The Financial-Stability Risk Of Negative Interest RatesVW Staff
When Depositors Pay Banks And Banks Pay Borrowers: New Report Analyzes The Financial-Stability Risk Of Negative Interest Rates by Federal Financial Analytics
Federal Financial Analytics finds that ultra-low rates pose significant systemic risk that could be especially vulnerable in current, fragile market conditions – sudden shock to new credit, funding flows into physical cash/virtual currency, MMF disruption, panic yield-chasing
WASHINGTON, DC, September 8, 2015 – A new report today lays out what would happen if the Federal Reserve is forced to go below the zero-lower bound (ZLB) in nominal interest rates by slow growth or market stress. Federal Financial Analytics, Inc. (FedFin) makes it clear that the Federal Reserve devoutly hopes policy actions that force nominal rates below the ZLB are a last-ditch action, but market turmoil and the looming U.S. fiscal-policy crisis make below-ZLB rates all too possible. If the FRB allows rates to fall below the ZLB, pushes them there, or is powerless to stop it, then severe financial-market stress is virtually assured, the FedFin report concludes.
“The Federal Reserve has no ammunition left with which to handle crises or promote growth. We are already in a market struggling with negative real rates,” said FedFin managing partner Karen Shaw Petrou. “We all know this in the rates we get from banks and those we are charged for high-quality loans,” she continued. “What happens if negative interest rates are no longer real, but also nominal – that is, when we have to pay banks to safeguard our money and – at least in theory – banks pay us to borrow? No one knows because it’s never happened here before, but the consequences are grave and warrant immediate, careful central-bank consideration and urgent protective action by financial-services firms and their customers.”
Key points in the new FedFin study include:
- Rates below the ZLB are not hypothetical because key policy-makers are considering them given the inability of the Federal Reserve to drop rates from current levels or acquire still more assets in any QE4 exercise.
- Negative interest rates could lead to a sudden reversal in the fundamental structure of financial intermediation (which would have far-reaching economic impact even if only short-lived). Bankers are unlikely to make new loans if they must pay borrowers to take them, with any sudden drop in credit availability undermining economic recovery. Depositors forced to pay banks to safeguard funds could shift them to physical cash (leading to risk of loss or theft) or the uncertain status of virtual currencies. Panic buying of real property would prove destabilizing.
- Banks now hold $2.5 trillion in excess reserves at the Federal Reserve. A drop in the interest paid on them would send shock waves through U.S. banks, especially if negative interest rates create few safe-haven alternative assets and new funds cannot be lent out for productive purposes due to negative interest rates.
- Capital markets are ill-prepared for negative interest rates because the cost of borrowing and that of assets are turned upside down. Many market-risk models do not anticipate this, meaning that capital may not be deployed for unprecedented stress.
- Yield-chasing incentives – already a source of severe systemic risk due to negative real rates – would become still more frantic if markets are forced to reckon with nominal negativity that immediately drives net interest margins and related profitability measurement.
The Financial-Stability Risk Of Negative Interest Rates – Introduction
Quite simply, there is no precedent for nominal negative interest rates, even during the U.S. Great Depression. As a senior global central banker has said, “An experiment is under way to test the ‘boundaries of the unthinkable’ in monetary policy.”1 This paper leaves for another day the question of whether transgressing the ZLB will have the desired monetary-policy effects in the European Union, Switzerland, or—should it come to that—in the U.S. However, financial markets will transmit the impact of negative rates quickly because private-sector institutions must quickly minimize risk and maximize gain. They will thus act in ways financial regulators may also find “unthinkable”—actions that could destabilize financial markets as the sum total of prudential and profit-seeking steps taken by individual banks, insurance companies, pension funds, and asset managers moves through financial markets. This paper thus assesses the financial-stability implications of negative rates so that policy-makers consider them in concert with monetary-policy objectives—a key and costly lesson of the 2008 crisis is that macroprudential risk to financial stability is entwined with monetary policy, meaning that a narrow-gauge view only of traditional central-bank goals (e.g., managing aggregate demand) may well exacerbate structural imbalances with dangerous financial-stability consequences.
Is a drop below the ZLB likely in the U.S.? Current market turmoil requires careful consideration, as does the mid-September conflict between Congress and the Obama Administration that could precipitate another U.S. fiscal-policy crisis. In our view, the Federal Reserve sees the ZLB as a no-trespassing sign for ordinary open-market operations, but it could well be forced to hop the fence if markets spiral dangerously toward flash crashes, liquidity freezes, and other systemic events. It could also be forced to resort to policies that lead to negative rates if economic weakness resulting from global turmoil demonstrates the need for additional quantitative easing and the FRB is reluctant or unable to add still more assets to its own balance sheet.
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About Federal Financial Analytics
Federal Financial Analytics, Inc. is a proprietary think tank providing analytical and advisory services on legislative, regulatory, and public-policy issues affecting global financial-services companies. Since 1985, the firm’s practice has been a unique blend of strategic advice and policy analysis, serving as a thought leadership resource for boards of directors and senior management seeking a forward looking assessment of risks, opportunities, governance, and other matters critical to success. Clients also include senior regulators and policy-makers around the globe, who rely on the firm’s objectivity for confidential forecasts of the market impact of actions under consideration.