Negative Interest rates and its Impacts

After the 2008 financial crisis, there is no other question in finance world that has raised more curiosity among investing class than “Negative Interest Rates”. The interest rate which has been lowered into the negative territory by the policy makers is the most basic rate in any economy is the rate at which the central bank will be lending electronic cash to a commercial bank on an overnight basis, the interest that the commercial bank needs to pay to the Central Bank on the money borrowed is based on this interest rate. This is one of the basic tools, which any central bank has to control the monetary policy or the money supply in the economy. In any economy all functioning commercial banks have accounts with the Central Bank. So, when a Commercial Bank borrows money from the Central Bank it has to pay interest in return.  If any commercial bank has excess reserves it will be paid an interest in return by the Central Bank, which makes perfect sense, but when this situation reverses and the commercial bank has to pay to the Central Bank to park excess reserves, we witness a situation of Negative Interest Rates. Many Central Banks including Sweden, Switzerland, Denmark, ECB and recently BOJ have slipping their interest rates into red.

The logical question, which arises here, is that how come banks have so much excess reserves lying with them. The answer to this question is Quantitative Easing (QE). Many central bankers deployed QE as a monitory tool after the 2008 crisis, latest by European Central Bank (ECB) and Bank of JAPAN (BOJ). Quantitative Easing is a large-scale bond buying open market operation by the Central Bank. But the focus remains how does a Central Bank implements negative interest rates in the system. Central Bank makes the electronic balances in those accounts shrink, which is witnessed by a deposit of €10,000 today becoming €9,999.92 tomorrow.

The impact of such a negative rate is that it pushes down short-term rates, which provides an economic boost by expanding credit and results in weakening the currency of the economy. The short-term interest rates actually go down because when the Central Bank cuts the overnight interest rates, these overnight rates drag down other rates: the rate one bank will pay another for a one-month loan, a three-month loan and a one-year loan and so on. Negative rates also spur banks and other investors to buy - short-term governments debt and this drags down the yields on these government bonds. Rates for financing in the capital markets – i.e. a company sets its yields bonds to investors—are linked to the yields on government debt considering this insight all other things being equal, they go down when government-debt yields go down.

The effect of negative interest rates on the economy has not been very convincing, there haven’t been sharp turnarounds in the countries that have tried negative rates and it is yet to be seen that strong economic benefits can be achieved using negative interest rates.

Negative Interest Rates heavily affect banks profitability for a simple reason that they cant charge their customers a negative rate for keeping cash with them as investors might prefer to keep cash rather, keeping cash is like depositing money at 0% rate but it is still better than loosing money with a negative rate. This affects banks primary business of lending and borrowing money.

In theory, negative interest rates should be able to reduce borrowing costs for companies and households and drive-up demand for loans and credit. In reality, the risk involved with it can have serious repercussions. If banks make more customers pay to hold their money, that cash could well go under the mattress, robbing the banks of a crucial source of funding and perhaps even triggering a bank run. Even if that doesn't happen, when banks absorbs the costs of negative rates on their profit and loss, it decreases the profitability, and might make them even less willing to lend. Two years into the experiment, it is still too early to say with surety if negative interest rates will work, If more central banks use negative rates as a stimulus tool, the policy might ultimately lead to a currency war of competitive devaluations.