Higher Rock Education - Economics Blog

Friday, December 09, 2016

Negative Interest Rates

Would you deposit your savings in a bank if they charged you to keep your money safe and did not pay you any interest? If not, what would you do with your funds? On August 16, 2016 Raiffeisenbank Gmund am Tegernsee, a small community bank in Germany began to charge their depositors 0.4% instead of paying them interest. (CNN Money, Aug 16. 2016) That's right, if you deposited andeuro;100,000 with them, they would charge you andeuro;400!

Many older retired families protect their savings because they rely on its earnings for a substantial portion of their income. The financial crisis of 2008 and the ensuing financial turmoil in the weaker European economies have resulted in a historically long period of low interest rates. Where should the retired invest? Many invest in savings accountsandhellip;but savings accounts have near zero interest rates. I am unaware of any other banks that went to that extreme of Raiffeisenbank Gmund am Tegernsee for consumers, but some banks have begun to charge larger corporate accounts for holding their money. European and Japanese interest rates are negative. So what other safe alternatives are there for retired German citizens? Perhaps they could invest in safe government guaranteed bonds. Today, the two year and five year bonds have a zero coupon rate, which means that they do not pay any interest while an investor owns the bond, plus the bond will be redeemed at less than the principle amount. This assumes the investor holds the bond until maturity. Investors are lending the government money knowing they will not be repaid in full. That's right, investors (the buyers) are paying the borrowers (the government) to use their money! Again, this is the result of negative interest rates. (Visit Bloomberg for current rates.)

What are Negative Interest Rates?

The European Central Bank (ECB) first established negative interest rates on June 11, 2014 when it set the deposit rate at -0.10%. Since then it has decreased it several times. Today it is -0.4%. (Key ECB Interest Rates) Who pays? Banks deposit their money with the Central Bank – The Federal Reserve in the US, the European Central Bank in most of Europe, or The Bank of Japan in Japan. Normally like consumers, they are paid interest on their deposits. However, when there is a negative interest rate the banks pay the Central Bank to hold their deposits. For example, if a bank averages deposits of andeuro;1,000,000 and the rate is -0.4%, the Central Bank will only return andeuro;996,000 when the member bank withdraws its funds. The negative rate is the interbank rate, or the rate banks are charged for holding deposits at the central bank. Normally, the banks absorb the cost, fearing that depositors would withdraw their money if they charged. (Raiffeisenbank Gmund am Tegernsee is a rare exception.)

Prior to negative rates, the ECB used more conventional methods to increase the money supply as well as purchasing other securities. It seemed like anything they could do to add money to the economy was considered. However, banks hoarded cash following the large increase in the money supply. Why? Because they were fearful the economies would further deteriorate and some banks would fail or borrowers would not be able to repay their obligations. Their managements believed it was better to hold onto cash and wait until there was an improvement in the economy. The European economy continued to founder. Pumping money into the economy did not sufficiently revive it. The ECB grew concerned that mounting deflationary pressures would push economies into a deeper recession. During deflationary periods, people hoard cash. Why buy something today when it will cost less tomorrow? This behavior reduces an economy's aggregate demand and exacerbates a recession.

Why were Negative Interest Rates Established?

Why did the ECB implement negative interest rates? In essence – they want to make it more expensive for banks to hoard cash. When a negative rate was established, the spread between holding deposits and making loans widened. Prior to increasing the spread, the only cost to banks was the opportunity cost of loans not made. After establishing a negative rate, the total cost became the opportunity cost of missed loans plus the real cost of paying for depositing funds. The theory is banks will choose to lend their excess deposits rather than hoard them. For a bank, a loan to a borrower creates an income generating asset. Deposits at the central bank are an asset, but they now cost money to maintain. Creating an incentive for banks to increase their lending will stimulate the economy. Businesses invest in new projects or upgrade their equipment. Families would borrow to acquire consumer goods. Each of these events is conducive to economic growth.

Large companies that pay banks to hold their money may seek other ways to invest it. The ECB hopes this incentive combined with the higher cost for banks to retain their money in deposited accounts will stimulate loans to further economic growth.

This unprecedented strategy carries several risks. First, there must be legitimate projects and needs. Businesses will not borrow unless they believe a project is viable. Banks will not lend if management believes a loan's risk is too high. Second, employing a negative deposit rate may send the message to the public that the Central Bank is concerned about the economy's future. Fear often results in increasing savings as insurance against losing a job or some other financial hardship. Consumers may choose to actually increase savings rather than spend more. Conversely, if more banks try to pass their added costs to consumers and begin charging depositors like Raiffeisenbank Gmund am Tegernsee then many consumers may withdraw their money and cause a run on banks. Either scenario harms the economy.

Banks provide all economies the needed capital to grow. A healthy banking community is essential. Negative interest rates have made it much tougher for banks to earn a profit. They are paying the central bank approximately .04% on money they hold at the central bank. The weak economies and available reserves have created a great deal of competition among banks for good loans. In other words, lending rates are also very low. This combination of less interest earned on loans and an added cost of doing business has made the banker's job much more challenging.

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