With its decision of today, ECB has made yet another move towards lowering interest rates on commercial banks’ excess reserves. What does that mean regarding interest rates at which banks grant loans and attract deposits from households and companies in the eurozone, and how far can ECB go along the way of deeper negative rates?

An analysis of the Bank for International Settlements points out that at least so far the moderately negative interest rates applied by central banks in Europe and Japan are passed on to the interest rates formed on the money markets in the same way as with positive interest rates. So far the effect of negative interest rates on the traded volumes – which are very low because of the cheap and ample liquidity created by central banks – has been only minor. In the eurozone and Switzerland the interest rates on the money market follow the changes in the deposit interest rate of the central bank, practically in identical proportions. In order to avoid negative consequences for their revenues, banks in the eurozone are trying to increase the tenure of deposits traded on the money market or to direct them to riskier clients. This is good news for ECB, because it indicates that the policy of negative deposit rates is achieving its goals. It also means that some markets peripheral to the eurozone, which continue to be characterized by need for extensive external financing, are also winning because they get access to more and cheaper liquidity created by ECB.

The same analysis shows that institutional and contractual limitations prevent negative rates on excess reserves from passing on to the interests for banks’ end customers on loans and deposits to the same extent as that would be possible for positive rates. For now, the moderately negative deposit rates of central banks are not leading to negative rates on loans to end customers, because the risk premiums even for the lowest-risk customers remain bigger than the extent in which the money market interests are on negative territory. Some existing contracts in the eurozone have clauses stipulating a floor for interest rates which does not allow negative values. Some of the new contracts are bound by the introduction of a floor for the end interest rate payable by the customer, which is fixed at the level at the time the loan is granted. Thus even if interests determined on the money markets continue to fall further as a result of the actions of central banks, this would not lead to a change in rates for end customers. In Switzerland, for example, in order to compensate for the loss of revenue coming from floating rate mortgage loans, banks increased their rates on fixed interest mortgage loans. The bottom line is that in order to protect their revenues, banks in different countries apply different practices. Differences continue and even grow bigger among banks, loan types and customers. This increases segmentation on the market, which is bad news for ECB as it starts to be a burden, increasingly so, on the transmission of interest rates determined by central banks to the real economy. Thus the existence of institutional and contractual limitations which are beyond the control of ECB start to mitigate the effect coming from the policy of negative deposit interest rates on the real economy.

The differences across deposits are even bigger. At first, there was some uncertainty as to how deposits in bulk would be treated – these are the deposits of banks, large corporate clients and institutional investors such as pension funds, insurance companies and mutual funds. Now the costs of banks from negative rates on excess reserves are passed on to the owners of deposits in bulk in the form of negative interests. Here as well of course this is only partial because as with the way commercial banks are treated by central banks, here also applies a tiered approach – up to a certain amount the interest is zero or even positive and only after that becomes negative.

The major exception is retail deposits. Banks do not wish to pass the negative rates of their operations with the central bank on this group of customers because they fear withdrawal of deposits. Some economists say that slightly negative interests on retail deposits are possible because the alternative – keeping cash – is related to storage and transportation costs for the cash on hand. Yet, the odds that a bank dares experiment by introducing negative rates on deposits for this category of customers are close to zero from today’s perspective.

All of that puts ECB in front of a dilemma. If the lower interest rates of ECB are not reaching interest rates on loans to households and companies, they don’t make any sense. If, however, they affect interest rates on loans but cannot affect those on deposits, this policy will have a negative impact on banks’ profits and if that continues for too long, it may start to decapitalize banks. Considering that the process of bank balance recovery in a number of countries in Europe has not ended, it may turn out that resolving one problem leads to aggravating another. Hence, ECB has to decide which risk is more unwanted from its perspective: the risk of delaying economic growth and the related deflation risks, or the risk of deterioration of the banks’ capital positions.

Everything shows that with the lack of other options for stimulating the economy, ECB will continue the policy of monetary loosening throughout this and the following year. Most probably this will require certain recalibration of the used instruments, and ECB will give up on negative interest rates on excess reserves long before the end of the monetary loosening cycle which is currently running. The reason is that although in general this instrument is for now working, there is big uncertainty regarding the behavior of customers provided that ECB continues along the same path. It is not clear whether the transmission mechanism will continue to work like so far or it will reach a tipping point. Moreover in the long run the pressure on revenues in the banking sector will sharpen. The consequences on the pension funds, insurance companies and other institutions which rely on liabilities with long tenure will go even farther (because for them the opportunities to earn from transformation of maturities are very limited).

This all leads me to believe that the opportunities for further use of this monetary loosening instrument are not quite so big. In other words, if ECB continues to introduce even deeper negative interest rates on excess reserves, we are not far from the time when the negative effects from the use of this instrument will start to exceed the positive ones.

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