The Real Problem With Negative Rates

(Bloomberg Opinion) -- The European Central Bank has just confirmed that negative interest rates will remain in place at least for the rest of this year, and potentially much longer. That may upset investors, who have long queried whether negative rates do more harm than good because of the collateral damage to the banking system. It’s true that keeping rates too low for too long could be counterproductive. But the real problem with the status quo is not the one that the market tends to focus upon.

Obviously the ECB has created a lot of cash in the process of buying trillions of bonds over the past five years. The banking sector is paying billions each year in negative interest on those cash balances. The ECB could reduce this direct cost without necessarily diluting the impact of the stimulus by applying the negative rate to only a fraction of the excess cash in the system. However, this is something of a side issue.

The fundamental problem is that there is a zero lower bound on retail deposit rates. That is, banks believe that their customers would liquidate those deposits and hold cash instead if they introduced negative rates. Once deposit rates have hit that zero bound, any additional cuts in the rates that banks charge on loans will just squeeze profitability. Beyond this point, banks may lend less and the rates at which they do lend may decouple from the rate set by the ECB. The transmission of monetary stimulus through the bank lending channel then starts to fade.

Academics have a technical name for this phenomenon: the reversal rate. That’s the point where interest rate cuts lead banks to scale back lending to protect the bottom line. There are two important things to note about the reversal rate and implications for policy.

First, the point at which negative rates start to hurt will depend on the state and structure of the banking system, so the reversal rate is likely to vary across countries. The more banks rely on issuing debt to fund their loan books rather than retail deposits, the lower the reversal rate will be because negative rates can be passed through into debt issues. The better capitalized banks are and the more pricing power they have – including their capacity to charge fees for access to deposit accounts – the better placed they are to withstand an episode of negative rates. Conversely, the more tracker loans that banks have originated – loans where the rate is contractually tied to prevailing market rates -- the greater the squeeze on interest income from rate cuts. 

Second, it can make sense for a central bank to take rates below their reversal rate – particularly in open economies with developed capital markets. Rate cuts beyond that point will still reach companies that raise funds in capital markets and can still stimulate the economy by depressing the currency. Indeed, even the banks will feel some benefit from going below the reversal rate if those rate cuts boost the economy and reduce potential credit losses. In that case, they’ll benefit explicitly from capital gains on the securities that they hold, and implicitly as there is less default risk on the loan portfolios.

We learned Thursday that even some members of the ECB’s governing council are concerned about keeping rates low for much longer, but the ECB’s latest guidance – that rates will stay at their current levels at least until the end of this year – and President Mario Draghi’s comments in the press conference suggests that Draghi is not panicking just yet. In any case, retreat is not the answer, at least not the complete answer. The ECB would be left with little room to support the economy in this and future business cycles. Recessions would likely be more severe. That could prove more damaging for the banks than modestly negative interest rates.

Eliminating the root cause of the problem is not easy. It will take time to transition to a cashless economy where banks will be able to charge negative rates on deposits. In the meantime, politicians and regulators could consider reforms that might lower the reversal rate across the banking sector as a whole, or for those banks that are particularly exposed to negative rates. They could do worse than look to Sweden where banks are more reliant on wholesale funding (through, say, issuing bonds) and therefore better placed to cope with negative rates.

Changes in the monetary policy framework could also reduce the frequency with which interest rates need to be taken down to the reversal rate and potentially beyond. The obvious answer here is to raise the inflation target.

A higher target will tend to go hand in hand with higher interest rates when the economy is in balance and that leaves more room to cut rates before you hit the reversal rate in a recession. Failing that, central bankers have to be more willing to purchase a wider selection of assets and on a larger scale as an alternative means of stimulating the economy.

It is a good thing that the ECB’s governing council discussed the costs and benefits of negative rates in the latest policy meeting. But those arguing for retreat have to offer a credible alternative that does not involve surrendering to deflation when the next recession arrives.

To contact the editor responsible for this story: Therese Raphael at traphael4@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Richard Barwell is a senior economist at BNP Paribas Asset Management.

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