Cooking the Books: Negative Interest?

‘NatWest has become the first bank to warn business customers it may charge negative interest rates on money held in current accounts’, reported the Daily Telegraph (25 July). But how can there be negative interest rates? Why would anyone lend money for a period only to get less back at the end of it?

Interest is the price of borrowing money and is governed by supply and demand, more by demand in fact. The rate of interest (or, rather, rates as there are different ones depending on the risk of non-repayment) reflects the state of the economy. When business is slack, due to a lack of enough profitable investment opportunities, the rate is low because supply, as from companies not reinvesting profits, is more than what other companies want to borrow. In times of recovery and boom, when profit prospects are seen to be good,  it is the other way round. Demand exceeds supply and the rate tends to rise.

Governments and their central banks try to control the economy by varying the rate of interest up or down with a view to decreasing or increasing bank lending. The only rate they can directly control is the rate at which the central bank will lend money to banks as ‘the lender of last resort’, or Bank Rate.

After the Great Crash of 2008 the Bank of England tried to revive the economy by reducing the bank rate to 0.5 percent, a record low that lasted until this August when it was reduced to 0.25 percent. It is this that has raised the spectre of the banks paying negative interest. Banks are financial intermediaries whose income (their profits as well as money to cover their operating costs) comes from borrowing money at one rate of interest and re-lending at a higher rate.

An ultra-low, even more a zero or negative (as already in Japan and the Eurozone) , bank rate creates a problem for banks as there are only two ways that they can maintain the spread between the rate at which they borrow and the rate at which they re-lend, and so their profits. They can increase the rate they charge borrowers or reduce below zero the rate they pay depositors. As the Bank of England put it when it cut the bank rate in August:

‘[A]s interest rates are close to zero, it is likely to be difficult for some banks and building societies to reduce deposit rates much further, which in turn might limit their ability to cut their lending rates.’

To avoid this, at the Bank set aside £100 billion for a ‘Term Funding Scheme’ under which banks can borrow money from at 0.25 percent provided they increase their lending by the same amount that they borrow, explaining:

‘[T]he TFS provides participants with a cost effective source of funding to support additional lending to the real economy, providing insurance against the risk that conditions tighten in bank funding markets.’

Note, in passing, the matter of fact assumption that banks need funding to make loans. No nonsense here about their supposed ability to create money to lend out of thin air.

This policy is just pushing on a piece of string. It’s not the supply side that’s the problem but the lack of demand from businesses, who don’t see enough profitable investment opportunities at the moment to use up the supply. Until they do, the economy won’t fully recover from the slump, however much the government fiddles about with the bank rate.