Why Negative Rates are Bearish for Banks

As developed economies grapple with the ever looming threat of deflation (which for France, Japan and Switzerland among others, is actually a reality), their respective central banks are turning to extreme measures to try and induce inflation. The measures? Breaking through the zero lower bound on interest rates and making them negative. Japan recently became the latest member of the negative rates1 club.

The rationale is quite simple really - set a lower interest rate to try and encourage borrowing and spending in an economy, with the end goal being to generate economic growth. However, commercial banks are taking strain because negative rates are changing the calculus.

Commercial banks, by and large, make their money on spreads. That is, there is a difference in the rate at which borrowers pay to loan money and the rate paid to depositors who lend banks money (with such deposits being used to fund the loans banks make). The positive difference between the rate charged to borrowers and the rate paid to depositors is in essence the bank’s margin.  Now, when negative rates are introduced by a central bank, this simply means that the central banks charge the commercial banks to hold their excess bank reserves with them. The implication is that banks would rather deposit their reserves with each other in the inter-bank market. But, this activity drives down inter-bank interest rates (JIBAR in South Africa, LIBOR in the U.K for example) to somewhere close to the rate set by the central bank.

These inter-bank rates feed through to longer-term rates and the rates which are offered on new loans to customers. Central banks hope that cheaper loan rates will incentivise borrowing and the financing of economic activity.

Now, on the other side of the coin, banks hold deposits for their customers and pay them a small rate of interest for this. Banks want to retain their spread on interest rates to stay profitable and keep shareholders happy. To do this, they need to reduce the rate they pay to bank customers on deposits. But what if this rate is already very low or zero? How do banks maintain their spread in this environment?

Banks could risk moving their interest rates on deposits to negative, in effect charging customers to hold their money. However, that may largely result in customers pulling their deposits out of banks and stuffing them under their mattresses. This mass withdrawal of funds from the banking sector would result in a very big problem for the financial sector and, ultimately, it would probably crimp economic growth.

Data

So banks have, by and large, stood by and taken the pain as margins have narrowed. This is why the Eurostoxx Banks Index, an index of European Bank stocks, has dropped 20.43% in Euro terms year-to-date (see figure above). Whether central banks will stick it out with negative rates is a difficult question; however if they do “normalise” in the future, it may present an opportunity to pick up a sector that has lost significant value.  

1By this we mean the rate earned on commercial banks’ deposits at the central bank