ECB policy: Looking at the negatives

Last week’s ECB meeting was, to the extent that it offered nothing more concrete than a 25bp cut in the refinancing rate, a disappointment. But markets were mollified by Draghi’s hint in his press conference of further rate cuts, including the possibility of cutting the deposit rate, which currently stands at zero, into negative territory.

The theory behind the introduction of a negative deposit rate is that it will provide banks with a disincentive to hoard cash at the central bank. Instead, the theory goes, they will deploy this excess cash into the real economy, boosting lending. And, if the cut in the deposit rate is accompanied by a reduction in the central banks’ main refinancing rate, that will lower interest rates for businesses and households.

That’s the theory. What about in practice? Well, examples of central banks that have employed negative interest rates are few and far between. In recent times, only the Swedish and Danish central banks have set negative deposit rates. The Swedish experience lasted for just over a year, and the overnight deposit rate remained in positive territory – it was only the one-week deposit facility that was negative. The Danish central bank, meanwhile, introduced a negative deposit rate in July 2012. But that was in response to upward pressure on the country’s currency peg to the euro, not to stimulate the economy. All of the other major central banks, including the BoJ during more than 15 years of deflation, have eschewed negative rates. And perhaps for good reason.

Certainly, the benefits of a negative deposit rate in the euro area are not immediately obvious. Yes, they may encourage banks to hold smaller cash balances at the central bank. But that doesn’t necessarily mean that will lead to higher lending. The introduction of a negative deposit rate may just encourage banks, in particular in the core, to accelerate repayment of their LTROs and further reduce their excess reserves, which have been falling in any case since Draghi’s “whatever it takes” comments last summer (see chart)

Financial institutions' lending from, and deposits at, the ECB

Finanical InstitutionsSource: Datastream and Daiwa Capital Markets Europe Ltd.

The fact that at its May meeting the ECB also decided to extend full allotment at all its main refinancing operations until July 2014 means that the incentive to hold precautionary cash balances is now reduced, given that banks now know they have unlimited access to ECB liquidity for at least another year. And, to the extent that banks will still want to hold some cash balances, the ECB is not the only place they can do that – a move to a negative deposit rate would see banks increasingly move their cash into short-term government bonds, pushing those rates (in some cases further) into negative territory.

This, of course, might also benefit peripheral short-term debt and possibly help lower peripheral banks’ refinancing costs further. But Italian and Spanish 2Y yields are at or close to their historical lows already and the sharp compression in peripheral spreads in the wake of the ECB’s OMT announcement has not helped to stimulate bank lending in recent months. A further, and likely marginal, decline in spreads is unlikely to change this.

Indeed, despite the marked improvement in peripheral banks’ refinancing costs in recent months, bank lending rates remain prohibitively high. This primarily reflects peripheral banks’ need to offer higher savings rates than their peers in the euro area’s core to maintain their deposit bases – the cost of ECB funding in determining lending rates is of largely secondary importance here. And yet it is here where lower rates are most desperately required.

Negative deposit rates may, in fact, paradoxically, lead to banks seeking to increase their margins. Top of the list of downsides of negative deposit rates is that they effectively act as a tax on banks’ operations. For example, a 25bps charge on the current level of deposits at the ECB (€124bn) would amount to more than €3bn per year – banks would either have to look to recoup those costs within their margins, accept lower levels of profitability or increase their risk exposure. All of this could have the effect of lowering bank lending.

A negative deposit rate brings other costs too. By pushing overnight rates to zero (or below) they can destroy money and repo markets. And the absence of a functioning money market infrastructure can constrain central banks in their ability to raise rates when the time comes to do so, something that the BoJ found when it looked to raise rates in the mid-noughties. Finally, they can also hamper any asset purchases the central bank may want to undertake (why would a financial institution sell a financial asset with a positive yield to hold cash, which would give it a negative yield?). This is a major reason that neither the BoJ, the Fed or the BoE have gone down the negative rate route.

The introduction of a negative deposit rate, therefore, isn’t the answer for the euro area’s travails. Indeed, the costs of introducing one would likely outweigh any benefits. It is hard to see why, by itself, it would encourage banks to lend against a backdrop of weak demand and pressure from regulators to boost capital ratios. If the ECB wants to stimulate lending, it is going to have to stimulate some growth in the first place. And if it needs negative rates to do that, which seems increasingly obvious, the better option would be to undertake a QE programme incorporating large-scale purchases of government debt. Such a programme would be particularly helpful in the periphery, where stimulus is most desperately required.

But Draghi last week explicitly ruled out ECB purchases of government bonds, saying that the ECB is not in the business of monetary financing. For ideological reasons, therefore, QE is not on the cards. That leaves the ECB with severely diminished options, as highlighted by the fact that it is even contemplating a policy option that has never before been tried in a major economy and which seems to offer little prospect of providing the sort of support that the euro area economy desperately needs.


Grant Lewis, Head of Research

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