In this post, let me present a solution before more fully presenting a problem for negative interest rate policy that shows up in news articles such as the three Financial Times articles shown above.

The Solution

It is time for the next step in negative interest rate policy. Even without any change in paper currency policy, it is possible to go to quite deep negative rates if banks are compensated financially for the difficulty of having negative rates on small checking and saving accounts.

Central banks are quite attentive to the strains on bank profits that can result from commercial banks’ understandable reluctance to make rates negative in modest-sized checking and saving accounts. There are two main ways that they help banks financially to make up for that. The most common is to have some amount of reserves kept with the central bank that can earn a positive or zero rate even though reserves held with the central bank beyond that are subject to a negative rate. The other way central banks help commercial banks financially is by lending to them at below-market interest rates (under certain conditions).

I see the next step in negative interest rate policy as more explicitly tying the financial help central banks give to commercial banks under negative rate policy to the provision by those commercial banks of nonnegative rates to households’ small checking and savings accounts.

Here is how it might work. In “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies” I write:

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. 

I expand on this in “Ben Bernanke: Negative Interest Rates are Better than a Higher Inflation Target”:

I have advocated arranging part of the multi-tier interest on reserves formula to kill two birds with one stone: not only support bank profits but also subsidize zero interest rates in small household accounts at the same time–the provision of which is an important part of the drag on bank profits as it is now. I think being able to tell the public that no one with a modest household account would face negative rates in their checking or saving account would help nip in the bud some of the political cost to central banks.

To avoid misunderstanding, it is worth spelling out a little more this idea of using a tiered interest on reserves formula to subsidize provision of zero interest in small household checking and savings accounts. To make it manageable, I would make the reporting by banks entirely voluntary. The banks need to get their customers to sign a form (maybe online) designating that bank as their primary bank and giving an ID number (like a social security number) to avoid double-dipping. In addition to shielding most people from negative rates in their checking and savings accounts, this policy also has the advantage of setting down a marker so that it is easier for banks to explain, say, that amounts above $1500 average monthly balance in an individual checking+saving accounts or a $3000 average monthly balance in joint couple checking+saving accounts would be subject to negative interest rates. That is, the policy is designed to avoid pass-through of negative rates to small household accounts but encourage pass-through to large household accounts, in a way that reduces the strain on bank profits.

Ruchir Agarwal and I expand on this even further in our IMF Working Paper “Enabling Deep Negative Rates to Fight Recessions: A Guide” in the subsection “Using the Interest on Reserves Formula to Subsidize Zero Rates for Small Households.” Here is the text of that subsection, in full:

The bank profitability problem arises in large measure from the difficulty banks face in passing on negative rates to their small retail depositors, which squeezes net interest margins. Experience with negative interest rates in Switzerland, Sweden, Denmark, and the eurozone indicates that as rates are cut below zero, negative interest rates are not immediately passed through to the small-scale bank accounts held by the typical household.

Banks are likely to make a distinction in their strategy towards legacy customers and hot-money customers. Legacy customers with de facto loyalty to a given bank are a long-run source of profits; if their accounts are not too large, shielding them from modest negative interest rates may not cost that much and may be worth a lot in not alienating them. Hot-money customers have little loyalty; the fact that they take advantage of a bank’s above-market zero deposit rate today doesn’t mean they will be there generating profits next year. So, there is relatively little lost from making new customers who are more likely to be hot-money customers face negative deposit rates. In addition, customers who have very large accounts are expensive to give a zero deposit rate in a negative rate environment. Moreover, those who are most expensive to give an above-market rate to tend to be more sophisticated and so less likely to quit a bank out of sheer emotional pique over negative rates. The upshot is that in an environment of negative interest rates, banks may shield most retail depositors (but not large, sophisticated depositors) from negative rates. Shielding retail depositors from negative rates may hurt banks’ profitability.

The bank profitability problem can be readily handled by transferring funds to banks when necessary, using existing central banking tools. For example, several central banks have already been doing this using a tiered interest-on-reserves formula. Danmarks Nationalbank has a negative interest rate on its certificates of deposit (CDs) but allows banks to place amounts up to a certain limit in their current account at a zero interest rate. The current account limit is set low enough to ensure transmission from the CDs to the money-market rates. The Swiss National Bank (SNB) allows a similar exemption from negative interest rates on any amount of deposits a bank holds below an exemption threshold. The SNB sets the exemption threshold at twenty times the minimum reserve requirements in reporting period 2014, minus the net increase in cash holdings since then. The Bank of Japan (BoJ) uses a three-tier system: reserves up to a certain balance earn 0.1 percent (basic balance), the next tier earns 0 percent (macro-add on), while the rest is subject to negative interest rates (policy-rate balance).

As mentioned above, another tool that has been used to transfer funds to banks is the European Central Bank’s negative lending rate through its targeted longer-term refinancing operations (TLTROs). Under TLTRO II, banks are able to borrow at the deposit facility rate (-0.4 percent) up to a limit, as long as they meet certain benchmarks for lending targets.

Building on these precedents, we recommend that central banks pursuing any approach to negative interest rate policy—including the clean approach—use the interest-on-reserves formula to subsidize banks in providing zero rates to small household deposit accounts. For example, a two-tiered system could 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, say, 5000 euros for a couple or 2500 euros for an individual, for an adult’s main bank. Such a system could be based on fully voluntary reporting by banks after individuals voluntarily sign up to get the subsidy. (Those with more than one bank would have to designate one bank for this effective subsidy.) Rogoff (2016) has advocated similar mechanisms to shield small depositors from negative rates.

We see four virtues to tying the amount of deposits with the central bank that a private bank can get zero interest rates on to the amount of household balances up to a given per-adult limit:

1. It takes care of the bank profitability problem, or the bulk of the bank profitability problem.

2. The limit defining what amounts of money are over the limit provides a marker for banks in explaining to customers that large accounts will have the over-the-limit amount subject to negative interest rates. This should make pass-through to large accounts a bit easier for the banks.

3. Being able to get zero interest rates on small-scale deposit accounts should reduce the incentive for households to do small-scale paper currency storage.

4. Avoiding negative interest rates on small deposit accounts avoids a potential political problem for the central bank. Because this would also be a customer relations problem for the commercial banks, the central bank should be able to rely on the commercial banks to avoid negative deposit rates as long as those banks can do so without hurting the bottom line. The subsidy through the interest-on-reserves formula ensures that banks can provide zero rates for small deposit accounts without hurting their bottom line.

If (i) the central bank is successful at avoiding massive paper currency storage, with its attendant disintermediation (a key objective in most of the policies discussed in this paper) and (ii) the central bank subsidizes the provision of zero rates to small deposit accounts, banks should only have a profitability problem if they fail to pass on negative rates to those with large deposit accounts. Fortunately, 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-tier 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).

[The following is the footnote at the end of the subsection:] Note that worrying about redistribution per se is typically not a mandated central bank objective in the context of monetary policy. Monetary policy actions do have redistributive effects. For example, there has been criticism of the regressive redistributive effects of quantitative easing (QE). By contrast, the policies proposed here do not present such concerns—and in fact have the opposite impact by redistributing towards lower-income households (although not redistribution towards the poorest of the poor, who may not have bank accounts at all.)

The Problem

This post is mainly about the bank profits problem, but I should mention the other two problems raised by negative interest rate policy, the paper currency problem and the political problem.

Martin Arnold’s September 4, 2019 article “ECB set to consider damage done by negative rates” has this to say about the paper currency problem:

Even if it launches these mitigation measures, some analysts believe the ECB is rapidly approaching the point at which the economics shift in favour of hoarding cash.

Klaus Wiener, chief economist at the German Insurance Association, said one insurer had recently been quoted a price for storing its cash of 0.2 per cent of its value, including insurance — half the cost of the ECB’s deposit rate.

There is some evidence that hoarding has already started. The amount of physical cash held in vaults and safes has swelled 57 per cent to €81.5bn since negative rates were introduced five years ago, ECB data shows — though that remains tiny compared to the over €6tn in eurozone bank deposits.

I doubt this quote of a 1/5 % all-in per year storage cost for paper currency is accurate, or we would likely see much more paper currency storage in the euro zone than we do see. If the ECB did see a more serious rise in paper currency storage, it could inhibit it with a version of the policy the Swiss National Bank and the Bank of Japan use: arranging the interest on reserves formula to penalize commercial banks that make net withdrawals of paper currency at the central bank’s cash window.

Leaving aside the political opposition of banks, which can be muted by anything that solves the bank profits problem, Richard Milne and Martin Arnold’s February 19, 2020 article “Why Sweden ditched its negative rate experiment” has this to say about the political problem:

One of the reasons the Riksbank gave for its decision to end negative rates was that the public struggled to understand the policy and thought it “strange”. 

Lack of understanding can certainly contribute to the political flak a central bank will get from negative interest rate policy. (To help people understand, I have a children’s story about negative interest rate policy.)

“Why Sweden ditched its negative rate experiment” also recounts Isabel Schnabel’s efforts to deal with the political problem:

Isabel Schnabel, a German economist who recently joined the ECB board, says that criticism of its monetary easing policies in her country “is all too often combined with claims and accusations that have no basis in fact”. While the average German saver is €500 out of pocket because of negative rates, Ms Schnabel says an average borrower is €2,000 better off and the overall gains outweigh the losses, with Berlin saving billions of euros on interest payments. 

On the bank profits problem, Clair Jones lays out the perspective of banks in her April 3, 2019 article “Draghi’s ECB tackles negatives of contentious interest rate policy”:

ECB president Mario Draghi pushed the world’s leading central banks into uncharted territory in 2014 when the eurozone deposit rate — what commercial banks pay to hold money at the ECB — went negative. Further cuts have pushed the rate to minus 0.4 per cent since 2016, part of a policy to spur banks to lend money rather than sit on it. Banks were dismayed at what has been in effect a tax on their activities, which ECB insiders say amounts to €7.5bn a year.

Similarly, in “ECB set to consider damage done by negative rates” Martin Arnold writes:

Critics say that negative rates weaken the eurozone’s already struggling banking system, discouraging lending and motivating insurers, banks and savers to hoard physical cash. Volker Hofmann at the Association of German Banks said eurozone lenders pay €7.5bn a year in negative rates on the excess deposits they hold at the ECB, adding: “It is a remarkable burden for banks who find it more or less impossible to convey this cost to retail savers.”

And in “Why Sweden ditched its negative rate experiment” Richard Milne and Martin Arnold write:

Eurozone banks say they have paid €25bn in negative rates to the ECB since it cut rates below zero in June 2014, eating into their already weak profits. 

…

The Association of German Banks said in a recent report that negative rates had cost eurozone lenders a total of €25bn since they were introduced. “This burden is depressing the profitability of the banks and will ultimately even constrain their lending capacity,” it warned. 

The same article mentions Markus Brunnermeier and Yann Koby’s paper with its brilliant title for marketing purposes: “The Reversal Interest Rate.” Richard and Martin write:

Much of the debate about negative rates hinges on the idea of a “reversal rate” below which lending activity by banks is subdued and starts to fall. 

Research published last year by Princeton University economists Markus Brunnermeier and Yann Koby found that many of the benefits of negative rates are front-loaded — such as gains in asset prices on bank balance sheets — while the corrosive side-effects last longer. 

The idea of a “reversal rate” beyond which interest rate cuts are contractionary is simply a theoretical restatement of the bank profits problem. (See “Markus Brunnermeier and Yann Koby's ‘Reversal Interest Rate’.”) If a central bank did nothing to address the bank profits problem, then at some point further interest rate cuts would weaken banks enough to be counterproductive. Fortunately, real-world central banks are quite attentive to the bank profits problem.

Tiered Interest on Reserves and Below-Market-Rate Lending as Remedies to the Bank Profits Problem. So far, the two main central bank policies to deal with the bank profits problem are tiered interest-on-reserves formulas and lending to commercial banks at below-market rates. Let’s look at both of them.

Claire Jones writes this in “Draghi’s ECB tackles negatives of contentious interest rate policy”:

One consideration is a three-tiered system, with part of each bank’s deposits at the ECB paying zero interest, and another portion attracting a positive rate.

…
A change to a tiered system on deposit rates would help him to win the argument for changing forward guidance from council members such as Mr Villeroy de Galhau, who are concerned that keeping expansionary monetary policy in place for so long will harm the region’s banks, already under pressure from sluggish growth.

…

Frederik Ducrozet, of Pictet Wealth Management, said Mr Draghi and other ECB doves, with the tacit support of Mr Villeroy de Galhau, appeared to be laying the ground for a change. “This does look like a mini coup,” he said. “[They are] forcing a discussion …Come September, if for some reason the ECB needs to extend forward guidance, a tiered reserves system is likely to emerge as an option to mitigate the cost of negative rates.”

In “ECB set to consider damage done by negative rates” Martin Arnold writes:

Christine Lagarde, who is set to succeed Mr Draghi at the helm of the ECB, last week said that “while I do not believe that the ECB has hit the effective lower bound on policy rates, it is clear that low rates have implications for the banking sector and financial stability more generally”.

The ECB should “closely monitor whether adverse side effects may emerge in the future, the longer low interest rates are in place”, she added.

…

One option is a tiering system in which a portion of banks’ excess deposits are exempt from negative rates. Other countries with negative deposit rates, including Switzerland, Denmark and Japan, have similar systems. And the ECB has another option: subsidised lending.

There is a geographical difference between the effects that these two mitigating measures have across Europe. Tiering is likely to provide more relief to German, French and Dutch banks, which hold more excess deposits; cheap loans help southern European banks, which have higher funding costs.

Why There Is a Bank Profits Problem. Since banks live on spreads (differences between interest rates), they wouldn’t be a bank profits problem if all interest rates went do in tandem, with spreads unaffected. And indeed, declines in interest rates—including declines in the negative region—tend to result in net capital gains because banks have long-term assets and short-term liabilities. So what is the problem? It is that rates on bank deposits such as checking and savings accounts may not go down smoothly. Evidence suggests that the bank profits problem is more severe for banks that rely heavily on retail deposits as a source of funds. Here, from “ECB set to consider damage done by negative rates”:

Research published last month by economists from the US Treasury department, the University of Bath, the University of Sharjah and Bangor University found “robust” evidence that bank lending growth was weaker in countries with negative rates.

The impact was greatest on banks funded mainly by retail deposits, they said. It has become more common for European banks to charge fees for current accounts, but they only mitigate a fraction of the extra cost of negative rates.

It is important to realize that the stickiness of retail deposit rates at zero is worse for small accounts. Richard Milne and Martin Arnold write in “Why Sweden ditched its negative rate experiment”:

Negative rates turn the principles of finance on their head by forcing commercial banks to pay to store money at the central bank rather than earn interest on it. At the same time, some countries and companies have been paid to borrow. Most recently, some individuals across Europe have begun paying to deposit large sums of money in banks, while mortgage borrowers in Denmark have received money from their house loans rather than having to pay interest. 

There is a way to make this stickiness of retail deposit rates worse. From the same article:

Olaf Scholz, Germany’s finance minister, said recently that he would examine whether it was possible to protect savers by banning banks from passing on the cost of what he called the ECB’s “penalty rates”.

By contrast, if banks are given an incentive to maintain nonnegative deposit rates for small savers in a way that supports bank profits, as I discuss in the first half of this post, Olaf Scholz can get a big chunk of what he wants without worsening the bank profits problem.

How the Paper Currency Problem Contributes to the Bank Profits Problem. Note that an important part of banks’ reluctance to lower retail deposit rates comes from their fear that small depositors would simply use paper currency instead of putting their money in the bank. Lowering the rate of return on paper currency is a good way to combat this. But trying to make sure that banks continue to provide nonnegative rates to small checking and saving accounts can also combat this. Paper currency is convenient in small amounts, but becomes less convenient for large sums of money. And the government has miscellaneous ways to discourage massive paper currency storage by the very wealthy or by large organizations. So getting those with small amounts of money to keep much of their money in the bank is an important win in the effort to avoid excessive paperization of the economy.

Note that I have written extensively on how in practice to lower the rate of return on paper currency. See “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide” for an organized bibliography.

Answering Two Other Attacks on Negative Interest Rate Policy.

Beyond the genuine problems raised by paper currency policy—the bank profits problem, the paper currency problem and the political problem—there are problems blamed on a central bank’s use of negative interest rates that are either (a) arguments against any interest rate cut, even in the positive region, or (b) pointing to problems arising from the decline in the long-run natural interest rate, which is beyond central banks’ control.

One of the most important arguments against interest rate cuts in general, even when they are needed to fight a recession, is that they might cause asset bubbles. For example, Richard Milne and Martin Arnold write in “Why Sweden ditched its negative rate experiment”:

Another risk from negative rates is that they inflate asset price bubbles, while also keeping alive zombie companies that without cheap money would collapse. In Sweden, the big concern has been the housing market, with Mr Ingves repeatedly issuing warnings about record levels of household debt. 

A series of measures to make mortgages harder to access have eased Swedish fears.

I have written several responses to this concern about asset bubbles:

• Why Financial Stability Concerns Are Not a Reason to Shy Away from a Robust Negative Interest Rate Policy

• Monetary Policy and Financial Stability

• Contra John Taylor

• With a Regulatory Regime That Freely Accomodates Housing Construction, Lower Interest Rates Drive Down Rents Instead of Driving Up the Price of Homes

One key problem caused by the decline in the long-run natural interest rate is the greater difficulty people have in saving for retirement—often pointed out by pension funds that have the responsibility of helping people save for retirement. This is a genuine problem, one I am very concerned about for my personal retirement saving. But it is a problem beyond the power of a central bank to affect—other than by avoiding the downward drag on long-term rates from long-lasting negative output gaps. Here is some of what I have written on this issue:

• Mario Draghi Reminds Everyone that Central Banks Do Not Determine the Medium-Run Natural Interest Rate

• Mark Carney: Central Banks are Being Forced Into Low Interest Rates by the Supply Side Situation

• What Monetary Policy Can and Can't Do

Conclusion

As a central bank goes to deeper negative rates, at some point it will have to address the paper currency problem—at least by penalizing commercial banks for withdrawing extra paper currency at the cash window as the Swiss National Bank and the Bank of Japan do, and ideally be taking paper currency temporarily off par, as I have long advocated as a key measure in the monetary policy toolkit. But as I say in “What is the Effective Lower Bound on Interest Rates Made Of?” it is currently worries about the bank profits problem—not the paper currency problem directly—that is most inhibiting central banks at negative rates from using deeper negative rates.

Using the interest-on-reserves formula to give banks incentives to provide nonnegative rates for small checking and saving accounts and keep banks from suffering for doing so is a way to take care of by far the biggest piece of the bank profits problem and help a great deal with the political problem at the same time. If there are headlines about negative deposit rates for regular people it is an unforced error for a central bank. They should get out ahead of any such headline by volunteering that they have a policy to encourage banks to avoid negative rates for small accounts.