Tuesday, 9 February 2016

The effect of negative interest on reserves depends on whether banks can discriminate between new borrowers and existing ones.

Unless I’ve dropped a clanger, which is more than possible. Anyway, what I mean is this.

The initial effect of negative rates is simply to impose costs on commercial banks. E.g. commercial bank X which has $1bn in reserves and which previously paid / received no interest on those reserves, and which then has to pay 1%, would face a bill of 1% times $1bn, i.e. $10million pa.

Commercial bank X now has a bigger incentive to lend more because for every $100 loaned, about $90 ends up being deposited with OTHER banks. That means that bank X owes the latter banks $90 in reserves, which of course bank X is happy to dispose of.

However, in order to persuade its customers to borrow more, bank X has to reduce the interest charged. Assuming bank X can discriminate between new borrowers and existing ones, the latter “additional loans” strategy will work for bank X. Of course other banks will be attempting the same ploy. Nevertheless, the net result ought to be additional loans for the economy as a whole, far as I can see. Reserves become a sort of hot potato which every bank tries to pass on to other banks.

However, banks’ EXISTING customer / borrowers are not going to be too pleased when they find out that NEW borrowers who are identical in every respect to themselves are being offered loans at a lower rate. But if the small print in loan agreements bars existing borrowers from re-newing their loans, there’s not much they can do about it. So in that case, negative interest rates on reserves WILL increase lending.

On the other hand if, or to the extent that existing borrowers can re-new their loans at the new lower rate, then negative interest on reserves won’t work. Reason is that (to repeat) the initial effect is to impose a cost on banks, and assuming banks were earning a standard return on capital prior to the negative rates, and assuming they have to continue to earn that standard return, they banks just have to pass on the cost of negative interest on reserves to customers. I.e. interest charged to borrowers will RISE. Ergo total amount loaned will FALL.

Or have I missed something?

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