We have updated our Terms of Use.
Please read our new Privacy Statement before continuing.

Deep dive

10 November 2015 By Swaha Pattanaik

The European Central Bank may be about to push the floor for euro zone policy rates deeper into negative territory. Three policymakers have told Reuters that the debate within the ECB is now less about whether to cut its bank deposit rate and more about by how much. While the benefits may be easier to quantify than the risks, the idea has some serious flaws.

There are a host of reasons why some might want a hefty cut in the deposit rate, which is currently minus 0.2 percent. This would weaken the euro, which might generate some much-needed inflation, and depress regional borrowing costs, which might otherwise edge up in sympathy with U.S. bond yields. Charging banks more to park money with the central bank should also theoretically encourage them to lend more, while easing would send a clear signal about the ECB’s determination to hit its inflation goal.

But there are also a host of other, less happy, potential consequences. Lower bond yields make global investors so desperate for returns that they overlook risks inherent in higher-yielding assets. They also make it harder for life insurers and pension funds to meet their long-term liabilities. Even worse, they risk squeezing banks, on whom the ECB is counting on to lend.

A very negative deposit rate will dent banks’ profitability since lenders are unlikely to pass on the full cost of parking deposits with the ECB. And while this increases the incentive to lend more, banks can only do so if there’s demand for loans. The more the ECB depresses longer-term yields, the less lucrative it becomes for banks to use short-term borrowing to fund longer-term lending.

Denmark, where a key rate was cut to minus 0.75 percent in February, and Sweden, whose policy rate has been at minus 0.35 percent since July, offer salutary examples. Danske’s third-quarter pre-tax profit undershot expectations and it said negative central bank rates were putting pressure on net interest income. It’s been a similar story for Swedish banks.

Some policymakers feel a small cut is already priced in. An outsized one would very likely deliver the sort of outsized market impact which some ECB policymakers are hankering after. But the costs – especially to banks – look bigger than the benefits.

 

Email a friend

Please complete the form below.

Required fields *

*
*
*

(Separate multiple email addresses with commas)