In the face of the global economic recession, central banks and governments around the world are pouring out economic policies to stimulate the economy. Among these policies, one of the most controversial today in the US economy is negative interest rates. Although this is making uproars in the US, Europe, and Japan, which are world superpowers are already running the negative interest rate today.
In fact, the negative interest rate is confusing as the scheme itself is unfamiliar to many. I certainly never learned this concept in school and even thought of the idea of it. Also, the negative interest rate does not apply to the public. The idea is that banks will take a portion of money one deposits money in the bank. This does not happen in the retail bank (except Sweden or Denmark). If the customer experiences $100m in the account becoming $99m in the following year, the customers will change the bank for sure. Banks will not let that happen.
The negative interest rate is not from the commercial banks the public uses but from the central bank to the retail banks. I will explain further in detail, but, quite simply, the negative interest rate is applied as a punishment for not lending enough money to the public.
In order to understand the negative interest rate, the relationship between the central bank the commercial bank must be understood. Unlike the general public, commercial banks have accounts in the central bank. No individuals have business with the Fed (central bank) except the banks. The banks use their central bank accounts to make transactions much more convenient. For example, when money is transferred from BOA to Chase, a real-money transaction is made inside the central bank’s accounts. Let’s say $100m is to be transferred from a bank to another. Nobody will see $100m cash shipping out from one bank to the other.
The notion of reverse interest rate effect of decreasing deposits is correct for the portion of the commercial bank’s money in the central bank. The portion here where negative interest kicks in is made up of the money given by the central bank for the purpose of the loan to the public. This could be comprehended as a penalty for not reaching the loan sales quota. In other words, the amount that goes over a certain number from the retail bank’s central bank account has to become loans, and banks will be losing money if they fail to make loans out of the excessive amount.
So far, I have explained where the negative interest rate is implemented in our economic system: the portion of the retail bank’s money from the central bank. To have a better understanding of which portion of the retail bank’s money, let’s take a look at the reserve ratio. Given the fact that there is only a small chance that depositors would suddenly withdraw all their money, banks lend a portion of depositors’ money to the public with interest. Sometimes though, some depositors need to withdraw all the money, and the bank gets into trouble if it cannot pay off the customer’s money because they used all the money to make loans. In response, all the retail banks are required to keep a certain amount of money, by the ratio denominated by depositors’ money. For example 1), if a bank has $100 deposits held and the reserve ratio is 10%, the bank needs to keep its $10 and is able to lend $90.
When the economy is growing strong, banks’ objective is to find a lessee to sell as many loans as possible. When the growth rate is higher than the interest rate, most of the businesses make enough profits to pay off their loans. On the other hand, when the economy slows down, banks choose the lessee with considerable discretion since not many borrowers could pay off their debts. In the recession, commercial banks deposit all the money received from the central bank back into the central bank’s account. In other words, all the money including the amount beyond required to keep is also being kept by the banks because they cannot find enough credible businesses or persons to sell its loans. The portion of the money that a bank keeps beyond the required amount by the reserve ratio is called the excess reserve ratio. Let’s look at another example 2) where a bank has $100 deposits held and the reserve ratio is 10% again. This time though, because the bank could not find a borrower, it deposits $40 in the central bank’s account. This makes the reserve amount to be $10, and the excess reserve amount to be $30.
Finally, this is where the negative interest rate I have been trying to explain kicks in. The negative interest rate is applied to the excess reserves that the central bank has given to commercial banks for the purpose of loan creations. For example, if the negative rate is -10%, the bank from example 2) must pay $3, 10% of $30 excess reserve, to the central bank. After all, negative interest rates symbolize the pressure central bank puts on commercial banks to encourage lending.
Lastly, I’d like to explain some of the misconceptions about the negative interest rates.
1. Depositors pay interest for their own money kept in checking account – The retail banks will not apply a negative interest rate to the general public unless all of the banks apply it at the same time. Otherwise all the depositors of the bank will withdraw all their money to change their bank. That is called a bank-run.
2. Debtors will not pay interest; they will be paid interest – Everybody will make as many loans as possible to get the free money. All banks will get into a deficit operation, which leads to bankrupt.
3. People are taking out huge loans with the lowest interest rates that have come again after the Lehman Shock, and an era of inflation is coming back – Banks are still reluctant to give out loans. Because of the negative interest rates, banks are looking at the government bonds purchases. There are not many businesses or persons that get their loans, and most of the money is still going to government bonds, stocks, and real estate. Although I agree with the speculation that inflation is coming back, it remains to be seen whether the negative interest rate will be the main cause.
Our daily lives do not receive direct impacts from the negative interest rates. Perhaps the situation where some are able to take advantage of low-interest rates for the saving accounts, loans, or mortgage could be seen as an impact. There is also another bright side for everyone that this is an era of change. We all have a chance.
This is an era of opportunity. Although not fair, starting any economic entity became incredibly convenient than before. Whether for investment or business, we all have to make decisions based upon the new era that is coming. In capitalism we are living in, the business objective for the most is to make more returns than the debts. What we need to make a note of the central bank’s rate is that the rates rise when the economy is growing, and the rates fall when the economy is slowing down. This means when the rates are high, the business seeks to optimize its operation. On the other hand, when the rates are low, the business has to come up with an innovative idea. This is time for a new player.
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