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Why Europe Is About To Plunge Further Into The NIRP Twilight Zone, And What It Means For Depositors

In some respects, today’s ECB presser was a snoozer. Reporters asked the same old questions (some of which we've been asking for years) and, more importantly, there were no glitter attacks.

Our ears did perk up however, when Mario Draghi admitted that, unlike the governing council’s last meeting, cutting the depo rate further into negative territory was indeed discussed. 

This is significant for a number of reasons. At the general level, it shows that DM central bankers are ready and willing to plunge the world further into the Keynesian Twilight Zone. As we outlined last month, this means the Riksbank and the SNB are now on watch. If the ECB cuts again, the Riksbank will be forced to act as well and as Barclays recently opined, the SNB may be compelled to go nuclear on depositors, as removing the negative rate exemption for domestic banks would force them to pass along the “cost” to customers: 

“In contrast, a cut in the ECB’s deposit rate further into negative territory likely would have a significant impact on the EURCHF exchange rate and provoke a more immediate response from the SNB. Indeed, we expect that a cut in the ECB’s deposit rate may have a greater effect on EURCHF than on other EUR crosses. Switzerland applies its negative deposit rate to only a fraction of reserves, currently about 1/3rd of sight deposits by our calculation. In contrast, negative deposit rates apply to all reserves held at the ECB, Riksbank and Denmark’s Nationalbank. Consequently, a cut to the ECB’s deposit rate likely has a larger impact both on the economy and on the exchange rate than a proportionate cut by the SNB. An SNB response to an ECB deposit rate cut could take one of two forms: 1) a further cut in its deposit rate and CHF Libor target range; or 2) the ‘nuclear’ option, removing all exemptions from the negative deposit rate. We think the latter is more likely and would have major implications for EURCHF." Most retail (private) depositors at domestic Swiss banks still do not face negative interest rates, but we would expect that to change if the SNB removed exemptions of domestic banks on sight deposits at the SNB. A removal of domestic banks’ exemption from negative deposit rates likely would force Swiss banks to pass on negative deposit rates as it would increase the proportion of assets charged negative rates to over 20%.

This is an important concept not only for what it says about the never-ending, tit-for-tat, beggar- thy-neighbor monetary policies that now pervade developed markets, but also for the degree to which it explains why NIRP has not yet led to a sharp increase in the demand for physical banknotes. Put simply: depositors haven’t yet felt the effects of the monetary insanity engendered by the global currency wars. 

Deutsche Bank’s Abhishek Singhania and Oliver Harvey have taken a close look at the proliferation of NIRP at the Riksbank, the SNB, the Nationalbank, and the ECB on the way to positing that not only is zero not the lower bound, but in fact no one has hit the lower limit for rates as of yet. 

First, there’s the obvious problem with negative rates. Namely, depositors will just take it to the mattresses (so to speak): 

The main concern with further cuts to policy rates is the problem of the zero lower bound. In academic literature, the challenge for central banks operating near or at zero interest rates is that it is technically unfeasible to impose interest rates on cash. Depositors charged at negative rates can simply exchange electronic reserves into paper currency.

Of course because fractional reserve banking is nothing more than a giant ponzi scheme wherein banks are perpetually borrowing short to lend long, instituting a rate negative enough to trigger a run on deposits would have the exact opposite effect from what central banks intended. That is, banks would be forced to sell assets to meet the outflows

As well as losing control over monetary policy, central banks would see financial conditions tighten as banks were forced to sell assets to meet depositor withdrawals. In extremis, the effect could be compared to a bank-run preceding capital controls or large scale currency devaluation. However, due to the more incremental nature of the impact of negative rates (e.g. 25bp charge on deposit holdings rather than a multi percent devaluation), interest rates would need to be slashed deeply negative for depositor withdrawals to resemble much more than a jog.

Obviously, if rates go negative enough to trigger a run that (literally) breaks the banks, then the lower limit will definitively have been reached, but at that point it will be too late. Back to Deutsche Bank:

So far, the experiences of the four European economies under negative interest rates, including the Eurozone, suggest that this theoretical constraint has not been reached. The demand for coins and notes has ticked up slightly in recent months, but remains at fairly muted levels. 



Why the lower bound constraint has yet to be reached, and how much more room there is to maneuver, is obviously crucial for the ECB and the three other central banks imposing negative rates. The main reason is that banks have not passed on negative policy rates to depositors. In none of the four economies are household deposit rates in negative territory, either for outstanding balances or new business. Why have negative nominal rates not passed through to depositors? 


Banks are of course hesitant to charge depositors for deposits for fear of damaging relationships. Or, in Deutsche Bank’s more condescending parlance, “banks are very reluctant to pass on negative rates to households [because] retail depositors [are] least likely to understand the wider monetary policy context behind such a decision.” Right, they aren’t likely to understand why they should have to pay the bank to lend out their money at a spread that nets the bank a profit and the reason they aren’t likely to understand it is because, frankly, it makes absolutely no sense. 

But the bank has to preserve its margins. With long-end rates falling on the asset side thanks to unconventional monetary policy, you either have to pass that along by reducing the rate you pay on your liabilities (i.e. deposits) or else your margins are going to get pinched - unless you find some other way to make up the difference, that is. 

The indirect cost of negative rates for banks is through margins. In theory, as unconventional monetary policy pushes down yields on the asset side of the balance sheet, banks need to cut rates on the liability side to preserve margins. As banks are reluctant to cut deposit rates into negative territory for the reasons above, their net interest margin may suffer. 

Right. So what’s the solution if it's not passing along NIRP to depositors? 

The SNB have noted that the consequence of introducing negative rates earlier this year was rising, not falling, mortgage rates as banks sought to protect falling liability margins by raising long-end rates. In a similar vein, Danish banks appeared to raise administration fees on new mortgages after rates first turned negative back in 2012. An analysis of long-end mortgage rates offered by banks across Sweden, Denmark and Switzerland suggests that at the long-end, rates have actually risen since the introduction of negative interest rates.

Got that? NIRP is paradoxically causing mortgage rates to rise because banks fear a depositor backlash from negative rates. So, this is yet another example of the unintended consequences of unconventional monetary policy.

We saw something akin to this in Sweden back in July when the Riksbank had sucked up so much high quality collateral via QE that the liquidity premium demanded by investors ended up pushing yields on 10-year govies higher in what amounted to the exact opposite of what the central bank intended. 

Note once again that there's no end to this. If the ECB cuts the depo rate further, then other NIRP countries will have to respond. If they don't, their currencies will soar, threatening inflation targets. Case in point, from this morning:

This means going deeper into NIRP, which, in light of the above, means rising borrowing costs right up until the breaking point when the hit to margins can no longer be offset. At that juncture, NIRP will have to be passed on to depositors lest NIM should simply flatline.

What happens next is anyone's guess but if depositors revolt and begin asking for their money back, banks' maturity mismatched business model means there are only three available options, i) sell assets to meet withdrawals, ii) institute capital controls, or iii) ban cash. Welcome to the future.