How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies

In a January 25, 2016 Goldman Sachs bulletin, analyst Dirk Schumacher writes:

We expect the ECB to ease monetary policy further at the March meeting via an extension of the APP programme until September 2017 and a cut in the deposit rate by 10bp to -0.4%.

I think it would be better policy for the ECB to go straight to the -.75% that has been pioneered by the Swiss National Bank, but every bit of interest rate cuts helps at least some in the current situation where the eurozone needs so much additional stimulus. 

The Goldman Sachs report also has a long discussion of the worries members of the European Central Bank’s monetary policy committee have about the effect of lower interest rates on bank profits. In the extreme, if bank profits go down too much, banks may exert their oligopoly power to raise lending rates to raise earnings in the short-run to compensate. The issue is that banks will want to shield some of their depositors from the negative rates, so they don’t want to fully pass through negative rates to their customers.

A “two-tiered system” in which a certain amount of deposits at the central bank get a zero interest rates and amounts above that get a lower interest rate seems hard to some of the ECB’s central bankers because that might hit banks harder in some countries than others. To me, the basic solution if a two-tiered system is desired is fairly straightforward: the two-tiered system should be designed to be equivalent to a subsidy to the deposit rates for household accounts below a certain size–say enough to provide a zero interest rate on an average balance over a month of 1000 euros worth of bank deposits per adult, for that adult’s main bank. (Those with more than one bank would have to designate one bank for this effective subsidy.) 

The value of tying the amount of deposits with the European Central Bank that a private bank can get zero interest rates on to the amount of household balances from accounts with 1000 euros or less is that this makes it natural for the private banks to pass on the negative interest rates to commercial and to the excess over 1000 euros in large accounts (which is helpful for transmission of the effects of the negative interest rates) while small household account are shielded from the negative interest rates (which is helpful politically). And it is easy enough to understand the rule and its intent that banks will be able to explain why they need to transmit negative interest rates to those with large accounts. (Of course, the cutoff could be set at some other level than 1000 euros, if desired.) And this policy is fully consistent with keeping bank profits unharmed by negative interest rates as long as they do pass on negative interest rates to large accounts and commercial accounts as they are supposed to.  

Experience in Switzerland, Denmark and Sweden suggests that the more sophisticated bank customers who have large accounts or have commercial accounts adjust quickly to negative interest rates after a few weeks of bitter complaining. The objective of a two-tiered system is to have negative interest rates prevail generally in the markets, but shield from negative interest rates those who are the least able to understand negative interest rates and perhaps to accomplish a bit of redistribution as well–though clearly not redistribution toward the poorest of the poor, who may not have bank accounts at all. 

Note that by buying enough bonds and crediting the sellers with reserves–or by lending reserves–the European Central Bank can guarantee that there are much more reserves in the system than would be subject to the zero interest rate. Thus, the other interest rate will be the marginal one. And it should go without saying that the rate on short-term bonds should be pushed close to the most negative deposit rate. Keeping the bond rate at zero would not be cutting rates enough.