Negative Interest Rates and the Banking Sector

Posted: 21st May 2017

By: Anas Ur Rasheed Khan

Overview

In this increasingly demanding and highly competitive world, being extreme is a requirement of the time. You need extreme motivation to work extremely hard to produce extreme results. As brutal and unforgiving as it may seem, it is what is currently stipulated. I mean, simply think of the 11-year-old child prodigy who recently beat arguably the two greatest minds of our time, Albert Einstein and Stephen Hawking, at an IQ test . Extreme? I think even Einstein would concur. Recently, our economic policy makers have also awoken to this extreme reality. They seem to have conceded that extreme measures will be necessary to produce the desired results; something that has propelled them out of the conventional limits of economic policy tools. This has delved the world into an era of Negative Interest Rates.

The Basics

When we talk about negative interest rates, there are essentially two key components of the policy that affect the commercial banking system. The first one is what is known as the ‘deposit rate’. This is the interest rate that the central bank pays the commercial bank on deposits with it. This is an extremely powerful policy tool because it effectively determines the benefits and/or costs of holding money instead of lending it for the commercial banks. After the 2008 financial crisis, we have witnessed many influential central banks permeate into the sub-zero space with this particular interest rate (see graph below). Having a negative deposit rate essentially coerces commercial banks to lend money by charging them for not doing so. Ultimately, by this means the central bank aims to boost lending (credit generation) in the hope that borrowed money will be spent, eventually driving up economic activity and inflation.

The second essential component is what the European Central Bank (ECB) terms as the rate on the ‘marginal lending facility (or what is more commonly known as the ‘discount rate’ in the US). This is the interest rate that the central bank charges on short-term loans acquired by commercial banks. We can link this back to the objective of credit creation because it effectively determines how much money commercial banks will borrow from the central bank and eventually lend it to the public. By rendering this particular interest rate negative, the central bank is literally paying commercial banks to borrow money from it and lend it on onto the public to be spent. I hope you can muster the sense of desperation that this procedure elicits.

A cause for concern?

By implementing the negative interest rate policy, central banks around the world are affecting the conventional banking system in two fundamental ways:

Another major affectation of the current scenario is that commercial banks are being propelled to take much more risks. I am sure, we all have heard the adage: “Go hard or go home”. An appetite for risk is admirable, but bear in mind that the banks are essentially playing this game on people’s hard-earned savings. Undertaking high-risk debt and indulging in risky investments runs the risk of defaults and, therefore, bank insolvency. It is also worth noting that the intensified credit creation might have formed bubbles in the markets ranging from commodities to real estate. One particular example of this is the real estate market in Demark, a country which has been exposed most to negative rates in history. Figures show that property prices in Copenhagen have risen 40–60 percent since 2012, when the central bank first imposed negative interest rates.

This so-called bubble can be attributed to a global hunt for yield as well as near-zero interest rates on mortgages. According to many analysts the current stock valuations around the world, particularly those in the US, which are currently at their highest levels since 1999, are reminiscent of a bubble especially if analysed in historical terms. The graph below modestly compares the alleged overvaluation and the leveraged environment reminiscent of previous recessions.

If these bubbles were to burst, the consequences would be extremely detrimental, and we could be looking at yet another global recession. Large-scale mortgage defaults and significant plunges in value of assets can severely damage the balance sheets of banks and other financial institutions around the world leading to insolvencies and bailouts.

As ominous as the outlook may seem, it should be borne in mind that in order for this policy of pervasive credit creation to be sustainable, actual profit-generating investment opportunities and a growing demand for goods and services must exist in the economy. Otherwise, the gain in valuations is spurious and only a reaction of massive credit creation. With the abysmal global outlook for growth, a tendency of risk-aversion has plagued the financial system. Negative bond yields are a testament to the fact that financial institutions (not only banks) are working to protect their money rather than investing it or lending it out because there is simply not enough demand for loans. An idiom quite fittingly explains this situation: “You can lead a horse to water, but you can’t make it drink”. Indeed, the policy makers have led the horse to water, but making it drink the water is a different story altogether.