The unintended consequences of Negative Rate World Part II. An update.

At the start of April I wrote about some of the unintended consequences of central banks setting negative interest rates. I also promised to update the blog as we spotted more interesting implications, and asked readers to submit examples too.  Thanks for those who got in touch.  Here are some more of the interesting things that happen when the zero lower bound ceases to exist, as well as links to some theoretical thinking on negative rates.

1. In the last blog we worried that banks would be unable to pass on negative rates to depositors (fearing deposit flight), and therefore could not pass on lower rates to borrowers, and so lending wouldn’t be boosted.  In fact whilst this remains broadly true we have seen some movement here.  The President of the German Sparkassen (savings bank) Association Georg Fahrenschon has said that “the era of free account management is over” and that commercial customers will pay “penalty interest rates”.  Household rates however will (so far) remain untouched.  Germany’s Sparkassen are 74% funded by non-MFI deposits. (Story source: FAZ).  In Spain, newspaper Cinco Dias reports that banks there are now charging 0.3% interest on deposits for large businesses.

2. The chief executive of UBS Sergio Ermotti has said that the negative rate environment makes his whole industry ask “do we still really want to take on client assets when doing so costs the bank money – and when we have to back up liquid assets with an unreasonably large amount of capital?” He also said that the bank had put up some loan rates as a result of the cost of negative deposit rates.  (Source: WBP online)

3. The Eurozone’s central banks have been earning millions of euros from deposits on which they would previously have paid interest.  The Financial Times reported that, for example, “the Central Bank of Ireland earned €28.5m on deposits from the government and credit institutions”.  For the larger European central banks this is presumably far more.  (Source: FT via Torben Hendricks)

4. The always interesting Bank of England blog, The Bank Underground, has written about the impact of negative rates on the derivatives market. The industry standard for pricing interest rate options is called the SABR model, and assumes that rates do not go below zero.  Fischer Black, who helped develop the thinking about options pricing, had said that “the nominal short rate cannot be negative”.  Modifications to the model, necessary since rates did go negative, now imply greater uncertainties of outcomes and hence higher hedging costs.  The need to hedge some of these risks, and others deriving from the historical sale of structured notes may have increased the demand for physical bonds and hence driven yields even further lower, increasing volatility at the same time.

5. The Japanese Ministry of Finance is printing more of the largest Y10,000 note, to cope with demand.  Production will increase to 1.23 billion of the notes per year, up from a typical level of 1.05 billion.  Cash held at home has thought to have increased by 14% in the last year.  Partly this may be due to negative rates, but it also could be due to the introduction of a new identification number regime (“My Number”) linking tax and social security.  (Source: Japan Times)

6. The 2015 conference by the Centre for Economic Policy Research called “Removing the Zero Lower Bound on Interest Rates” included not just the economic debates, but discussion of the implications for legal and payments systems.

7. This link from 2012 from the New York Fed’s equivalent of The Bank Underground blog, Liberty Street Economics, is worth a read. Amongst other “disruptions” that might occur from negative rate environments, it suggests that large corporations who can’t physically hold enough cash to make it possible to withdraw it from banking systems, might financially innovate.  They give the example of a special-purpose bank, with a vault full of physical cash, issuing cheques giving a claim on that cash.  At some level of negative rates the SPV becomes able to charge a fee that makes it attractive to corporates to own a physically small cheque backed by cash held in a secure facility, rather than to keep their money in the traditional banking system.  They also suggest that people might stop banking cheques – even if you try to pay somebody early, you might find you can’t get rid of your cash.  In a final great quote the Fed says that “if rates go negative, we may see an epochal outburst of socially unproductive – even if individually beneficial – financial innovation”.

Please post any more sightings of either unusual economic or market behaviour as a result of negative rates, or links to interesting academic work on the subject, into the blog comments below!