Asset management

20 May 2013

Economist Insights Money for something

The ECB stopped paying interest last July on deposits it holds for European banks, and it may soon turn its deposit rate negative: making the banks pay for the privilege of depositing their excess cash. Money borrowed from the central bank effectively ends up back at the central bank after passing through various transactions in between, so banks will always pay the borrowing rate and receive (or pay) the deposit rate. Widening the gap between the two rates could stimulate bank lending and therefore the economy. But there is also the risk that the banks do not behave the way the ECB would like and reduce borrowing, move money out of the Eurozone or simply pass on the higher costs to customers. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

Most of us think that when we deposit money in a bank account, we should be paid interest on that deposit after all, we are effectively lending our money to the bank. In todays ultra-low interest rate environment, the interest we earn may be negligible but at least we are getting paid some interest. Banks themselves have their own bank accounts at central banks, and the banks were used to being paid interest on those deposits. In Europe the European Central Bank (ECB) stopped paying interest on reserves last July, and may now make the banks pay for the privilege of depositing their excess cash at their central bank (a step Denmark has already taken). To understand why the ECB may do this, we need to understand how banks interact with their central bank (see chart 1). Suppose that Bank A needs liquidity so it decides to borrow from the ECB. Suppose that Bank A also makes a mortgage loan, which the borrower pays to the house seller. That seller then deposits that cash into their bank account in Bank B. If Bank B does not lend out this money, it must deposit the cash at the central bank as excess reserves. The key point is that the money that Bank A borrowed ends up back at the ECB (via Bank B in this simple example, but there could be many more transactions in reality and the logic still holds as the money is spent). So the banking system as a whole is paying the repo rate to the ECB for the original borrowing and then receiving the deposit rate on the same amount. The difference between the repo rate and the deposit rate is known as the rate corridor, which is effectively the cost of central bank liquidity for the banks. In theory a bank will access that liquidity if it thinks that it can earn more interest

on a loan it might make or a bond it might purchase (taking into account the risk). With the ECB repo rate at 0.5% and the deposit rate at 0%, the rate corridor is 0.5%. To increase the rate corridor without hiking the repo rate (a bad idea when you are in your sixth consecutive quarter of recession), the ECB will need to push the deposit rate negative.
Chart 1: Roundabout Illustrative example of how bank borrowing from the central bank leads to increase in excess reserves
Borrow cash Bank A Repo rate Central Bank Mortgage rate House Deposit rate Bank B Deposit excess reserves Interest Cash Asset Deposit in bank account Savings rate House seller Payment Mortgage loan House buyer

Source: UBS Global Asset Management

Why would the ECB want to widen the rate corridor? The hope is that by increasing the cost of holding liquidity banks would start using that extra liquidity to make more loans in order to earn enough interest to cover their increased cost of liquidity. Banks could also buy government or corporate bonds, but

bonds are just another form of lending. All this lending would be a positive stimulus for the economy and aid recovery. Unfortunately there is the risk that banks do not react the way the ECB would like them to. The first risk is that banks simply decide to reduce the amount of cash that they have borrowed from the ECB. This could actually reduce the money supply and the amount of lending, which would be bad for economic activity. The second risk is that banks could instead pass on the higher liquidity cost by increasing loan rates or cutting the interest rate that they pay savers who deposit their money in bank accounts. In short, it could perversely increase interest rates and maybe even spell the end of free banking as banks start to charge people for holding their cash (just as the ECB would be doing to the banks). Banks could also react to the negative deposit rates by shifting cash outside the Eurozone, for example to their subsidiaries in the US or the UK. While euros are always a claim against the ECB, moving money out would shift that claim out of excess reserves so it would not be subject to the deposit rate. But it would also move the cash out of the monetary base, which is effectively a monetary tightening. On the plus side, it would put downward pressure on the euro, which is supportive for growth. Negative core, positive periphery Europes fiscal problems stem in part from the divergence within the member states, and monetary policy is no different. Banks in the periphery face risks of bank runs and threats to their retail depositor base, so these banks were keen users of the ECBs repo facility and borrowed large amounts of cash (see chart 2). Banks in the core tended to have less need for the extra cash, but they have seen their deposits increase. These are two sides of the same event: if investors repatriate cash from the periphery to the core it creates a funding problem for the periphery but creates cash in the core. In the wake of such liquidity pressures, Italian and Spanish banks have together accessed almost EUR 600 billion from the Eurosystem (the ECB plus all the national central banks), but have put hardly any more back into excess reserves. Some of the borrowing ends up as required reserves, some ends up overseas and some ends up financing external deficits causing a surge in Target-2 imbalances between core and periphery central banks. As a result, excess reserves in core banks in Germany, the Netherlands and France increase even though, as in the case of Germany, they did not borrow much from the ECB. In theory bank borrowing should all end up as excess reserves, but in fact the cash can also end up in many different places on the balance sheet. While all borrowing pays the repo rate, only some of the resulting bank deposits will end up receiving the deposit rate (or paying it if negative). For instance, required reserves do

not earn any interest. Hence the effect of a negative deposit rate is not as clear cut, nor as effective, as the neat example in chart 1 would suggest. The divergences within the Eurozone mean that banks are likely to react differently. Banks in the periphery are likely to ignore a negative deposit rate simply because they have so little in the way of excess reserves that it hardly affects them. Any reaction is likely to come in the core. In the Netherlands and France, where banks have both borrowed and built up excess reserves, banks could react in any of the ways described earlier. In Germany, where banks have hardly borrowed from the ECB, banks will have to do one of the following: increase their lending to the periphery, which is what the ECB hopes for; move the money out of the Eurozone; bear the higher cost of liquidity; or try to pass the costs on to their customers. It is not surprising that German banks have been lobbying the Bundesbank to try to prevent deposit rates going negative. In aggregate, negative deposit rates would be riskier for the ECB than for the Fed, the Bank of England or the Bank of Japan. The other central banks are engaged in quantitative easing (QE), so they have forced extra cash into the banking system and whatever the banks do, that QE will end in monetary stimulus. A negative deposit rate could in theory incentivise core banks to start lending back to those in the periphery. This would reduce market fragmentation and help to restore a functional allocation of liquidity between Eurozone countries. However, it could also result in monetary tightening by incentivising banks to increase their cost of lending or by reducing their profitability if they decide to bear the costs. No wonder the ECB has been reluctant to make depositing money cost something rather than nothing.
Chart 2: I borrow, you pay Selected bank interactions with the Eurosystem (ECB and national central banks) by country, EUR bn outstanding 200 150 100 50 0 -50 -100 -150 -200 -250 -300

Excess reserves

Borrowing from the Eurosystem

Source: National central banks balance sheets, UBS Global Asset Management Note: total of borrowing does not equal excess reserves because chart excludes a number of items including required reserves and Target-2 balances. Excess reserves include the deposit facility and fixed term deposits.

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