Editor’s Note: When the European Central Bank made the unprecedented announcement of a negative interest rate policy (NIRP) early last month, we reached out to Benn Steil, director of international economics at the Council on Foreign Relations, for some perspective about what negative rates are intended to achieve and how everyday Europeans would be affected. Both he and former Fed economist Catherine Mann, now at Brandeis International Business School, were skeptical that the ECB’s two-pronged policy of one, pushing negative the interest rate at which banks hold their money at the ECB, and two, incentivizing banks to loan commercially with access to cheap funds, would necessarily do all that much to increase bank lending and stimulate the economy. (See “Will the European Central Bank’s negative interest rate be an economic positive?”)
Now, several weeks after NIRP went into effect, we return to Steil and CFR analyst Dinah Walker for a more data-driven analysis of how negative interest rates are playing in the eurozone. Their conclusion remains the same: the policy is unlikely to spur much eurozone growth without more ambitious banking interventions first.
Steil has previously contributed to Making Sen$e, writing about John Maynard Keynes and the Bretton Woods conference, both based on his book, “The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order.”
— Simone Pathe, Making Sen$e Editor
Nearly three years after officially entering into recession, the eurozone economy continues to languish, with year-on-year growth climbing a mere 0.9 percent in the first quarter. Bank lending to eurozone businesses, which has been declining since the start of the crisis, is moribund, suggesting continued stagnation. Although earlier European Central Bank interventions succeeded in prodding eurozone banks to buy up more of their governments’ debt, the private sector remains largely on the sidelines.
The ECB seems finally determined to address this head-on. Its recent headline-grabbing policy initiatives put it into largely uncharted territory. These feature negative interest rates for bank deposits at the ECB and a scheme offering cheap four-year funds to banks that boost commercial loans. The latter won’t actually start up until September, so let’s have a look at the immediate prospects and early performance of the former.
On June 11, the ECB became the first major central bank in the world to cut a key policy rate below zero. The interest rate on its deposit facility was lowered from 0 percent to negative 0.10 percent. This means that banks are now being charged 0.10 percent for keeping excess funds at the ECB (that is, funds beyond what is necessary to meet their mandatory reserve requirements).
At the same time, the ECB lowered the rate at which it lends euros to banks from 0.25 percent to 0.15 percent and has stopped “sterilizing” the liquidity created by its 2010 Securities Markets Programme. When the ECB purchased bonds under that scheme, it effectively created new deposits – deposits of the proceeds of the bond sales by the banks. Now, the ECB will stop paying banks interest on these deposits. All this is intended to discourage banks from keeping funds idle at the ECB, and to prod them to lend instead.
How does this work? Lowering the rate banks can earn from depositing funds at the central bank should lower the rate at which banks are willing to lend to one another. This reduces the cost of funding for banks that borrow from other banks to meet their central-bank reserve requirements. Similarly, lowering the rate at which the central bank is willing to lend money reduces the cost of funds for banks that borrow directly from the central bank to meet their reserve requirements. If banks have a lower cost of funds, loans to households and businesses that would not have been profitable when funding costs were higher suddenly become profitable. This should spur private-sector lending and increase economic activity.
How about when central-bank deposit rates go negative? While central banks have decades of experience influencing the economy by changing short-term interest rates, they have almost no experience with negative rates. Theory suggests that negative rates should be ineffective as a spur to economic activity, as banks can always convert central-bank deposits into cash, and store that cash in a vault as a means of avoiding a negative deposit rate. In practice, however, there are significant costs associated with storing large amounts of currency, and banks will be willing to incur negative deposit rates as long as this cost is less than the cost of storing currency.
What actual experience with negative rates can we draw on? Very little. Denmark tried it briefly in 2012 in order to discourage foreign money flowing in — and driving up the Danish krone — as a hedge against a eurozone collapse. It had the main intended effects: deposits declined, and the krone depreciated. But it’s hard to draw clear lessons from the experience. First, the initiative came right around the same time as ECB president Mario Draghi’s famous pledge to do “whatever it takes” to preserve the euro, which dampened fears of eurozone disintegration and reduced investor incentives to park savings in Denmark. Second, Denmark is tiny; its currency is not a major global reserve currency like the euro. Thus the Danish case study may have little relevance for the ECB.
So how have negative rates actually played out so far in the eurozone? Despite the dramatic optics of rates going negative, as long as banks are not financially motivated to store cash in vaults, a fall in the deposit rate from 0 percent to -0.10 percent is actually nothing more than a small, 10 basis-point-fall in the deposit rate. And, in fact, the ECB’s deposit-rate cut has had a small positive effect, no different from that which would be expected from any small cut in the central-bank deposit rate. The overnight interest rate at which eurozone banks lend to one another (“EONIA”) fell to its lowest level ever after the negative ECB rate was implemented. But it remains positive. This means that banks are generally happier paying the ECB to park funds there than they are paying their fellow banks something less in order to park funds with them; the latter still involves some measure of credit risk.
Particularly worrying, however, is the fact that 151 banks are still borrowing 115 billion euros in funds through the ECB’s main refinancing operations at 0.15 percent — five times higher than the 0.03 percent EONIA rate at which credit-worthy banks borrow from other banks – despite the fact that there is more than enough liquidity in the system to fulfill reserve requirements if banks were willing to lend to one another. This suggests that many banks are still in such bad shape that they remain on public-sector life support. Such banks are in no position to boost private commercial lending, irrespective of the ECB’s interest-rate initiatives.
This leads to a larger point about ECB policy. Eurozone banks have to date shown little inclination to pass on lower borrowing costs to private business, owing to a legacy of unacknowledged bad debts built up during the first decade of the euro’s existence. Eurozone policymakers have been struggling to strengthen the balance sheets of both banks and governments, but each is dragging down the other. Banks facing large loan losses have been increasing their already outsize exposure to eurozone sovereign debt, an investment that falls in value as fears rise that the governments will be called on to bail the banks out. European banks have been trying to repair their balance sheets by raising capital, but uncertainty over the quality of their assets makes such capital expensive. They have therefore resorted to cutting back on their lending, which further weakens the eurozone economy.
The eurozone will, therefore, have to undertake more radical banking interventions before we start seeing significantly more plentiful and less costly private-sector credit.
In this, the ECB should heed the lessons of the 2009 U.S. federal banking supervisors’ stress tests. These were a turning point in the U.S. financial crisis, stemming from the market perception that they were tough and credible. The supervisors could, critically, afford to be tough, as funds from the Troubled Asset Relief Program (TARP) were by that time available through the Capital Assistance Program to recapitalize banks deemed to have a shortfall. In the end, the Capital Assistance Program did not need to provide any capital to banks following the stress tests. The knowledge that the CAP backstop was available was sufficient to encourage private investors to step forward.
The board of governors of the eurozone’s 500 billion-euro European Stability Mechanism, which provides assistance to struggling economies and banks, has agreed on the operational framework of a reform by which the ESM would allow direct bank recapitalization once the ECB has assumed supervisory responsibility for eurozone banks, which should happen in November. While German law expressly forbids the ESM from assuming direct bank financial risk, Germany’s coalition parties agreed last November to support the ESM making available up to 60 billion euros for bank recapitalization. German finance minister Wolfgang Schäuble has indicated that once the Bundestag amends the law he will be in a position to vote for the necessary reforms within the ESM board. The reform is an important step in the right direction.
However, the operational framework that has been agreed upon requires significant capital contributions from the government of the country in which the bank is domiciled before the direct recapitalization instrument can be used, so it does nothing to break the “vicious circle” between weak banks and weak sovereigns that it was initially intended to break. Until it is broken, and banks can be recapitalized without dragging down their over-indebted governments, the ECB will get little traction in boosting eurozone growth through low – or even negative – interest rates.