The Effect of Negative Interest Rates in Europe

In his press conference last week, European Central Bank (ECB) President Mario Draghi signaled that policymakers may be more open to a cut in the central bank’s deposit rate. Although Mr. Draghi acknowledged this move could have negative side effects, he added “we will be able to deal with the negative consequences … we will look at this with an open mind.” Several major central banks considered negative deposit facility rates during and after the financial crisis, but so far, all have determined that the idea did not pass the cost/benefit test. If the ECB goes through with it, the change could have significant consequences for interest rates, including in the U.S. Below we provide a basic primer on negative central bank deposit rates in Q&A format.

Q: What is the ECB’s deposit rate?

A: The interest rate the ECB pays to commercial banks on their reserves. Just like in the U.S., commercial banks in the euro area hold deposits at the central bank. These deposits are known as reserves (or sometimes “excess liquidity”). In a world with expanded central bank balance sheets, the rate of interest on these deposits is the most important benchmark rate in the money markets. The reason, of course, is that banks will not lend at any rate lower than the risk-free overnight rate they can earn at the ECB. The deposit rate therefore serves as the hurdle rate for all other types of lending.

Q: What change is the ECB proposing?

A: Mr. Draghi hinted the ECB would consider cutting the deposit rate from zero to perhaps -25 or -50 basis points. With a negative deposit rate, banks would actually owe interest to the ECB on their overnight cash. In effect, banks would pay a fee or tax on their reserves.

Q: Is the move intended to get banks to “lend out” their reserves?

A: No, but many people are confused about this. Although it is commonplace to say so, banks do not really “lend out” reserves. The Federal Reserve (the Fed), for example, has about $3.3 trillion in assets, which are primarily the bonds it purchased through QE. The Fed also has $3.3 trillion in liabilities and capital. Its liabilities consist of (1) paper dollars in circulation and (2) reserves (i.e. the deposits of banks at the Fed). If banks actually “lent out” these reserves, what then happens to the Fed’s balance sheet? It cannot get any smaller unless the Fed sells its assets, which is unrelated to bank lending activity. In reality—although not in Money & Banking textbooks—bank reserves and bank lending are mostly unrelated. Charging a negative interest rate on those reserves will not get them “lent out” any faster.

Q: So what is the purpose of cutting the deposit rate?

A: A negative deposit rate might moderately ease financial conditions in the euro area and thereby stimulate growth. There are two main channels through which a negative deposit rate might work. First, banks will try to minimize their reserve holdings by buying other liquid, short duration assets—such as short-dated German government bonds. As stated above, banks cannot reduce the overall level of reserves by lending or buying other assets. However, individual banks can trade reserves between themselves—you can think of it as a game of banking system hot potato. This effort to minimize reserves increases demand for other bonds, which lower rates throughout the economy. Second, banks may pass on the negative deposit rates to customers—possibly through higher fees. In response, retail depositors may try to move out the maturity spectrum (lowering term yields), move out the credit spectrum (tightening spreads), or move overseas (weakening the exchange rate).

Q: What are the potential side effects of a negative deposit rate?

A: A negative deposit rate could impair functioning in some parts of the financial system. Unlike in economic models, the real-world financial system is made up of specific intuitions, with various objectives, mandates and regulations. These constraints may mean that financial intuitions will not respond in an optimal way to negative rates. For example, money market funds may not be able to move out the curve because of maturity restrictions, and insurance companies may not purchase riskier assets because of credit-quality rules. Moreover, there may be long-run costs—such as the impairment of institutions in the money markets—that could cause the ECB problems in the future. This is one of the reasons the Fed has decided to keep its deposit rate at +25 bps instead of zero. Lastly, if banks cannot pass on the costs of the negative rate (in effect, a tax) to customers, it may weaken bank profitability and thereby limit lending.

Q: Will the ECB go through with it?

A: This may be a bad idea whose time has come. A negative deposit rate would be a poor way to stimulate the economy. However, Mr. Draghi sounded open minded about it, and the Fed also came close to cutting its deposit rate in the fall of 2011. Plus, the ECB does not have many other good options (at least among the things that it is willing to consider). Ultimately the decision will depend on the economic outlook and the ECB’s consideration of the cost/benefit tradeoffs.


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