Heard about negative interest rates?

Bank of England this week announced a bigger than expected monetary stimulus to support the British economy struggling from BREXIT and the second lockdown driven by another wave of COVID-19. Curiously, they also announced that the bank is working on negative interest rates. But what exactly is the negative interest rate and how does it even work?

Negative interest regimes are a fairly new-age phenomenon and a tool that central banks have used only in recent history. The idea behind negative interest rate programs is primarily to stimulate economic growth.

What happens in a negative interest rate environment?

  1. Banks will start lending more given that the excess liquidity they hold is being charged negative interest rates.
  2. Businesses will be more ready to invest in new ventures leading to job creation and increased demand for capital goods.
  3. The value of the currency will go down due to reduced demand for it causing exports to become cheaper.
  4. Individuals will feel encouraged to spend more increasing overall consumption/demand given that the money in their bank is returning negative interest rates.

While it is all well-intended, it is neither a win-win nor a free lunch. Banks and individual savers ultimately pay the price when interest rates turn negative.

The basics first - How do banks make money?

Banks tend to make money through what is called the net interest margin. This is the spread (difference) between the deposit interest rate and the interest rate on loans. This is their main source of income. So in theory, a positive or negative interest environment should not really matter because banks can still add a spread over the negative interest rate that they are being charged by the central bank and dole out loans. But the reality is quite different.

Banks are required to maintain a certain level of un-invested reserve capital in order to cater to regulatory requirements. The ratio of these reserves to deposits is called the CRR or the cash reserve ratio in India. Banks are also required to maintain additional reserves called the statutory liquidity in the form of cash, gold, central bank approved securities. In addition to these, banks regularly tend to hold on to excess liquidity as part of their regular risk management process. This is especially true in a recessionary environment and is done to preserve capital and keep non-performing assets low. Keep in mind that when the economy is not doing well, several businesses tend to go bankrupt and banks end up losing a lot of money lent to these institutions.

In a recessionary environment

In a recessionary environment, individuals and private investors significantly cut back on their consumption and investment decisions. Demand goes down, people save more and this money enters the banking system.

In an attempt to increase demand and push commercial banks to lend more money, central banks reduce interest rates. But when interest rates are already very low, central banks are left with no choice but send interest rates into negative territory. What that does is gives them the power to start penalising the commercial banks for holding excess liquidity instead of lending. This is negative for the banks.

However, no matter how much money we keep depositing in banks, they usually don’t charge us, individuals, negative interest rates. They can, but they don’t. This is because if they start charging us negative interest rates, we would start withdrawing all of the money we have in cash and hoard it at home. And this will cause all sorts of problems from more thefts & burglary to perhaps even run on banks.

Exacerbating this, central banks for over a decade now have embarked on what is called as quantitative easing/asset purchase program. This is nothing but creating “new money” out of thin air and using this new money to buy government/private sector bonds. Some of these are rated junk bonds with little to no demand from the general investing public at large. This in turn creates even more liquidity in the monetary system all of which finds its way back to the banking system, which is already suffering from an excess liquidity problem and negative interest rates.

You can see why the thought of this creates a headache for some of the largest banks and terror to their shareholders. It is also obvious why this causes nightmare to common individuals like us and savers. Our deposits are earning little or no nominal interest from the banks, and sometimes even earning a negative real interest rate due to inflation.

So, how do banks deal with this problem?

Banks have found innovative ways of managing these negative interest rate regimes. They have resorted to buying safe assets like government bonds. They have learned to discourage new deposits by charging wealthy individuals account maintenance charges. And now and again, have also increased loans to the private sector.

But desperate times can call for desperate measures. Recently, a bank in Denmark offered home mortgage loans at -0.5% interest per annum. You know what that means? If you took out a loan of 100 bucks at the beginning of the year, your total outstanding principal at the end of the year assuming you have made no repayments is only 99.50. Effectively, the bank is paying a part of the original principal amount. They can do this because parking money at the central bank can be even more expensive for them.

Well then, what about us individuals?

How does one manage negative interest rates or even low-interest rates? The answer to this lies in the basic economics of demand and supply.

Consider for a moment the amount of “new money” being created by central banks around the world. The supply of money available in the system is increasing significantly. But what about the demand for money?

 Money buys assets and commodities, and that’s where its demand comes from. But the actual supply of these assets (like stocks, real estate, etc.) itself is limited. So when the supply of money increases and the demand for money does not increase as quickly, the value of money depreciates and leads to inflation. This can lead to asset price inflation and “bubbles”.

This is one of the most fundamental concepts in economics and has implications in pretty much every single aspect of our daily lives. We need to wear this lens of demand & supply while looking at some of the bizarre things that are happening in our world today.

When the supply of money increases, its value depreciates against assets and commodities. Or in other words, equity, real estate, gold, commodities tend to appreciate while cash and money saved in bonds and fixed deposits suffer. But when there is so much gloom in the economy with economic contraction underway, how could one risk their hard-earned money in investments like stocks? And this is where financial risk management tools like diversification, stock selection & asset allocation come into play.

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