Low interest rates over a very long period of time – possible?

In the wake of restrained loans approval policies among commercial banks on the one hand and constantly rising central bank liquidity on the other, in January 2012 the European Central Bank (ECB) resolved to lower the minimum reserve requirement from 2% to 1% of the volume of a bank’s deposits used for the calculation. At present, the interest paid on the minimum reserve is 0% and thus corresponds to the main refinancing rate at which the ECB makes central bank money available to commercial banks. In total, the minimum reserve requirement of all banks taken together runs at around EUR 123 billion. By contrast, the interest rate at which commercial banks can deposit their surplus reserves with the ECB has since March 2016 been minus 0.4%.

In 2012 the ECB lowered the minimum reserve rate to 1%, because the significance of the instrument had dwindled given full allocation of the tender transactions used to fine-tune the money market, and the intention was to make monetary policy as a whole more expansionary. Faced with a massive surplus of central bank liquidity, however, with the reduction in the minimum reserve rate the interest on commercial banks’ total deposits with the ECB fell, as one part of the minimum reserves (bearing better interest) became surplus reserves (bearing less interest). Surplus reserves bear interest at the deposit rate, which at minus 0.4% at present is 40 basis points down on the interest on the minimum reserves.

That said, the deposit facility alone now tallies about EUR 600 billion, which at an interest rate of minus 0.4% p.a. means the banking system is being drained of a good EUR 2.4 billion a year. A deposit in largely risk-free assets is no alternative in this context. The interest rate is low, as is the scale of the spread to the credit markets, and the reduction in the ECB’s bond buyback programme points to a slight rise in yields. Investing in the bond market thus entails, in the event of an increase in yields, a present-value risk which can swiftly exceed the “punitive interest” of 40 basis points for the deposit rate. For this reason, despite involving a “certain loss” of 0.4 percent per annum, the deposit facility is an alternative for parking liquid funds that is being widely used and therefore contributes to the pressure on banking sector revenues.

The ECB reduced the deposit rate deep into negative territory back then in order to support its intention of stimulating bank loan approvals. Today, fundamental conditions have improved appreciably. The Eurozone economy is now in better shape, loans approvals have picked up, and there is hardly any more talk of a credit squeeze even in southern Europe. On the other hand, criticism of the ECB’s low-interest policy is mounting. Critical voices are to be heard above all in Germany. In the absence of worthwhile investment opportunities on the loans or securities side, many banks find themselves forced to pass on the negative ECB rates to their deposit customers. The longer this situation endures, the greater the pressure will be, especially as bank revenues are also under sustained pressure from other factors, including the increasing expenditure required to meet regulatory requirements.

If the ECB were now to enable free liquidity over and above the minimum reserve to be deposited with it at the refinancing rate, commercial banks could use the existing liquidity to grant loans at more favourable conditions. Put simply, maintaining liquidity costs banks less, meaning they would need to earn less by furnishing loans or would focus on less risky investments in securities. An allowance corresponding to treble the minimum reserve requirement (3x EUR 123bn = ~ EUR 350bn) would thus cut the costs of the deposit facility (~ EUR 600bn) for the EMU banking system by more than half, as the allowance would then bear interest of 0% p.a. rather than minus 0.4%.

In light of the increasing demands to terminate the phase of ultra-expansionary monetary policy and not only reduce the bond purchasing programme, but also increase key rates again, this allowance could be one initial measure to also become active at the interest end. The ECB would then, on the one hand, accommodate those who advocate leaving key rates unchanged. And in fact the refinancing rate and deposit rate for surplus reserves could be held at their level hitherto for longer than would otherwise be possible. On the other hand, a significant allowance at which surplus liquid funds can be parked with the ECB at zero interest would lessen the pressure on commercial banks to have to pass negative interest on to their clients.

The ECB would thus on principle pursue the Swiss model. There, allowances are set for each bank individually for which, as with the minimum reserve requirement, 0% interest applies, while that for surplus reserves is minus 0.75%.

Conclusion: A tiered deposit rate that enables banks to deposit some of their surplus reserves at an interest rate of 0%, just as they do with their minimum reserve, could serve to ease the pressure on commercial banks, while the key lending rates would factually remain unchanged. The banks would then have greater scope to lower their loan terms further. It would above all lessen the pressure of having to charge an increasing number of clients negative deposit rates. Negative interest already being charged could then be raised and brought back towards zero. A trend towards higher money market interest is unlikely to then evolve. Along with due communications on the part of the central bank, such a measure would most probably be greeted without upsets by the bond market.

Overall, a tiered deposit rate might enable the ECB to uphold its “official” interest rates longer. A later increase in the deposit rate would thus not be excluded, but the transition to raising the regular deposit rate and later the refinancing rate too could be smoothed in this way.

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