Abstract
Euro Area Policies: Selected Issues
Negative Interest Rate Policy (NIRP): Implications for Monetary Transmission and Bank Profitability in the Euro Area1
Several central banks in Europe have adopted a negative interest rate policy (NIRP) to achieve price stability and/or reduce appreciation pressures. Negative interest rates so far have had an overall positive impact, supporting easier financial conditions and contributing to a modest expansion in credit, demonstrating that the zero lower bound (ZLB) is less binding than previously thought, including with respect to central banks’ signaling capacity. But looking ahead, further rates cuts when deposit rates remain sticky will lower bank profitability and may offset the benefits from higher asset prices and lower funding costs in a bank-dominated financial system. For the euro area, this suggests that further monetary accommodation should rely more on credit easing measures than on further lowering negative interest rates.2
A. Background
1. Over the last two years, central banks have pushed the marginal policy rate into negative territory in response to macroeconomic challenges. The Danmarks Nationalbank (DN), the European Central Bank (ECB), Sveriges Riksbank (SR), and the Swiss National Bank (SNB) all cut their key policy rates to below zero over the period from mid-2014 to early 2015, and the Bank of Japan (BoJ) in February. In addition, the Hungarian central bank (Magyar Nemzeti Bank (MNB)) adopted a negative deposit rate in March 2016 (see text figures). Some central banks have taken policy rates into negative territory to primarily counter a subdued inflation outlook (ECB, BoJ, SR), while others have focused on mitigating spillover effects from the unconventional monetary policy (UMP) measures (Mircheva and others, 2016) and to ward off appreciation pressures (DN, SNB). In Hungary, NIRP was also used to promote new lending and reduce vulnerabilities, in particular regarding public debt. Most central banks have also introduced a tiered deposit rate to reduce banks’ cost of holding excess reserves while still allowing for a strong pass-through to money markets (see more details in Appendix I, Table A1 and Appendix II).
Major Reserve Currencies: Effective Marginal Policy Rates, 2010-2016
(Percent)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Bloomberg, L.P.; and Haver Analytics.Note: Policy rates used for each country are the following: EA: deposit rate; US: Fed funds rate; UK: O/N interbank rate; Japan: deposit rate.Other Currencies: Effective Marginal Policy Rates, 2010-2016
(Percent)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Bloomberg, L.P.; and Haver Analytics.Note: Policy rates used for each country are the following: SWE: reverse repo rate; DEN: repo rate; HUN: deposit rate; BGR: deposit rate; CHE: deposit rate.B. Advantages and Disadvantages of NIRP
2. The willingness and capacity of central banks to pursue effective NIRP strongly signals their commitment to price stability objectives and supports portfolio rebalancing. In an environment of low inflation, negative rates restore the signaling capacity of the central bank by effectively removing the ZLB, which helps avoid a deflation equilibrium as the real rate adjusts downward (see text figure)—and contributes to a significant flattening of the yield curve. If banks hold excess reserves, cuts to the central bank deposit rate lower the money market rate and other interest rates, encouraging banks to take greater risks, strengthening the portfolio rebalancing channel—an important transmission channel of the asset purchase program (Heider and others, 2016).
Inflation and Interest Rates, Jan. 2002-April 2016
(In percent, monthly)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Bloomberg, Haver Analytics, and IMF staff calculations.3. However, with sticky deposit rates, NIRP potentially weakens bank profitability through lower net interest income. If negative policy rates are transmitted to lower lending rates (and term premia), they are likely to reduce the profitability of maturity and liquidity transformation unless banks can substitute more wholesale funding at lower money market rates and/or negative rates are also imposed on deposits (or fees are applied). However, retail deposit rates tend to be downward sticky3 since (i) households and small businesses do not face the same set-up cost faced by banks and corporations in storing cash due to relatively small amounts of excess liquidity and (ii) a zero percent interest rate could be a psychological threshold.4 As a result, banks’ net interest margins (NIMs), defined as net interest income relative to average interest-earning assets, compress as lending rates for new loans decline, and existing (variable rate) loans re-price while deposit rates remain sticky or do not adjust as quickly. This could reduce bank profitability and impair the pass-through to lending rates in absence of any mitigating actions. Of course, if banks eventually decide to lower retail deposit rates below zero (as already done on large deposits in several countries), this would increase the chances of “leakages” to cash5 but will also induce higher household consumption and portfolio rebalancing towards other investment opportunities, with beneficial effects on aggregate demand.6
4. Other factors could compensate for the adverse impact of NIPR on interest margins.
Stronger credit growth and/or higher non-interest income. The credit supply effects of reduced profitability from lower lending rates can be offset by the credit demand effects if banks (can) increase lending (Appendix I, Box A1)—but this becomes more difficult if credit demand is low, assets re-price quickly, and competition among banks is high. Banks could also supplement declining interest margins with alternative sources of income, such as fees and commissions.7
Higher asset prices, asset quality, and lower funding costs. Portfolio rebalancing with negative rates reduces risk premia, easing financial conditions and ultimately supporting credit creation and economic activity. The resulting decline in risk aversion increases asset prices and generate capital gains on banks’ appreciating asset holdings. Furthermore, higher asset prices (especially in tandem with higher inflation) are likely to raise future income and strengthen borrowers’ repayment capacity, leading to a reduction in bank non-performing loans (NPLs).
Stronger aggregate demand through portfolio rebalancing. Portfolio rebalancing helps lower firms’ general cost of capital via lower term premia, which puts downward pressure on corporate bond yields.8 At a lower cost, more investment projects would become profitable, raising investment and credit demand. Higher credit demand can offset declining margins, and, in turn, reinforce the impact of TLTRO II on bank profitability (Appendix I, Box A2). Higher asset prices and lower interest expenses for indebted households (who tend to have higher marginal propensity to consume) also boost household consumption through wealth effects.
5. On the other hand, a prolonged period of negative rates could raise financial stability concerns. In particular, the downward stickiness of deposit rates encourages the substitution of less stable wholesale funding for deposits. German, Italian, Portuguese, and Spanish banks, whose deposit base is wider than in the rest of the euro area average, have stronger incentives to trade off market-based sources of funding against more stable (term) deposit funding (Figure 1). As much as negative rates ease financial constraints on borrowers in the short run, they could distort the long-term debt affordability of borrowers if lending rates become negative in real terms.9 The reduced debt service burden under NIRP could delay the exit of nonviable firms, hurting demand prospects of healthy firms by adding to excess capacity and delaying the efficient allocation of capital and labor. By effectively removing the profitability constraint of investments if real borrowing rates drop to (or even fall below) the ZLB, NIRP might also delay corporate restructuring in high debt countries, especially if inflation does not pick up, placing greater emphasis on debtor screening and debt enforcement standards. In these instances, more assertive supervision and regulatory pressures would be needed to address large amounts of non-performing loans and debt overhang problems (Syed and others, 2009).
The Impact of NIRP on Bank Profitability and Implications for Credit Growth
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
C. The Impact of Negative Interest Rates
6. Negatives rates have been fairly effective thus far in reducing money market and lending rates (Elliott and others, 2016; Viñals and others, 2016). At the same time, retail and corporate deposit rates also declined, allowing banks to maintain their lending margins and supporting credit growth given the importance of the bank lending channel.10 In cases where sticky deposits (with a limited scope for cheaper wholesale funding)11 have compressed lending margins, many euro area banks have been able to more than offset declining interest revenues with higher lending volumes, lower interest expenses, lower risk provisioning and capital gains (Cœuré, 2016).12
7. Money markets have quickly adjusted to modestly lower deposit rates without causing a collapse of interbank lending. In the environment of excess liquidity, the observed money market rate will be at or just above the marginal policy rate at which excess reserves are remunerated (or penalized under NIRP). In all countries, money market rates closely followed the marginal policy rate (Appendix III, Figure A1). In some countries, a tiered central bank deposit rate has facilitated the smooth transmission of the marginal policy rate to money markets reducing the cost of interbank lending. However, several factors, in particular related to the design of a tiered reserve system, could keep the money market rate away from the deposit rate as the technical floor of the policy rate corridor. These include: (i) the amount of excess liquidity and the fraction that is exempted from the marginal policy rate, (ii) the spread between the marginal and average policy rate for excess reserves, and (iii) banks’ willingness/ability to lend excess liquidity to each other (fragmentation).
8. Despite lower lending rates, so far there is limited evidence of negative rates having damaged bank profitability. Lending rates declined, in most cases, as long as deposit rates still had some room to drop to the ZLB (see text figures), allowing banks to transmit lower policy rates without impeding their profitability (Appendix I, Box A3).13 While bank profitability has been a long-standing structural challenge for many euro area countries regardless of current monetary easing, the aggregate NIM has remained broadly stable (Appendix III, Figure A2). Euro area banks have reportedly reduced their lending rates to both households and firms over the past six months while offsetting the negative impact on lending margins by some small increase in fees and commissions and cost cutting. According to the ECB’s recent Bank Lending Survey (ECB, 2016a) negative rates seems to have also led to an increase in household lending in the euro area, and the impact is expected to continue going forward (Appendix III, Figure A3).14 Moreover, reduced profitability from lending also puts pressure on the “self-healing powers” of highly cyclical and fragmented banking systems in many euro area countries—such as facilitating bank consolidation and paving the way for greater operational efficiency.
Euro Area: Marginal Policy Rate and Lending/Deposit Rates—NFCs
(Percent)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Bloom berg, L.P.; and Haver Analytics.Note: Policy rate used for this chart is the ECB’s deposit rate.Euro Area: Marginal Policy Rate and Lending/Deposit Rates—Households
(Percent)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Bloom berg, L.P.; and Haver Analytics.Note: Policy rate used for this chart is the ECB’s deposit rate.9. The direct cost imposed on excess bank reserves by NIRP has been found small when compared to the size of the overall balance sheet. The implementation of NIRP has important implications for banks’ cost of holding central bank liabilities depending on the structure of reserves and their remuneration (Appendix I, Box A4) and the transmission of the marginal policy rate to money markets (Appendix I, Box A5). For instance, the peak charge in Switzerland has been 0.03 percent of total banking sector assets. In the euro area, and in countries with an even more negative deposit rate (Denmark, Sweden and Switzerland), there have been no signs of cash hoarding (see text figure); most of the recent increase in some countries can be explained by the normal relation between currency in circulation and movements in the short-term interest rate, with the latter representing the opportunity cost of holding cash rather than deposits. Irrespective of whether interest rates are positive or negative, the amount of currency in circulation increases when interest rates decline. In addition, bank profitability is far less sensitive to declines in negative rates on excess reserves (even under a tiered system) since cash balances of banks represent only a fraction of their deposit base.
Currency in Circulation at Time of Negative Deposit Rates
(Percent, year-on-year)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Haver Analytics. Note: the x-axis shows monthly intervals.Euro Area: Currency in Circulation and Pervasiveness of Negative Interest Rates, 2012-2016
(Percent)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Bloomberg L.P. and IMF staff calculations. Note: 1/ denotes the extent to which the 1-month EONIA forward rate curve is in negative territory, calculated as the product of the maturity term and the interest rate.10. Going forward, the transmission of negative rates might become less effective as interest rates become more negative. This would leave little room for further adjustment of deposit rates to more negative rates without compromising bank lending spreads. While the extent to which deposit rates are sticky remains to be seen, it is very likely that lending rates will decline more than deposit rates in the near term, further reducing interest earnings. Banks might also be less inclined to reduce lending rates unless they can offset lower interest margins by substituting wholesale funding for more expensive deposit funding (which represents a large part of euro area bank liabilities). This holds particularly true in countries where banks face greater earnings pressure, and credit growth has been low. The role of negative rates in reinforcing the transmission of monetary policy to the real economy and supporting aggregate demand would be an offsetting benefit. However, if lending rates do not adjust, monetary transmission could be weakened.
D. Assessment for the Euro Area
11. While concerns about their impact on bank profitability have for the most part not yet materialized, negative rates are expected to erode banks’ earning capacity going forward amid a flattening yield curve. Estimates of the impact of the recent decline in policy rates on banks’ NIMs suggest a small effect (7 basis points for a 50-basis point reduction in the policy rate),15 but early evidence from countries with negative rates suggests that this impact may increase non-linearly as the policy rate falls below the ZLB (while deposit rates remain non-negative). Although it is unclear whether banks still have room to cut deposit rates, banks may be reluctant to do so due to competition. Despite broadly stable average NIMs so far, the impact of monetary policy on euro area banks is becoming increasingly adverse. Indeed, the ECB’s recent Bank Lending Survey (ECB, 2016a) suggests that bank profitability has recently declined and is expected to remain depressed.
12. Lower bank profitability would weigh on bank equity prices and could blunt the effect of NIRP on credit recovery. Since negative rates are easier to pass on to lending rates than deposit rates, the prospect of low policy rates for a longer time—amplified by structural challenges to banks in many euro area countries—has already worsened the outlook for bank earnings. Any expectation of further reduction to the already negative rates would lower expectations of banks’ future earnings, weighing on equity prices (Figure 2). While the ECB’s monetary easing has reduced the cost of borrowing, since Q3 2015 equity risk premia have risen and price-to-book ratios have declined, with the average cost of equity now exceeding the return on equity. This would encourage capital-constrained banks to reduce credit (in absence of sufficiently high-yielding but less capital-intensive lending opportunities), reducing the effectiveness of negative rates as a policy measure.
Bank Equity Valuation and Credit Growth
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
13. Despite the potential mitigating effect of higher aggregate demand and asset quality—as well as the potential benefits of negative rates for the implementation of the ECB’s asset purchase program—there are two important adverse implications that need to be considered for NIRP within the euro area:
Monetary transmission may become less effective in economies most in need of stimulus. Given the wide deposit base in most euro area countries, the extent to which deposit rates are sticky has a direct impact on bank profitability and the effectiveness of NIRP on monetary transmission. Even if banks were to fund themselves increasingly via money markets, the benefit from wholesale funding at negative rates will be limited by the existing deposit base and cannot offset the negative impact of lower rates on existing loans if credit growth is insufficient (Figure 1). In particular, bank profitability is likely to decline in countries with large outstanding loan amounts at variable rates if lending growth is insufficient to offset diminishing interest margins as existing loans re-price. Among countries with a high share of variable rate loans, such as Italy, Portugal, and Spain, also (still) high asset impairments amplify concerns about banks’ earnings capacity, and restrict their ability to supply credit to the real economy. In this regard, TLTRO II (Appendix I, Box A2) could facilitate the transmission to lending rates by mitigating the potentially adverse impact of negative rates on banks’ lending margins.
The direct cost of negative deposit rates would be disproportionately greater for banks in surplus countries. Given the imbalances within the euro area, the Target 2 settlement of capital flows generates large amounts of excess liquidity in the banking sectors of surplus countries, such as Germany and the Netherlands.16 In addition, the implementation of the Eurosystem’s asset purchasing program has generated additional liquidity in other core economies in excess of their national share of asset purchases, such as France (see text figure). Both developments have led to a very uneven distribution of excess liquidity, affecting banks differently across the euro area.17 In principle, tiering of the deposit rate could mitigate the direct cost of NIRP and ensure effective transmission of the marginal policy rate (to short-term rates) even if rates became more negative. However, the heterogeneity of national banking systems within the euro area might complicate the effective implementation of a tiered reserve regime (Appendix I, Box A4).
EuroArea: Rising Financial Fragmentation, January 2015-March 2016
(absolute change, EUR billion)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Bloomberg L.P., ECB, Haver, NCBs, and IMF staff calculations. Note: */The use of ECB liquidity reduces the Target 2 balance and is subtracted; 1/ public sector purchase program (PSPP; 2/ expected based on changes in balance of payments after accounting for general “leakage” from Target 2 due to non-euro area trade and portfolio flows.E. Conclusion
14. So far, NIRP has had an overall positive effect in improving credit conditions and supporting aggregate demand. Negative interest rates have helped lowered bank funding costs and may have contributed to improved asset valuations. In addition, negative rates have significantly enhanced the signaling effect of the ECB’s monetary stance, which complemented the impact of asset purchases on the flattening of the yield curve. In some countries rate cuts have been passed through to corporate and household borrowers thereby contributing to a modest credit expansion and bolstering the economic recovery. Concerns about their negative effect on bank profitability have for the most part not yet materialized.
15. However, further reducing the deposit rate is likely to entail diminishing returns, since the lending channel is crucially influenced by banks’ expected profitability. NIRP involves a difficult trade-off between implementing unconventional policy measures to support aggregate demand and mitigating adverse effects on bank lending channel. Further cuts towards the “true” lower bound could weaken monetary transmission as lending rates do not adjust and/or deposits are increasingly substituted for cash. Lower bank profitability could then constrain credit expansion and undermine the aim of monetary easing. Looking ahead, further monetary accommodation should then rely more on credit easing measures and expanding the ECB’s balance sheet. Such measures help raise asset valuations and aggregate demand, while also supporting the bank lending channel.
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Appendix I. Implementation and Impact of Negative Interest Rates
Monetary Transmission under NIRP1
We assess the impact of negative rates on bank profitability and its implications for monetary transmission when deposit rates become sticky using a full equilibrium specification. We adapt the DSGE model by Gerali and others (2010), which was estimated using euro area data. In the model, banks enjoy monopoly powers in intermediating funds between savers and borrowers and setting rates on loans and deposits. The modeled banking sector comprises two retail branches, which are responsible for lending and deposit-taking, while the wholesale unit manages the capital position of the banking group subject to a simple solvency constraint, and, in addition, provides wholesale loans and raises wholesale funding. Banks face different adjustment costs when changing rates. A higher cost implies lower adjustment for a given shock, and, thus, the rates are more “sticky.”
We find that sticky deposits under NIRP either weaken bank profitability or diminish monetary transmission. We examine three different scenarios reflecting banks’ response to a policy rate cut assuming that deposit rates are bounded at zero percent (text chart below). Banks can substitute some cheaper wholesale funding for deposit funding but potentially offsetting components of banks’ net operating income are ignored (e.g., capital gains from higher asset prices and lower provisioning cost from higher debt service capacity of borrowers). In the first case (blue line), we assume that the pass-through from the policy rate to deposit rate remains unchanged. Banks reduce the both deposit and lending rates, and their profitability increases over time as output and inflation outturns improve. In the second case (green dotted line), price-setting banks face (artificially) higher adjustment costs in setting deposit rates (i.e., deposits are “sticky”). Banks optimally choose to lower lending rates to increase lending volume at the cost of deviating temporarily from the minimum capital requirement. Bank profitability declines significantly as lending volumes are initially insufficient to offset the compression of lending margins due to sticky deposit rates. In the third case (red line), the solvency constraint is strictly enforced for the second scenario of sticky deposits. Here, monetary transmission breaks down as banks increase lending. However, the impact on output is still positive, although smaller over the short term, as the wealth and substitution effects (from lower discount rates) push up loan demand, consumption and investment.
1 Prepared by Jiaqian (Jack) Chen and Andreas (Andy) Jobst.The Impact of NIRP on Bank Profitability and the Mitigating Impact of TLTRO II
Euro area banks are under pressure to maintain current profitability from lending in an environment of continued monetary easing. A decline in term premia and a lower marginal policy rate reduce banks’ net interest margin (NIM). Based on the historical pass-through of easing measures, it is possible to determine the minimum annual increase in lending (over the average maturity term of the loan book) required to offset the projected decline in net interest income as a result of the impact of the recent ECB monetary policy measures. The recently expanded asset purchase program (with monthly purchases of €80 billion, up from €60 billion, and the reduction of the deposit rate to -0.4 percent, down from -0.3 percent), are estimated to lower the NIMs of euro area banks by 11 basis points on average (Germany: 5 bps; France: 4 bps; Italy: 11 bps; Spain: 13 bps).
The decline of NIMs is greater in countries with a higher proportion of variable rate loans and a higher cost of risk (such as Italy and Spain).1 These findings suggest that aggregate lending growth in the euro area would need to increase to 2.3 percent annually (up from 1.8 percent at end-January) for banks to maintain current profitability over the amortization period of their current loan book (see text figures).
Annual Loan Growth Required to Maintain Net Interest Margin, end-2015
(y/y percent change) 1/
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Sources: Bloomberg L.P., EBA Transparency Exercise (2015), ECB, SNL, and IMF staff calculations. Note: */ assumes that new lending is fully funded using TLTRO I funds at a weighted average borrowing rate of -20bps.1/ based on the historical pass-through of policy rates and the elasticity of net interest margins to changes in term premia between Jan. 2010 and Feb. 2016; total mortgage and corporate loans at end -2015 to EA residents.; scenario assumes an increase of monthly asset purchases (until Sept. 2017) by the ECB and a deposit rate cut of 10bps (as per ECB decision on March 10).The launch of a second series of targeted longer-term refinancing operations (TLTRO II) will support bank lending (ECB, 2016b). Starting in June, banks will be able to borrow up to 30 percent of eligible non-mortgage private loans over a four-year period at the prevailing MRO rate. TLTRO II has two components to incentivize new lending (see text figures): (i) conditional liquidity (at the marginal policy rate, equivalent to the rate on the deposit facility prevailing at the time of the allotment) if banks exceed a benchmark (red line) for net new lending of at least 2.5 percent by January 2018, and (ii) unconditional liquidity at either the MRO rate of currently zero percent if banks do not satisfy the lending benchmark or at a discount to the MRO rate if banks exceed the lower benchmark (blue line).2 The size of the decrease of the interest rate for conditional liquidity is graduated linearly depending on the percentage by which the bank exceeds the lower benchmark (which is calculated similar to those under current TLTRO).3
For banks with positive lending growth over the 12 months prior to January 2016, the benchmark is zero net lending. The benchmark is lowered by the decline in eligible net lending in the same period for banks that have seen negative lending benchmark net lending.
TLTROII Benchmark for a Bank with Positive Credit Growth
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Deutsche Bank; ECB; and IMF staff calculations.TLTRO-II Benchmark for a Bank with Negative Credit Growth
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Deutsche Bank;; ECB.; and IMF staff calculations.TLTRO II could mitigate the potentially adverse impact of NIRP on bank profitability. Realigning the cost of refinancing to the marginal policy rate (if banks meet a defined minimum rate of net lending growth) facilitates the pass-through of improved bank funding conditions to the real economy by encouraging more lending. It also helps maintain bank profitability, especially in countries where banks face high cost of risk and/or would refrain from lowering lending rates to preserve profit margins without jeopardizing their deposit base (see text figures). Past evidence suggests a high effectiveness of TLTRO in stimulating new lending. Meeting the requirements for TLTRO II funding at the marginal policy rate implies at least 1.2 percent annual lending growth over a two-year period for banks with positive net lending in 2015 but a continued decline in the eligible loan book for banks that have been de-leveraging.
Use of Funds from Past and Future TLTROs
(Percent of Respondents) 1/
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: ECB Bank Lending Survey and IMF staff calculations. Note: 1/ for survey responses in 2015, the percentage share of responses was re-scaled to unity due to multiple responses or missing responses/responses with no stated preference; 2/ first two series of TLTRO in Sept. and Dec. 2014; 3/ tender offers in Jan. and July 2015; 4/ tender offer in Jan. 2016 only.ECB TLTRO-II Benchmarking: Net Lending to Non-Financial Corporates and Households, Dec. 2014-Jan 2016
(Percent)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Sources: Bloomberg L.P, Haver, and IMF staff calculations. Note: 1/ Net lending growth required to qualify for TLTRO II borrowing at the ECB deposit rate (−0.4%).Low and Negative Interest Rates in Denmark and Sweden1
Negative interest rates were introduced in Denmark and Sweden for different reasons. In Denmark—which pegs to the euro—they were introduced in July 2012, in conjunction with other measures, to deter speculative pressures on the peg at a time when the country faced sizeable capital inflows in response to strains in the euro area. Inflows surged once more in 2015, after the Swiss National Bank (SNB) abandoned the currency ceiling to the euro, and the ECB announced the expansion of its asset purchase program, triggering the Danmarks Nationalbank (DN) to further cut the deposit rate by 70 bps over the course of four weeks. In contrast, the Swedish Riksbank adopted NIRP as part of a package of measures aimed at raising inflation to the two percent target and preventing a de-anchoring of inflation expectations.
Sweden: Bank Interest Rates, New Agreements
(In percent)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Sources: Statistics Sweden and Fund staff calculations.Denmark: Bank Interest Rates, New Agreements
(In percent) 1/
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Sources: Statistics Denmark and Fund staff calculations. Note: 1/ 3-month moving average.The decline in bank interest margins under NIRP was contained by the high share of wholesale funding. Money market rates turned negative and banks’ assets re-priced downwards quickly in response to policy rate changes given the high share of variable rate loans (with a greater importance for household loans in Sweden) (see text figure). While lending rates declined, albeit to a lesser extent in Denmark (Jensen and Spange, 2015),2 retail deposit rates did not drop below the ZLB (see text figure). As a result, the interest spread between lending and deposit rates narrowed—a development that began in Sweden as interest rates reached low levels in 2014, before turning negative in 2015. However, a relative narrow deposit base (with a high reliance on non-deposit funding at 52 percent of total funding at end-2015) allowed banks to benefit from lower money market rates (below their cost of deposit funding), mitigating the overall impact of NIRP on banks’ net interest margins (NIMs), which remained positive in aggregate.3
Estimated Sensitivity of the Average Household Lending and Deposit Rates to a Change in the Interbank Rate, 2008-2015
(multiple)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Sources: Bloomberg L.P., Haver, and IMF staff calculations. Notes: 1/ deposit rate less 3-month money market rate.Change in Lending Spread and Net Interest Margin (NIM)
(percentage points)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Sources: Bloomberg L.P., Danmarks Nationalbank, Sverige Riksbank, and IMF staff calculations. Note:lending spread is calculated for all new loan agreements (non-financial institutions and households) between June 2014 and Jan. 2016;NIMs have been calculated on a bank-by-bank data using publicly reported data up to March 2016.Also others factors have so far limited the effects of NIRP on bank profitability, despite the high degree of asset re-pricing. In Denmark, fee income rose as the volume of mortgage refinancing increased with falling interest rates and provisions declined with improved loan portfolio quality (DN, 2015). In Sweden, fee income also increased with rising inflows to banks’ investment funds and an expansion of their corporate advisory services (Asterlind and others, 2015). Whereas lending growth remains subdued in Denmark, higher loan volumes in Sweden have also helped compensate for lower rates. However, the compensatory effect of credit growth in an environment of NIRP weighing on banks’ net interest income also raises the importance of prudent lending, especially to households.
1/ Prepared by Rima A. Turk and Andreas (Andy) Jobst. For a more detailed analysis of the performance of banks in Denmark and Sweden, see Turk (forthcoming). 2/ Negative interest rates have not been fully passed through to bank deposit and lending rates to households. However, large deposits from firms and institutional investors are paying negative interest rates. 3/ During the first quarter of 2016, however, NIMs for Swedish banks have declined (Kuelpmann and others, 2016).The Mechanics of Tiered Reserve Systems
The implication of NIRP for banks’ cost of holding central bank liabilities varies with the structure of reserves and their remuneration. Excess reserves at both the ECB and the Swiss National Bank (SNB) are held as overnight deposits whereas the Danmarks Nationalbank (DN) and the Sveriges Riksbank (SR) use a combination of overnight fine-tuning operations and one-week term deposits to attract reserves and other central bank liabilities above required amounts (“liquidity surplus”). While the ECB was the first central bank to move its deposit rate significantly into negative territory, it continues to maintain a single negative rate for excess reserves. In contrast, other central banks (Bank of Japan, DN, and SNB)1 have put in place tiered reserve regimes for excess reserves2 to mitigate burdens on bank earnings, facilitate market transactions (by exploiting the uneven distribution of excess reserves among financial institutions), and discourage higher holdings of physical currency.3 Excess reserves are partially exempted from the marginal policy rate for overnight deposits (Denmark and Japan) or sight deposit account balances at the central bank (Switzerland). Central banks have historically used tiering regimes to try and protect the interests of domestic retail depositors while attempting to push as much of the costs onto wholesale (and especially foreign) investors whose deposits contribute mostly to excess reserves. Thus, the ideal size of the exemption threshold is determined by the amount of domestic retail funding banks have at the time of the introduction of the system (i.e., the level of deposits central banks want to protect).
A tiered reserve regime enhances central banks’ capacity to lower the effective policy rate by reducing the direct cost of negative rates on excess reserves. The direct cost imposed on excess bank reserves by NIRP has been found small when compared to the size of the overall balance sheet. For instance, the peak charge in Switzerland has been 0.03 percent of total banking sector assets. Exempting a certain amount of excess reserves from the marginal policy rate avoids imposing the full impact of negative deposit rates on banks. Thus, at the same direct costs to banks, the marginal policy rate can be lower in a tiered reserve regime. The cost of holding depends on excess reserve holdings in the tier with the lowest marginal policy rate (i.e., deposit rate). The tiering (and the difference of policy rates in each tier) determines the extent to which the interest rate of an additional unit of (excess) reserves differs from the average interest rate for all reserves.
Existing tiered regimes can be broadly categorized based on the number of tiers and the allocation of excess reserves across these tiers: (i) constant allocation (e.g., Switzerland), where the exemption threshold for deposits is specific to each bank (as a fixed multiple of a bank’s required reserves); and (ii) dynamic allocation, where fine-tuning operations determine the share of excess reserves to be placed with the central bank as more costly overnight deposits (Denmark, Sweden) or the portion subject to negative rates is designed to increase over time in line with the monetary base target (Japan). The exemption threshold should be as high as possible to minimize the banks’ average cost of holding excess reserves while being sufficiently low to transmit the marginal policy rate to money markets (and increase the opportunity cost of lending rather than depositing cash as reserves with the central bank). Central banks tend to adjust the tiering over time so that the amount of excess reserves below the exemption threshold is sufficient to keep money market rates aligned with the marginal policy rate.
1 The SR administers a de facto tiered reserve regime. The marginal policy rate is determined by the central bank’s reserve repo operations (“market-maintaining repo facility”) while accepting excess reserves as overnight deposits at the repo rate minus 10 bps or as certificates of deposits, which are issued at the repo rate minus 75 bps for a maturity term of one week. 2 A loosely defined tiered reserve system also applies to the ECB, which remunerates overnight deposits in the current account at the MRO rate of 0 percent, effectively exempting about one-seventh of current reserves from the marginal policy rate. 3 Negative interest rates create incentives for banks to hold cash rather than reserves, and for households and nonfinancial corporates to hold cash rather than bank deposits. In countries with an even more negative deposit rate than that of the euro area (Denmark, Sweden and Switzerland), cash in circulation has increased, but growth rates remain within the range seen over the last decade.Reducing the Direct Cost of NIRP and the Role of Tiering in Monetary Transmission
The implementation of a second effective deposit rate for excess reserves (such as through tiering) would increase the ECB’s general capacity to pursue NIRP while mitigating the direct cost to banks. Currently, banks’ overnight deposits (€310 billion) and current account balances (€613 billion) amount to about €923 billion. The minimum reserve requirement of €115 billion is remunerated at the MRO rate of 0 percent, which leaves excess reserves of €808 billion subject to the negative deposit rate of −0.4 percent as the marginal policy rate—setting the lowest rate at which banks would be prepared to lend to each other. Assuming that the direct cost of NIRP does not exceed 0.03 percent of total assets of the euro area banking sector (which reflects the recent experience in Switzerland as a theoretical benchmark),1 the current deposit rate has exhausted the theoretical tolerance of euro area banks. However, for a tiered reserve regime excluding 75 percent2 of excess reserves from the negative deposit rate (in line with reserve system in Switzerland), the Eurosystem could theoretically tolerate a negative deposit rate of up to −1.6 percent (as the direct cost of NIRP remains unchanged).
Euro Area: Actual and Theoretical EONIA Rate
(percent/EUR billion)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Bloomberg L.P., ECB, and IMF staff calculations. Note: 1/ The theoretical EONIA rate is calculated as the average of the MRO and deposit rate, weighted by the relative proportion of the ECB’s current account balance and excess reserves.Euro Area: Secured and Unsecured Lending Volumes
(EUR billion)
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Source: Bloomberg L.P., ECB, and IMF staff calculations. Note: 1/ Composite outstanding volume of general collateral (GC) repo on German, French, and Italian government debt; 2/ trading volume of overnight contracts.The effective monetary transmission of NIRP to money markets would require fine-tuning of the exempted portion of excess reserves over time. In its current reserve regime, the ECB achieves negative short-term money market rates by setting a positive policy rate (MRO at 0 percent) and a negative interest rate on the deposit facility (-0.4 percent) while maintaining excess reserves in the banking system. The money market rate is pushed down towards the lowest marginal policy rate because banks individually will try to lend their surplus liquidity to other banks in the interbank market in an attempt to avoid having to use the central bank’s deposit facility—but only as long as the lending rate exceeds the deposit rate.3 Thus, the transmission of the marginal policy rate is also affected by the dispersion of the excess liquidity among banks and banks’ willingness/ability to lend excess liquidity to other banks.4
1 The assumption of exempting 75 percent of reserves from a negative deposit rate was based on the experience in Switzerland where the share of the overall reserve stock subject to negative deposit rates averaged 23 percent until end-2015. In practice, given the significant heterogeneity of bank business models, banks’ tolerance threshold for the direct cost of negative rates might be different in the euro area than in Switzerland. 2 The exemption of a certain amount of reserves can vary over time (and would need to decrease as excess liquidity declines). The opportunity cost of lending can be increased (on average) by calibrating the tiering such that the price of depositing cash with the ECB would be the same (or higher) than the expected net interest margin from lending multiplied by the share of the deposit base funding loans (i.e., the inverse of the aggregate loan-to-deposit ratio of the banking sector). 3 The money market rate could be higher than the lowest marginal policy rate if the exempted portion of excess reserves is too large, leaving banks little incentive to engage in interbank lending; thus, lower supply of liquidity could create potential scarcity in some parts of the system, pushing up money market rates above the technical floor of the ECB deposit rate. 4 Given that the average daily quoted turnover underpinning EONIA fixings has only been about €12.6 billion (or 1.5 percent of excess liquidity) since January 2016, the impact of the marginal policy rate on money market rates is quite sensitive to changes in bank behavior and rate setting.Overview of Central Banks with Negative Interest Rate Policy (NIRP)
A loosely defined tiered reserve system also applies to the ECB, which remunerates overnight deposits in the current account at the MRO rate of 0 percent (as of March 16, 2016), effectively exempting about one-seventh of current reserves from the marginal policy rate.
In conjunction with the exit from the exchange rate floor.
Overview of Central Banks with Negative Interest Rate Policy (NIRP)
| Objective | Instrument | Rate | |
|---|---|---|---|
| Bulgaria (two tiers) |
Transmission of the ECB’s monetary policy stand; also aimed at avoiding potential losses to the central bank | Deposit rate | −0.30% (Jan. 4, 2016); -0.40% (March 16, 2016); Note: the same interest rate as the ECB’s deposit facility |
| Denmark (two tiers) |
Countering safe haven inflows and exchange rate pressures (continued FX interventions) | Certificates of deposit (CD) | −0.20 % (July 2012-early 2014) -0.05% (Sept. 2014) -0.20% (Jan. 19, 2015) -0.35% (Jan. 22, 2015) -0.50% (Jan. 29, 2015 -0.75 % (Feb. 5, 2015) |
| Euro Area (no tiers)1 |
Price stability and anchoring inflation expectations (in conjunction with asset purchase program) | Deposit rate | −0.10% (June 11, 2014) -0.20% (Sept. 10, 2014) -0.30% (Dec. 9, 2015) -0.40% (March 16, 2016); asset purchase program increased by €20 billion/month (until March 2017) |
| Hungary (no tiers) |
Price stability and countering exchange rate pressures (in conjunction with small QE) | Deposit rate | −0.05% (March 23, 2016) |
| Japan (three tiers) |
Price stability and anchoring inflation expectations (in conjunction with QE) | Deposit rate | −0.10% (Feb. 16, 2016) |
| Switzerland (two tiers) |
Reducing appreciation and deflationary pressures2 | Sight deposits at the SNB (with an exemption threshold) | −0.75% (Jan. 15, 2015) |
| Sweden (no tiers) |
Price stability and anchoring inflation expectations (in conjunction with QE) | Reverse repo rate | −0.10% (Feb. 12, 2015); QE of SEK10 billion -0.25% (March 18, 2015); QE increased to SEK30 billion -0.35% (July 2, 2015) -0.50% (Feb. 11, 2016) |
A loosely defined tiered reserve system also applies to the ECB, which remunerates overnight deposits in the current account at the MRO rate of 0 percent (as of March 16, 2016), effectively exempting about one-seventh of current reserves from the marginal policy rate.
In conjunction with the exit from the exchange rate floor.
Overview of Central Banks with Negative Interest Rate Policy (NIRP)
| Objective | Instrument | Rate | |
|---|---|---|---|
| Bulgaria (two tiers) |
Transmission of the ECB’s monetary policy stand; also aimed at avoiding potential losses to the central bank | Deposit rate | −0.30% (Jan. 4, 2016); -0.40% (March 16, 2016); Note: the same interest rate as the ECB’s deposit facility |
| Denmark (two tiers) |
Countering safe haven inflows and exchange rate pressures (continued FX interventions) | Certificates of deposit (CD) | −0.20 % (July 2012-early 2014) -0.05% (Sept. 2014) -0.20% (Jan. 19, 2015) -0.35% (Jan. 22, 2015) -0.50% (Jan. 29, 2015 -0.75 % (Feb. 5, 2015) |
| Euro Area (no tiers)1 |
Price stability and anchoring inflation expectations (in conjunction with asset purchase program) | Deposit rate | −0.10% (June 11, 2014) -0.20% (Sept. 10, 2014) -0.30% (Dec. 9, 2015) -0.40% (March 16, 2016); asset purchase program increased by €20 billion/month (until March 2017) |
| Hungary (no tiers) |
Price stability and countering exchange rate pressures (in conjunction with small QE) | Deposit rate | −0.05% (March 23, 2016) |
| Japan (three tiers) |
Price stability and anchoring inflation expectations (in conjunction with QE) | Deposit rate | −0.10% (Feb. 16, 2016) |
| Switzerland (two tiers) |
Reducing appreciation and deflationary pressures2 | Sight deposits at the SNB (with an exemption threshold) | −0.75% (Jan. 15, 2015) |
| Sweden (no tiers) |
Price stability and anchoring inflation expectations (in conjunction with QE) | Reverse repo rate | −0.10% (Feb. 12, 2015); QE of SEK10 billion -0.25% (March 18, 2015); QE increased to SEK30 billion -0.35% (July 2, 2015) -0.50% (Feb. 11, 2016) |
A loosely defined tiered reserve system also applies to the ECB, which remunerates overnight deposits in the current account at the MRO rate of 0 percent (as of March 16, 2016), effectively exempting about one-seventh of current reserves from the marginal policy rate.
In conjunction with the exit from the exchange rate floor.
Appendix II. Overview of Other Countries with NIRP
Denmark
In Denmark, negative rates were adopted to counter large capital inflows speculating against the long-standing Danish peg to the euro. The Danmarks Nationalbank (DN) cut its key deposit rate four times between January and February 2015 to a record low -0.75 percent (from -0.05 percent) to defend its currency peg against the euro—and following the announcement of the ECB’s QE program and the Swiss National Bank abandoning its exchange rate floor in mid-January. In March 2015, the DN announced an increase in the current account limit to DKK145 billion from DKK37 billion, thereby increasing the amount of deposit that banks could keep at the central bank without being charged the deposit rate and softening impact on banks. Like in Switzerland, the ability to pass on negative interest rate to depositors was limited to large corporate customers. Denmark’s experience so far also points to the importance of activity-based fees, such as mortgage application fees, and a long-term strategy of encouraging a shift from deposits into wealth management products to cope with reduced lending margins under NIRP.
Sweden
In the case of Sweden, rate cuts in 2014 and earlier were driven by persistently low inflation. A notable decline in inflation expectations preceded the shift to negative rates and domestic QE in February 2015, although the move followed the announcement of the ECB’s QE program in mid-January, which might otherwise suggest exchange rate pressures as the motivation for the change in the policy rate. In February 2016, the Swedish Riksbank (SR) reduced the reserve repo rate by another 0.25 percentage points to the current level of -0.50 percent, in combination with its own asset purchase program of government debt securities in the amount of SEK40 billion, which amounts to more than 35 percent of the market (and more than twice the relative size of the ECB’s QE covering 17 percent of the euro area government bond market).
Japan
On January 29, 2016, the Bank of Japan introduced a three-tiered reserve deposit system (effective on February 16) with a negative interest rate on marginal excess reserves. The first tier, remunerated at 0.1 percent, applies to the average outstanding balance of current accounts accumulated under Quantitative and Qualitative Monetary Easing (QQE) up until January 2015 (approx. ¥210 trillion). The second tier, remunerated at 0 percent, is the macro add-on balance, including required reserves and the reserves equivalent to the amount of the various lending programs (¥40 trillion). An additional portion will be added to this second tier over time in line with the monetary base target. The third tier, remunerated at -0.1 percent, is the policy rate balance, that is, the residual reserve deposit, which is where additional reserves created by QE will initially go until the second tier is adjusted (currently ¥80 trillion/year). The amount in the third tier is expected to remain in the range of ¥10-30 trillion (Barr and others, 2016). To prevent financial institutions from increasing cash holding significantly, any increase in cash holding are deducted from the zero interest rate tiers of current account balance.
Switzerland
On December 18, 2014, the Swiss National Bank (SNB) announced negative interest rates on Swiss franc-denominated sight deposits above a pre-defined threshold which took effect on January 22, 2015. For domestic banks, the threshold was set to 20 times a bank’s required reserves as of the reporting period ending November 19, 2014 minus (plus) any increase (decrease) in cash held. The SNB does not charge banks with negative interest rates on their cash deposits below the threshold. Thus, some Swiss banks benefited from being able to obtain market funding at negative rates and place the funds raised with the SNB at zero percent, realizing additional net interest income. Switzerland exited its exchange rate floor vis-à-vis the euro at the same time as it announced a further cut of the central bank deposit rate from -0.25 to -0.75 percent (effective January 22, 2015) less than a month after it announced the cut in the policy rate from 0 to -0.25 percent, which had turned out to be insufficient to stem large safe haven flows. Following the announcement, Swiss banks made more extensive use of this opportunity by raising significant amounts of interbank and/or customer deposits, which helped improve their NIMs.
Hungary
Given subdued inflation pressures and a structural liquidity surplus, the Hungarian National Bank (Magyar Nemzeti Bank, MNB) has gradually eased its monetary policy stance and introduced unconventional instruments. The objective has been to strengthen the interest, credit, and expectation channels, and lessen vulnerabilities. Conventional measures have included a gradual reduction of the policy rate, lowering and narrowing of the interest rate corridor, an effective reduction of reserve requirements, as well as changing the collateral requirements for the MNB’s lending facilities. Effective March 23, 2016, the MNB reduced the policy rate and reduced the overnight deposit rate from 0.10 to -0.05 percent. Several unconventional monetary policy measures have also been introduced, including (i) supporting SME lending by providing cheap MNB funding for banks to on-lend to SMEs and offering incentives to banks (through interest rate swaps and a special deposit facility) to increase their lending to SMEs; and (ii) incentivizing banks to substitute government securities (especially long-term and local currency-denominated) for excess reserves with the MNB.
Appendix III. Monetary Conditions in Countries with NIRP
Marginal Policy Rate (Central Bank Deposit Rate) and Money Market Rates
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Marginal Policy Rate (Central Bank Deposit Rate) and Bank Net Interest Margin, January 2010–February 2016
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Marginal Policy Rate (Central Bank Deposit Rate) and Credit Growth, January 2005–June 2016
Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A004
Prepared by Andreas (Andy) Jobst and Huidan Lin. We thank EUR, MCM, RES, and SPR colleagues for helpful comments and suggestions. We are also grateful to staff from the Directorate Monetary Policy and the Directorate General for Macro-Prudential Policy and Financial Stability at the European Central Bank (ECB) for helpful feedback.
The distributional implications of negative interest rates are beyond the scope of this paper.
The stickiness of deposit rates reflects the avoidance of being penalized to save and is determined by the actual costs of holding cash rather than deposits; under these conditions, demand for cash is likely to be greatest for economic agents with high excess liquidity and increases if negative interest rates are expected to persist for some time.
For example, compared to more sophisticated agents, households may simply react more instinctively to negative rates viewing negative rates as “abnormal” or “theft.”
For a comprehensive analysis of how cash hoarding can be prevented under NIRP, see Agarwal and Kimball (2015).
Thus, the “true” limit on negative deposit rates would the level at which households would find it preferable to hoard large amounts of cash. Given the costs with moving and storing cash, this rate can be well below zero.
For instance, charging retail clients fees to maintain checking accounts as it is done commonly in the United States.
Even though the portfolio rebalancing channel would apply to any reduction of policy rates, its effectiveness is likely to increase in an environment of negative interest rates.
This would necessitate a tightening of lending standards if greater risk-taking due to NIRP undermines the usefulness of asset impairment levels in detecting financial distress.
See McAndrews (2015) for a critical review of issues concerning negative interest rates.
Banks could substitute wholesale funding for higher cost retail deposits (also to meet stable funding requirements under the Basel liquidity risk framework); however, longer term funding contains some term premium, and market access might be limited for smaller banks.
ECB staff estimate that negative rates have contributed about one percent to corporate lending growth since July 2014 (Rostagno and others, 2016).
Whether this effect is stronger or weaker at negative rates remains unclear. Recent work by Claessens and others (2016) suggests that banks’ NIMs are negatively impacted by interest rate cuts, and this effect increases the lower the policy rate.
However, negative interest rates had little impact on corporate lending volumes over the past six months, but some positive impact is expected for the coming months.
NIMs have been estimated for all large euro area banks that are directly supervised by the ECB using publicly reported data on consolidated bank balance sheets. For some banks with sizeable (and, in most cases, more profitable, foreign operations), the reported NIMs might overstate the profitability of lending within the euro area.
Note that the extent to which TLTRO II boosts the usage of ECB liquidity (and not just facilitates a rolling over of existing liquidity), existing Target 2 imbalances are bound to increase. This would be consistent with a more positive credit impulse and hence stronger domestic demand growth.
Several countries with NIRP (Bulgaria, Denmark, Japan, and Switzerland) have installed tiered reserve systems, which have facilitated the pass-through of the marginal policy rate to money markets and reduced the direct cost of NIRP (Appendix I, Box A3).
