Stockholm (Ekonamik) – While the implied intergenerational transfers created by low-interest rates and asset purchases are quite familiar to investors and the wider public at this stage, the more technical implications of negative deposit rates are more byzantine
Following the ECB’s recent decision to cut rates on the deposit facility we take the opportunity to review the tradeoffs involved when the ECB effectively charges banks for the excess reserves on their accounts.
What is the Deposit Facility Rate?
The Deposit Facility Rate (DFR) is “the interest banks receive for depositing money with the central bank overnight.” The rate is one of the three main rates that the ECB sets and has been negative since the ECB’s June 2014 meeting, when it was cut from 0% to -0.1%. It had subsequently been lowered to -0.2%, -0.3% and 0.4% in September 2014, December 2015, and March 2016.
This is also the rate that the ECB charges on excess reserves held in banks’ current accounts above the reserve requirement.
Since the beginning of the financial crisis in 2008, the ECB has been conducting asset purchases. These included some tentative efforts into the covered bond market prior to 2015. However, the ECB only really got into the business of asset purchases with the introduction of the Public Sector Purchase Programme (PSPP), through which it began purchasing government bonds from Eurozone countries.
Since 2015, the ECB has returned with more vigour to covered bonds (CBPP), as well as morgaged-backed securities (ABSPP) and corporate bonds (CSPP). However, the PSPP remain by far the largest of the ECB’s asset purchase programmes.
The Relationship Between Asset Purchases and the Deposit Facility
A relatively obscure and technical fact about excess reserves in a bank-based financial system – where banks provide the channel through which monetary policy is transmitted to households – is that the banking system as a whole is unable to change its reserves. Only the central bank can do so via asset purchases and sales. In the words of the ECB,
“Excess liquidity by definition stays with the central bank. An individual bank can reduce its excess liquidity, for example by lending to other banks, purchasing assets or transferring funds on behalf of its clients, but the banking system as a whole cannot: the liquidity always ends up with another bank and thus in an account at the central bank. It is a self-contained or, in other words, closed system. The liquidity cannot even leave the euro area, unless physically in the form of banknotes.”
According to the New York Fed,
“While an individual bank may reduce the level of reserves it holds by lending to firms and/or households, the same is not true of the banking system as a whole. No matter how many times the funds are lent out by the banks or used to make purchases, total reserves in the banking system do not change.”
“Central bank liquidity facilities and other credit programs create—essentially as a by-product—a large quantity of reserves.”
“The total quantity of reserves is determined almost entirely by the central bank’s actions, and in no way reflects the lending behaviour of banks”
Unsurprisingly, the relationship between asset purchases and the excess reserves is visible in the accounts of the ECB…
… and of the Fed.
Passing the Cost of Asset Purchases to the Economy
As the quotes from the Fed should clarify, the excess reserves are not problematic per se. Contrarily to what many have suggested, “one cannot infer from the high level of aggregate reserves (…) that banks are ‘hoarding’ funds rather than lending them out.” The ECB agrees. “The existence of excess liquidity is not an indicator of how much lending takes place in the economy.”
Where the ECB diverges from the Fed is in the negative interest rates it has been charging since 2014, which effectively create a cost for banks in the Eurozone. This cost is not the purpose of the negative rates of course. The goal for the low deposit rates is to impose a lower limit on EONIA, the overnight interbank rate, which is one of the determinants of real-world rates such as credit card and mortgage rates. Given that the excess reserves are a mechanical accounting effect, their cost is also mechanical and for all intents and purposes, also an unintended consequence.
Unfortunately, as unintended consequences go, this is a relatively expensive one. The issue came up during the Q&A that followed the ECB’s announcement, with one journalist citing Deutsche Bank’s CEO as saying that “if the ECB is continuing this type of monetary policy it may lead or will lead to a destabilisation or a collapse of the financial system.” More practically, the outgoing president of the ECB acknowledged the danger that banks will start charging people for holding deposits too. “We certainly are aware of the negative side effects on the people, especially in those parts of the eurozone where the negative rates are being passed to corporate,” said the ECB president. “So far as far as I understand its [only] corporate depositors, but it’s an increasing percentage of them, so we are concerned.”
Clearly this cost did not go unnoticed by the ECB. The complex two-tiered approach of imposing deposit rates only on balances above a multiple (x6 for now) of the reserve requirements is a way to mitigate this cost at a time when new asset purchases are likely to push excess liquidity to new heights.
We are in relatively unknown territory, with this level of asset purchases and negative rates. The MRO and the marginal lending facility are still positive, which means banks face negative rates all around. The ECB continues to think of its policy rates as a band around the MRO. However, since 2014, MRO volumes have paled in comparison to the Deposit facility. Maybe it is time for the ECB to bring the other 2 rates down as well so that banks may be able to profit from borrowing from the ECB, now that the ECB can profit from borrowing from them.