Negative interest rates and banking instability

Negative interest rates are back in the news as they seem to be generalising. This is a topic I have covered several times over the past couple of years.

Back in June 2014 in particular, I wrote two posts about negative interest rates on ECB deposits. Here, I explained the negative impacts of this policy on banks, from an accounting and profitability perspective. I concluded:

Many European banks aren’t currently lending because they are trying to implement new regulatory requirements (which makes them less profitable) in the middle of an economic crisis (which… also makes them less profitable). As a result, the ECB measures seem counterproductive: in order to lend more, banks need to be economically profitable. Healthy banks lend, dying ones don’t.

The ECB is effectively increasing the pressure on banks’ bottom line, hardly a move that will provide a boost to lending. The only option for banks will be to cut costs even further. And when a bank cut costs, it effectively reduces its ability to expand as it has less staff to monitor lending opportunities, and consequently needs to deleverage. Once profitability is re-established, hiring and lending could start growing again.

Subsequently, I wrote about the fact that some German banks had started charging their non-retail customers for holding deposits with them. I started with the following bank’s (basic) economic profit equation introduced in the post mentioned above:

Economic Profit = II – IE – OC – Q

where II represents interest expense, IE interest income, OC operating costs (which include impairment charges on bad debt), and Q liquidity cost.

From this equation, I showed how banks attempted to pass negative deposit interest expenses onto some customers, thereby neutralising the effect the ECB was expecting, that is: lending growth.

But of course, ECB economists aren’t that clueless, and knew that this could happen. So they hoped that a second effect could ‘stimulate’ aggregate demand: that customers believe themselves to be better off spending their money (pushing inflation up) rather than getting effectively taxed.

Unfortunately, this relies on

1. a simplistic and very mechanical view of human beings, and
2. a flawed understanding of banking mechanics.

I addressed point 2 in several posts. In a banking system relatively free of regulatory constraints, as banks’ customers attempt to spend as quickly as possible after getting their salary paid in, the velocity of the money supply increases, but so does banks’ liquidity cost (Q in the equation above). Why? Because banks’ funding structure becomes more unstable, leading them to accumulate more low-risk, liquid assets as a share of total assets in order to face possible adverse clearing and in order to reduce the liquidity mismatch between the growing turnover of their deposit base and their longer-term investments.

Worse, if customers do not spend but instead merely decide to withdraw their deposits and keep their cash under their mattress, not only is bank’s funding structure more unstable, but it also shrinks, leaving banks with fewer funds to ‘lend out’.

In both case, credit supply (particularly long-term) is likely to get affected and bank shareholders/bondholders are likely to require higher returns to offset what they perceive as higher liquidity risk. Given that returns are already pretty depressed, no wonder I recently said that banks were bleeding shareholders.

Moreover, recent banking regulation amplifies this phenomenon. Basel 3 introduced the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), which require banks to hold a certain type and amount of liquid assets and ‘stable’ funding on their balance sheet to face short-term withdrawals. From the instability and increased deposit turnover I described above, it seems obvious that those rules would further constraint banks’ ability to freely decide how to allocate credit (and how much).

Those are conclusions I reached already two years ago. Am I the only one to hold such view? Apparently not, given what a number of analysts have recently said. According to The Telegraph:

Sub-zero rates would discourage banks from expanding their operations, crimp cross-border lending in the eurozone and result in higher credit costs in the beleaguered currency bloc, according to Morgan Stanley.

“This is all contrary to the ECB’s desire to ease credit conditions and support financial stability,” said Mr van Steenis.

“It is an unnecessary and dangerous experiment to take in case there are non-linear impacts on deposit stability and financials stability writ large.

“The ECB’s action is flipping from a positive to a negative for European banks,” he added.

What about point 1 above? Well, a recent survey by ING provides some colour as to how people would react if nominal rates on their saving accounts turned negative (real rates have often been negative but, you know, money illusion).

Those are some of the results:

The chart doesn’t show the percentage who responded ‘spending more’. So here is the answer (my emphasis):

No less than 77% said that they would take their money out of their savings accounts if rates went negative. But only 12% would spend more, with most suggesting that they would either switch into riskier investments or hoard cash ‘in a safe place’.

So much for raising inflation…

Of course, once effectively facing negative rates, those respondents might behave differently, but the survey highlights that the effects of the policy on aggregate demand may not end up as positive as central banks expect, while harming the banking system and hence making it less able to lend for productive purposes.

PS: However, and as usual, I strongly disagree with Frances Coppola’s assertion (about excess reserves) that:

But of course the reserves do not disappear from the system. They simply move to another bank, which then incurs the tax. The banking system AS A WHOLE cannot avoid negative rates on reserves.

No, as I and George Selgin recently described, if the whole system extends credit, excess reserves gets converted into required ones. Hence the tax disappears. Nevertheless, this is a lengthy process, as operationally, it is almost impossible for banks to increase their loan book/buy assets quickly enough to offset the recent extremely rapid growth in the monetary base, in particular at a time of new regulatory implementation. (please note that this reasoning only applies to policies that only charge negative rates on excess reserves)

PPS: I also wrote about whether or not a free banking system would ever apply negative rates here.