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Negative interest rate on bank deposits at the central bank: an option for the ECB?

For a long time considered as impossible to implement, the negative interest rates on deposits of commercial banks at the central bank is now often mentioned as an option for the European Central Bank (ECB).
By Urszula Szczerbowicz
 Post, November 27, 2013

In July 2012, the ECB lowered to zero the rate on its deposit facility for the first time. However, it has not yet decided to impose negative interest rates on banks’ deposits, as did the central bank of Sweden (between July 2009 and September 2010) and the central bank of Denmark (since July 2012).

The goal for setting a negative rate on banks’ deposits is to encourage them to redistribute in the form of loans the money they have accumulated at the central bank.

Since the beginning of the subprime crisis, unconventional monetary policies have led to a considerable increase in excess reserves (deposits) of financial institutions at the central bank. However, banks have preferred to keep these reserves at the central bank rather than lending them on the interbank market, investing in securities or lending to businesses and households. This choice is partly motivated by the remuneration of these deposits which reaches 0.25% at the Fed and 0.1% at the Bank of Japan (BoJ).

At first, the remuneration of deposits appears counterproductive because it encourages banks to build up reserves and discourages lending. However, the remuneration of excess reserves seems necessary in the pursuit of unconventional monetary policies, particularly those that involve the expansion of central bank balance sheet via assets purchases (quantitative easing). The increase in excess reserves in this case is a consequence of direct interventions in securities markets that the central bank wants to support: the excess reserves are the liabilities of the central bank that compensate the increase in assets. If the banks decide to reduce their excess reserves, the central bank would be forced to limit its purchases of assets. This is why the Bank of Japan maintains a positive interest rate on reserves: the commercial banks would refuse to sell sovereign bonds if the reserves they get in return were not remunerated, or worse, were "taxed" by the negative interest rate.

In the United States, the slowdown in purchases of securities is looming and the Fed is now considering a reduction in the interest rate on deposits (see Fed's press release, November 20, 2013).

In the euro area, where no unconventional asset purchases are presently implemented, a negative rate on deposits is being considered (at least in the press). Although the ECB does not buy unconventional securities, its balance sheet has grown rapidly as a result of a program of massive funding of the banking sector (3-year LTRO). The difference between the quantitative easing based on securities purchases (the Fed and BoJ), and the quantitative easing based on loans to banks (ECB), is that the former has the objective in terms of asset increase (Fed: $ 85 Bln / month for the Fed, BOJ: doubling the assets in 2 years). The liabilities side of the central bank, and the excess reserves the most often, must increase to match those purchases. The ECB on the other hand has no target for its assets: in the 3-year LTRO operations, the commercial banks decide themselves how much they borrow from the ECB. If they decide to pay back the 3-year loans, the excess reserves will decline but unconventional policy of the ECB will not be compromised. Given that the ECB does not need the excess reserves to conduct its unconventional policy, it can more easily consider their "taxation".

The prospects for reducing the remuneration of reserves are encouraged by the positive effects of previous actions. The decline in deposit rates by the ECB to zero in July 2012 has contributed to a significant decline in overnight deposits facility at the central bank (see a previous post on the blog du CEPII) and seems to have favored resumption of interbank market. The Danish experience also confirms the effectiveness of lowering deposit rates. The negative rate on deposits has been implemented to discourage foreign capital inflows and to stop the Danish currency appreciation. Lowering deposit rate to - 0.20% increased the gap between European and Danish interest rate which made investments in Danish krone less attractive and prevented its appreciation.

The decline in deposit rates to a negative level is an exceptional measure that does not come without risks. The lack of sound investment projects can push banks to fuel bubbles or to lend to customers at risk which may result in an increase in bad loans. Moreover, the negative rates decrease banks profits and they may be tempted to pass on this shortfall to their customers by raising the interest on loans.
Money & Finance  | Economic Policy 
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