Will negative interest rates encourage banks to lend more plentifully and cheaply and help support economic recovery? I am not convinced. I fear they are a dangerous experiment with diminishing positive impact.
Conventional thinking is that negative rates are just a natural continuation of quantitative easing, like dialling down the air conditioning. This, though, underestimates how financial intermediaries may actually respond. They erode banks’ margins. They give lenders an incentive to shrink, not grow. They encourage banks to seek out opportunities overseas rather than in their home markets. They also risk disruptions to bank funding. All go against the grain of the central banks’ desire to ease credit conditions and support financial stability.
That is not to say QE has not helped the global economy and enabled banks to repair their balance sheets. Low rates have improved the affordability of their loans, reduced bad debts and lifted the value of assets, thereby increasing collateral values. But market expectations largely incorporate this already, and persistent low rates will act as an increasingly chill wind on banks’ profitability.
One counter argument is that negative rates have so far proved fairly benign in Sweden, Denmark and Switzerland. The details are more troubling. Banks have tried hard to offset negative rates by charging more for lending — particularly for mortgages — and charging higher fees. As a result, borrowing costs have gone up not down.
The crux of the matter is this: the market is no longer sure how low rates might go in a range of countries. Peter Praet, chief economist of the European Central Bank , said last week: “As other central banks have demonstrated, we have not reached the physical lower boundary.” As long as this uncertainty remains, it is hard for banks to know whether the loans they are making are economically sensible or for investors to price banks’ securities with confidence. Beyond a further 10-20 basis point cut in the deposit rate of the ECB, the effect on banks’ earnings could start to be exponentially negative.
Denmark and Switzerland have sought to lighten the impact with tiered schemes, which seek only to tax excess deposits and dissuade foreign investors from leaving their cash in that market. The ECB is trying an alternative: a new targeted longer-term refinancing operation, which offers to pay banks to lend. But this does not fully offset the drag of negative rates. I estimate that only 5 to 15 per cent of the €1.6tn incremental in TLTRO above its predecessor will in fact be drawn, based on a poll of the eurozone’s largest banks at Morgan Stanley’s Financials conference last week. Almost no northern European banks said they would take any of these funds. Put another way, about half of TLTRO may end up simply being old funding operations rolled into this subsidised rate without new lending.
For banks, the indirect consequences of negative rates may matter more than the direct effect. There is a risk that market liquidity will be reduced, as negative rates mean financial intermediaries hoard high-yielding assets. There is also a question over how money market funds, which help many corporates to manage their finances, will navigate negative rates. In Japan all 11 companies running money-market funds have stopped accepting new investments.
Negative rates, if passed on by banks, could also start to erode consumer trust in banks as the right place for their cash. Sales of safes have risen in Germany and Japan since they were implemented.
Commercial banks and other market financial institutions are more sensitive to negative rates than central banks. If central banks fail to appreciate this, they may do more damage than good.
Huw van Steenis is a managing director at Morgan Stanley and a member of the World Economic Forum’s Global Agenda Council