For months, one question has preoccupied financial new commentators we follow: Is the Bank of England (BoE) about to take short-term interest rates negative in the UK? Monetary policymakers at the BoE have admitted in various comments that it is under discussion. Whilst BoE Governor Andrew Bailey recently said it wasn’t on the docket, his institution sent UK banks a letter on Monday asking them to explain their “current readiness to deal with” zero percent or negative rates.[i] This seemingly prompted a large media backlash, with many financial commentators we follow warning about looming trouble for banks’ earnings and savers’ deposits if rates drop below zero. In our view, there is some merit to this criticism, however overstated it might be, and considering these risks can help peoples set expectations. On the bright side, though, our research shows negative rates haven’t caused recession or bear markets in other countries using them in recent years.
The interest rate in question is the Bank Rate, which is the rate the BoE pays on reserves banks hold there. It is also the primary influence on the rate banks pay to borrow from each other as well as the interest rate on savings accounts. In theory, the purpose of taking a benchmark rate like the Bank Rate negative is to discourage banks from hoarding reserves. If banks must pay the BoE to store their excess reserves instead of earning a tiny return on them, the theory goes, banks will find lending more attractive—stimulating the economy as banks extend more funding to households and businesses.
It is a nice seeming theory, but reality hasn’t totally proven it to be true. In the eurozone, the European Central Bank (ECB) adopted negative rates in June 2014. At the time, loan growth was negative—tied to the eurozone’s sovereign debt crisis-driven regional recession—as Exhibit 1 shows. It did improve from there, returning to positive year-over-year growth in February 2015 and accelerating in the months and years ahead. But relative to the eurozone’s history, loan growth in the negative rates era wasn’t robust—it was in line with the recovery from the financial crisis, before the debt crisis, but far below the economic expansion that ended in 2007.
Exhibit 1: 15 Years of Eurozone Loan Growth
Source: FactSet, as of 12/10/2020. Loans to Euro Area Residents, year-over-year percent change, October 2005 – August 2020.
This doesn’t surprise us. In our view, negative rates function like a tax on bank balance sheets, and to presume a small tax alone will spur lending strikes us as grossly oversimplified. Banks lend at long-term interest rates. One thing all negative short-term rate nations have in common? Ultra-low long-term rates, which take a huge bite out of loan revenues.[ii] Our research indicates this sapped the incentive to lend to all but the most creditworthy borrowers, largely shutting out small businesses and companies with below investment-grade credit ratings. Avoiding a small tax, for many banks, likely wasn’t a good reason to lend to shaky borrowers for a pittance. Instead, we found that many just settled for holding cash and letting their earnings take a hit.
The San Francisco branch of America’s Federal Reserve examined this in a wide-ranging study on negative interest rates globally, which they published last month. According to their findings, whilst negative rates corresponded with improving loan growth in the short term, their impact turned negative the longer they lingered. The same held for bank profitability: “While banks suffer losses on net interest income, due in part to their reluctance to pass negative interest rates along to retail depositors, they more than offset those losses through increases in profits on noninterest income. In particular, banks charge higher fees and experience capital gains on securities holdings when rates go negative. However, the data clearly show that losses on interest income accelerate over time and begin to outweigh the gains from noninterest income. As a result, the impact on overall profitability falls below zero.”[iii]
As the San Francisco Federal Reserve’s report indicated, some banks attempted to minimise the damage by charging fees on large deposits. Financial news commentators we follow reported this happening at several banks in Denmark and Germany, for instance, in recent years. Although these fees didn’t directly hit most small savers, they reportedly did hit pension funds with cash reserves stored at commercial banks, as they were subject to fees on institutional deposits—indirectly hurting retirees depending on them.
We think there is sufficient evidence that negative rates don’t work as intended. In our view, savers and the broader economy would benefit most if monetary policymakers resisted the temptation to adopt them. If they don’t, however, other countries’ experiences at least give us a framework to set expectations. Some financial commentators speculate that negative rates would spell the end of free banking in the UK, with savers potentially facing monthly fees. That is possible, but if other countries are a reliable guide, then those fees would at least start with the largest accounts, sparing most retail depositors.
As for equity markets, negative rates didn’t trigger bear markets (broad equity market declines of -20% or worse with identifiable fundamental causes) in the eurozone, Japan, Sweden or Denmark.[iv] The eurozone and Japan largely underperformed global markets since adopting negative interest rates, but that was tied more to fundamental issues that predated negative rates, in our view.[v] To say it differently, negative rates didn’t alter pre-existing trends in relative performance. In our view, it isn’t likely to be different for the UK, which is already underperforming the world during this bull market—largely due to its lack of Tech shares, which are leading, and heavy tilt toward value-orientated shares, which are lagging. (Value-orientated shares are companies that have relatively lower valuation metrics such as price-to-earnings ratios and that tend to carry higher debt, making their prospects dependent more on the economy’s ups and downs than long-term investment in growth-orientated endeavours.) Negative rates probably just exacerbate this trend, as they add a headwind to the value-heavy Financials sector, which is nearly 17% of UK market capitalisation, meaning the market value (in pounds) of all outstanding shares.[vi]
In our view, adopting negative rates is a faulty solution to a self-imposed problem: Very small spreads between short- and long-term interest rates. This, in our view, is the real reason lending is weak throughout the developed world. Again, banks borrow at short-term rates and lend at long-term rates, so the spread between the two represents their potential profits on new loans. If the spread between short- and long-term rates were wider, banks’ potential lending profits would be bigger, which we think would boost the incentive to lend to a wider swath of companies. The easy solution to this, in our view, would be for the BoE and its global brethren to stop quantitative easing asset purchases, which reduce long rates and are therefore responsible for flat yield curves. That would likely enable more lending despite the small interest rates paid on excess reserves, because the risk/reward tradeoff would be more favourable. We have over a century of economic theory and data showing steeper yield curves boost lending and economic growth.[vii] Allowing that to happen, rather than trying to offset small interest rate spreads by taxing bank balance sheets through negative rates, strikes us as a much simpler way to address the problem with fewer potential unintended side effects.
[i] “Bank of England Asks Banks If They Are Ready for Negative Interest Rates,” Larry Elliott, The Guardian, 12/10/2020
[ii] Source: FactSet, as of 12/10/2020. Statement based on 10-year government yields in Germany, France, the Netherlands, Sweden, Denmark and Japan.
[iii] “Commercial Banks Under Persistent Negative Rates,” Remy Beauregard and Mark M. Spiegel, Federal Reserve Bank of San Francisco Economic Letter, 28/9/2020.
[iv] Source: FactSet, as of 12/10/2020. Statement based on MSCI EMU, MSCI Japan, MSCI Sweden and MSCI Denmark returns with net dividends.
[v] Source: FactSet, as of 12/10/2020. Statement based on MSCI EMU, MSCI Japan and MSCI World Index returns with net dividends.
[vi] Source: FactSet, as of 10/12/2020. MSCI UK IMI market capitalisation on 12/10/2020.
[vii] A Monetary History of the United States, 1867 – 1960, Milton Friedman and Anna Jacobson Schwartz, Princeton University Press, 1963.
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