the sting of paying for deposits.

That could stoke what many experts are already labelling a ‘bubble’ in the stock markets.

Seven, depressing interest rates further into negative territory is not the way to lift economic growth. The lack of sustainable growth in the eurozone and the U.S. is not a monetary problem.

Governments on both sides of the Atlantic also need to step up and do their parts, and not depend on their respective central banks to do all the heavy lifting on economic growth.

Really, negative interest rates are not the answer.

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